Rise of Alternative Investments and the Impact on Investment Accounting

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2 Rise of Alternative Investments and the Impact on Investment Accounting Session 603 IASA 86 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

3 Introductions Rise of Alternatives Operational Challenges Impact on Insurance Accounting & Reporting Technology Consequences

4 Introductions Dennis Case Executive Director, JP Morgan Chase Scott Ferrante President, ConVista Consulting Mike Herling VP, Princeton Financial Systems

5 What are Alternatives? They include private equity, hedge funds, managed futures, bank loans, real estate, derivatives and commodities contracts. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity. Primarily consist of assets on schedule BA. Depending on asset types, they could also be on schedule D or DB.

6 Low Yield Environment The Quest for Yield in a multi year, low yield market has driven insurers and other financial institutions to allocate a far greater percentage of assets towards non-traditional investments with growth toward derivatives and private equity. Schedule DB and BA are growing at the expense of schedule D Assets (Stocks and Bonds). Insurers of all sizes are increasing allocation to more complex investments.

7 Reported Schedule BA Assets (000,000) Cost 115, , , , , , ,332 BACV 110, , , , , , ,555 Fair Value N/A 130, , , , , ,714 Total Invested Assets 4,328,289 4,624,048 5,022,781 % BA of Total Notes: As of % of 4,500 insurance companies reported BA assets. Top 10 insurance groups account for 63% of all Schedule BA assets. Top 25 account for 80%. Source:

8 Reported BACV BA Assets (000,000) Affiliated % Unaffiliated % Total % Life 45, , , P/C 75, , , Health 3, , ,244 2 Fraternal 1, ,201 1 Title Total 125, , , Note: Totals for Life and P/C are similar but Life sector is mostly unaffiliated while P/C sector is predominately affiliated. Source:

9 Analysis of Investment Income (000) BACV 110, , , , , , ,555 Investment Income 9,370 10,735 12,540 10,252 7,272 10,002 Return 8.5% 8.4% 8.9% 5.4% 4.2% 5.6% Note: Investment income includes Fair Value and FX adjustments, OTTI and Amortization. Source:

10 Schedule BA Categories By BACV (000) Note: Affiliated % Unaffiliated % Total % JV, Partnership, LLC 84, , , Other Asset Classes 20, , , Fixed or Var Rate 8, , ,906 6 Capital & Surplus Notes 5, , ,736 5 Non & Collateral Loans 7, , ,579 4 Housing Tax Credits , ,616 2 Transportation Equipment Investment income includes Fair Value and FX adjustments, OTTI and Amortization Mineral, Oil & Gas Total 125, , , Source:

11 Operational Challenges Title VII of Dodd-Frank requires that most derivatives contracts, formerly traded exclusively in the OTC market, be subject to central clearing. With the central clearing issue (mostly) behind us, the focus of discussion is now on alternatives. Central clearing uses an agency to act as a central counterparty to remove individual counterparty credit risk and distribute risk among the clearing agency s participants that must satisfy the agency s capital and margin requirements.

12 Operational Challenges Security Master Data Cash Processing and Reconciliation Valuation Reporting

13 Impact on Insurance Accounting and Reporting Accounting for Schedule BA Alternatives Assets (private equity, hedge funds, real estate partnerships, etc.) is particularly challenging for insurance companies. The equity method of accounting is used for GAAP accounting. SSAP 48 requires an evaluation and allocation of the cumulative earnings of each investment when cash distributions are received.

14 Impact on Insurance Accounting and Reporting The amount of cash distribution must be determined if it has been paid from cumulative positive earnings. If it has, it is to be recorded as ordinary income (dividends received) on Schedule BA, assuming the remaining cumulative earnings exceeds the cash distribution received. Otherwise, the cash received is recorded as ordinary income only up to the amount of cumulative positive earnings. Any cash received in excess of positive earnings or from cumulative losses, is treated as a return of capital. The cost of the investment is reduced and the impact flows through unrealized gains and losses.

15 Impact on Insurance Accounting and Reporting As a result of this treatment, although the GAAP and STAT valuation of the investment will be equal, the cost and resulting unrealized gains/losses can be different. This procedure and the normal delays in receiving capital statements from the General Partners/Administrators creates a burden for both insurance accountants and traditional insurance investment accounting systems.

16 Technology Insurance investment accounting systems have struggled to completely automate the multi basis accounting challenges of Schedule BA assets affected by SSAP 48 and the timeliness of tax information (K1). As a result, many insurance companies making these investments have had to develop accounting workarounds using tools such as Excel, Access.

17 Technology Anytime key accounting information is maintained outside of the core accounting system on user s desktops, it creates operational and audit risk. The flow of data to management reporting, the general ledger, Schedule BA, etc. is then subject to manual intervention and possible compromised control.

18 Consequences - Legislation has Increased Regulatory Complexity Dodd-Frank Act (2010): 849 pages Gramm-Leach-Bliley Act (1999): 145 pages Gramm-Leach-Bliley Act (1999): 145 pages Sarbanes-Oxley Act (2002): 66 pages Sarbanes-Oxley Act (2002): 66 pages Interstate Banking Efficiency Act (1994): 61 pages Interstate Banking Efficiency Act (1994): 61 pages Glass-Steagall Act (1933): 37 pages Glass-Steagall Act (1933): 37 pages 340 pages Federal Reserve Act (1913): 31 pages Federal Reserve Act (1913): 31 pages 18

19 Consequences (Unintended and Intentional) Complex regulation generally creates less black and white rules and regulations (i.e. Dodd-Frank). Data regarding alternatives are generally not as transparent in the public domain. Systems need to be more flexible since valuations and operational issues are subject to interpretations. The need for more expertise to handle the complexities caused by regulations and system structuring requirements has created staffing challenges both in quality and quantity.

20 Consequences (Unintended) Systems increasingly becoming more flexible to different accounting interpretations and operational work flows. Higher Cost Solutions. Greater openness to the outsourcing of systems (i.e. cloud/bpo).

21 Consequences (Intentional) Alternatives do provide a higher yield. Good for long term asset and liability management. Regulations have allowed for growth in alternatives with minimal problems (yet).

22 Questions?

23 Please Complete the Session Evaluation Form on the Conference App and Include Your Conference Registration ID# to be Included in a Drawing for a Free Conference Registration for the 2014 Annual Conference! NOTE: Your Conference Registration ID# is Located at the Bottom Left Hand Corner of Your Badge. IASA 86 TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW