Session 177 OF, The Convergence of Capital Markets and Insurance Moderator: Erik J. Thoren, FSA, CERA, MAAA Presenters: Prannoy Chaudhury, FSA, MAAA Jean-Francois Lemay, FSA Erik J. Thoren, FSA, CERA, MAAA SOA Antitrust Disclaimer SOA Presentation Disclaimer
Jean-Francois Lemay Capital Markets Investment Structures Oct 26, 2016
Structures of Capital Market Investments in Insurance 2
Capital Markets Capital Markets have used many different ways to enter the life insurance space Capital Markets may look at the insurance industry to: Access a risk that that is not correlated to other markets like mortality/longevity Access assets to manage Or simply invest in an area where returns are thought to be attractive The ideal structure to enter the market will depend on the goal and the specific situation of the capital provider 3
Direct Investment in an Onshore Insurer Capital Market$ Asset Manager Requires onshore regulatory approval Assets will be subject to onshore admitted asset rules and RBC requirements Arm s length asset management contract Co Ownership IMA Reinsurance 4
Direct investment in an Offshore Reinsurer Capital Market$ Offshore Reinsurer Co Asset Manager Co No onshore regulatory approval Reinsurance will be done on a funds Withhled / Modlco / Assets in trust basis. Assets will be subject to onshore admitted asset rules but Offshore Capital requirements Investment Management Agreement will be between the co and the Asset Manager. Ownership IMA Reinsurance 5
Direct investment in an Offshore Reinsurer using a Sidecar Capital Market$ Offshore Sidecar Asset Manager Added benefit of not having to manage the reinsurer and ability to select slice of risk Offshore Reinsurer Co Co Ownership IMA Reinsurance Management Agreement 6
Direct investment in an Offshore Reinsurer And Co Capital Market$ Asset Manager Onshore regulatory approval, but reinsurance to offshore company allows to get the capital benefits. Onshore company becomes a source of new business to offshore reinsurer Offshore Reinsurer Co Co Ownership IMA Reinsurance 7
Direct investment in an Offshore Reinsurer And Co - stacked Capital Market$ Offshore Reinsurer Co Co Offshore reinsurer can be used for third party reinsurance. Stacked structure allows offshore reinsurer to have a greater capital base. Co Asset Manager Ownership IMA Reinsurance 8
Some Tax Efficiencies Capital Market$ Offshore Re (Cayman/BDA) Co Benefit from have multiple jurisdictions: Irish/953(d) will have no FET Cayman may have more flexible capital rules and no FIT. Co Offshore Re (Ireland/953d) Asset Manager Ownership IMA Reinsurance Management Agreement 9
Some More Capital Efficiencies Solvency II friendly jurisdictions for European business. Capital Market$ Ownership IMA Reinsurance Offshore Re (Cayman) Co (US) Co (Europe) Co Asset Manager Offshore Re (Ireland/953d) Offshore Re (Bermuda/Ilse of Man/PR) 10
Cell Company Structure Each deal is collateralized and immune to default of other cells Capital Market$ Offshore Re (Cayman) Cell/PIC Cell/PIC Cell/PIC Co (US) Co (US) Co (US) Ownership IMA Reinsurance Co (Europe) Co Asset Manager Offshore Re (Ireland/953d) Offshore Re (Bermuda/Ilse of Man) 11
Complete the circle and reinvest in the capital markets Capital Market$ Offshore Re (Cayman) Cell/PIC Cell/PIC Cell/PIC Co (US) Co (US) Co (US) Co (Europe) Co Asset Manager Offshore Re (Ireland/953d) Offshore Re (Bermuda/Ilse of Man) 12
Capital Markets Other points of entry Longevity swap Cat bond Premium finance 13
XXX / AXXX Reserve Financing Presented by: Prannoy Chaudhury, FSA, MAAA Consulting Actuary, Milliman Inc. Society of Actuaries - Annual Meeting (Session 177) October 26, 2016
Agenda Introduction to XXX / AXXX reserve financing Common solutions to financing XXX / AXXX strain Hot topic: AG 48 Role of actuaries in reserve financing transactions 2
Introduction to XXX / AXXX Reserve Financing Many banks and reinsurers are willing to finance the excess of statutory over economic reserves The definition of economic reserves has historically been a negotiated deal term that for XXX/AXXX financing deals has often been GPV determined with best estimate assumptions. The graph below shows how XXX economic and excess reserves can vary over time. 120.0% 100.0% 80.0% 60.0% 40.0% Statutory Excess Economic 20.0% 0.0% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 3
Why do most large stock life insurers and reinsurers use reserve financing? Most competitors price term life and universal life assuming debt-like financing costs for excess reserves o Results in better pricing for consumers Reserve financing frees up surplus that can be used to improve RBC ratios, finance sales growth, or invest in acquisitions The nature and structure of reserve financing utilized can impact rating agency views of an insurer s capital adequacy, financial flexibility or enterprise risk management 4
Key steps in a XXX/AXXX transaction Insurer identifies a particular block of XXX/AXXX business for reserve financing Insurer receives proposals from financing providers (and selects one) Insurer creates a Captive Reinsurer to which the chosen block of XXX/AXXX business will be ceded Insurer works with its state of domicile and the Captive s state of domicile regulator to receive approval (e.g., the transaction structure is presented along with the Captive s pro-forma) 5
Common Solutions to Financing XXX / AXXX Strain Structured reinsurance (3 rd party) Funded solutions (involving captive surplus note issuance) Letters of credit ( LOC ) Credit Linked Notes ( CLN ) Other forms of collateral acceptable to the cedant s regulator 6
Financing Structure: Non-recourse LOC Bank Cash Drawn on LOC if needed LOC Fees Life Insurer or Professional Reinsurer Reinsurance Premiums Reinsurance Claims Captive Reinsurer Popular since 2010 Some banks have additional features (with extra boxes and arrows) to differentiate their solutions Most non-recourse LOCs to date have been conditional, whereby a draw is only permitted after economic reserve assets, and the Captive s surplus assets are depleted 7
Financing Structure: Credit Linked Note ( CLN ) Popular since 2012 Captive issues a Surplus Note bought by the SPV, and Captive buys the credit linked note ( CLN ) with a lower coupon In good times, the coupon difference is paid to financing provider as a fee In bad times, financing provider covers SPV s CF shortfall Life Insurer or Professional Reinsurer Reinsurance Premiums Reinsurance Claims CLN interest & principal SPV ` Captive Reinsurer Fee=Surplus Note interest CLN interest SPV s CF shortfall Surplus Note interest & principal Financing Provider 8
Key reserve financing market development: AG 48 Applicable for new transactions effective after 12/31/2014 One must determine Actuarial Method Reserves ( AMR ) that now replaces the Economic Reserve o o AMR is based on VM-20 (PBR) guidelines Interesting insights gained from AG 48 transactions regarding a PBR world. AMR must be backed by Primary Securities (cash, bonds etc.) Excess of AMR, up to Statutory Reserve, can be backed by Other Securities (LOC, CLN asset, etc.) Excess of XXX/AXX Statutory Reserves over AMR Mezzanine Layer = (AMR - Economic Reserves) XXX/AXXX Statutory Reserves 9 AMR Economic Reserves
Role of Actuaries in Reserve Financing Transactions Develop actuarial projections o o Review experience studies to determine best estimate assumptions If working for a bank or other provider of financing, advise on key risk factors for the block of business. Analyze financing proposals o o Quantitative: for e.g., impact of the different transactions on the distributable earnings of the Insurer Qualitative: regulatory approval, rating agency view of the transaction Develop deal model o o Based on the terms of the chosen transaction structure (documented across a number of legal documents), develop a deal model that incorporates items such as the Captive s priority of payments Help determine the Captive s capitalization and dividend thresholds. 10
Questions? Thank You Contact Information o Email: prannoy.chaudhury@milliman.com o Phone: +1 646 473 3114 11
THIS DOCUMENT SHOULD NOT BE REPRODUCED IN ANY FORM WITHOUT PRIOR WRITTEN APPROVAL The convergence of capital markets and insurance secured finance Erik Thoren, CFA, FSA October 26, 2016
Agenda Capital markets overview Why secured finance? What is secured finance? What else do I need to consider? Summary USP0221
Capital markets overview Insurers have been living in a tough environment Chart 1: 10-year global government yields Chart 2: Spread between 2- and 10-year yields Tough environment yield over the past decade Can you find higher returns using alternatives to debt? Move into alternative investments (i.e., PE, hedge funds, real estate equity) is not a panacea Chart 3: US credit spreads Where else can you search for yield? Extend duration Lower credit quality Less liquidity Source: Bloomberg, as of October 2016. USP0221
Capital markets overview Credit and liquidity risks in the marketplace Higher Credit risk Lower Mid-market private debt Mezzanine, second lien Distressed debt Residential and consumer Commercial real estate loans Secured corporates High yield bonds Broadly syndicated bank loans Investment grade bonds Secured finance Lower Liquidity Higher For illustrative purposes only. USP0221
Why secured finance? Complexity and illiquidity premium creates a potential attractive risk-adjusted return Spread over 3month Libor (bp) 750 700 650 600 550 500 450 400 350 300 250 200 150 100 50 0 +340bp AAA A BBB Investment grade High yield BB Representative secured finance universe Investment grade corporate bonds As of June 30, 2016. The spreads shown are for illustrative purposes only. USP0221
Why secured finance? Regulation has created opportunities to extract illiquidity/complexity Increasing regulation has reduced bank lending Leading to wider secured credit spreads Long term investors (insurers) can provide an alternative source of finance to borrowers Illiquid secured finance provides an interesting opportunity for insurers Risk/reward opportunities are compelling no need to sacrifice credit quality while seeking additional return Analysis of bank balance sheet asset base Yoy Change 25% 20% 15% 10% 5% 0% -5% -10% -15% 2006 2008 2009 2011 2012 2014 Assets Source: Bloomberg, TRACE and Morgan Stanley, as of June 30, 2014. USP0221
What is secured finance? Introduction Secured finance refers to lending that is secured against a single asset or portfolio of assets Typically, investors provide capital in return for interest and principal payments Investments can be structured with different credit and cash flow timing characteristics e.g., senior investment grade tranches (e.g., AAA, AA or A) with a supporting junior ranking tranche (e.g., BB), where principal of most senior tranches paid off first Examples of collateral include: Residential mortgages Commercial real estate loans Corporate loans Auto loans Credit card debt Principal from mortgages Priority of payments Debt (e.g., 60%) Collateral pool (e.g., mortgage loans) Interest and principal from mortgages Interest from mortgages Senior loan For illustrative purposes only. Losses Junior loan/ equity Equity (e.g., 40%) USP0221
What is secured finance? Collateral and liquidity characteristics Residential and consumer Commercial real estate Secured corporate Liquid Prime residential mortgage backed securities (RMBS) Auto loans (ABS) Credit card debt (ABS) Collateralized mortgage backed securities (CMBS) Collateralized loan obligations (CLO) Whole business securitizations (WBS) Illiquid Mortgage warehouse Bridge lending Auto/credit card warehouse Office Retail Hotel Corporate loan warehouse SME warehouse For illustrative purposes only. USP0221
What is secured finance? The trade-off between liquid and illiquid Securities Loans Origination Public market Proprietary channels Underwriting and valuation Public Loan-level underwriting Private information Loan-level underwriting Structuring None (structuring is already done so your decision is take it or leave it ) Negotiate deal terms and security package Trading Public tradable market More Liquid Limited liquidity, hold to maturity or e.g., sell to syndicate/ club member Less Liquid For illustrative purposes only. USP0221
What else do I need to consider? Are we able to? What are our ALM considerations? How much liquidity can we sell? Are they permitted? Do we want to? What is my risk appetite? What are my collateral and structure preferences? How much will we allocate? How can we? How familiar are we with investing in these assets? What are we able to access? Should we do this in-house or hire an external manager? USP0221
Summary More opportunity exists now for insurers as a result of bank deleveraging Reach for yield does not have to come at the cost of increased credit risk Secured finance provides an interesting opportunity for insurers: Enhanced yield vs. investment grade corporate bonds by extracting illiquidity and complexity premium Most insurers familiar with or already invest in liquid secured finance types Illiquid assets may be particularly attractive due to increase yield and protection There are a lot of decisions to make along the way USP0221
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