Risk of Affiliated Investments Micah Rivera, CPA

Objective The valuation and liquidity of affiliated investments lends itself to complexity. Valuation is affected by the type of entity or security owned and by the circumstances of ownership. In addition, since these securities may be in the private placement market, liquidity is a legitimate concern. This session will aid in understanding the valuation and liquidity risk involved and appropriate responses to address the risk.

Risk of Affiliated Investments Key Outline I. Definition & Background II. Accounting III. Risk IV. Mitigation Strategies

Background The risk that an investment in a member company of the same financial conglomerate or financial group may be difficult to sell, lose its value, or create a drain on the financial resources of the insurer

What are affiliated investments? Investment in an entity that is within holding company system or a party that, directly or indirectly, through one or more intermediaries, controls, is controlled by, or is under common control with the reporting entity. The expectation is that this investment produces a probable future benefit to contribute to future net cash inflows of the reporting entity. (SSAP No. 4, paragraph 2) (SSAP No. 48)

Variations in Asset Types Bonds Stock Mortgage Loans Partnerships Joint Ventures Limited Liability Company Bonds Stock Real Estate Partnerships Joint ventures Limited liability companies

Schedule BA Asset by Affiliate and Segment In the last 10 years, the U.S. insurance industry has doubled its allocations to Schedule BA investments from $141 billion to $304 billion; however, the levels of allocation vary by industry segment and company size. The increasing allocation to alternative asset class has been driven by large insurance companies and remains highly concentrated. More than half of Schedule BA assets are reported as affiliated investments, which accounted for most of the growth in BA investments. (Neamgroup)

Schedule BA Asset by Affiliate and Segment

What drives insurers to invest in affiliated investments? Diversification, low correlation to the general market Return More favorable borrowing terms Minimize broker cost Drivers Diversification, low correlation to the general market Return Minimize broker cost More favorable borrowing terms

Accounting The risk that an investment in a member company of the same financial conglomerate or financial group may be difficult to sell, lose its value, or create a drain on the financial resources of the insurer

Accounting for affiliated investments Market valuation approach Traded on major exchange Ownership percentages for determining the discount rate Percentages exceeding 85% will result in the SCA being recorded on an equity method The admitted investment in SCA entities shall be valued using either the market valuation approach, or one of the equity methods adjusted as appropriate in accordance with the guidance in SSAP No. 25-Affiliates and Other Related Parties (SSAP No. 25) The admitted investment in SCA entities shall be valued using either the market valuation approach, or one of the equity methods adjusted as appropriate in accordance with the guidance in SSAP No. 25-Affiliates and Other Related Parties (SSAP No. 25)

Market Valuation Approach Traded on major exchange Ownership percentages for determining the discount rate Percentages exceeding 85% will result in the SCA being recorded on an equity method

Market Valuation Approach Ownership Percentage Discount 10% 0.00% 29% 9.50% 48% 19.00% 67% 25.67% 11% 0.50% 30% 10.00% 49% 19.50% 68% 26.00% 12% 1.00% 31% 10.50% 50% 20.00% 69% 26.33% 13% 1.50% 32% 11.00% 51% 20.33% 70% 26.67% 14% 2.00% 33% 11.50% 52% 20.67% 71% 27.00% 15% 2.50% 34% 12.00% 53% 21.00% 72% 27.33% 16% 3.00% 35% 12.50% 54% 21.33% 73% 27.67% 17% 3.50% 36% 13.00% 55% 21.67% 74% 28.00% 18% 4.00% 37% 13.50% 56% 22.00% 75% 28.33% 19% 4.50% 38% 14.00% 57% 22.33% 76% 28.67% 20% 5.00% 39% 14.50% 58% 22.67% 77% 29.00% 21% 5.50% 40% 15.00% 59% 23.00% 78% 29.33% 22% 6.00% 41% 15.50% 60% 23.33% 79% 29.67% 23% 6.50% 42% 16.00% 61% 23.67% 80% 30.00% 24% 7.00% 43% 16.50% 62% 24.00% 81% 25% 7.50% 44% 17.00% 63% 24.33% 82% 26% 8.00% 45% 17.50% 64% 24.67% 83% 27% 8.50% 46% 18.00% 65% 25.00% 84% 28% 9.00% 47% 18.50% 66% 25.33% 85% Exhibit E – Sliding Scale Discounting of SCA Entities Using the Market Valuation Approach

Equity Method: Insurance Entities If a SCA investment does not meet the requirements for the market valuation approach: Investments in U.S. insurance SCA entities shall be recorded based on either 1) the underlying audited statutory equity of the respective entity’s financial statements, adjusted for any unamortized goodwill as provided for in SSAP No. 68-Business Combinations and Goodwill (SSAP No. 68) or 2) the underlying audited statutory equity of the respective entity’s financial statements, adjusted for any unamortized goodwill, modified to remove the impact of any permitted or prescribed accounting practices that depart from the NAIC Accounting Practices and Procedures Manual.

Equity Method: Non-Insurance Entities SAP 97 Paragraph 8.b.ii - Investments in both U.S. and foreign noninsurance SCA entities that are engaged in the following transactions or activities: Collection of balances as described in SSAP No. 6-Uncollected Premium Balances, Bills Receivable for Premiums, and Amounts Due From Agents and Brokers Sale/lease or rental of EDP Equipment and Software as described in SSAP No. 16R-Electronic Data Processing Equipment and Software Sale/lease or rental of furniture, fixtures, equipment or leasehold improvements as described in SSAP No. 19-Furniture, Fixtures, Equipment and Leasehold Improvements Loans to employees, agents, brokers, representatives of the reporting entity or SCA as described in SSAP No.20-Nonadmitted Assets Sale/lease or rental of automobiles, airplanes and other vehicles as described in SSAP No. 20-Nonadmitted Assets Providing insurance services on behalf of the reporting entity including but not limited to accounting, actuarial, auditing, data processing, Underwriting, collection of premiums, payment of claims and benefits, policy owner services Acting as an insurance or administrative agent or an agent for a government instrumentality performing an insurance function Purchase or securitization of acquisition costs And if 20% or more of the SCA’s revenue is generated from the reporting entity and its affiliates

Equity Method: Non-Insurance Entities Qualify for paragraph 8.b.ii., the underlying equity of the respective entity’s audited U.S. Generally Accepted Accounting Principles (GAAP) financial statements shall be adjusted to a limited statutory basis of accounting Investments in both U.S. and foreign noninsurance SCA entities that do not qualify under paragraph 8.b.ii., shall be recorded based on the audited U.S. GAAP equity of the investee.

Appropriate Valuation Procedures Exhibit D – Determining the Valuation Method Under SSAP No. 97

Risk The risk that an investment in a member company of the same financial conglomerate or financial group may be difficult to sell, lose its value, or create a drain on the financial resources of the insurer

Risk of Affiliated Investments Liquidity Selling securities in non-public offerings exempt from registration under the federal securities laws. These offerings are known as private placements Private Placements: an offering of a company's securities that is not registered with the Securities and Exchange Commission (SEC) and is not offered to the public at large. No ready secondary market Source: www.secatty.com

Risk of Affiliated Investments: Valuation Likely will contain limited information on the company’s business Private placement marketing materials are oftentimes issued with inaccurate statements or omitted information Lack of due diligence procedures prior to offering them Valuation is left up to mathematical models that may use unreliable factors. Oftentimes, valuations are left up to personal estimates. Source: www.secatty.com

Risk of Affiliated Investments: Regulatory/RBC Affiliated investments adversely affect RBC. The risk-based capital for U.S. life insurance companies, property and casualty insurance companies, health entities and investment subsidiaries is calculated on a “see through” basis (multiplied by the percent of ownership). This requires “looking through” all holding and subsidiary companies to the lowest level of ownership for each affiliated stock investment. Source: www.naic.org

RBC CHARGES Source: www.naic.org

RBC CHARGES CONTINUED Source: www.naic.org

Mitigation Strategies The risk that an investment in a member company of the same financial conglomerate or financial group may be difficult to sell, lose its value, or create a drain on the financial resources of the insurer

Risk Mitigation Strategies: Liquidity The insurer has liquidity measurement, monitoring and management framework which includes a written liquidity plan with contingency and stress-testing features. The insurer has policies in place to ensure that dividends paid to affiliates are within regulatory limits, do not cause a liquidity strain on the insurer, are approved by the board of directors (or committee thereof) and have received regulatory approval (if required) prior to payment. The insurer monitors parent or holding companies for financial solvency/liquidity issues. Dividends being paid from the subsidiary to the parent insurer. A lot of companies push dividends up from the SCA which can make the SCA insolvent. Source: NAIC Examiner Handbook

Risk Mitigation Strategies: Valuation The board of directors (or committee thereof) reviews strategic business plans and financial reports for other members of the holding company system and evaluates any risks and new initiatives that could impact the insurer including reputational risks and legal risks. Other entities in the holding company system make presentations to the board to explain operations and risks. The insurer has procedures in place to value its investments in subsidiary, controlled and affiliated entities to ensure compliance with the requirements of SSAP No. 97. Source: NAIC Examiner Handbook

Risk Mitigation Strategies: Governance/Monitoring Governance structure that routinely challenges, approves and reviews its investment strategy The insurer has an investment strategy that outlines asset allocation by type, rating and acceptable ranges for higher risk products. Concentrations in strategies (e.g., hedge fund, private equity, leveraged buyout, venture capital) with a specific focus on volatility in income and valuation are considered in the allocation. The insurer has its own process that is not solely dependent upon credit rating agencies, to evaluate the credit worthiness of securities for investment purposes. The process is utilized prior to significant purchases and on an ongoing basis. Source: NAIC Examiner Handbook

QUESTIONS?

Micah Rivera, CPA M 704-692-3774 E Micah.rivera@dhgllp.com