1. Risk of Affiliated Investments Micah Rivera, CPA

2. 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.

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

4. 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

5. 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)

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

7. 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)

8. Schedule BA Asset by Affiliate and Segment

9. 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

10. 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

11. 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)

12. 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

13. 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

14. 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.

15. 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

16. 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.

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

18. 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

19. 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:

20. 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:

21. 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:

22. RBC CHARGES
Source:

23. RBC CHARGES CONTINUED
Source:

24. 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

25. 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

26. 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

27. 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

28. QUESTIONS?

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