Bermuda long-term sector regulatory highlights – Q3-Q4/24

Focus on asset-related approval applications and block reinsurance approval applications

New instructions and insights from the Bermuda Monetary Authority’s (“BMA”) market papers regarding asset allocation and use of collateral in block reinsurance treaties

1 ASSET AND SCENARIO BASED APPROACH (SBA) RELATED APPROVALS – FOCUS ON LONG-TERM SECTOR

1.1 On October 10, 2024, the BMA published instructions for "Asset and SBA-related Approvals" which outline the process, requirements, and fees for submitting applications.

1.2 Assets that need approval include:

1. non-publicly traded assets;
2. below investment grade assets;
3. residential mortgages;
4. commercial mortgages;
5. structured assets;
6. alternatives;
7. long-term investment credit assets; and
8. affiliated assets.

1.3 Any potential losses or risk of downgrades on these assets must also meet minimum standards set by the BMA.

1.4 To apply, companies must submit a memo explaining which assets need approval, any other approval requirements (such as default and down grade costs) and the qualitative and quantitative basis of the application. Generally, this involves following the requirements outlined for each specific asset type in the BMA’s Capital and Solvency Return 2024 (Interim) Instructions Handbook for Class E, Class D & Class C Insurers (the “Instruction Handbook”).

1.5 Applicants must also complete a Lapse, Liquidity, and SBA Return (LLSBA) and pay the relevant fee based on the type of assets which require approval as set out in the BMA’s 2024 Fee Notice[2].

1.6 Structured asset applications must include a market conditions and spreads overview, an investment policy, thesis and risk appetite, an asset listing and portfolio overview, stress testing and attestation.

1.7 The applicant must provide details on how structured assets proposed to be used in the SBA satisfy the “predictable and stable cashflows” requirement. In addition, they must provide details on the assumptions used in modelling structured assets in the SBA.  Where some structured assets are considered highly liquid by the applicant and the company wishes to request to treat these as sellable in the SBA, a broader assessment of the registrant’s liquidity position should be provided and complemented with detailed supporting data and liquidity analysis specific to the respective structured asset class segment.

1.8 An application for default and downgrade costs is to be included as part of the asset application, including all supporting analysis.

2 BERMUDA LONG-TERM INSURANCE MARKET REPORTS – FOCUS ON LONG-TERM SECTOR 

Following positive feedback on the supervisory experience and market information shared in the BMA’s paper, published in December 2023, on "Supervision and Regulation of PE Insurers in Bermuda”, the BMA shared further experience and market insights by publishing, in August and September 2024, a series of reports on the Bermuda Long-term (re)insurance market.  The market papers include helpful insights into the BMA’s perspective on the use of private credit investments, collateral structures in ModCo and Funds Withheld reinsurance and on liquidity risk management practices.  These insights may be helpful to long-term insurers when making asset admissibility applications and block reinsurance approval applications.

2.1 Private Credit – Deep dive on Direct Loans, CLOs, and Private Placement

2.1.1 Noting that some insurers are increasingly investing in private credit, a development driven by factors such as the prolonged- low interest rate environment, the report gives an overview of relevant private credit asset classes, their historical loss experience and forward looking considerations not captured in historical data. Private credit can offer better terms, more favourable loss experience and some diversification relative to public bond markets.  Indeed, Historical data point to good/superior historical credit loss experience of private as compared with public investments of similar quality, although with some more concerning trends in very recent history. 

2.1.2 Private assets may fit within an overall high quality investment portfolio backing long-term liabilities, provided that the assets and liabilities are well-matched and the insurer have adequate governance rand risk management frameworks in place. However, it is still important to ensure that the illiquidity premium is adequate relative to the risks, particularly in the context of recent years as demand for certain assets has tended to outstrip supply, depressing spreads.

2.1.3 Assuming that liquidity risk is effectively managed from a held to maturity perspective, the focus of risk assessment shifts to the underlying fundamental credit risk.

2.1.4 Recent developments are raising concerns about the future performance of private credit assets:

1. Some assets are “untested” in the conditions of a truly severe financial crises or downturn (eg CLO 2.0 and 3.0 structures).
2. There is evidence of loosening underwriting standards/decreasing protections increasing leverage on direct loans.
   1. borrowers taking on higher levels of debt.
   2. a shift from industrial sectors to technology, software and healthcare, which have higher returns but lower tangible collateral.
   3. increased negotiating power of borrowers, leading to “covenant-lite” loans.
      1. CLOs have been a subject of recent regulatory scrutiny particularly from the NAIC and the BMA is also assessing the risks and following international developments closely.

2.1.5 Data on public markets reveal recent below historical average and declining leverage loan recovery rates, attributed to higher total debt leverage, higher first-lien debt leverage and reduced junior debt cushions. Covenant lite term loans are thought to contribute.  With that said, it is not clear that these trends apply to private markets where each loan transaction may be structured in a bespoke way, including use of covenants.

2.1.6 These risk factors underline the importance of assessing the underwriting standards of the asset manager and the credit risk of the investments on their own merits; and of having the right set of skills and expertise for such assessment.

2.1.7 A proper risk assessment of private investments should be based on an understanding of the mechanics of the assets and structures, within the context of the relevant trends and risks/factors not in the data set and combined with robust stress testing and scenario analysis. In the case of insurers investing in private assets, a holistic risk assessment should crucially include the nature of the liabilities (duration and predictability).

2.1.8 Valuation risk is a of particular materiality in relation to private fixed income assets. There is a paucity of data as relevant credit spreads and probabilities of default and recovery rates may not be observable in the markets and difficult to assets.  This affects insurers’ financial statements and solvency ratios in the economic balance sheet framework.  It also affects asset manager fees.  Indeed, valuation by asset managers can create a conflict of interest and increase risk of aggressive valuation.  From a supervisory perspective, therefore, valuation risk has two dimensions:

1. Inherent valuation risk arising lack of observable traded prices; and
2. Conflicts of interests and agency problems.

The latter can be contributed to by the role and influence of asset managers eg as owners, directors and setters of long-term insurer strategic asset allocation.  Where are conflicts of interest are present, independent validation procedures are of crucial importance, instead of relying on controls within the asset manager.

2.2 Collateral structures in the Bermuda long-term insurance market

2.2.1 This paper discusses use of collateral in Funds Withheld (FWH), Modified Coinsurance (ModCo) and collateral trusts[3] structures in asset-intensive long-term reinsurance[4]. It reaches various conclusions:

1. the use of collateral in asset intensive reinsurance is an effective and significant safeguard in both normal and adverse conditions;
2. that FWH and ModCo structures can significantly reduce reinsurer counterparty credit risk and enforce discipline between parties involved;
3. however, such structures are not foolproof, highlighting the need for supervisors to remain vigilant and continue strengthening regulator-to-regulator collaboration.

2.2.2 The following emerge as important and valuable contractual mitigations in any effective collateral structure:

1. assets are agreed between the reinsurer and cedent in accordance with the investment guidelines agreed to by both parties;
2. the assets will typically be required to follow the investment laws of the state in which the cedent is domiciled;
3. pre-agreed limits applicable to asset allocation, currency, single issuer counterparty and credit quality/rating limits for each type of asset;
4. agreed valuation approaches for collateral assets;
5. recapture provisions in the reinsurance treaty define the payment and timing of payment the cedent will receive if the reinsurer runs into financial distress, with provisions that are typically more onerous if the reinsurer is 'at fault' for the recapture;
6. covenants that typically provide constraints on reinsurer asset liability management, jurisdiction and currency of exposure, liquidity, and capital management.

2.2.3 The effectiveness of ModCo or FWH structures depends on:

1. robust design and contractual safeguards;
2. quality of assets in the collateral account; and
3. effective implementation.

2.2.4 Robust design and contractual safeguards

1. The degree to which safeguards are robust depends on the maturity of the risk management systems of both parties. Weak risk management on the part of either party can compromise the protection offered by these structures.  Indeed, the BMA is “very averse to cedents who do not have the prerequisite capabilities to properly identify and mitigate risks”.  It does not approve transactions by reinsurers with weak risk management systems or outstanding supervisory or compliance concerns.

2.2.5 Quality of assets in the collateral account

1. Poor-quality or illiquid assets in collateral accounts can pose a risk during periods of stress and assets prone to high market volatility can lead to fluctuations in the collateral value, leaving the account underfunded during market downturns.
2. Affiliated assets are (unsurprisingly) identified in the paper as a significant supervisory concern, especially where there is significant potential for conflicts of interest. This potential becomes elevated under times of stress, as the insurer may not be able to fully enforce its rights in the assets because the counterparty is affiliated, or the exercise of the insurer's rights would cause further adverse consequences across the group of affiliated companies.
3. Assets should comply with investment laws and regulations applicable in the ceding jurisdiction. The fact that, in ModCo and FWH transactions, the assets still sit on the cedent's balance sheet and the cedent has legal title to the assets, reduces the risk of assets being held that are not admissible in the ceding jurisdiction were a recapture to occur.

2.2.6 Effective implementation using clear and detailed contractual mitigations

1. These mitigations can be summarized as follows:
   1. an outline of the specific assets to be held as collateral;
   2. the criteria for asset quality;
   3. procedures for valuation;
   4. audit rights; and
   5. conditions under which assets can be substituted or liquidated etc.
2. The mitigations are needed on the cedant as well as the reinsurer side. Best practice seems to be for dedicated compliance teams to regularly monitor and report on compliance with reinsurance contractual obligations including for FWH, ModCo and collateral trust account structures.  A lack of monitoring and of expertise in understanding particular risk features of assets can result in problems both on the cedant and reinsurer side.

2.3 Liquidity risk in the Bermuda long-term insurance market

2.3.1 Bermuda long-term insurers maintain significant diversification against less liquid assets[5]. However, instances of urgent liquidity needs can still occur where, for example, increased interest rates can cause policyholders to cash out their policies earlier than expected (surrender risk).  These risks are compounded if there are potentially illiquid assets on the balance sheet.

2.3.2 It is therefore essential that regulators work together globally to address gaps in regulatory frameworks regarding liquidity risk. Regulators should further enhance insurance regulation by focusing on liquidity stress testing, risk management planning and indicators of liquidity risk.

2.3.3 On the asset side the drivers of liquidity risk depend on the nature of the assets themselves and market conditions, such as illiquidity, extensions of principal payments in the event of interest rate rises, margin calls on derivatives driven by market risk. On the liability side, they comprise optionality such as surrender rights, interest rate rises leading increased lapse risk, reinsurer default, shortfall in new and renewal premiums.

2.3.4 Bermuda insurers must adhere to rigorous liquidity risk management requirements. The BMA mandates a holistic liquidity risk management framework that long-term insurers must adhere to.  This framework includes the following key components:

1. liquidity risk management program approved by their board of directors;
2. identify and understand the sources of cash inflows and outflows under various scenarios;
3. clear liquidity metrics and thresholds must be defined;
4. Stress Testing and Contingency Plans.

2.3.5 Long-term insurers in Bermuda must:

1. conduct stress tests under both moderate (1-in-20 years) and severe (1-in-200 years) scenarios and report the outcomes to the BMA;
2. maintain a liquidity buffer consisting of highly liquid assets that can be readily converted to cash. This buffer is designed to cover unexpected cash outflows, ensuring that insurers can meet their obligations even under severe stress conditions;
3. meet a 105% Liquidity Coverage Ratio (LCR), which means that available liquidity sources must be higher than the potential surrender after a severe liquidity stress scenario.

2.3.6 In addition, companies using the Scenario-Based Approach (SBA) must meet additional liquidity requirements. Detailed liquidity risk reporting is in place as part of the SBA framework.  Companies that use the SBA and have lapse risk in their liabilities are required to run additional liquidity and lapse stress tests and meet detailed reporting requirements.

2.3.7  Liquidity risk management practices

1. In 2023, the Authority conducted a targeted survey to assess the impact of rising interest rates on lapse rates and liquidity risk. The survey revealed that while lapses increased significantly from Q4 2022 into Q1 2023, most insurers were able to manage these increases within expected ranges. Regular stress testing and reporting to the board were identified as crucial components of managing liquidity risk.
2. other supervisory sources of data are internal liquidity risk stress tests in CISSAs which for long-term insurers include liquidity risk appetite monitoring, internal stress tests, and qualitative commentary on their liquidity risk frameworks.
3. CISSAs, on-sites and surveys show different levels of maturities in the liquidity risk frameworks of long-term insurers in Bermuda. Given these different levels of maturity, it remains important that insurers continue to develop their internal  liquidity risk management processes.

2.3.8 Asset allocations and available liquidity sources

1. Bermuda long-term insurers hold a diversified asset mix with over 60% of their investments in cash and quoted bonds.
2. The BMA’s mandated stress tests restrict the types of assets that can be utilised in liquidity stress scenarios, along with compulsory haircuts to eligible assets.
3. The BMA’s aggregated market data show that Bermuda long term insurers depend on higher credit quality liquid assets to satisfy the 1-200 year liquidity stress test. 27% of total liquidity sources consist of cash, sovereign and public corporate bonds with a rating of AA- or higher. Investment grated public corporate bonds, sovereign bonds and cash make up nearly 90% of total liquidity sources.

2.3.9 Liabilities and lapse stress tests

1. The BMA’s regulatory stress tests (eg interest rate, credit spread and underwriting risks stress tests) are tailored to both assets and liabilities, including situations in which policyholders surrender their policies en masse. Shocks are applied to all lapsable policies, whether lapsing is beneficial for the insurer or not.
2. Bermuda long term insurers hold sufficient liquid assets to handle a sudden 100% lapse shock with liquid assets averaging 7% greater than surrender values. Comparable data for different jurisdictions indicates that for all jurisdictions the potential surrender value is slightly or significantly greater than the liquid assets, emphasising the need for regulators to cooperate to ensure robust liquidity risk framework.
3. The substantial LCRs are partly explained by the prevalence of US long-term risks reinsured in the Bermuda market, where underlying products have hefty initial surrender penalties. However, these penalties decrease over time.  With time, therefore, the benefits to the policyholder may offset economic sanctions.  Proactive input from brokers on surrenders can also increase the incidence. This is an increased risk in an environment with higher rates and heightening competitive pressures in the savings market.  It is therefore vital for insurers to regularly review lapse rates including timely updates form cedants and more closely monitoring sizable contracts. They should also enhance contingency plans for sustained high lapse rates.
4. While the overall sector shows strong resilience against liquidity shocks, some insurers show liquidity shortage under stress scenarios. The BMA engages with the management of those companies to ensure adequate risk mitigation measures.

 

 

[2] https://www.bma.bm/viewPDF/documents/2024-01-26-12-02-41-2024-Bermuda-Monetary-Authority-Fees.pdf

 

[3] While not prevalent, business that is conducted on a pure coinsurance basis, is mainly identified with some affiliated reinsurance, as most third-party reinsurance is typically collateralised. Affiliated reinsurance is typically conducted in the context of group supervision. As a result, there are additional specific mitigants.

[4] Defined as “a form of reinsurance that transfers the investment and biometric risks associated with a block of insurance liabilities from a ceding primary insurer to another insurer or reinsurer”.

[5] With high liquidity coverage ratios (median 418% post 1-200 years stress test).