BMA proposes to intensify governance and risk management expectations applicable to commercial insurers investing in non-publicly traded assets

The Bermuda Monetary Authority (BMA) has issued a consultation paper on “Proposed Instructions and Guidance on the Application of the Prudent Person Principle (PPP)” (CP).

The PPP is a principle that all Bermuda insurers and insurance groups are required to adopt in relation to the investment of their assets.  The BMA’s Insurance Code of Conduct (Code) applies the PPP as a requirement applicable to insurers.  The Insurance (Group Supervision) Rules 2011 (Group Rules) applies it to insurance groups.  In both cases, it is an integral part of the risk management framework with regard to investment risk.

The PPP requires that an individual entrusted with the management of a client’s funds may only invest in instruments that any reasonable individual with objectives of capital preservation and return of investment would own.  As applied to an insurer (or insurance group), the PPP requires that the insurer (or insurance group), in determining the appropriate investment strategy and policy, may only assume investment risks that it can properly identify, measure, respond to, monitor, control and report while taking into consideration its capital requirements, short-term and long-term liquidity requirements and policyholder obligations.  Further, investment decisions are to be executed in the best interest of policyholders.

Building on recent enhancements to the supervisory regime applicable to insurers and insurance groups, which responded to risks flowing from the increased allocation by insurers (particularly long-term insurers) to illiquid, hard-to-value assets that are non-publicly traded, the CP consults on the BMA’s expectations relating to the application of the PPP by commercial insurers and insurance groups.

While the BMA’s focus in recent related market papers has been on long-term insurers, including deep dives into the use of private credit structures, the proposals in the CP are addressed to all commercial insurers and insurance groups.

Many of the themes in the CP, such as the contribution of the asset manager to valuation uncertainty risk in the case of private credit structures and how fee structures can distort the incentive to act in policyholders’ best interests, chime with supervisory observations in other recently-published papers, such as the BMA’s Evaluating Private Credit market paper (see Kennedys bulletin on this) and its white paper on the Evolution of Asset Intensive Reinsurance (see Kennedys bulletin on this).

Highlights from the proposals

The proposals in the CP emphasise the importance of:

• ensuring capabilities and resources are available to appropriately identify, measure, monitor, respond to, control and report on risks and complexities unique to non-publicly traded assets;
• adequate investment in infrastructure, people, tools and systems;
• the need for a suitable and up to date mix of skills and experience within the board;
• resources and experience to hold and manage collateral, where foreclosed on;
• due diligence on rating providers;
• independence in the valuation process;
• awareness of:
  • risks involved in the asset management process particularly in connection with non-publicly traded assets;
  • valuation uncertainty risk;
  • affiliated and related party exposure;
  • conflicts in outsourcing;
  • how fees in the investment chain can affect value, checking fees align with industry standards and value delivered;
  • the potential for conflicts to arise in a variety of contexts, especially where there is related party asset management and origination.

Substantive proposals

The substantive proposals in the CP may be summarised as follows:

Investment Strategy

An insurer’s investment strategy must include a plan tailored to the insurer’s use (if any) of non-publicly traded, illiquid, less transparent, structured credits, off-balance sheet exposures, and related party-originated assets, among other bespoke and complex assets.

Investment Risk Management

When insurers invest in asset structures or other instruments where the risk exposure is dependent on the performance of underlying assets, they should also include the risks of these underlying assets within the scope of their investment risk management framework.

Effective monitoring of investments should cover:

• changes in value or characteristics, including underlying/look-through risk and exposures, changes in the external environment that may affect the security of assets;
• changes in concentrations, asset-liability mismatch, defaults, credit rating transitions and changes in credit spreads.

Insurers should perform stress-testing to consider the impact of scenarios on capital, short-term and long-term liquidity and policyholder obligations.

Governance

Insurers with investment strategies that include illiquid, hard-to-value assets that are non-publicly traded and can be more complex than liquid traded assets, should expect the BMA to exercise close ongoing supervisory scrutiny of their governance.

Specific areas of governance that the BMA expects the board of an insurer to devote attention to as part of its responsibilities for oversight of the insurer’s compliance with the PPP include:

• identification and disclosure of affiliated and related party exposure;
• establishing and implementing policies, processes and procedures to identify and manage conflicts; and
• appropriate structures to deal with conflicts effectively, especially where there are related-party asset management and origination activities and end-to-end fees charged by the related asset management.

An effective risk culture should ensure that senior management compensation is, where applicable, aligned with the long-term nature of insurance liabilities.  (This reflects concerns expressed by the BMA regarding possible short-termism in some asset management relationships discussed in the white paper on the Evolution of Asset Intensive Reinsurance.)

Insurers must consider the nature of their investments, including, where applicable, any lack of or limited historical data, the illiquid and complex nature of the investments.

When outsourcing investment management activities, attention to the following is required:

• the need for the investment management agreement to comply with the laws of the jurisdiction in which assets are governed under the laws of the ceding company’s jurisdiction but the insurer has the economic exposure;
• the need for the insurer’s board to include:
  • individuals with a suitable and up to date mix of skills and experience that covers the major business areas, including investments, to make informed decisions and provide effective oversight of the risks; and
  • an appropriate number of INEDs who among them have sufficient breadth of understanding of the investment strategy to provide effective challenge to the executives. The BMA expects to see evidence of effective challenge, relevant knowledge and experience, including the ability to solicit appropriate professional advice with in-depth expertise in the asset classes being pursued by the insurer.
• Where discretionary asset management powers are granted, the BMA expects insurers to exercise appropriate oversight, particularly in relation to non-publicly traded, illiquid, non-traditional assets and other bespoke and complex assets.

Outsourcing of Investment-Related Services

For an insurer whose investment strategy includes non-publicly traded/complex assets, the outsourcing-related governance and internal controls required by the Code and the Group Rules, such as due diligence, impact assessment, oversight and accountability, ongoing monitoring and contingency plans, translate into the following:

• an assessment of whether the investment manager has the skills to understand the investment risks; and
• a need to retain adequate investment risk expertise in-house even when outsourcing, so the insurer can supervise effectively.

Attention needs to be focused on:

• the involvement of the different parties and how they impact the creation, extraction and diminution of value in the investment chain.
• identification of potential conflicts of interest and mitigation of the risks in the best interests of policyholders.
• strategy in the event of portfolio loan default, including an evaluation of whether parties in the chain have sufficient motivation to act in the best interests of policyholders when deciding on the strategy for recovering value.
• where investments are managed centrally by a group function, the need for the investments to be managed with due regard to the needs of individual entities in addition to those of the group as a whole.
• the alignment of fees with the value provided and industry standards.
• policies and procedures for the review, approval and monitoring of fee arrangements, as well as disclosing fee structures and potential conflicts of interests to the BMA. There is an emphasis on ensuring fees do not distort the incentive to act in policyholders’ best interests.

Match to Liabilities

In ensuring that there is adequate asset-liability matching (ALM) between investments and the nature, duration, risk and cashflow profile of policyholder obligations, insurers should assess the materiality of any embedded optionality in proposed assets and the extent to which this may erode ALM and introduce additional risks, including by considering how the optionality may vary over time and under stress conditions.

Any mismatching should not expose policyholders to risks that cannot be effectively managed by the insurer.

Complex and Non-Publicly Traded Assets

An insurer considering complex assets should comprehensively assess the inherent risks due to limited transparency and information flow, volatility misestimation and difficulties in identifying and reflecting changes in risk profile.  In particular:

• an assessment of capabilities and resources to determine if it can appropriately identify, measure, monitor, respond to, control and report on risks and complexities unique to non-publicly traded assets;
• adequate investment in infrastructure, people, tools and systems;
• holistic due diligence that includes an assessment of tail risks and whether the insurer should have the resources and expertise to deal with any workouts in the case of default. The insurer should ask itself whether it has the resources and expertise to hold and manage collateral.

Ratings

Insurers should not place “blind reliance” on ratings provided by rating providers.  The BMA expects insurers to demonstrate that due diligence is carried out on the assets and the rating providers to assess if they have the adequate expertise in rating the specific asset type.  Insurers must also perform their own assessment of the credit risk of investments and monitor it on an ongoing basis.  Where the assessed risk is not consistent with the external ratings, the insurer should have mechanisms in place to ensure that the level of capital it holds is not materially understated.  If only one rating provider is used, the BMA expects the insurer to demonstrate an understanding of the asset class, the individual asset and the potential ratings “jump risk” that could result from any new developments on the rating provider.  The BMA expects insurers to use publicly-issued ratings over privately-issued ratings by default where feasible and otherwise to demonstrate with clear justification why the insurer is unable to use public ratings.

Limits need to be set so that the insurer’s liquidity needs under normal and stress conditions can be met without forced sale of less liquid non-publicly traded assets. 

Valuation Uncertainty Risk

Valuation risk was a factor identified by the BMA in its market paper on Evaluating Private Credit published in September 2024 as a particular issue in the case of private fixed income assets.  Credit spreads, probability of default and recovery rates may not be observable, which can impact insurers’ financial statements and solvency ratios in their economic balance sheet.

Again, the emphasis is on the need for sufficient infrastructure and expertise, external or internal, independently to value non-publicly traded assets and to measure and monitor the associated uncertainty in valuation, and the need for policies and procedures on how this should be reflected in the report values.  

Where unavoidable, the asset manager may be used in a valuation process, subject to good governance, transparency and control of conflicts.  However, this does not absolve the insurer from its obligation to assess and manage valuation uncertainty risk via independent valuation. 

Insurers should assess the potential impact that valuation uncertainty could have on solvency position under different adverse conditions or scenarios.

Effective Date

The BMA proposes that the Instructions and Guidance will enter into force on 1 July 2025.