1 New York State Insurance Department Stress Testing & Other regulatory investment issues * NYIA Educational Seminar 2/12/09 Matti Peltonen Bureau Chief

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New York State Insurance Department

Stress Testing&

Other regulatory investment issues*

NYIA Educational Seminar2/12/09

Matti PeltonenBureau Chief

New York State Insurance DepartmentCapital Markets Bureau

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•Capital Markets Bureau –Assists in regulation and monitoring of capital markets & risk management activities of New York licensed insurers

–Insurance companies’ capital markets activities:•investments•derivative use•Borrowing & securities lending•Securitization•Asset allocation

–Risk management: measuring, managing, and controlling (capital market) risks – including stress testing

–Enterprise Risk Management: how market, credit, and operational risk are incorporated into the insurer’s corporate structure & culture


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CMB activities: Provide examination support

Insurance companiesPublic retirement systems

Review special transactions, valuation Approve and monitor derivative activity Assess asset & liability management Train staff in capital markets issues Assess solvency & identify problems through financial analysis Evaluate corporate governance Review use of third party investment management Monitor securitization of insurance risk


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Current Critical Issues & Initiatives:

•Credit Crisis

•Financial Guarantee Insurers

•Stress Testing

•Enterprise Risk Management

•Securities Lending

•Subprime and other structured securities

•Valuation

•Derivatives

•Rating Agencies

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•Stress Testing

•After the turmoil in many sectors of investments, we considered it prudent to meet with companies on how they conduct stress testing, and how the stress testing has changed in 2008

•CL #25(2008) was issued 11/18/08

•All companies are expected to have scenario stress testing process in place as part of prudent management

•Stress testing: how different economic scenarios are analyzed

•First round of reviews completed – focus on large NY domestics

•Second round starts – probably - during spring 09

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•Stress Testing Questions

•Governance and Operations

•Details of risk management structure

•Stress testing methodology, market shocks

•Reporting

•Disaster recovery

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•Stress Testing – Market Shocksa. Interest rate shocks

b. Basis spreads

c. Credit spreads and swap spreads.

d. Equity market shocks

e. Changes in volatility in relevant inputs.

f. price shifts (such as equities, commodities, currencies, real estate, etc)

g. Yield curve shifts

h. Changes in credit quality

i. Changes in liquidity

j. Rating agency downgrades

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•Stress Testing – Market Shocksk. increases in inflationary pressures

l. deflation

m. continued fall in equity markets and falls in real estate

n. increased default rates leading to counterparty failures, including collateral arrangements in hedging, securities lending or other arrangements

o. Effect of increased defaults on value of collateral (RMBS, credit card receivables, student loans, etc).

p. changes in lapse rates

q. Collateral calls

r. natural catastrophes (hurricane, flood, earthquake)

-what are the extreme scenarios used

-what is the technology used to run reports and analyses

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•Credit Crisis

•Mortgage-backed securities

•Residential: subprime, Alt-A, home equity

•Commercial real estate

•Other structured securities (e.g CDOs, CDO^2)

•Borrow short & lend long (SIVs, banks, securities lending)

•Corporate bonds (Bloomberg story – up to $1 trillion in losses)

•FGIs, including impact on municipal debt

•Monitor insurance industry exposures

•Monitor how different asset classes perform (illiquidity, credit, price):

•Municipal auction-rate securities

•Subordinated/hybrid debt issued by financial firms

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•Financial Guarantee Insurers

•Analysis of risk exposures/solvency, modeling capabilities, risk management

•Examinations

•Impact on municipal securities market

•Ensure adequate financial guarantee capacity

•Restructuring of old companies

•Capital

•New capacity

•Structured securities

•New legislation / regulation / circular letter

•ACA, AG, AMBAC, CIFG, FSA, FGIC, MBIA, Syncora (Berkshire)

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•Financial Guarantee Insurers/Structured securities CDO SquaredMortgages RMBS Inner CDO CDO Squared Bondholders

Control rights

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage

Mortgage

Senior (AAA)

Junior (BBB)

Mezzanine (A)

AAA

AA

Equity

A

BBB

AAA

BBB

FGI:CDS guarantees

payments

•Theory: by subordination, you can create AAA security from subprime

•Underestimated the value erosion caused by the rise in delinquencies and defaults

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•Structured Securities: CPDO•Constant Proportion Debt Obligation

•Structured security leveraged up to 15 times with CDS off iTRAXX

•CDSs rolled on the exchange every 3/6 months

•Dependent on spreads, contract liquidity, max leverage

•If spreads widen, leverage goes up

•Initially rated AAA, as the probability that interest and principal would be paid was estimated to be 99.2%

•Coupon LIBOR+2%

•Initiated re-formation of NAIC Invested Assets Working Group

•Euromoney’s “Obituary” in November 2008 for the 600 billion issued$$$ $$$ $$$

Money mkt Arranger CDS G/L SPV CDS G/L InvestorsLIBOR (CDS c/p) Libor+premium Libor+premium

Premium sell protection

CDS

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• Enterprise Risk Management (“ERM”)

• ERM: capability to consistently identify, measure, aggregate and manage risk exposures within predetermined tolerance guidelines

• The ERM structure: combines market risk, credit risk, operational risk and insurance risk, economic capital, and disaster planning

• Oversight by Chief Risk Officer

• Insurance companies’ ERM is at various stages of development

• Capital Markets Bureau:

• Establish evaluation criteria

• Develop an audit&examination program to assess ERM

• Incorporate assessment of ERM into examination process

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• Enterprise Risk Management (“ERM”) / Risk-Focused Exams

Modeling/analyzing insurance companies’ portfolios

• traditional approach: verification of balance sheet• risk-based approach - portfolio analysis:

-using the filed statutory information on investments -upload portfolio (into Excel & Bloomberg) for analysis -enables a more dynamic risk assessment, using (for example):

-bonds: duration, Value-at-Risk, rating distribution

-sector exposures (telecommunications, energy)

-equities: P/E, beta, etc.-scenario testing

• Metrics• Problem: understanding liability structure (on duration basis)• IAWG: improve information in the annual statement + “database symmetry”

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•Insurance companies enhance income by lending securities to broker/dealers, banks, hedge funds

•Lender receives cash as collateral (typically 102% of value)

•Problem: some insurers have reinvested the cash collateral in subprime and other structured securities, which have significantly fallen in market value – and as a result, the collateral is no longer adequate

•The Department issued a Circular Letter (16/2008) indicating an enhanced review of the activity in upcoming examinations

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The problem; short-term securities lending program was used to finance long-term investments in securities (to leverage balance sheet)

Market value fell either on both sides, or for the securities where the borrowed money was invested

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Derivatives

•Regulation of CDS

•Derivatives Working Group (NAIC)

•Update Derivatives Model Regulation (282)

•Prior approval

•Update Annual Statement Schedule DB (Derivatives)

•Transparency

•Hedge effectiveness

•Permitted uses: •Hedging

•Income generation

•Replications

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Valuation

•Problem: market value (what another counterparty pays) is far from the discounted cash flow value, which can be far from amortized cost

•Annual Statement

•Pricing proposal (VOS), effective 12/08 for Schedule D

•Company can select the source (instead of SVO Unit Price)

•Pricing source needs to be disclosed

•Same method for derivatives (Schedule DB)

•Eventually, both D and DB likely to follow FASB Levels 1,2,3

•SSAP 43 ->SSAP 98&99 Other Than Temporary Impairment

•Change (98): written down to fair value (instead of undisc. cashflows)

•99: discount can be amortized if principal unimpaired

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Rating Agencies

•Unrated securities are filed with the SVO (assigns NAIC 1-6)

•Rated Securities, NAIC relies on the NRSROs (“AROs”) for about $2.6 trillion of rated securities

•Rating translated into NAIC 1-6

•SVO Initiatives WG -> SVO-NRSRO

•NAIC continues to rely on NRSROs (RBC, statement value)

•A review of the FE process, and reliance on the NRSRO ratings?

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NAIC Work

In addition to developing and enhancing securities and derivatives regulation in New York State, New York is at the forefront of work that is done on those areas in the NAIC:

•Valuation of Securities Task Force (Chair)

•Derivatives Study Working Group (Chair)

•Invested Assets Working Group (Vice Chair)

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Asset Allocation% of inv. assets Life P&C

Bonds 74.8 65.8Preferred Stocks 2.2 1.3Common Stocks 4.6 26.2

Mortgages&real estate 10.5 0.4Other inv assets (BA) 2.8 4.1

Cash & short term inv. 2.7 6.8Affiliated investments 5.3 16.1

% of bonds Life P&CNAIC 1 69.3 91.8NAIC 2 25.1 5.9NAIC 3 3.3 1.1NAIC 4 2.0 0.9NAIC 5 0.4 0.2NAIC 6 0.1 0.0

Documents

1 New York State Insurance Department Stress Testing & Other regulatory investment issues * NYIA Educational Seminar 2/12/09 Matti Peltonen Bureau Chief