Key Points
- The BMA has issued papers on collateral, liquidity and private credit that focus on these subjects in the context of asset-intensive (or funded) reinsurance for life and annuity business.
- The papers recognize the dominance of funds withheld/modified coinsurance structures and encourage their use, noting the importance of carefully drafted contractual provisions.
- The recent enhancements to the BMA’s approach to the regulation of liquidity are discussed, along with liquidity risks.
- The historic performance of private credit is considered in a positive light alongside the risks that such investments can pose.
Increased strengthening of the global regulatory landscape in the(re)insurance industry has led to a similar increase in engagement betweenregulators and those they regulate. Specifically, Bermuda continues to be anattractive choice for (re)insurers and investors alike, continuing itstransformation into one of the world’s largest specialist reinsurance markets.
In order to maintain its status as a leading venue, the Bermuda MonetaryAuthority (BMA) routinely publishes articles on its guidelines and approaches.Recently, it published papers on collateral structures, liquidity riskandprivate credit.
The papers can be regarded as a thoughtful strengthening of aspects of theBermuda regime and another step toward making Bermuda more attractive tocedent jurisdictions against a global backdrop of onshore regulatory cautionregarding the volume of asset-intensive reinsurance flows offshore.
In this update, we review the BMA’s commentary on:
- Collateralised reinsurance transactions.
- Its updated approach to liquidity risk.
- Private credit considerations for reinsurers.
In keeping with the overall theme of building a stronger regulatory regime,there is a key theme throughout: stability.
Collateralised transactions and structures are considered an effectivesafeguard by the BMA, particularly in asset-intensive reinsurance sectors suchas life and annuity reinsurance. However, the macroeconomic environment ischanging.
Reinsurers must be aware of the need to stress test their liquidity in theface of immediate shocks and access to assets, reinforcing the potentialbenefits of a properly constructed collateralised policy and warning of thedangers of a sudden policyholder lapse en masse.
It is not coincidental that these three papers were published at more or lessthe same time.
The BMA notes in the papers that despite the risks and rewards of variousfinancing methods, its approach to governance is through the lens of keyprinciples, notably the prudent person principle (PPP), in which (re)insurersmust be confident in their internal governance procedures to ensure thatunavoidable or unforeseeable events can be risk-managed appropriately.
Collateralised Reinsurance Transactions in the Bermuda Long-Term InsuranceMarket
For long-term asset-intensive reinsurance for life and annuity business (alsoknown as funded reinsurance), the BMA has noted that collateralised structuresmay be an effective and significant safeguard for cedents and their underlyingpolicyholders and beneficiaries.
The BMA’s Experience With Collateralised Reinsurance Transactions
The BMA’s experience has been that the use of contractual mitigation tools incollateralised long-term reinsurance transactions, such as funds withheld(FWH) and modified coinsurance (ModCo) structures, have significantlydecreased an insurer’s counterparty credit risk exposure to Bermudianreinsurers.
The BMA highlights that where collateral is not ring-fenced into a segregatedcustody account subject to legal limits or placed in an equivalent structure,the following risks and concerns are more likely to materialise:
- The cedent will have little to no — or limited — legal control, ownership, visibility or influence over the underlying assets.
- The reinsurer will be able to deal with the assets, subject to treaty and regulatory standards, without input from the cedent.
- The cedent will rely on the reinsurer for the receipt of claim payments, even in periods of financial stress.
- The cedent risks a reinsurer default on the value of the assets required to satisfy policyholder obligations.
To mitigate such risks and concerns, the BMA recommends that parties rely oncontractual mitigation tools that allow the cedent to exercise control overthe collateralised assets. The BMA’s approach is in keeping with its findingsthat FWH and ModCo structures have become increasingly popular in the Bermudalife reinsurance market.
Examples of robust contractual mitigation tools the BMA has encounteredinclude binding and enforceable limits and investment guidelines between theparties, the inclusion of covenants in reinsurance treaties that constrainreinsurers’ asset liability management, and the following, which are ofparticular importance:
- Retention of legal title to the assets by the cedant: The BMA notes this as one of the strongest tools to ensure the cedent’s participation in asset management decisions taken with respect to the underlying assets. Considering the level of collaboration the BMA expects between cedents and reinsurers in managing collateralised assets, the BMA will, as part of its onsite review process of insurers, survey governance arrangements between the parties and relay its findings to the reinsurer (and, where concerns are identified with an overseas cedent, to the cedent’s regulator).
- Custody or trust accounts: Policyholder obligations may exceed the value of the assets used as collateral, in which case the reinsurer must “top up” the custody account. Where assets are held in the cedent jurisdiction, the cedent has ease of access to the premiums of its underlying policies and any other collateral assets. The Bermudian reinsurer will assume the risk of “topping up” the relevant collateral account if the assets are insufficient. However, under the custody or trust structure, the cedent’s risk of defaulting on policyholder obligations is minimised, as the cedent has recourse to the collateral if the reinsurer fails to “top up” the account and may already be in possession of sufficient assets to fulfil policyholder obligations (if there is overcollateralisation). It should also be noted that the Bermudian reinsurer may conversely benefit where the assets held are more than required and, upon expiry of the reinsurance, there will be a release of assets to the reinsurer — though some would say this is economically inefficient.
The BMA’s Guidance on Bolstering Long-Term Collateral Structures
Despite the BMA’s encouragement of contractual mitigation tools for long-termreinsurance, it notes that such tools are not foolproof. The BMA will morereadily grant transaction approval for structures that have:
- Robust design and contractual safeguards: Cedents and reinsurers should have strong and mature risk management systems. Those systems must, at a minimum, be capable of identifying and mitigating emergent risks. The BMA will usually withhold transaction approval to reinsurers who have weak management systems or outstanding supervisory or compliance concerns. The BMA views parties with weak or insufficient systems in place as problematic, as it creates problems for the BMA-supervised reinsurer.
- High-quality assets as collateral: Collateral should be appropriately liquid. Parties wishing to hold affiliated assets must now obtain BMA approval, which will entail meeting a “significantly high bar.” Any assets held must also adhere to long-standing Bermuda regulatory requirements, namely the PPP and the Bermuda Solvency Capital Requirement (BSCR), and the ceding jurisdiction’s laws.
- Effective implementation measures: Cedents and reinsurers should have specialist in-house compliance teams to monitor and report frequently on their reinsurance obligations. Cedents should not use as collateral assets outside of their internal compliance team’s expertise, and a reinsurer should review a cedent’s proposed assets to secure compliance with the relevant investment guidelines and regulatory requirements.
In summary, the BMA views collateralised reinsurance structures as animportant safeguard insofar as asset-intensive business is concerned. Suchsystems have proved effective and secure. They are viewed as sufficiently“tried and tested.” The BMA recognises that such systems are not withoutvulnerability, but this can be mitigated by strong governance and improvedinternal risk identification and management systems. Such measures are viewedas robust and delivering the level of protection for which they were designed.
An Updated Approach to Liquidity Risk
Liquidity risk is the risk that a company may not have sufficient liquidassets to meet its cash flow or collateral obligations as they fall due forpayment. As a result of investments in alternative assets, rising interestrates and a regional banking crisis in the United States, the BMA identifiedliquidity risk management as a key regulatory focus area.
For Bermuda’s long-term insurers (BLTIs), liquidity risk typically emergesfrom mismatches in timing between asset and liability cash flows. Long-terminsurers generally hold illiquid liabilities that position them to be moreresilient to liquidity risks.
We examine below the BMA’s analysis of liquidity risk in the Bermuda long-terminsurance market.
Bermuda’s Long-Term Insurance Market
BLTIs maintain diversified investment portfolios, including a high proportionof liquid assets such as cash, corporate bonds and sovereign securities. As aresult, BLTIs have high liquidity coverage ratios, indicating their ability tomeet liability cash flows in stress events.
Similarly, the structure of Bermuda’s long-term insurance market itselffurther supports the industry’s resilience toward liquidity risks: The bulk ofBermuda’s long-term reinsurance market covers US reinsurers who typically levysubstantial surrender charges for policy lapses. Such charges may act as astrong disincentive to policy surrenders and therefore limit the impact onliquidity risk.
The BMA’s Approach to Liquidity Risks
The BMA has reviewed its regulatory framework for BLTIs, introducing aholistic framework including higher reporting requirements, increased focus oninsurer-specific stress tests (as required in the Commercial Insurers’Solvency Self-Assessment (CISSA), akin to a Solvency II Own Risk and SolvencyAssessment, or ORSA) and a renewed commitment to onsite BMA inspections.
The key features of the regulatory framework are as follows:
- Liquidity targets: The BMA mandates insurers to maintain a liquidity buffer consisting of sufficient highly liquid assets to cover unexpected cash flows under severe stress conditions. The threshold is set at a 105% liquidity coverage ratio (LCR), which requires insurers to hold a higher proportion of available liquid assets than the potential surrender amount due under a severe stress event.
- Regulatory stress testing: Policyholder behaviour is fundamental in determining liquidity risk; insurers are required to conduct stress testing to demonstrate their ability to withstand severe situations in which policyholders surrender where possible en masse, causing substantial cash outflows. Insurers must include stress test outcomes to the BMA in their mandatory annual filings.
- Internal stress testing: Companies are required to perform internal liquidity stress tests, aimed at assessing the impact of each individual company’s specific risk factors.
- Liquidity risk management programs: Each insurer’s board of directors must approve risk management programs entailing a clear delineation of responsibilities and annual reviews. Insurers are encouraged to continually review economic conditions, interest rates and market sentiment to adjust their liquidity management strategies.
The Impact of the BMA’s Updated Guidance on BLTIs
Despite their overall resilience to liquidity risks, some BLTIs still faceliquidity shortages under stress scenarios. The BMA closely manages suchinsurers through company-specific onsite inspections, targeted sectorwideassessments and the CISSA process.
The key drivers of liquidity risk for BLTIs include:
- Holding excessive illiquid assets.
- Adverse market conditions, such as interest rate increases.
- Reinsurer defaults.
- Shortfalls in new business.
- Challenges in meeting urgent short-term liquidity needs.
As policyholders seek to take advantage of high interest rates elsewhere insearch of better returns, liquidity risk increases proportionally. In the2020-2023 period, there was a noted upward trend in surrender payments as aproportion of new premiums. In addition to usual economic penalties, time wasalso a crucial factor: The more quickly a policyholder could access theirfunds, the more likely the BLTI would be to need to engage in a rapiddistribution of assets to meet its policy obligations.
The BMA highlights the advantage of increasing the time delay in order toensure that the sale of assets may be spread evenly and appropriately.Nonetheless, a 2023 BMA survey revealed that most BLTIs successfully navigatedthrough this period of rising policy lapses.
In summary, the BMA is satisfied with the resilience of BLTIs in the event ofliquidity-related shocks, and the Bermuda industry has demonstrated robustnessin recent years in an increasingly uncertain macroeconomic environment.
Insurers are encouraged to continue to stress test their liquidity riskroutinely, particularly in light of increasing policy lapses, in order toensure long-term stability and preparation to navigate liquidity challenges,safeguard policyholder interests and maintain market stability.
An Assessment of Private Credit for (Re)insurers
As a result of an increase in investors (including insurers) turning toprivate credit in search of higher yield, the BMA has reported on the benefitsand risks associated with investments in private credit for BLTIs. In thisupdate, we refer to “private credit” as meaning direct loans (includingleveraged loans), collateralised loan obligations (CLOs) and private debtplacements.
Despite the allure of higher yields and low rates of credit loss, the BMAnotes that prevailing private credit trends create material tradeoffs andpotential risks for BLTIs.
Private Credit’s Historical Track Record
Private credit’s historical track record has been favourable in thelow-interest, more high-covenant (although see below) environment since the2007-09 global financial crisis. However, as the global economy rebounded inthe wake of the pandemic and interest rates surged globally, the BMAunderscores that in relation to private credit asset classes, there areforward-looking considerations that cannot be accurately captured in thehistorical data.
Historically, relative to comparable public debt investments, investments inprivate credit have resulted in:
- Higher yields: Private credit allows investors to capture an “illiquidity premium” — the difference between the yield of a private debt investment as compared to the yield of a theoretical, otherwise identical, public debt investment. The illiquidity premium arises from the compensation demanded by investors for taking on risks, such as illiquidity and complexity risks. In the context of insurance in Bermuda, the premium is delivered by insurers’ application of discount curves provided by the BMA.
- Lower rates of credit loss and higher recovery rates: Direct loans have significantly lower rates of credit loss and higher recovery rates relative to comparable public debt investments, especially throughout macroeconomic periods of financial distress. Similarly, CLOs have yielded minimal credit losses since 2008.
Nonetheless, private credit investments pose inherent risks for (re)insurers,namely:
- Illiquidity risks: Private credit investments have long-term horizons that may exceed those of an insurer’s corresponding funding sources. Accordingly, mismatched investments may jeopardise an insurer’s ability to adhere to capital and liquidity requirements mandated by the BMA.
- Valuation risk: The balance sheet value of private credit investments may materially deviate from their fair value, as there are no readily available trading values through which to observe valuation. Overvaluation of private credit investment values on an insurer’s balance sheet can compromise their compliance with the BSCR and result in denial of regulatory approvals.
Prevailing Trends and Future Risks
Whereas BLTIs may be attracted to investing in private credit, the BMA’sanalysis of trends and future risks in the space suggests insurers should bemore risk-averse than expected.
Specifically, the BMA notes that private credit assets may be “untested” inadverse market conditions. For instance, newer CLO structures have not beentested under severe financial crisis conditions. Internationally, variousorganisations (including the BMA) continue to scrutinise such structures.
In addition, insufficient lender protections may increase credit loss ratesand lower recovery rates. Excess demand for leveraged loans has resulted inso-called “covenant-lite” loans that include fewer lender protections.Likewise, such loans include more borrower-friendly terms while the borrowersthemselves continue to take on increasing amounts of leverage, exacerbatingdefault risks.
The BMA’s Guidance for Insurers Investing in Private Credit
The BMA views (re)insurers’ investments in private credit through the prism ofthe PPP, which provides that an insurer “may only assume investment risks thatit can properly identify, measure, respond to, monitor, control and report,”taking into account its capital and liquidity requirements.
In order to adhere to the PPP, (re)insurers investing in private credit shouldconduct regular bottom-up stress testing and scenario analysis.
The BMA further emphasises that, from a liquidity standpoint, long-terminsurers with illiquid liabilities are most suited to private creditinvestments, and liquid liabilities should not be used to fund theseinvestments. The BMA expects that insurers will conduct thorough CISSAs andadhere to the aforementioned liquidity risk management programmes andpractices when holding private credit investments.
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.
