The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of US insurance companies. A list of archived Capital Markets Bureau Special Reports is available via the index


 

Update on U.S. Insurance Industry Exposure to Securities Lending and Repurchase Agreements

In July 2011 and January 2012, the NAIC Capital Markets Bureau published special reports on the U.S. insurance industry’s exposure to securities lending and repurchase agreements (repos), respectively. The reports included in-depth definitions, analysis and discussion of the aforementioned investment practices. They not only discussed the U.S. insurance industry’s exposure, but also detailed how the industry treats these types of investments in terms of accounting, reporting and disclosures. To not repeat our previous research, this report provides a brief refresher regarding the definitions along with an update on U.S. insurance industry exposure as of year-end 2013. In addition, the report discusses recent accounting amendments for repos and current regulatory trends in the repo market.

 

Overview

Repos and reverse repos are economically similar to securities lending, but there are some structural differences. Securities lending is the act of loaning a bond, stock or other security to an investor in an over-the-counter market. It requires the borrower to post collateral in the form of cash or security. For most U.S. insurers, securities lending is intended to be a low-risk investment strategy. In securities lending agreements, securities borrowers typically post cash in the amount of at least 102% of the fair value of the loaned securities at the time the agreement is initiated according to Statement of Statutory Accounting Principles (SSAP) No. 103 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which, in turn, is invested by the securities lender (i.e., the insurance company). Once invested, the cash posted by insurance companies is referred to as the “reinvested collateral.” If the value of the collateral drops below 100%, then, per SSAP No. 103, the borrower is required to post additional collateral to make whole the 102%.

Repos and dollar repurchase agreements (dollar repos), are commitments whereby insurance companies initially sell securities in exchange for cash, and then they agree to repurchase the same (or substantially the same) securities back from the counterparty on an agreed-upon date at a predetermined price within 12 months, but most often overnight. In effect, repos are a collateralized short-term loan, whereby the collateral may be a Treasury security, money market instrument, federal agency security or mortgage-backed security. While all repos may repeatedly be “renewed” between counterparties, current NAIC model law, specifically, the Defined Limits Model Investment Law, and several state laws require repos to have a maturity date within one year for insurance companies in order to qualify as admitted assets (i.e., assets deemed unavailable due to encumbrances or third-party interests). Short-term repos that are renewed are considered admitted assets if other requirements are met.

Tri-party repos are the same as repos except they involve a custodian bank as an intermediary (which administers the transaction) between the two counterparties. A reverse repo is a transaction where a bank or other financial institution buys securities or another asset from a seller provided that it will resell the same securities or asset to the same seller for an agreed-upon price on a predetermined date (typically the next business day). The reverse repo is effectively the same as a repo but from the buyer’s perspective. Insurance companies engage in repos and reverse repos primarily as a short-term investment strategy and for access to low-risk cash flow.

Various factors influence why an insurer would enter into a repo rather than a securities lending agreement and vice versa. While they are both categorized as secured financings, Federal Reserve Bank of New York research suggests that repos are generally entered into when two parties prefer to interact directly with each other (rather than through an agent) or if specific collateral is desired. Repos are a common source of short-term funding for counterparties and also serve as a way to obtain specific securities. Securities lending agreements are usually completed against cash collateral, and are “used not only for short selling, but also for other borrowing transactions such as security-for-security arrangements.”

Securities Lending and Securities Lent in the U.S. Insurance Industry

Securities Lending

Insurance companies engage in securities lending to enhance returns on their investment portfolios, loaning out securities that are not actively traded. Securities lending is primarily intended to be a low-risk investment strategy, allowing insurance companies to earn a modest income through fees charged to borrowers. Within the U.S. insurance industry, limitations on securities lending programs vary by state laws. For example, in New York, securities lending is subject to general provisions of New York Insurance Law, whereby a domestic insurer may not have more than 10% of its admitted assets invested in, or loaned upon, the securities of any one institution.

As of year-end 2013, the U.S. insurance industry had an aggregate of approximately $61.6 billion book/adjusted carrying value (BACV) in investments lent under securities lending agreements (see Table 1). As expected, life companies accounted for the majority of securities lending activity because of their buy-and-hold investment strategy, at $56.2 billion BACV.

Table 1: U.S. Insurance Industry Securities Lending Activity – Year-end 2013 ($mil)

As of year-end 2013, approximately $60 billion of securities lending activity had been recorded on-balance sheet, while about $2 billion was off-balance sheet. In comparison, as of year-end 2010, there was approximately $51 billion of securities lending activity on-balance sheet and about $4 billion off-balance sheet. According to guidance in SSAP No. 103, “Collateral which may be sold or repledged by the transferor or its agent is reflected on balance sheet, along with the obligation to return the asset. Collateral received which may not be sold or repledged by the transferor or its agent [i.e. must be held and returned] is off-balance sheet.” Note that for both on- and off-balance sheet reinvested collateral, summary information is required to allow for identifying potential liquidity constraints related to any potential duration mismatches.

Table 2 below shows a breakdown of the reinvested collateral for the insurance industry’s securities lending programs as of Dec. 31, 2013. As the table shows, short-term invested assets plus cash and cash equivalents totaled 35.8% of total reinvested collateral. Corporate bonds were 19% of the total. In addition to receiving a fee on the securities lending transaction (i.e., as the securities lender), insurers also reap the return on the invested collateral.

Table 2: Securities Lending as of Dec. 31, 2013 ($ mil BACV)

About half of the reinvested collateral carried NAIC 1 designations, indicating the high credit quality, and almost 60% were considered investment grade based on both the NAIC 1 and NAIC 2 designations. A large proportion (about 39%) of the reinvested collateral did not have a designation (or the designations were unavailable). This is not a surprising trend (and not a cause for concern) given the nature of the short-term securities lending agreements.

Table 3: Securities Lending Cash Collateral Credit Quality as of Dec. 31. 2013

Disclosures Regarding Collateral and Duration

Since 2010, insurers have been required to disclose the maturity dates of the collateral (in Note 5E to the financial statements) such that the reinvested collateral is categorized into maturity “buckets.” To the extent the duration of the reinvested collateral does not match the timing with which the borrower can return the borrowed securities and demand its cash collateral back, the securities lender is required to explain additional sources of liquidity to mitigate this mismatch.

Table 4 below shows groupings of maturity dates with respect to the reinvested collateral as of year-end 2013. Most of the cash collateral (40.6%) had been invested in securities maturing in less than one year (that is, sometime in 2014), followed by approximately 25% maturing between one and four years. Reinvested collateral with maturity dates beyond 20 years includes structured securities, particularly residential mortgage-backed securities that typically have a 30-year legal final maturity date. Longer maturity dates imply longer duration for the lent securities and, therefore, a risk of higher market volatility.

Table 4: Maturity of Reinvested Collateral ($mil) as of Dec. 31, 2013

To address any mismatch in the maturity of the reinvested collateral and when a borrower can demand return of the cash collateral (as indicated in the applicable securities lending agreement), summary information is required on the duration of when the lent securities are expected to be returned to the insurance company and when the cash collateral is to be returned to the borrower. This helps identify potential liquidity constraints within the securities lending program. Securities lending agreements are often intended to be short-term in nature, and most agreements allow the borrower to return the loaned security(ies) on short notice (and at no penalty) in exchange for the cash collateral posted to the insurance company. As a result, the insurance company must be able to liquidate the reinvested collateral on short order (or find other sources of cash) to return the cash to the borrower.

In 2013, three life companies accounted for 48% of the insurance industry’s total securities lending activity as of year-end 2013, in terms of fair value of reinvested collateral. Also noteworthy: The largest life company accounted for 44% of total securities lending activity. The 10 largest life companies accounted for about 70% of the industry’s total securities lending activity. Securities lending activity for the largest life company increased to $19.0 billion in 2013 on a fair value basis from $18.5 billion in 2012. For each of these three companies, there was no significant duration mismatch between securities lending agreements and the reinvested collateral.

Securities Lent

Insurance companies lend various types of securities (i.e., securities lent) to counterparties, which consist of banks or other institutional investors. As of year-end 2013, NAIC data shows that there was approximately $80.2 billion in BACV associated with securities lent by the insurance industry to borrowers. That is, the insurance industry identified a total of approximately $80.2 billion of securities as “lent securities” in the reporting process; however, it did not necessarily lend out the full amount of each security that comprises this total. This is because insurers only lend a portion of what they receive as collateral from the counterparties. Based on data reported in insurers’ general interrogatories, approximately $59.7 billion of the total $80.2 billion in BACV associated with securities was actually lent to borrowers as of year-end 2013. The majority of securities lent activity (slightly more than 88%) occurred within the life industry.

Table 5 below shows the total $80.2 billion in BACV that was associated with securities lent by the insurance industry, grouped by bond types, as of year-end 2013. In securities lending, borrowers request to receive a specific security that covers a particular position. As of year-end 2013, approximately half of securities lent consisted of corporate bonds at 51.6%. The need to borrow securities is heavily dependent on market dynamics, including the volume of new issuance and market expectations for an asset class, as well as broker-dealers seeking to cover short positions.

Table 5: Securities Lent as of Dec. 31, 2013 ($mil)*

* Represents all securities identified by the insurance industry in the reporting process as “lent securities” and not necessarily the (smaller) loaned amount.

U.S. government bonds represented the second-largest bond type lent to borrowers, at 33.7% of the total amount of associated securities lent (or $27.0 billion), which includes U.S. Treasuries. Other government bonds comprised a much smaller proportion of securities lent, at $5.7 billion.

In terms of credit quality, as of year-end 2013, approximately 72% of investments associated with securities lent were designated NAIC 1, or the highest NAIC designation; approximately 95% of securities lent by the insurance industry were in the overall investment grade category (i.e., designated NAIC 1 or NAIC 2).

Table 6: Collateral Quality of Investments Associated with Securities Lent (Dec. 31, 2013)*

*Does not include securities lent included on Schedule DA (short-term).

With regard to maturity dates, NAIC data showed that securities that had maturities extending beyond 20 years were almost 70% of total industry securities associated as securities lent. The longer maturities imply longer duration for the lent securities and, therefore, the potential for vulnerability to market volatility. About a quarter of the securities were scheduled to mature in one to 10 years.

Table 7: Maturity Date of Investments Associated with Securities Lent (Dec. 31. 2013)

Repurchase Agreements in the U.S. Insurance Industry

Insurance companies engage in repurchase agreements (repos), dollar repos and reverse repos primarily as a short-term investment strategy and for access to low-risk cash flow. As previously published in a Capital Markets Special Report dated January 2012, when insurance companies engage in repos and dollar repos, they initially sell securities in exchange for cash, and they agree to repurchase the same or substantially the same (i.e., they have the same primary obligor; same risks and rights; same maturity; identical contractual interest rates; similar assets as collateral; and same aggregate unpaid principal amounts, as defined in SSAP No. 103) securities back from the counterparty on an agreed-upon date at a predetermined price within 12 months, but most often overnight. With reverse repos, insurance companies purchase securities from a counterparty in exchange for cash and agree to resell the same (or substantially the same) securities to the counterparty on an agreed-upon date for a predetermined price within a 12-month time frame. Similar to repos, reverse repos are also, most often, overnight transactions.

The insurance industry may also engage in dollar repos and dollar reverse repos, which are essentially the same as repos and reverse repos, respectively, except that they involve debt instruments that are pass-through securities collateralized by the Government National Mortgage Association (GNMA or Ginnie Mae), Federal Home Loan Mortgage Corp (FHMLC or Freddie Mac) and Federal National Mortgage Association (FNMA or Fannie Mae). In addition, tri-party repos involve a custodian bank or international clearing organization (the tri-party agent) as an intermediary between the two counterparties; that is, the tri-party agent administers the overall transaction, in particular collateral allocation, between the collateral holder and cash investor. The two clearing banks in the United States are JPMorgan Chase and Bank of New York Mellon.

U.S. Insurance Industry Repo Activity

Table 8 below shows the U.S. insurance industry’s approximate exposure to repo, dollar repo and reverse repo agreements as of year-end 2013. These amounts were calculated based on codes as reported by insurers in Schedule D, Part 1 and Schedule DA (long-term and short-term debt, respectively). As of year-end 2013, approximately $27.4 billion included exposure to repos and dollar repos; the overwhelming majority was with life companies. This means that insurance companies sold an estimated $27.4 billion securities related to repo agreements in exchange for cash. This amount increased from year-end 2012 (approximately $20 billion) and more significantly from year-end 2010 ($13.0 billion).

Table 8: U.S. Insurance Industry Repo/Reverse Repo Agreement Activity ($mil) – Dec. 31, 2013

Insurance companies usually enter into repos to raise short-term cash; those that engage in repos or dollar repos sell securities to a counterparty (such as a bank) in exchange for a discounted cash or collateral value (most commonly, receiving cash). The cash or collateral received by the insurer must have a fair value equal to at least 95% of the fair value of the securities sold to the counterparty. Upon the agreement’s termination — which often is overnight, although some agreements may extend longer, expiring within 12 months — the insurance company repurchases the same or substantially the same securities from the dealer at a predetermined price. According to the accounting rules within SSAP No. 103, repos are most often accounted for as collateralized borrowings; that is, the securities sold by the insurer continue to be accounted for as an investment owned by the insurer, and the proceeds from the sale are recorded as a liability. Otherwise, if certain conditions are met as described in SSAP No. 103, repos may be accounted for as a sale of financial assets and a forward repurchase commitment.

When an insurance company engages in a reverse repo agreement, it purchases securities from a counterparty (such as a bank) in exchange for cash (most often) or collateral securities. At the end of the agreement — typically one business day, although it may extend to up to 12 months — the insurance company resells the same (or substantially the same) securities at a predetermined price back to the counterparty. Reverse repos are accounted for as collateralized lendings. The amount the insurer pays for the securities purchased is considered an investment by the insurer.

Table 9 below shows a breakdown of the types of collateral securities (initially) sold by the insurance industry in connection with repo agreements as of year-end 2013. The majority — or almost 60% — were U.S. government bonds, including U.S. Treasury notes.

Table 9: Repos – Collateral Securities Sold ($mil BACV) as of Dec. 31, 2013

Not surprising, credit quality of repo collateral — included in Schedule D, Part 1 (long-term debt) — was almost entirely investment grade evidenced by the NAIC 1 and NAIC 2 designations.

Table 10: Credit Quality of Repo Collateral ($ mil) as of Dec. 31, 2013*

*Excludes amounts reported in Schedule DA

Accounting Amendments for Repos

In June 2014, the Financial Accounting Standards Board (FASB) issued an update to accounting standards related to repos and repurchase-to-maturity transactions (the latter of which are repos where the settlement date is at the maturity date of the transferred financial asset such that the repo agreement would not require the transferor to reacquire the financial asset). As written by FASB: “First, the amendments in this [u]pdate change the accounting for repurchase-to-maturity transactions to secured borrowing accounting. Second, for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement.” The amendments also include two new disclosures: ”The first disclosure requires an entity to disclose information on transfers accounted for as sales in transactions that are economically similar to repurchase agreements. The second disclosure provides increased transparency about the types of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings.” These amendments are currently under review relative to statutory accounting principles for the U.S. insurance industry.

Trends in the Tri-Party Repo Market

Since the financial crisis, the Federal Reserve has expressed concerns regarding the tri-party repo infrastructure. That is, in a distressed market, the Fed believes there would be too much reliance on the two aforementioned financial institutions (JPMorgan Chase and Bank of New York Mellon) as clearing banks, particularly if one or both were to fail. Not only would there be a major disruption to the financial system in general, but also the $1.6 trillion tri-party repo market could result in “fire sales” of repo collateral similar to events that occurred in the 2008 financial crisis. Consequently, the Fed is exploring options to expand clearinghouse services among other market participants, including other banks and qualified investors (such as mutual funds).

In addition, due in part to the Fed’s quantitative easing via bond buying, along with more strict regulatory requirements for banks, the tri-party repo market has been challenged with incomplete or failing repo agreements because desired collateral is too difficult or expensive for counterparties to obtain. In such instances, the repo borrower pays a 3% penalty. A contributing factor has also been a decline in Treasury bill supply. Agreement failures are not so much a concern regarding the status of the repo market, but more a cause for concern over future liquidity, when it will be needed. As of mid-July 2014, the Fed owned about 20% (or $2.39 trillion) of all Treasuries , with banks accounting for $547 billion in Treasuries and agency-related debt. According to Fed data, such repo failures reached as much as $197.6 billion mid-June compared to $51.6 billion in 2013, $28.8 billion in 2012 and $2.7 trillion in October 2008.

Lastly, in August 2013, the Financial Stability Board (FSB) published a report that included recommendations for addressing financial stability risks relative to both repos and securities lending. An FSB Data Experts Group (DEG) was formed “to develop FSB standards and process for global data collection and aggregation on securities financing transactions that are relevant for monitoring global financial stability risks,” according to an August 2014 FSB draft document. The DEG has been finalizing its proposed standards and expects to complete its work by the end of 2015. Impact, if any, on the U.S. insurance industry, therefore, has yet to be determined.

Summary

Reinvested collateral from securities lending agreements was $61.6 billion as of year-end 2013, and there was approximately $80 billion BACV associated with securities lent to counterparties (estimating approximately $57 billion to $58 billion actually lent based on collateralization requirements). In comparison, repos were a smaller amount of the industry’s securities financing transactions, at $27.2 billion BACV as of year-end 2013. While market risk is inherent in both securities lending and repos (that is, there is a risk of market value decline with respect to the securities purchased or sold as collateral), provisions requiring counterparties to “make whole” any deficiencies in overcollateralization mitigate this concern. Additionally, as the data shows, the majority of securities sold or purchased in these types of transactions largely consist of U.S. Treasuries or government-related securities; therefore, credit risk is minimized by the high credit quality of these investments. As added reassurance, these transactions are short-term agreements, often expiring overnight.

Consequences of the 2008 financial crisis, particularly where securities lending was involved, have resulted in more regulatory scrutiny of securities financing transactions. FASB has issued an accounting standards update (to be effective for the first interim or annual period beginning after Dec. 15, 2014) that includes new disclosures regarding information on transfers accounted for as sales for transactions similar to repos, along with requiring more transparency about the types of collateral pledged in transactions considered to be secured borrowings. In addition, a specialized group within the FSB is currently reviewing the potential for financial stability risks posed by securities lending and repos, with recommendations to follow. Neither the FASB amendments, nor the work being done by the FSB data group, has yet to impact the U.S. insurance industry.

The Capital Markets Bureau will continue to follow developments related to securities lending and repos and provide more insightful research as deemed appropriate.

Questions and comments are always welcomed. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org

The views expressed in this publication do not necessarily represent the views of NAIC, its officers or members. NO WARRANTY IS MADE, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY OPINION OR INFORMATION GIVEN OR MADE IN THIS PUBLICATION.

© 1990 - 2014 National Association of Insurance Commissioners. All rights reserved.

 


Questions and comments are always welcome. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org.

The views expressed in this publication do not necessarily represent the views of NAIC, its officers or members. NO WARRANTY IS MADE, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY OPINION OR INFORMATION GIVEN OR MADE IN THIS PUBLICATION.

© 1990 – 2016 National Association of Insurance Commissioners. All rights reserved.