Growth in BA Assets Brings Higher Yields and Regulatory Risk – a Primer

While the U.S. interest rate environment has remained at historic lows over the past 30 years, insurance companies have increasingly turned to non-traditional investments (alternative investments) – those that typically are reported on Schedule BA  (“BA Assets”) of the statutory quarterly and annual statements – to boost yield and build their portfolios.

These higher-yielding investments – typically in private equity interests, hedge funds, and real estate, among other instruments – can produce yields of 10% or more, compared with the 2% and 3% yields generated by traditional bonds in recent years.

However, these higher-risk, higher-yield investments are also generally illiquid and may fall outside the guard rails of state regulations that strictly limit how much of an insurance company’s investments can be “BA assets.” Typical limits are around 5% of total assets or a percentage of statutory surplus.

BA assets are not bad, but they must be watched, particularly now, as insurers seem to be adding them to their investments at an increasing rate as the U.S. is encountering a rapid increase in Fed-induced interest rates.

Industrywide, exposure to long-term BA assets continues to rise, according to a report by the National Association of Insurance Commissioners (NAIC). At year-end 2021, total exposure had increased by nearly 15% from the prior year to a total of $522.8 billion. This marked the third consecutive year of double-digit year-over-year growth.

While the NAIC report noted that the significant growth in BA assets did not likely represent a material risk in a stressed environment with the overall concentration at 6.5% of total cash and invested assets, the report did observe that the concentration was growing. Moreover, the NAIC is currently engaged in a “Bond Project,” which will ultimately redefine what qualifies as a bond. Some items that no longer qualify as bonds will fall into the BA asset category, which could threaten to raise the percentage of BA assets above that allowed by state regulations for some insurance companies.

The bottom line is that the level of risk posed by a concentration of BA assets may not be fully recognized by insurance company leaders, as this sector of the investment realm involves a different level of investment sophistication. Today’s rising interest rate environment could influence some of that risk as investment managers find the climbing yields available with newly issued traditional bonds more attractive.

But state regulators have been watching closely as the industry reacts to a changing environment. In the risk-based capital environment, BA assets get a larger capital requirement in terms of what companies must set aside – reaching potentially 30%, of asset carrying value, as opposed to traditional bonds, which might require a 0% to 2% RBC charge. Companies pay an RBC premium for having BA assets on the books.

Schedule BA Reporting

One of the key challenges of Schedule BA asset reporting is ensuring that the reported values are accurate and reliable. Insurers must use appropriate valuation methods and accounting standards to ensure their reported values are consistent with market conditions and regulatory requirements. In addition, insurers must maintain detailed records and documentation to support their reported values and ensure they can be audited and verified by regulators.

Several types of assets may be included in Schedule BA, including fixed-income securities, equities, real estate, and other types of investments. Each of these assets must be valued and reported in accordance with specific accounting standards and regulatory requirements. For example, partnerships must be valued based on separate independent GAAP audits of the specific partnership entities.

In addition to providing detailed information about an insurer’s assets, Schedule BA asset disclosure reporting also includes information about the insurer’s investment strategy and risk management practices. For example, insurers may be required to disclose their investment guidelines, risk tolerance levels, and other relevant information that can help regulators to evaluate the insurer’s overall risk profile.

Another important aspect of Schedule BA asset reporting is the need to record any impairments or losses on assets. If an asset’s value has declined significantly, the insurer may need to recognize an impairment loss on the asset, which will affect their reported financial results. Schedule BA assets can be complicated to periodically value due to their illiquid nature. As noted, the statutory standard of annual valuation typically involves audited GAAP equity of the BA asset entity. This may or may not substantiate the true underlying collateral. Accordingly, corporate boards and audit committees should be particularly inquisitive of these assets to their internal and external investment managers.

Monitoring Your Schedule BA Asset Program

Over the past decade, the growing interest in BA asset investments has necessarily sharpened auditors’ attention on insurers’ asset portfolios. BA investments require more detailed auditing procedures and, therefore, expand the amount of time an audit takes as well as the amount of documentation the insurer must provide.

Insurance company leaders should consistently monitor the changing market forces and interest rate impacts on investments and must receive clear and consistent communication from their investment managers as to the investments in BA assets. In addition:

• Make sure you are getting the proper audit. BA assets must be independently audited in order to maintain an admitted asset status for statutory reporting purposes.
• Perform asset and liability matching analysis regularly to determine comparability with maturing liabilities.
• Understand specifically what you have in BA assets and make sure the company is meeting state regulatory requirements.
• Pay close attention to interest rate fluctuations and the actions of the Federal Reserve Board.
• Review traditional investments to rebalance your portfolio.
• Clearly understand that in many instances there will be material tax-basis carrying value differences versus traditional statutory book accounting due to the nuances of partnership tax rules. This will substantially increase tax preparation services.