NAIC 2022 Summer National Meeting
Global Insurance Solutions
Regulators propose a significant overhaul of the regulatory treatment of collateralized loan obligations (CLOs)
Schedule D bonds – Regulators address comments received on the principles-based bond accounting proposal
New reporting requirements to provide more transparency into the nature of insurers’ related party relationships
Guidance amendments adopted for principal-protected securities to include alternative structures that pose similar risks
CLOs – Regulators propose significant overhaul of regulatory treatment
The VOSTF plans to overhaul the regulatory treatment of CLOs, instituting a modeling framework to assign NAIC Designations in an approach that would be similar to the current approach for residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). The goal of the project is to:
Move CLOs away from a reliance on rating agency ratings. Currently, CLOs are eligible to use the filing exempt process, which allows insurers to use NRSRO3 credit ratings for determining NAIC Designations, and thus RBC charges.
Eliminate the risk-based capital (RBC) arbitrage that exists from holding CLO tranches versus holding the underlying collateral pool directly.
The expectation is that once the proposed changes have been adopted, certain CLO tranches will carry higher RBC charges than the equivalent NRSRO rating currently assigns.
Industry participants that submitted comment letters for regulator review highlighted their concerns with this potential change, including impacts on the CLO market, the need for change considering that senior CLO tranches have performed extremely well during several economic downturns and the timeline for when the change would be implemented.
Regulators provided responses to the industry’s concerns, acknowledging the benefits of CLOs, while also stating a desire to ensure that aggressive structuring within the CLO market doesn’t add more risk to insurers’ balance sheets.
Any regulatory changes adopted by VOSTF will need to be coordinated with the Risk-Based Capital Investment Risk and Evaluation Working Group (RBCIREWG), as VOSTF is also requesting new RBC factors set at 75% (NAIC 6.B) and 100% (NAIC 6.C) that would be applied to lower tranches, particularly CLO equity tranches.
Regarding timing, regulators are targeting a year-end 2024 implementation, which would allow for opportunities to gain input from the industry and coordinate with other regulator groups on guidance language, reporting changes and RBC treatment.
Principal protected securities (PPS) – Guidance revisions to capture alternative structures within PPS guidance
The SVO has adopted edits to its PPS definition to include alternative structures that didn’t fit cleanly into the current definition but pose similar risks. These alternative structures are separate from the typical special purpose vehicle (SPV) issued notes and can include issuer obligations that depend on other non-Schedule D-1 assets to satisfy contractual payment obligations. The guidance also clarifies that while some securitizations, such as CLO combo notes, are PPS, other securities, such as defeased or pre-refunded securities and broadly syndicated CLO/ABS securitizations, will not be considered PPS.
The SVO to clarify its role in interpreting and making accounting and reporting determinations
To clarify its role in interpreting accounting and reporting guidance, the SVO is amending its guidance to clarify that:
The SVO can assign NAIC Designations to investments that it does not think are eligible for Schedule D or Schedule BA reporting so long as it has the methodology to do so.
The SVO has the authority, at its discretion, to notify the appropriate regulators of any investments that, in its opinion, would not or might not be eligible for reporting on Schedule D or Schedule BA.
The SVO would also maintain its authority to offer its accounting and reporting opinion, when requested to do so, with it being understood that such opinions would not be authoritative and might not reflect the opinion of the relevant state regulator.
RMBS/CMBS price breakpoints to be expanded due to the adoption of the new bond RBC factors
Due to the 2021 expansion of the bond RBC factors from six to 20 factors, additional price breakpoints are being added to retain consistency for financially modeled RMBS/CMBS. This will also ensure that these securities can be mapped to the most appropriate NAIC Designation category.
Exposed Items, to be further considered
SVO looks to add additional market data analytics for securities within its scope
To assist regulators by providing additional or alternative ways to measure risk, particularly for private and customized securities, the SVO is proposing to collect various analytical measures4 on Schedule D-1 securities and Schedule BA holdings where the SVO performs risk assessments. The additional data provided to the SVO would also be an important step in the NAIC finding ways to reduce its increased reliance on rating agency ratings.
Currently, the SVO is considering two possible approaches – one where the NAIC produces the analytics, and another where insurers provide the analytics. Because of the pros and cons of each approach, regulators are weighing which method would be best, considering the inherent variability within the analytics, along with the potential cost and resources needed to implement a change of this magnitude.
Securities with “other non-payment risks” – Clarifying guidance amendments
A revised amendment is being proposed to update the definition for securities that possess “other non-payment risks5,” which are assigned a subscript of “S” with their NAIC Designation. The SVO will address these securities in two parts: 1) an update to the definition to provide clarity on when non-payment risks exist and 2) make securities with other non-payment risks ineligible for the filing exemption.
For the second part, the SVO will defer making a change to the filing exemption guidance while working through issues on specific situations pertaining to maturities equaling or exceeding 40 years and certain deferred principal or interest payment features.
Investment RBC Updates
Regulators to prioritize new projects on new capital charges for CLOs
The RBCIREWG detailed plans to place its initial focus on two RBC projects covering CLOs. The first is to develop new RBC factors for all CLO tranches – this will be a long-term project. The second will be to develop an interim solution to address CLO RBC arbitrage until the long-term project can be completed. This also includes plans to address the RBC treatment of residual tranches for all securitizations more broadly. The effective date the interim projects are likely to target is a year-end 2023 implementation, with the long-term CLO project extending out further to accommodate the need to collaborate with the American Academy of Actuaries and other regulator working groups.
Asset valuation reserve (AVR) factors updated to correspond with expanded RBC bond designation categories
To account for the expanded bond RBC factors, life insurance regulators have adopted corresponding changes to AVR that expand the basic contribution, reserve objective and maximum reserve factors. This change was necessary due to AVR’s direct relationship to the post-tax bond capital charges. The changes will be effective for year-end 2022.
Statutory Accounting Updates
Schedule D bonds – Regulators address comments received on the principles-based bond proposal (Ref #2019-21)
After an extended comment period, which allowed the broader insurance industry to respond to the latest version of the proposed bond definition6, regulators have summarized their responses to the industry’s concerns on various elements of the proposal, which include:
U.S. Treasury Inflation-Protected Securities (TIPS) – A revised guidance footnote will be added clarifying why TIPS are included in scope as a SSAP 26 issuer obligation and Schedule D bond.
SVO-identified credit tenant loans (CTLs) – Regulators confirmed that SVO-identified CTLs7 will be included as Schedule D bonds, as they are being scoped in, as opposed to qualifying under the principles-based bond definition.
Stated interest and additional returns – A key element of the proposed bond guidance is the analysis of the interest component. Under the guidance, all returns in excess of principal repayments should be considered interest, as certain structures could have a stated interest rate, while also including a variable component that can add significant additional returns (e.g. principal protected notes). Within the industry’s comments was a request that this “stated interest and additional returns” language be restricted only to equity-backed ABS. Regulators disagreed, stating that this language should apply to non-equity-backed ABS structures also, as the analysis of whether a structure is a bond in-substance will need to consider all sources of potential return. Therefore, no revision to the proposal is expected.
First loss tranches – Within the industry’s comments was a request to allow first loss tranches on Schedule D-1, if there was substantive credit enhancement, such as overcollateralization. Regulators disagreed with this recommendation, stating that residual tranches are not permitted on Schedule D-1, regardless of any potential overcollateralization of the collateral assets to the total debt issuance. But to minimize confusion, regulators are proposing a guidance revision to clarify its stance (contractual principal and interest payments and substantive credit enhancements are required to qualify for Schedule D-1). Residual tranches will, in all instances, be reported as Schedule BA assets.
Feeder funds – Within the industry’s comments was a recommendation that language be added regarding feeder funds to explicitly allow insurers to look beyond their equity interest in the feeder to the secondary fund and determine what is held, in-substance, by the secondary fund. If the secondary fund holds debt instruments, then the issuance from the feeder fund would be considered debt and not an equity-backed instrument. In support of that notion, regulators will incorporate language that clarifies how feeder funds shall be assessed under the principles-based bond definition for inclusion on Schedule D-1.
ABS as short-term investments – Remarks from some in the industry have questioned the restriction of ABS from being reported as short-term bonds on Schedules DA and E-2. Regulators are not supportive of short-term reporting for ABS for reasons that include:
Schedule D-1 will have the transparency regulators are looking for once the proposed granularity is added, which is being worked on in parallel with the revised bond definition. Schedules DA and E-2 are currently not included as part of this project.
ABS customization could lead to securities intentionally designed with shortened maturities (or rolled maturities), thereby bypassing guidance put in place for Schedule D-1 bonds.
Regulators will require that all ABS (if eligible for Schedule D reporting), regardless of maturity, be reported on Schedule D-1. This would include securities, such as asset-backed commercial paper, which may have short maturities but are often backed by physical assets or high-risk loans.
Single-borrower securities backed by secured loans – One request from the industry expressed a desire for secured loan structures issued in security form be in scope of SSAP 26R as issuer credit obligations. If reported as SSAP 26R bonds, no further analysis would be required to receive Schedule D-1 bond treatment. Regulators disagreed with this notion, as there could be several types of secured loan SPV or lease structures that could be reported as bonds without the proper analysis required by the bond proposal to support that treatment (i.e. credit enhancement/meaningful cash flow analyses). Issuer obligations are required to be primarily supported by the general creditworthiness of an operating entity. These secured loan structures, as defined within the comment letters, are structures that pass through cash flows. That feature results in them being the type of securities that the bond proposal is attempting to address with its revised accounting guidance. Regulators are not suggesting changes to the proposal to accommodate these secured loan structures. But because of the more favorable treatment received by similarly structured securities, such as municipal revenue bonds and project finance bonds, regulators are willing to refine the guidance to add clarity on which structures would be reported as issuer obligations.
Bonds that move from Schedule D-1 to Schedule BA – There will be certain securities that no longer qualify for Schedule D-1 bond and will need to move to Schedule BA. Regulators are set to draft measurement-related guidance to address the treatment for Schedule BA bonds. There may be certain bonds, such as equity-backed structures, where fair value measurement is appropriate, while there may be others, such as pass-through structures, where amortized cost is more appropriate.
New Markets Tax Credits – It is expected that debt instruments issued by Certified Capital Companies8 (CAPCOs) will continue to be in scope of SSAP 26R bonds and be reported as Schedule D-1 bonds. The New Markets Tax Credit (NMTC) program is a similar federal-based program that incentivizes community development and economic growth through the use of tax credits to attract private investment to distressed and low-income communities. The main difference between the programs is that CAPCOs benefit from state tax credits and NMTC programs benefit from federal tax credits. Therefore, regulators support NMTC debt investments qualifying for Schedule D-1 reporting and will consider new NMTC guidance as a separate agenda item.
Regulators have also released reporting schedule changes to Schedule D, which will include a split within Schedule D-1 for issuer credit obligations (Section 1) and asset-backed securities (Section 2). The changes will also incorporate significant increases in granularity within the statutory reporting of bond investments.
As a follow-up, regulators will release a revised bond definition and issue paper and suggested schedule changes, along with updated SSAP guidance for a comment period ending October 7.
Related party reporting (Ref #2021-21)
Guidance revisions were adopted to institute new requirements for identifying related party/affiliate relationships, which includes a look through of affiliated investment structures and new reporting disclosures. The new related party requirements will force insurers to highlight various relationship scenarios, regardless of whether the investment is captured on an “affiliate” reporting line, and detail the nature of the relationship.
Via new reporting codes, each quarterly and annual statement investment schedule will detail whether the following exist:
A direct creditor relationship between the insurer and the related party via a loan or investment.
Securitizations or similar investment vehicles (such as mutual funds, limited partnerships and limited liability companies) involving a relationship with a related party as sponsor, originator, manager, servicer or other similar influential role. Also included will be vehicles in which the structure reflects an in-substance related party transaction even if it doesn’t involve a relationship with the related party.
The new disclosures, which become effective for year-end 2022, will provide added transparency into the nature of insurers’ related party relationships, which has been a regulatory focus in recent years, primarily due to increased exposures to limited partnerships, CLOs and other customized, structured securities in certain corners of the insurance industry.
Derivatives and hedge accounting – Regulators adopt targeted improvements to the accounting for hedging activities (Ref #2021-20)
Because of recent changes9 to U.S. GAAP on derivatives and hedging, regulators have adopted statutory revisions to minimize guidance differences and retain consistency between statutory accounting and U.S. GAAP.
The adoption will update the supporting documentation and applicable language in SSAP 86, which includes:
The assessment of hedging effectiveness – This change will ensure that transactions identified to be highly effective hedges under U.S. GAAP would also be identified as highly effective hedges under statutory accounting. SSAP 86 has reference guidance that has not been meaningfully updated since its original issuance (and as a result, includes outdated U.S. GAAP guidance10). U.S. GAAP for derivatives has gone through several changes over the years, resulting in the need to have corresponding statutory revisions.
Measurement of excluded components in hedging instruments – Supporting documentation within SSAP 86 addresses components permitted to be excluded when determining hedge effectiveness. The revised guidance addresses the treatment for:
Foreign currency forward contracts that have a premium/discount – the premium would need to be amortized into income over the life of the contract or hedge program.
Foreign currency swaps with a cross-currency basis spread – fair value changes shall be reflected as a component of the foreign currency swap’s periodic interest accrual.
All other excluded components – the excluded component shall be measured and reported at fair value, with changes in fair value recognized as unrealized gains or losses. Any unrealized gain/loss shall be realized as the derivative transaction is closed out.
The effective date of the changes is January 1, 2023, with early adoption permitted.
Freddie Mac “When-Issued K-Deal” (WI Trust) Certificates (Ref #2022-08 / INT 22-01T)
Guidance revisions have been adopted to clarify that investments in the Freddie Mac WI Program are to be reported as bonds from initial acquisition, in scope of SSAP 43R. WI Trust certificates are bonds where the cash proceeds from the bond purchase are used to secure newly issued K-Deal Certificates (i.e. Freddie Mac fully guaranteed structured pass-through certificates). Questions were initially raised as to what the appropriate accounting treatment should be for WI certificates prior to the delivery of the K-Deal Certificates, which typically occurs within 90 days of settlement.
Exposed Items, to be further considered
Fair value hedging – Portfolio layer method and partial term hedges (Ref #2022-09)
Under U.S. GAAP, guidance changes were adopted in 2017 that made hedge accounting more accessible for portfolios of prepayable financial assets. The revisions also included changes that permitted partial term hedging, allowing fair value hedges of interest rate risk that only covers a portion of the term of the hedged financial instrument. The changes were in response to the difficulties companies had getting their interest rate hedges to qualify for hedge accounting. Additionally, recent U.S. GAAP adoptions in 2022 expanded the scope of the hedge accounting guidance to include:
Hedges of multiple layers are allowed for a single closed portfolio (in what is now known as the “portfolio layer method”). Previously, only one hedged layer was permitted for a single portfolio of assets (formerly referred to as the “last-of-layer” method).
Non-prepayable assets can be included in a hedged closed portfolio.
Eligible hedging instruments in a single-layer hedge may include spot-starting or forward-starting constant-notional swaps or spot-starting or forward-starting amortizing-notional swaps. Also, the number of hedged layers (single or multiple) should align with the number of hedges designated.
Statutory accounting regulators have exposed guidance edits to incorporate aspects of the U.S. GAAP guidance for portfolio hedges and partial term hedges into SSAP 86. One statutory-specific limitation is that the proposed hedge accounting methods will only be applicable to assets and will not be permitted when hedging liabilities.
Related party exemptions – Foreign open-end funds (Ref #2022-13)
Recently adopted guidance pertaining to related parties (see above: Related party reporting) clarified that investments in ETFs and mutual funds do not reflect ownership in an underlying entity, regardless of the ownership percentage an insurer has, unless that ownership results in “control” with the power to direct the activities of an underlying company. Regulators are proposing similar provisions be extended to foreign open-end funds that are within the scope of SSAP 30R—Unaffiliated Common Stock. This would exempt these investments from the look-through provisions required by SSAP 25.
Collateral loans (Ref #2022-11)
To address any inconsistencies regarding the collateral loan guidance in SSAP 20—Nonadmitted Assets and SSAP 21—Other Admitted Assets, regulators are proposing guidance edits to clarify that the assets pledged as collateral for admitted collateral loans must also qualify as admitted invested assets.
1 Valuation of Securities Task Force
2 Securities Valuation Office
3 Nationally Recognized Statistical Rating Organization
4 The proposed data points include market yield, market price, purchase yield, weighted average life, spread to average life UST, option-adjusted spread, effective duration and convexity.
5 Other non-payment risks are typically associated with contractual agreements between an insurer and the issuer in which the issuer is given some measure of financial flexibility not to make payments that otherwise would be assumed to be scheduled, given how the instrument has been denominated or where the insurer agrees to be exposed to a participatory risk.
6 The principles-based bond definition refers to the Statutory Accounting Principles Working Group project that will redefine what is eligible for reporting as a bond on Schedule D-1.
7 SVO-Identified CTLs are mortgage loans that qualify for bond treatment after receiving a SVO structural assessment.
8 A certified capital company is a state-legislated venture capital firm that can be a partnership, corporation, trust or limited liability company, profit or not-for-profit and which may capitalize itself in a variety of ways. Investors who acquire an equity interest or qualified debt instrument from a CAPCO receive state premium or income tax credit
9 In 2017, the FASB issued Accounting Standard Update 2017-12: Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities to reduce complexity and align hedge accounting with risk management activities.
10 Back in 2009, to simplify its guidance structure, FASB began to transition to the current Accounting Standards Codification (ASC) and away from its previous structure, which referenced older derivative guidance such as FAS 133, Accounting for Derivative Instruments and Hedging Activities.