A guide to fixed income ETF – NAIC statutory accounting and capital treatment
The potential benefits of systematic valuation and the additional portfolio flexibility that exists due to the new RBC factors
Statutory accounting treatment for fixed income ETFs
National Association of Insurance Commissioners (NAIC) statutory accounting guidance allows certain exchange-traded fund (ETF) investments to be reported as bonds, subject to an assessment and subsequent approval by the Securities Valuation Office (SVO). This allows a SVO-identified fixed income ETF to be carried on a balance sheet as a bond on Schedule D – Part 1. Once approved by the SVO, a credit quality-based NAIC Designation is assigned that will determine the ETF’s statement carrying value (Exhibit 1).
Fixed income ETFs can be carried and reported at either fair value, usually the ETF’s net asset value, or systematic value (SV), an aggregate cash flow valuation methodology that produces a bond-like accounting treatment. For life insurers, SV is permitted for fixed income ETFs rated NAIC 1 through 5. For P&C and health insurers, SV is allowed only for investment grade ETFs, those rated NAIC 1 or 2.
Exhibit 1: Insurers often have a choice how to treat fixed income ETFs on their balance sheets
Once chosen, SV is an irrevocable election1 that allows fixed income ETFs to be carried at a valuation that is similar to amortized cost and eliminates market volatility from carrying value. Hence, electing SV tends to lead to significantly less accounting volatility than fair value (Exhibit 2).
Exhibit 2: SV generally leads to less accounting volatility
Illustrative example of fair value vs. SV statutory carrying value of an ETF purchased at $100
Investors looking to carrying ETFs using SV need to attain certain data and cash flow information from the ETF’s provider (Exhibit 3). These inputs are used to calculate the monthly effective interest which, when netted against the ETF’s monthly distributions, produce the monthly change in SV (Exhibit 4).
Exhibit 3: Data required to calculate SV
Exhibit 4: Illustrative example of how SV works
Opportunities for life insurers, following recent RBC changes
Because SVO-approved fixed income ETFs can be treated as bonds, they are also eligible to receive bond capital charges. This has been a key factor in the broader adoption of fixed income ETFs by insurance general account investors, and it provides additional flexibility for insurers to manage their bond allocations. Further, with the adoption of the new bond risk-based capital (RBC) charges for life insurers (Exhibit 5), fixed income ETFs can potentially play a larger role in life insurance portfolios.
The impact of these RBC changes will be felt unevenly throughout the industry, due to the new C-1 bond factors, as well as revisions to the portfolio adjustment factor, also known as the size factor. For example, certain areas within the ratings hierarchy have become more capital efficient, such as higher-quality high yield securities, which can now be potentially paired with high-quality investment grade credits without an adverse impact to RBC (Exhibit 6).
Exhibit 5: Expanded NAIC bond RBC charges for life insurers, by credit rating
Exhibit 6: The capital efficiency within the credit quality spectrum will shift due to the new bond RBC factors
Left chart sub-title: Life insurers: Change in RBC (Investment Grade)
Right chart sub-title: Life insurers: Change in RBC (High Yield)
Life insurers may wish to leverage ETFs to rebalance their portfolios to gain broader exposure to these more efficient segments, screening for the investment grade and high yield ETFs that fit their needs best. While this could be executed in cash bond markets, the liquidity benefits and tighter bid-ask spreads that ETFs provide may reduce overall trading costs (Exhibit 7).
Additionally, ETFs may allow for operational efficiencies by limiting the amount of line items required to be traded, which may prove valuable in periods of market stress should investors need to derisk the portfolio (Exhibit 8). Insurers can also look to the ever-evolving ETF market for solutions beyond passive strategies, including active and alternatively weighted fixed income ETFs that may help complement their existing portfolio holdings and potentially add new sources of return.
Exhibit 7: High yield ETF vs. high yield cash bond liquidity
Exhibit 8: High yield ETF trading in periods of market stress
Fixed income ETFs can be a useful tool for insurance investors, whether to enhance overall liquidity, gain specific market segment exposures or access active managers for potential alpha. Through the use of SV, coupled with updated bond capital charges, insurers may also be able to take advantage of additional accounting and capital benefits. Please contact your J.P. Morgan Asset Management Client Advisor to learn more.
JPMorgan ETFs with National Association of Insurance Commissioners (NAIC) Designations