In Brief

• Regulators continue discussions on the Schedule D bond project, focusing on new reporting disclosures and rules around credit enhancement for asset-backed securities
• The NAIC’s reliance on NRSRO credit ratings is being further scrutinized by regulators
• New guidance clarifies that residual tranches of securitizations are not Schedule D bonds
• Guidance clarifications confirms NAIC 1.A Designation for zero-loss RMBS/CMBS
• Principal protected securities – proposed guidance revision to capture alternative structures
• Derivative hedging requirements may be revised to keep statutory guidance aligned with U.S. GAAP

Statutory Accounting Updates

Proposed bond definition – Regulators continue to discuss the project’s next steps (Ref# 2019-21)

Back in May, SAPWG released its proposed bond definition, designed to clarify what should be considered a bond for regulatory purposes. In response to the exposure, regulators scheduled a follow-up meeting in August to discuss the industry’s comments on the proposal. Within the submitted comment letters, further clarity was requested on a number of topics, including:

• Whether interest only and principal only strips would qualify for Schedule D-1, and would they be issuer obligations or ABS
• A desire for additional examples for more traditional ABS, such as collateralized loan obligations (CLOs)
• The appropriate accounting treatment for CTLs, GLFs and other real estate lease-backed securities
• Does a first-loss tranche need to exist for a structured security to be classified as a bond (and how does that impact pass-throughs without government guarantees)
• What would be the appropriate reporting schedule and risk-based capital charge for investments disallowed for Schedule D-1, such as:
  • Structures where investors are required to purchase a pro rata share of an equity tranche, in conjunction with the debt investment (i.e. stapling)
  • Debt investments that don’t meet the criteria for inclusion on Schedule D-1, but are recognized as bonds in financial markets, including debt issued by funds and non-agency mortgage-backed securities
  • Structures where the repayment of amounts owed substantially relies on refinancing

Most recently, discussions have centered on the residual tranches (see below: Residual tranches), along with proposals to create more reporting granularity and clarify credit enhancement requirements for ABS.

Potential reporting changes include a new Schedule D-1 sub-schedule that details bond investments that have certain characteristics (e.g., ABS backed by financial assets that are not self-liquidating and ABS backed by cash-generating non-financial assets).

Changes are also being considered to revise the “sufficiency” definition previously captured in the bond proposal, which required all ABS to have sufficient credit enhancement to qualify for reporting as a bond on Schedule D-1. The revised guidance intends to reflect more of a principal concept and instead reflects a “substantive credit enhancement.” The new guidance indicates that the intent is to clarify that an ABS structure should put the security holder in a different economic position than having owned the underlying collateral directly. Enhancements that are nominal or lack economic substance do not put a holder in a different economic position.

Moving forward, NAIC staff and regulators intend to work on developing an issue paper and proposed SSAP revisions. There have also been discussions between SAPWG¹ / VOSTF² / CATF ³ on the appropriate RBC charges for residual tranches and potential RBC impacts related to investments that no longer qualify for Schedule D-1.

Adopted Items

Residual tranches – Guidance amendments adopted to clarify accounting treatment (Ref #2021-15)

To address inconsistencies in the way insurers across the industry have reported the residual tranches of securitized bonds, SAPWG has adopted a few notable guidance amendments to SSAP 43R to clarify its accounting treatment. The new guidance clarifies that:

• Residual tranches are not to be reported on Schedule D; they are to be reported on Schedule BA.
• The term “non-rated” was removed from previous guidance revisions to eliminate confusion. The guidance clarifies that these revisions apply to tranches with “no contractual payments of principal and/or interest,” as the holders of these investments are only paid after contractual interest and principal payments have been made to the other tranches.
• These tranches are to be reported at the lower of amortized cost or fair value.

The effective date of these changes is December 31, 2022, with early adoption permitted. The reporting of these securities on Schedule D-1 is allowed for year-end 2021, but they must be reported with a NAIC 6* Designation (a self-designated NAIC 5GI is not allowed).

Credit tenant loans – Guidance revisions adopted to clarify which CTLs are in scope of SSAP 43R (Ref# 2021-11)

Back in July, the SVO adopted revisions to its P&P Manual clarifying the definition and treatment of CTLs. SVO-Identified CTLs are defined as mortgage loans in scope of SSAP 37 that qualify for a SVO structural assessment. Insurers have the ability to file these structures with the SVO to determine whether the mortgage loan can be reclassified from Schedule B to Schedule D. In response to the SVO’s action, SAPWG has adopted an amendment that explicitly clarifies that the SVO-Identified CTLs detailed above are in scope of SSAP 43R, which is the bond accounting guidance for loan-backed and structured securities. These modifications are also intended to provide a short-term solution, as regulators continue to work toward revising bond accounting guidance via the “Proposed Bond Definition” project.

Preferred stock – Valuation of callable instruments (Ref #2021-10)

SSAP 32R guidance for callable preferred stock has a valuation ceiling that requires perpetual preferreds, mandatory convertible preferred stock and publicly traded preferred stock warrants be reported at fair value, with a ceiling that is not to exceed any currently effective call price. This revision seeks to clarify that this ceiling should only apply in situations where the call is currently exercisable by the issuer, or the issuer has provided notice of its intent to call/redeem the preferred stock.

Preferred stock – Permitted valuation methods (Ref #2021-17)

This agenda item adopts minor edits to the preferred stock guidance, which 1) removes references that indicated that cost is a permissible valuation method (historical cost isn’t allowed; amortized cost is permissible), and 2) removes references pertaining to debt securities when describing allowable valuation methods for redeemable preferred stock.

Exposed Items, to be further considered

Derivatives and hedging – Guidance revisions being considered regarding hedge effectiveness requirements (Ref #2021-20)

Due to U.S. GAAP changes on derivatives and hedging, regulators are considering developing revisions to statutory guidance that will impact hedge effectiveness determinations for hedge accounting, with the goal of retaining consistency between U.S. GAAP and statutory accounting principles.

Because of the revisions in FASB’s ASU 2017-12⁴, there is a disconnect between U.S. GAAP and statutory accounting for certain types of effective hedging relationships. This is problematic as it results in inconsistent documentation of hedging transactions, while also hindering insurance entities from electing to enter hedging transactions not currently permitted within statutory guidance.

The changes being considered include:

• Partial Term Hedging – U.S GAAP allows companies to enter into fair value hedges of interest rate risk for only a portion of the term of the hedged financial instrument. Previously, these transactions were not treated as highly effective due to offsetting changes in the fair value as a result of the difference in timing between the hedged item’s principal repayment and the maturity date of the hedging derivative. Under statutory accounting, because of the use of amortized cost within hedge accounting, this could cause an issue with the financial statement presentation of a hedged liability after the derivative position has been closed out.
• Last of Layer Hedging – For a closed portfolio of prepayable financial assets, an entity may designate as the hedged item, a stated amount of the asset or assets that are not expected to be affected by prepayments, defaults and other factors affecting the timing and amount of cash flows if the designation is made in conjunction with the partial term hedging election. The “last of layer” hedge provision is permitted only for a closed portfolio of prepayable financial assets, or beneficial interests secured by a portfolio of prepayable financial instruments (e.g., mortgage-backed securities). Key elements that would need to be addressed for statutory accounting include 1) ensuring that individual assets are not adjusted at hedge termination, and that a portfolio approach is utilized, 2) whether the last of layer strategy should be allowable for insurance liabilities, 3) whether hedge effectiveness bifurcation should be allowed and 4) having the scope of the guidance mirror U.S. GAAP.
• Hedges of Interest Rate Risk When the Hedged Item Can be Settled Before Scheduled Maturity – The U.S. GAAP guidance for hedge effectiveness is being expanded for prepayable instruments. Regulators will need to consider how this would be applicable under statutory accounting.
• Expansion of Excluded Derivative Components in the Assessment of Hedge Effectiveness – As the new GAAP guidance expands the ability to exclude certain components of a derivative from the assessment of hedge effectiveness, revisions would need to be considered to specify the required statutory reporting when changes in the fair value of a derivative are separated and treated differently.

Regulators are requesting feedback and comments from the industry on whether they should move forward with formally developing SSAP 86 revisions on the aforementioned items.

RMBS / CMBS – Minor edits proposed for MBS subject to financial modeling when assigning NAIC Designations (Ref #2021-23)

This agenda item proposes updating SSAP 43R to reflect the SVO’s updated NAIC designation/NAIC designation category guidance for modeled legacy and non-legacy⁵ RMBS/CMBS securities . The potential amendment proposes two alternative revisions for possible inclusion into SSAP 43R:

• Option #1 would retain summarized modeling guidance in SSAP 43R, which would be updated for this change and any subsequent modeling changes, or
• Option #2 would remove the financial modeling guidance from SSAP 43R and refer users to the SVO’s P&P manual.

Related party reporting (Ref #2021-21)

This agenda item proposes revisions to SSAP 25 and 43R to clarify application of the existing affiliate guidance. Revisions to SSAP 25 highlights scenarios where investment vehicles, such as limited partnerships, trusts and other special purpose entities, would need to be disclosed as being an affiliate/related party due to direct or indirect control, which could include common management. Specific to loan-backed and structured securities (LBaSS), the guidance SSAP 43R will clarify that LBaSS issued by a related party or acquired through a related party transaction or arrangement is subject to the affiliate guidance and disclosure requirements of SSAP 25.

VOSTF/SVO Updates

NRSRO credit ratings – Regulatory concerns and proposed changes to the filing exemption process

An issue that regulators continue to highlight as an area of concern is the NAIC’s reliance on rating agency ratings to assess investment risk for regulatory purposes. Through the filing exempt (FE) process, the NAIC relies on NRSRO rating agencies for the vast majority of insurer investments, with no oversight as to the analytical basis, nor the consistency of risk assessments across credit rating agencies.

Recently, NAIC staff conducted an analysis that compared ratings between rating agencies for jointly rated issues. Their analysis showed significant differences between rating agencies, particularly amongst securities with private ratings. The SVO also reviewed a sample of privately rated securities, with the results showing NAIC Designations obtained from the FE process differed significantly from the SVO’s independent analysis. The SVO’s analysis identified a significant number of securities with material differences, where the private ratings were 3-6+ notches higher than SVO estimates. These material differences could result in a lower RBC charge than the security’s risk profile would suggest. If a significant portion of an insurer’s portfolio suffers from being “over-notched,” it could potentially lead to undercapitalization during times of economic stress.

A huge reason why concerns are heightened now can be partly attributed to the increased usage of private ratings within the industry. The SVO estimates that there are over 5,000 privately rated securities held on statutory balance sheets today, versus only approximately 2,000 held as recently as 2018.

To address these issues, NAIC staff is proposing four potential solutions to begin the process of actively managing and overseeing credit ratings:

1. Require at least two (or more) ratings for every security and use the lowest rating to determine the NAIC Designation. If a security has only one rating, require it to be reviewed by the SVO to determine whether the SVO deems the rating reasonable.
2. Conduct an in-depth study of the NAIC’s use of credit ratings and SVO-assigned NAIC Designations as to their consistency and comparability for regulatory purposes, specifically the determination of RBC factors.
3. Put the rating process under a contractual relationship by offering NRSROs the opportunity to respond to a request for qualifications (RFQ). The RFQ would look at historical coverage, consistency, persistence, comparability and predictiveness of each rating along with any other analytical and qualitative benefit they may provide to the NAIC for its regulatory purposes. Under this process, the NAIC would enter into a contract with only those NRSROs that adequately meet the RFQ criteria.
4. Regulators can instruct the SVO to remove any rating agency from the approved NRSRO list at any time.
5. Some combination of the options above.

Regulators detailed that the SVO’s latest analysis will serve as a starting point for discussions led by VOSTF beginning next year. Regulators have also expressed a desire to take a conservative approach, so as to not spook markets and the industry by creating uncertainty regarding its future plans.

Adopted Items

Residual tranches – SVO guidance revised to reflect the accounting changes made to SSAP 43R

In response to the accounting changes adopted on residual tranches (see above: Residual Tranches), the SVO has also adopted amendments confirming that, effective December 2022, residual tranches are ineligible for the filing exemption and are to be reported on Schedule BA without an NAIC Designation.

Privately rated securities – Clarifying guidance amendments adopted on the NAIC 5GI Designation

The SVO adopted minor edits to its private letter rating guidance clarifying that a NAIC 5GI Designation maps to an equivalent of NAIC 5.B. For all privately rated securities, insurers are required to provide the SVO with a copy of a private letter rating rationale report, which details the credit rating provider’s rating methodology and its in-depth analysis of the transaction. In situations where a rationale report is not available for submission to the SVO, certain securities⁶ may need to be reported using a NAIC 5GI Designation.

RMBS / CMBS – Guidance amendment will add back zero-loss criteria for legacy securities

In response to a request from notable industry participants, regulators will add back zero-loss language to the guidance for modeled RMBS and CMBS. The guidance amendment will allow zero-loss legacy modeled securities to be mapped to a NAIC 1.A Designation Category instead of the midpoint designation⁷ of NAIC 1.D. This revision helps to keep the NAIC Designation of these securities aligned with its corresponding credit quality.

Bank loans (i.e. direct lending) – Guidance amendment adopted to clarify the SVO’s ability to review and assign NAIC Designations

The SVO has amended its guidance to clarify that bank loans can be reviewed and assigned NAIC Designations. The review methodology used for credit assessments mirrors the process used for corporate bonds. This guidance amendment will help to maintain consistency with the NAIC’s accounting guidance, which treats bank loans as bonds for regulatory purposes.

The SVO to add the U.S. International Development Finance Corporation to the “U.S. Government Full Faith and Credit – Filing Exempt” list

As a result of the 2018 Better Utilization of Investments Leading to Development (BUILD) Act, which merged existing U.S. government development finance and aid programs, the U.S. Overseas Private Investment Corporation (OPIC) and the Development Credit Authority of the United States Agency for International Development (USAID), were merged into a new agency called the U.S. International Development Finance Corporation (DFC). This guidance amendment adds this new agency to the SVO’s “U.S. Government Full Faith and Credit – Filing Exempt” list. Securities issued or backed by entities on this list are exempt from filing with the SVO and are not assessed capital charges.

Spanish GAAP to be added to the list of Countries and Associated National Financial Presentation Standards in the SVO’s Purposes and Procedures Manual (P&P Manual)

The SVO adopted changes to the P&P Manual to add Spanish GAAP to its list of National Financial Presentation Standards. Certain companies in Spain, where insurers may look to invest in via the U.S. private placement market, are not required to use international or global accounting standards (such as IFRS). This will allow the SVO to accept audited financial statements prepared in accordance with Spanish GAAP, when analyzing a security for an NAIC Designation.

Exposed Items, to be further considered

Securities with “Other Non-Payment Risks” – Filing exemption clarification

An amendment has been proposed to update the definition in the P&P Manual for securities that possess “Other Non-Payment Risks” (which are assigned a subscript of “S” with its NAIC Designation). This revision will add these investments to the list for securities that are not eligible for the filing exemption.

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.

Principal protected securities – Guidance revision to capture alternative structures

The SVO seeks to edit the principal protected securities (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 SPV issued notes, and can include issuer obligations that depend on other non-Schedule D-1 assets to satisfy contractual payment obligations.

Schedule BA assets with bond or fixed income characteristics – Revisions to clarify rules on NAIC Designations

The SVO is proposing guidance revisions that will better clarify that Schedule BA assets are not eligible for filing exemption (i.e. they must be filed with the SVO to receive a NAIC Designation). The revisions will also clarify that the SVO has the ability to assign NAIC Designations to assets that are not expressly covered by other sections of the SVO’s guidance. This is beneficial for life insurers, as the RBC rules allow Schedule BA assets with NAIC Designations more favorable capital treatment.

Working capital finance investments (WCFI) – NAIC Designations for unrated subsidiaries of rated parent companies

Proposed guidance would allow the SVO to assign NAIC Designations to issues of non-guaranteed, unrated subsidiaries of rated parent companies. This is relevant for WCFI with unrated obligors that are wholly owned, but not guaranteed by their parent entities. Under the proposal, the unrated subsidiary would rely on the NAIC Designation equivalent of its parent, with the SVO having the ability to notch down or decline that designation based on its analytical judgement. If the SVO’s analysis results in an NAIC Designation below NAIC 2, any investments related to the below-investment-grade WCFI program would become nonadmitted.