In Brief

• Regulators continue to work toward redefining bond accounting rules and Schedule D-1 eligibility 
  
  
• Non-legacy RMBS and CMBS securities – methodology changes were adopted for determining NAIC Designations
  
  
• The SVO¹ proposes rule changes regarding its review of privately rated securities
  
  
• The SVO seeks to add rules regarding the use of derivatives in fixed income funds
  
  
• SAPWG² issues guidance on whether cryptocurrencies are considered admitted assets
  

A small group of industry representatives, the state of Iowa and NAIC staff continue to work toward creating a clear definition of what should be captured as a bond in Schedule D-1. This project is in response to investments identified by regulators and the SVO that may be a bond in legal form (e.g. debt-issuing trust or special purpose vehicle) but not in substance. Once the proposed definition is complete, it will then be exposed publicly to allow for comments and discussion from the broader industry.

Regarding the project’s stages, the current phase is to identify what should be captured in scope of Schedule D-1. The next phase would then attempt to outline the necessary revisions to SSAP No. 26R (bonds with creditor relationships) and SSAP No. 43R (loan-backed securities, structured securities and mortgage-referenced securities).

It is anticipated that if there are investments that no longer qualify for Schedule D-1, they will be captured on Schedule BA. It is also anticipated that NAIC staff and regulators will work with the Capital Adequacy Task Force to ensure that these investments are assessed for appropriate accounting, reporting and RBC.

Adopted items

In response to recent changes to the Freddie Mac Structured Agency Credit Risk (STACR) and Fannie Mae Connecticut Avenue Securities (CAS) programs, where it is anticipated that future Freddie Mac STACR and Fannie Mae CAS issuances will be solely conducted through a Real Estate Mortgage Investment Conduit (REMIC) trust, this adopted agenda item will allow credit risk transfer securities from Freddie Mac and Fannie Mae to remain in scope of SSAP No. 43R (as Schedule D bonds) when a REMIC structure is used in the STACR or CAS programs.

This adoption revises the accounting treatment for perpetual bonds held as investments within scope of SSAP No. 26R. After some reconsiderations, adopted modifications include requiring ordinary bond treatment for perpetual bonds that have an upcoming, scheduled call date. These would be carried at amortized cost (utilizing the yield-to-worst concept) in instances where a termination date (i.e. call date) is known. For perpetual bonds that do not possess or no longer possess a call feature, fair value reporting would be required.

This adopted agenda item is designed to clarify the identification of related parties and affiliates in SSAP No. 25—Affiliates and Other Related Parties and to incorporate new disclosures to ensure regulators have the full picture of complicated business structures.

The guidance amendments clarify that 1) any related party identified under U.S. GAAP or SEC reporting requirements would be considered a related party under statutory accounting, 2) non-controlling ownership over 10% results in a related party classification regardless of any disclaimer of control or disclaimer of affiliation, and 3) disclaimers of affiliation and control for statutory accounting impact holding company group allocation and reporting, but do not eliminate the classification as a “related party” and the disclosure of material transactions required by SSAP No. 25.

This adoption expands the existing called bond disclosures to include bonds that were terminated early through a tender offer.

This agenda item revises the accounting guidance for publicly traded preferred stock warrants to bring the guidance in line with publicly traded common stock warrants, which receive a special carve-out from being subject to derivative treatment, and are reported within SSAP No. 30R—Unaffiliated Common Stock. This revision 1) expands the scope of SSAP No. 32R—Preferred Stock to include publicly traded preferred stock warrants and 2) requires publicly traded preferred stock warrants to be reported at fair value.

Exposed items, to be further considered

Under this proposed revision, guidance from INT 20-01: ASU 2020-04 - Reference Rate Reform, which granted temporary waivers from derecognizing hedging transactions and provides some exceptions for assessing hedge effectiveness as a result of transitioning away from LIBOR, would be expanded to include derivative instruments affected by changes to the interest rates used for discounting, margining or contract price alignment (regardless of whether they reference LIBOR or another rate that is expected to be discontinued as a result of reference rate reform). This exception would allow for the continuation of existing hedge relationships, and thus not require hedge de-designation.

SAPWG has received numerous inquiries on the statutory accounting treatment for cryptocurrencies, most of which have inquired on whether cryptocurrencies (such as Bitcoin) are permitted to be admitted assets. The inquiries have also centered on whether Bitcoin is captured in the cash definition within SSAP No. 2R—Cash, Cash Equivalents, Drafts, and Short-Term Investments. An interpretative guidance update, INT 21-01T: Statutory Accounting Treatment for Cryptocurrencies, is being exposed that clarifies that cryptocurrencies do not meet the definition of cash within statutory guidance and are non-admitted assets for statutory accounting.

Temporary guidance amendments

Notable temporary guidance still currently in effect:

• Freddie Mac Single Security Initiative (INT 19-02)
• Troubled Debt Restructuring Due to COVID-19 (INT 20-03)
• Troubled Debt Restructuring of Certain Investments Due to COVID-19 (INT 20-07)

Adopted items

Non-Legacy RMBS/CMBS securities – The SVO adopts methodology changes for determining NAIC Designations 

The VOSTF³ has adopted an amendment that would remove the use of price breakpoints when determining the NAIC designation for all non-legacy RMBS/CMBS. Non-legacy is defined under SVO guidance as financially modeled RMBS/CMBS securities that closed on or after Jan. 1, 2013. Prior to this adoption, RMBS/CMBS were modeled, then applied to a series of book-adjusted carrying value price breakpoints to determine a final NAIC designation. The VOSTF previously considered eliminating the price breakpoint process in years past, but decided against making a change after the industry expressed concerns that there would be significant adverse RBC implications.

The issue arose again after the negative effects of the pandemic caused economic assumptions used in the year-end 2020 modeling process to result in a significant number of MBS securities losing their zero-loss distinction. Per SVO rules prior to this adoption, RMBS/CMBS deemed zero-loss were reported with an NAIC 1 designation. Securities that were not deemed zero-loss are subject to the price breakpoint process, which caused many securities to be reported as NAIC 2, 3 or 4 due to book values held at a premium, which is more of a result of the low yield environment, and not because of any significant deterioration of credit quality. This adopted amendment will lessen the impact of legacy regulatory processes on insurers’ solvency measures and their reporting and assessments of credit risk.

SVO guidance updated to reflect the merger of DBRS and Morningstar

The SVO’s guidance will be updated to reflect the effects of the merger between DBRS and Morningstar. The update includes the name of the new legal entity and the ratings symbols of the new company being merged into a single set of symbols.

Exposed items, to be further considered

SVO proposes rules changes regarding its review of private-rated securities 

The VOSTF has proposed new rules that would allow the SVO to review all privately rated securities (whether processed via electronic feeds or by direct submission to the SVO) and would require a private rating letter rationale report for any privately rated securities.

This proposed amendment is in response to SVO concerns that it lacks authority to use its own judgment to determine if a CRP⁴ rating is useful and appropriate for NAIC designation use. These concerns have become heightened due to the increased use of bespoke securities, which are eligible for an NAIC designation through the filing exempt (FE) process.

To address those issues, the SVO is proposing changes that would require a private rating letter rationale report that would detail the CRP’s rating methodology and an in-depth analysis of the transaction. The SVO is also seeking to gain additional authority over evaluating the appropriateness of the rating or methodology utilized by the CRPs. This additional information would help the SVO 1) determine if the assigned rating is appropriate for NAIC use and 2) to decide in which manner an NAIC designation would be assigned (i.e. a CPR equivalent through the FE process or requiring the security be filed for an official review).

The SVO recognizes that some obstacles and confidentiality restrictions may exist that limit the transmission of sensitive deal information, but it nonetheless remains committed to stronger regulatory oversight of these securities and plans to work with the industry to address those obstacles.

The SVO seeks to add rules regarding the acceptable use of derivatives in fixed income and preferred stock funds

In an attempt to provide greater clarity and predictability to fund sponsors and investors regarding the acceptable use of derivatives in funds, the SVO is proposing to create two new threshold tests that would permit some funds to have greater flexibility in their use of derivatives. This is in response to the SEC’s newly adopted rule⁵ on the use of derivatives by registered investment companies. Hence, the SVO is proposing similar, but more definitive rules on the acceptable uses of derivatives for fixed income and preferred stock funds via a proposed guidance amendment that would create one test for all funds on the Fixed Income-Like SEC Registered Funds List, and a second, separate test for the SVO’s other identified fund listings.

For funds on the SVO-Identified Bond / Preferred Stock ETF Lists and the Schedule BA Non-Registered Private Funds with Underlying Assets Having Characteristics of Bonds or Preferred Stock List, the proposal would create a threshold whereby the gross notional amount of derivatives that impose no future payment or margin posting obligation on the fund cannot exceed 10% of its net asset value, except for certain currency and interest rate hedges and other conditions⁶ that could create future payment or margin posting obligations on the fund.

For funds on the NAIC Fixed Income-Like SEC Registered Funds List, the SVO is supportive of considering a larger derivative threshold, where derivatives would be allowed for up to 20% of the fund’s NAV. The SVO’s proposal is also open to the possibility of having a wider range of approved SEC-registered funds being eligible to receive NAIC Designations.

The proposed guidance amendments have been exposed for comment from the industry and will be further addressed at future task force meetings.

¹ Securities Valuation Office
² Statutory Accounting Principles Working Group
³ Valuation of Securities Task Force
⁴ Credit Rating Provider
⁵ SEC Rule 18f-4, an exemptive rule under the Investment Company Act of 1940 (the “Act”), permits mutual funds (other than money market funds), ETFs, registered closed-end funds and business development companies to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act. In connection with these new rules, the SEC amended rule 6c-11 under the Act to allow leveraged or inverse ETFs to operate without obtaining an exemptive order. The rule specifies that funds that use derivatives are required to implement a written derivatives risk management program and limit fund leverage risk via VaR testing. Funds are exempt from these requirements if the fund’s derivatives exposure is limited to 10% of its net assets, excluding certain currency and interest rate hedging transactions.
⁶ These potential obligations include certain futures or forwards on fixed income or preferred stock held in the fund’s portfolio, reverse-repurchase agreements associated with specific fixed income or preferred stock investments held by the fund and non-margin borrowing for purposes other than investment.