NAIC 2021 Summer National Meeting – Statutory Accounting and SVO Updates
Global Insurance Solutions
- Proposed accounting changes for Schedule D bonds released for industry review
- SVO adopts rule changes on privately rated securities
- Guidance amendments adopted for fixed income funds with derivatives, credit tenant loans and real estate lease-backed securities
- SAPWG clarifies accounting treatment for cryptocurrencies
- Hedge accounting rules further relaxed due to reference rate reform
Statutory Accounting Updates
Schedule D Bond Project – Regulators expose their revised bond definition (Ref #2019-21)
Back in May, SAPWG1 released its proposed bond definition, designed to clarify what should be considered a bond (whether captured in SSAP No. 26R—Bonds or SSAP No. 43R—Loan-Backed and Structured Securities) and reported on Schedule D-1: Long-Term Bonds. Bond guidance under current statutory accounting principles is very broad, so regulators have placed an emphasis on revising its bond language to address concerns regarding how certain investment structures are accounted for and reported.
The guidance for what qualifies as an issuer obligation bond is mostly unchanged, but the proposed guidance does attempt to modernize elements of the bond language to provide more clarity on what qualifies as a true creditor relationship (less of an emphasis on legal form; more important is a consideration of the substance of the bond’s terms).
For SSAP 43R bonds, the proposed guidance highlights specific characteristics that must be present for a security to meet the definition of an asset-backed security (ABS). The new definition lays out the two defining characteristics:
- The assets owned by the ABS issuer must either be financial assets or cash-generating non-financial assets. Also, the reliance on cash flows from the sale or refinancing of cash generating non-financial assets does not preclude a bond from being classified as an ABS so long as there is a meaningful level of cash flows to service the debt.
- The holder of a debt instrument issued by an ABS issuer is in a different economic position than if the holder owned the assets directly. The bondholder is typically in a different economic position if such debt instrument benefits from credit enhancement through guarantees (or other similar forms of recourse), subordination and/or overcollateralization.
Additionally, a separate reporting section on Schedule D is being considered, for the purpose of capturing additional disclosures on the underlying collateral held by ABS.
Regulators will assess feedback from the industry and will look to discuss its next steps during the next SAPWG meeting.
Reference Rate Reform (Ref #2021-01, INT 20-01)
Under this revision, guidance from INT 20-01: ASU 2020-04 - Reference Rate Reform, which granted temporary (optional) waivers from derecognizing hedging transactions and provides some exceptions for assessing hedge effectiveness as a result of transitioning away from LIBOR2, is being 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 will allow for the continuation of existing hedge relationships and thus not require hedge de-designation.
Cryptocurrencies (Ref #2021-05)
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 21-01: Accounting for Cryptocurrencies, has been adopted that clarifies that directly held cryptocurrencies do not meet the definition of cash within statutory guidance and are non-admitted assets for statutory accounting.
Exposed Items, to be further considered
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 proposed 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.
Rules changes adopted on the SVO’s3 review of privately rated securities
The VOSTF4 has adopted new rules that will require a private rating letter rationale report for all privately rated securities, whether processed via electronic feeds or by direct submission to the SVO.
The new guidance is in response to SVO concerns that it lacks authority to use its own judgment to determine if a CRP5 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 a NAIC Designation through the filing exempt (FE) process.
To partially address those issues, the SVO will require a private rating letter rationale report that details the CRP’s rating methodology and its in-depth analysis of the transaction. The effective date of the new guidance (except for “deferred submission6” and “waived submission7” private letter rated securities) is January 1, 2022. For deferred submission securities, the effective date for submission of the rationale report is January 1, 2024, and for waived submission securities, the rationale report need not be submitted to the SVO so long as an insurance company is prevented from doing so due to confidentiality or contractual reasons.
The SVO has also been attempting to gain additional authority from the VOSTF over evaluating the appropriateness of private ratings. In addition to the rationale reports, the SVO is still recommending to the VOSTF that it be given full discretion to require securities to be filed for review, if it sees fit, or to decline to assign any NAIC Designation, but VOSTF has decided to defer its decision on that for now.
Fixed income funds – Guidance revisions adopted on the acceptable use of derivatives
In an attempt to provide greater clarity and predictability to fund sponsors and investors regarding the acceptable use of derivatives in fixed income and preferred stock funds, the SVO has adopted rule changes that would permit some funds to have greater flexibility when using derivatives.
Under the new rules, for any of the following transactions, a fund’s derivative exposures (in normal market conditions) would be limited to 10% of the fund’s net assets:
- Derivatives under which a fund is, or may be, required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payments or otherwise
- Short sale borrowings
- Reverse repurchase agreements or similar financing
For the above transactions, exposures would be calculated based on the gross notional amounts of derivatives, the value of assets sold short for short sale borrowings and/or the proceeds received by the fund but not repaid for reverse repurchase agreements.
For any derivatives where the fund is not required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payments or otherwise, exposures would be calculated based on the derivative’s market value.
Interest rate derivatives and option contracts exposures will be allowed to be calculated using other defined methods consistent with market practice8. Additionally, certain currency and interest rate derivatives that hedge currency or interest rate risk associated with one or more specific equity or fixed income investments of the fund would be exempt from the 10% exposure calculation.
The new rules will also continue to require look-through assessments for all funds that desire bond or preferred stock regulatory treatment, which includes a requirement that a fund “predominantly hold9” bonds or preferred stock. The credit risk assessment portion of the SVO’s methodology for reviewing funds will also be updated to include a calculation of derivative exposure and, if appropriate, the inclusion of derivatives in its weighted average rating factor (WARF) methodology analysis.
Credit Tenant Loans and Real Estate Lease-backed Securities – Guidance amendments adopted to clarify filing exemption eligibility
The SVO has adopted guidance amendments to clarify the difference between credit tenant loans (CTL) and real estate lease-backed securities in regards to their eligibility for the filing exemption10.
The original intent of the SVO’s CTL guidance was to allow certain mortgage loans to be reported on Schedule D-1, as opposed to Schedule B, due to their reliance on the creditworthiness of a credit tenant. As CTLs have evolved from solely being direct mortgage loans, to now also including structures that more resemble securities, guidance amendments were needed to better specify which securities qualified for the filing exemption and which securities didn’t.
This guidance amendment clarifies that the filing exemption will not apply CTLs and ground lease financing transactions (GLF) in scope of SSAP 37 (i.e. mortgage loans eligible for Schedule D). Additionally, for securities that resemble CTLs and GLFs but are NOT in scope of SSAP 37, they also can be filed with the SVO for a rating, but the final regulatory treatment will partly be the result of the ongoing SAPWG project currently underway that will ultimately decide which securities should be considered a bond for Schedule D-1 reporting purposes (see “Schedule D bond project” above).
Working Capital Finance Investments – Newly adopted revisions will align the SVO’s guidance with SAPWG’s recently adopted accounting amendments
In May of last year, SAPWG adopted modifications to SSAP No. 105R—Working Capital Finance Investments that were designed to make the asset class more attractive to insurers by easing technical requirements. The SVO has subsequently adopted new guidance revisions to align the P&P Manual11 with SAPWG’s accounting revisions by removing any existing inconsistencies.
Exposed Items, to be further considered
Working Capital Finance Investments – 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 SVO would have the ability to assign an equivalent NAIC Designation based on the parent, notch the designation up or down based on its own analytical judgment or choose not to assign any NAIC Designation.
1 Statutory Accounting Principles Working Group.
2 London Interbank Offered Rate.
3 Securities Valuation Office.
4 Valuation of Securities Task Force.
5 Credit Rating Providers, aka NAIC-approved NRSRO rating agencies.
6 Private letter rated securities issued after January 1, 2022, for which an insurance company cannot provide a copy of a private rating letter rationale report to the SVO due to confidentiality or other contractual reasons. Insurers may report these securities on the General Interrogatory (with a PLGI suffix) until year-end 2023. After year-end 2023, if the insurance company still cannot provide a copy of a private rating letter rationale report for whatever reason, the securities can be reported with an NAIC 5GI Designation in accordance with SVO guidance.
7 Private letter rated securities issued from January 1, 2018 to December 31, 2021, for which an insurance company cannot provide a copy of a private rating letter rationale report to the SVO due to confidentiality or other contractual reasons still in force. Insurers may report these securities on the General Interrogatory with a PLGI suffix.
8 Interest rate derivatives and option contracts will often require “adjusted notional” amounts that better reflect the fund’s exposure to interest rate changes or the exposure that an option creates to the underlying reference asset.
9 Within SVO guidelines, funds that “predominantly hold” bonds or preferred stock are defined as funds holding at least 80% of its assets in bonds for bond funds, or at least 80% of its assets in preferred stock for preferred stock funds.
10 Securities eligible for filing exemption are exempt from having to file with the SVO for an NAIC Designation. Filing exempt securities can rely on the rating(s) of an approved credit rating provider to attain an equivalent NAIC Designation.
11 The Purposes and Procedures Manual maintains all of the cumulative policies of the VOSTF, including the procedures and methodologies adopted and used for credit assessments. It also provides information on the operational and administrative procedures conducted by the NAIC, the SVO and the Structured Securities Group to support the VOSTF.