Highlights:

• SVO revised its proposal on filing exempt securities, adding additional oversight and transparency measures to alleviate industry concerns
• IMR and AVR receive renewed focus to ensure appropriate loss allocations
• Regulators work to better clarify accounting treatment of residual tranches
• RBC for Schedule BA bonds to be reviewed following Schedule D changes

The SVO released an amended proposal addressing its authority over filing exempt (FE) securities

As a follow-up to its controversial efforts to assert more authority over FE securities, the SVO has revised its initial proposal to address industry concerns. The amended proposal will lean on the SVO’s Senior Credit Committee (SCC) to decide if it agrees with SVO staff when they have identified a security that warrants a closer look regarding its FE status. If the SCC determines that a security’s NRSRO rating represents an unreasonable assessment of risk, the security will be placed “under review” – with a new corresponding designation symbol (UR) denoting it is under review status. If, after a full assessment, the security’s rating is deemed to be three or more notches different than the SCC’s assessment, the security will be removed from FE and given a designation symbol of DR to denote its revoked status.

The VOSTF will be presented with all of the SVO’s analysis for oversight and feedback purposes and an anonymized summary of all SVO ratings challenges would be published online for transparency purposes. Insurers can also appeal and request an independent, third-party review, if desired (at the insurer’s expense):

• If the independent review results in an NAIC Designation Category that is one or less notches different from the FE-produced NAIC Designation Category, the FE designation will stand.
• If the independent review results in an NAIC Designation Category that is more than one notch different from the FE-produced NAIC Designation Category, then the SVO’s opinion will remain.

The deadline for comments on the revised proposal is January 26, 2024.
 

Exposed Items, to be further considered

Private letter ratings (PLR) – SVO adds guidance amendment establishing a default issue date for securities with insufficient documentation

To address documentation issues with some private transactions, for the purposes of determining whether a security requires a PLR rationale report³, the SVO is proposing to allow a practical expedient that assumes any security subject to the PLR guidance that was acquired after January 1, 2022, will be deemed to be issued on or after January 1, 2022, unless documentation showing an earlier issue date is provided.

RBCIREWG to examine the RBC impact of the reporting changes for Schedule BA bonds

With the adoption of SAPWG’s⁴ principles-based bond definition, there will be certain bond types that no longer qualify for Schedule D and will be reported on Schedule BA. Because of the change, there is a concern that there will be fixed income assets that receive overly punitive Schedule BA capital charges, even though a lesser capital charge may be more appropriate. The SAPWG’s goal with its accounting change was not to infringe on the Capital Adequacy Task Force’s role in assigning appropriate capital charges. Therefore, the Risk-Based Capital Investment Risk and Evaluation Working Group (RBCIREWG) will assess the impact of the reporting change and propose potential solutions.

Regarding NAIC Designations and the filing exemption, the expectation is that the SVO will keep its current policy in place of requiring that all Schedule BA assets be filed with the SVO if an insurer desires an NAIC Designation.

Adopted Items

Newly designed Schedule D blank adopted in support of bond accounting changes (Ref #2023‐06BWG)

To support the forthcoming changes to the accounting for bond investments, regulators have adopted a newly designed Schedule D reporting blank. The new schedule will split Schedule D, Part 1 into two sections – Section 1 for issuer obligations and Section 2 for asset-backed securities. The effective date of the new schedule is the first quarter of 2025, in line with adoption of the new bond accounting rules.
 

Asset Valuation Reserve (AVR) and Interest Maintenance Reserve (IMR) – A long-term project will better define the accounting guidance for AVR and IMR (Ref #2023-14)

Regulators have established a long-term project to better define the accounting rules for AVR and IMR in SSAP 7 – Asset Valuation Reserve and Interest Maintenance Reserve. Historically, SSAP 7 only provided a brief overview without instructions containing more detailed language. The goal is for the project to address a few disconnects between the statutory accounting principles and the annual statement instructions for AVR/IMR, while specifically addressing a few topical issues.

Future discussions are likely to be focused on:

• Absolutes in allocating between IMR and AVR – Clarity has been requested for situations where a sale occurred before an official downgrade, but the sale was clearly the result of a notable decline in credit quality (see below, Allocating losses between IMR versus AVR).
• Bond IMR/AVR allocation – The guidance for IMR/AVR differs between issuer obligations and ABS. Also, since the current guidance was implemented before the expansion of NAIC Designations from 6 to 20, the guidance is no longer clear on what constitutes a designation change.
• Perpetual preferred stock allocation – The guidance hasn’t been reviewed since the accounting change requiring that all perpetual preferred stock be reported at fair value (see below, IMR/AVR – Preferred stock).
• Delineation of non-interest versus interest and realized versus unrealized – The proposal will focus on principles-based concepts to establish the division between interest and non-interest changes, as well as the reporting of unrealized and realized changes. This will help ensure consistent application across the industry.
• Derivative guidance – Guidance revisions will be needed to improve the reporting of interest rate derivatives held at fair value (i.e., derivatives that do not qualify for hedge accounting).
• Reinsurance ceded/assumed – While the annual statement instructions include guidance for removal of IMR for reinsurance ceded and the acquisition of IMR for reinsurance assumed, the impact of reinsurance, particularly with the dissolution of reinsurance agreements when IMR had initially been transferred, is a common question on determining IMR and AVR for insurers.
• AVR/IMR cross checks – Better cross checks are needed to ensure that items are being mapped to AVR/IMR correctly between reporting schedules.
• Overall IMR and AVR reporting in general accounts and separate accounts – The reporting of IMR and AVR, including how positive balances in one account impact negative balances in another account, as well as the treatment of net negative IMR, will be a long-term focus. This will lead to a need for guidance revisions in SSAP 7 and SSAP 56 (Separate Accounts).
   

Allocating losses between IMR versus AVR (Ref #2023-15)

The SAPWG previously released a proposed guidance amendment to address non-interest rate related losses and remove the ability to allocate those losses to IMR. The expansion of the NAIC Designation bond scale from 6 to 20 created some unintended ambiguity in determining when a loss should be reported in AVR (e.g., should the allocation of losses to IMR or AVR be notch based or based on full designation changes). In response to industry feedback, the SAPWG has agreed to table changes related to bond IMR/AVR allocations and tackle the issue as part of a broader project on various IMR-related issues.

Conversely, regulators have decided to adopt a guidance revision for situations where there is a known credit event that significantly negatively impacts the price of the security and it wasn’t reflected in the NRSRO rating/NAIC Designation when the security was sold. Realized losses in those situations will be recognized in AVR. This change was prompted by the regional bank failures that took place earlier this year.

For mortgage loan holdings, realized gains or losses from mortgages that meet any of the following criteria shall be reported in the AVR, and not IMR:

• Any mortgage loan sold/disposed of with an established valuation allowance under SSAP 37
• Interest is more than 90 days past due
• The loan is in process of foreclosure
• The loan is in course of voluntary conveyance
• The terms of the loan have been restructured during the prior two years

The adopted revisions for severe credit events and mortgage loans are effective January 1, 2024.
 

Residual tranches – Guidance amendment adopted to clarify definition and reporting requirements (Ref #2023-12)

Regulators have adopted revisions to accounting guidance to better clarify the definition and reporting requirements for investment structures that represent residual interests or a residual security tranche. When reviewing the 2022 annual statements, regulators concluded that insurers might have underreported residuals, possibly due to the various forms that residual investments can take. The structural design of a residual interest or residual security tranche can vary, but the overall concept is that they receive “residual” cash flows after all debt holders receive contractual interest and principal payments. Guidance is being added to SSAP 48 – Joint Ventures, Partnerships and Limited Liability Companies and SSAP 43R – Loan-Backed and Structured Securities that also specifies:

• Residuals exist in structures that issue one or more classes of debt securities created for the primary purpose of raising debt capital backed by collateral assets.
• The primary source of debt repayment is derived through rights to the cash flows of a discrete pool of collateral assets.
• The collateral assets generate cash flows that provide interest and principal payments to debt holders through a contractually prescribed distribution methodology (e.g., waterfall dictating the order and application of all collateral cash flows).
• The residual holders in the structure continue to receive payments from the collateral so long as there are cash flows in excess of the debt obligations. The payments to the residual holder may vary significantly, both in timing and amount, based on the underlying collateral performance.

Respondents to the proposal suggested clarifications on the types of structures that should be captured by this guidance, but regulators shelved any further action, believing that the guidance is clear in its intent. Bonds that fall under SSAP 26R as an issuer obligation⁵ wouldn’t be expected to have a residual tranche (which could include debt issued by private funds or other vehicles), but ultimately, whether an instrument is to be reported as a residual interest will be determined by the substance of the transaction.

This guidance adoption is effective immediately.
 

Residuals in preferred stock and common stock (Ref #2023-23)

Guidance amendments have been adopted to clarify the treatment of preferred and common stock residuals. Regulators have become aware of investments that are being repackaged and issued separately as debt and “preferred share” interests to circumvent SVO’s rules that require an SVO filing (which could thereby improve its regulatory treatment) and potentially avoid Schedule BA placement.

The revised guidance would clarify in SSAP 30R (Preferred Stock) and SSAP 32R (Common Stock) that structures with equity components that are, in substance, residual tranches are required to be reported on Schedule BA as residuals. Naming convention alone doesn’t drive investment classification – the substance of the transaction will drive its reporting requirements.

This revised guidance is effective immediately for year-end 2023 reporting.
 

Short-term investments (Ref #2023-17)

Regulators have adopted revisions to the guidance in SSAP 2R – Cash, Cash Equivalents, Drafts and Short-Term investments that confirms principal concepts for the types of investments that should be permitted for reporting as either a cash equivalent or a short-term investment. The review of short-term investments is in response to noted situations where certain types of investments, particularly collateral loans or other Schedule BA items, are being specifically designed to meet the parameters for short-term reporting. Regulators had become aware of short-term collateral loan investments where rules are being circumvented so that they can qualify as a short-term investment on Schedule DA and not Schedule BA, thereby receiving better regulatory treatment (e.g., reduced RBC charges, exclusions from state investment limitations).

The amended guidance includes a revision that excludes an investment from being reported as a cash equivalent or short-term investment unless it would also qualify as an issuer credit obligation under SSAP 26R – Bonds. Such investments will then only qualify as a cash equivalent or short-term investment if it has a maturity date within 3 months (cash equivalents) or 12 months (short-term holding) from the date of acquisition or meets the specific requirements for money market mutual funds or cash pooling arrangements. This would ensure that certain investment types are captured in the intended reporting schedule.

To align with the principles-based bond project adoption, the effective date of this new guidance is January 1, 2025.
 

Collateral loans – Guidance added to clarify collateral admittance and fair value requirements (Ref #2022-11)

Regulators have adopted an amendment to the collateral loan guidance in SSAP 21 – Other Admitted Assets that would clarify that 1) any assets pledged as collateral for admitted collateral loans must also qualify as admitted invested assets, 2) if the collateral is a joint venture, partnership, LLC or an SCA⁶, audited financial statements are required on a consistent annual basis to attest to the legitimacy of the collateral’s fair value and 3) any amount of the loan outstanding that is in excess of the permitted relationship of fair value of the pledged investment to the collateral loan shall be treated as a non-admitted asset. These guidance clarifications would limit potential RBC arbitrage opportunities by certifying the fair value of the collateral and ensuring that the assets used as collateral are admissible under statutory rules where a collateral loan may be used as a conduit.

Exposed Items, to be further considered

IMR – New quarterly and annual statement disclosures proposed for negative IMR (Ref #2023‐13BWG)

A new reporting requirement is being proposed for life insurers to disclose negative IMR in the Notes to Financial Statements and General Interrogatories. The update will allow regulators to easily verify the overall impact of negative IMR on surplus and the split of any negative IMR between general accounts and separate accounts.
 

IMR/AVR – Preferred stock (Ref #2023-29)

A guidance revision is being proposed to clarify that realized gains and losses on perpetual preferred stock shall not be added to the IMR, regardless of NAIC Designation, and will follow the same concepts that exist for common stock in reporting realized gains/losses to AVR. The current guidance for redeemable preferred stock will remain as is for now (which is the same as bond investments), since redeemable preferreds are more akin to debt instruments.
 

Residual tranches – Carrying value, income recognition and OTTI considerations (Ref #2019-21)

Due to their varying complexity and cash flow profiles, regulators are examining the most appropriate accounting treatment for residual tranches. There are concerns that some of the more common accounting approaches may not fit well and other alternatives need to be considered.

Regulators are therefore proposing a measurement method for residuals referred to as “effective yield method with a cap.” Under this method, the book adjusted carrying value (BACV) will be limited to initial cost, and the recognition of interest income/reduction of the cost basis will depend on the cash flows received. Cash flows received that are within the allowable earned yield will be reported as interest income, and cash flows received in excess of the allowable earned yield will reduce the carrying value. The allowable earned yield is established at acquisition as the discount rate that equates the best initial estimate of the residual’s cash flows to its acquisition cost and is not to be updated after acquisition.

To simplify the accounting and reduce complexity, the proposed guidance also allows for a practical expedient for the measurement method that would permit insurers to use a “cost recovery method” approach. Under this approach, all cash flows received from residual tranches will be taken as a reduction of BACV. Once the BACV reaches zero, then all cash flows received will be recognized as interest income.

For OTTI, the proposed guidance for residuals is now consistent with SSAP 43R – Loan-Backed and Structured Securities. OTTI assessments are to be done on an ongoing basis, with a realized loss booked if the present value of expected cash flows is less than the BACV.
 

Collateral loans – Reporting change seeks to improve collateral transparency (Ref #2023-28)

Regulators are proposing to expand the reporting requirements for collateral loans, which would help regulators more easily identify the types of collateral backing each collateral loan. With the adoption of Ref #2022-11 (see above, Collateral loans – Guidance added to clarify collateral admittance and fair value requirements), clarifications of statutory rules require that collateral must reflect a qualifying investment (meaning that it would qualify for admittance if held directly by the insurer). This additional disclosure requirement would help regulators ensure compliance and identify admitted and non-admitted collateral loans.

¹ Valuation of Securities Task Force
² Securities Valuation Office
³ The SVO requires private letter rating rationale reports for most privately rated securities that detail the NRSRO's rating methodology and its in-depth analysis of the transaction. This requirement began in 2022 in response to SVO concerns over the lack of transparency on private debt transactions and increased allocations. 
⁴ Statutory Accounting Principles Working Group
⁵ Under SSAP 26R, an issuer credit obligation is a bond for which the general creditworthiness of an operating entity or entities, through direct or indirect recourse, is the primary source of repayment. Operating entity or entities includes holding companies with operating entity subsidiaries where the holding company has the ability to access the operating subsidiaries’ cash flows through its ownership rights. An operating entity may be any sort of business entity, not-for-profit organization, governmental unit or other provider of goods or services, but not a natural person or “ABS issuer."
⁶ Subsidiary, controlled or affiliated entity


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