Highlights:

• Discussions continue on CLO modeling and RBC arbitrage on securitized assets
  
  
• Rated notes – regulators defer action on structured equity and funds transactions
  
  
• Regulators make continued progress on proposed bond accounting guidance
  
  
• Negative IMR – regulators lean toward allowing negative IMR, as a percentage of surplus

Regulators continue discussions on CLO modeling and RBC arbitrage on securitized assets

Following the adoption of new rules that will move credit assessments away from rating agencies and have the NAIC’s Structured Securities Group (SSG) financially model CLOs³, regulators have continued discussions on next steps for the modeling project. In response to industry comments on the proposed methodology, regulators have created an ad hoc group to resolve and clarify any technical and modeling issues. The first issue to be addressed by the ad hoc group will be the prepay/discount dynamic and its impact on tranche losses.

As the SSG progresses with formalizing this modeling process, the current goal for regulators is 1) for the industry to have a better understanding of the NAIC’s approach to modeling CLOs and 2) to work in parallel with the RBC working group as it progresses on its interim RBC solution for residual tranches.

Regarding RBC, the industry put forth a broad range of suggestions on ways to address RBC arbitrage for CLOs and other securitized assets. There was a lack of support for the previously proposed NAIC 6 solution with three capital factors (NAIC 6.A = 30%, NAIC 6.B = 75%, NAIC 6.C = 100%), primarily due to the absence of a quantitative analysis that typically accompanies a change in the capital framework. Additionally, there appeared to be more support for a single NAIC 6 residual tranche factor, just with a higher factor (45% has been proposed, for example).

Another tool that has been proposed to assist in the factor development is the use of sensitivity testing. Sensitivity testing in the RBC framework provides a “what if” scenario for calculating RBC using alternative capital factors, which allows regulators to assess the impact of a potential change before making the change official. To that end, the regulators have directed NAIC staff to work with the ACLI⁴ to facilitate an exposure for public comment on the ACLI’s proposed sensitivity test. The exposure will also include the revised RBC structural change for residual tranches with only a single capital factor included (with the charge yet to be determined), as there appears to be less of an appetite for a three-factor solution.

Because of the recent emphasis on residual tranches, not just for CLOs but for other ABS as well, regulators have expressed a desire for residuals to be more clearly defined. 2022 was the first year that residual tranches were reported separately, and what should go into the residual category may need to be more explicitly defined. Currently, there is no specific statutory accounting guidance that targets residuals, which will need to be addressed by accounting regulators to ensure consistency moving forward.

Also, for residual tranches, regulators will inquire with accounting vendors to see when the latest a proposed change of the capital framework can be incorporated into the reporting systems for 2023 year-end reporting. That will inform regulators as to whether a 2023 effective date is feasible, or if 2024 is a more realistic goal.

Exposed Items, to be further considered

Rated notes (structured equity and funds transactions) – Regulators to maintain filing exemption and defer adopting new rules; to seek other ways to enhance oversight

In December, the SVO released a proposal that adds a new category to its guidance for “structured equity and funds” transactions that would cover notes issued by structured vehicles backed by equity, limited partnership interests and/or fund investments. The plan would remove rating agencies from performing credit assessments and leave control of those assessments in the hands of the SVO. After initial pushback from the industry, the SVO has paused those plans and deferred adoption of the proposal while it looks to gain the desired transparency from current processes already in place.

Among the initial concerns within the industry was that this proposal has significant overlap with the parallel accounting project to define the types of securities that will be allowed bond treatment under statutory rules. The outcome of the accounting project and the documented analysis required for Schedule D-1 access should filter out questionable securities, thereby lessening the SVO burden in this area.

Another concern recognized by all involved was the need to include these types of securities in other areas of the statutory guidance. As accounting regulators look to better define residual tranches, VOSTF is asking that accounting regulators consider structured equity and funds transactions when creating its new accounting definitions. There is also hope within the industry that as regulators work through defining certain security populations, it will create more clarity on the securities regulators are targeting versus others that are not in scope.

Lastly, there are worries from some that regulators do not have the resources needed to undertake this task, when compared with the rating agencies. While the rating agencies have collectively developed expertise in this space, even the largest NRSROs⁵ aren’t experts in all areas of the structured market. That has led to fragmentation, where certain NRSROs have niche expertise in certain corners of the market, and that expertise that would be difficult to duplicate within the SVO.

As the SVO looks to enhance transparency, an option being considered is to institute rule changes that would give the SVO the ability to challenge private ratings on an individualized basis directly with an insurer. This, in combination with the private letter rationale reports⁶ the SVO already receives for every private transaction, could satisfy regulator goals on rated note structures. NAIC staff will produce enhanced oversight procedures for regulator review, detailing how they could be improved, and discussions will continue on this topic during future meetings.

The SVO to amend its guidance pertaining to the credit deterioration of firms issuing letters of credit in reinsurance transactions

In response to the recent banking crisis affecting firms such as Silicon Valley Bank and Signature Bank, the SVO is proposing to update its guidelines for the removal of a financial institution from the list of Qualified U.S. Financial Institutions (QUSFI) eligible to issue letters of credit that can be used to reduce an insurer’s liability when ceding reinsurance to certain assuming insurers. To qualify as a QUSFI, the financial institution issuing a letter of credit must have a minimum rating of BBB-/Baa3. But the speed of recent bank failures has prompted the SVO to amend its guidance, allowing for prompt removal of a failed firm from the list once action has been taken or announced by its primary regulator.

Exposed Items, to be further considered

Schedule D bonds: Discussions continue on the principles-based bond project (Ref #2019‐21)

Regulators continue to work on the project to reform the accounting guidance for bonds on Schedule D-1. Based on recent industry comments, the Statutory Accounting Principles Working Group has incorporated several revisions into its proposed guidance, which include:

• Guidance for residual tranches will specifically be covered in SSAP 21R – Other Admitted Assets and reported on Schedule BA, at the lower of amortized cost or fair value. Residual tranches do not qualify for reporting as a bond on Schedule D-1.
• Replication (synthetic asset) transactions (RSATs) will continue to be covered in SSAP 86 – Derivatives and are not subject to the principles-based bond definition.
• An exception for nominal interest rate adjustments has been added, defined as adjustments that are too small to be taken into consideration when assessing an investment’s substance as a bond. This was in response to concerns that certain instruments with non-debt variability features, such as sustainability-linked bonds, wouldn’t meet the new bond definition. The guidance also clarifies that any adjustments that cause an investment to meet the definition of a structured note⁷ would not be considered a nominal adjustment.
• A guidance edit will clarify that, for the purposes of transitioning to the new guidance once adopted, investment assessments are required as of origination to determine whether investments qualify for bond treatment. If historical information isn’t readily available, companies are permitted to use current or acquisition information for making that determination.
• Transition guidance will clarify that the new guidance shall be applied prospectively beginning with the first year of adoption (projected to be January 1, 2025). For disclosures that provide comparative information, reporting entities shall not restate the prior year’s information in their 2025 disclosures.
• Further discussion is planned for bonds that don’t qualify as bonds. Those discussions will focus on 1) how these securities will impact RBC and 2) the admittance of debt securities when the source of repayment is derived through rights to underlying collateral.

New Schedule D blank released, in support of forthcoming bond accounting changes (2023‐06BWG)

To support the forthcoming changes to the accounting for bond investments, regulators have released 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 anticipated effective date of the new schedule is the first quarter of 2025, in line with the planned adoption of the new bond accounting rules.

Negative IMR (Ref #2022‐19)

Late last year, the NAIC was asked by the ACLI to reconsider its rules toward negative interest maintenance reserve (IMR) balances. Under current statutory rules for life insurance entities, a net negative IMR balance is a non-admitted balance, with the offset resulting in a direct charge to surplus. As interest rates have risen, realized losses on disposed bonds are causing IMR balances to decline. A rising rate environment is generally favorable to the life insurance industry, but the current treatment of negative IMR can create the perception of decreased financial strength through understated surplus and lower RBC ratios.

In its comments to regulators, the ACLI outlined a broad framework of safeguards that could be implemented to address regulator concerns and ensure prudent portfolio and asset liability management:

• Ensure there is reinvestment in fixed income securities if securities are sold
• Enhancement to asset adequacy testing (AAT) – only allow negative IMR if it is included in AAT
• Shorten the amortization period for negative IMR
• Limit negative IMR as a percentage of surplus, assets, etc.
• Restrict surplus via the special surplus funds
• Financial strength requirement – allow negative IMR only if a company’s RBC ratio indicates that it is financially strong
• Create an “opt-in framework” with documentation requirements, in combination with one or more of the above safeguards

The ACLI isn’t in favor of incorporating all of these, but felt it was sensible to lay out possible alternatives for regulators as they consider next steps.

In response to the ACLI’s proposal, regulators will produce an exposure that allows negative IMR as a percentage of surplus. The starting point will be 5% of surplus as an interim solution, but that is subject to change as a longer-term solution is developed.

Corporate Alternative Minimum Tax Guidance (Ref #2023‐04)

Due to the complexity involving the new corporate alternative minimum tax (CAMT) that was adopted into federal law as part of the Inflation Reduction Act, NAIC staff will begin a multi-level project to address several accounting challenges that CAMT presents, including 1) deferred tax assets (DTAs) due to CAMT and how DTAs can be used and reflected for statutory purposes, 2) projecting income from a group of companies that sit outside of the reporting entity, 3) estimating partnership/alternative investment income for financial statement income projections, 4) the treatment of tax-sharing agreements and 5) RBC thresholds for DTA admissibility.

There is no stated timeline attached to the project, but any changes are likely to be expedited due to CAMT going into effect in 2023.

Collateral loans (Ref #2022-11)

Regulators have re-exposed 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 any other investment that would qualify as a subsidiary, controlled or affiliated entity (SCA) if directly held, an audit is required to attest to the legitimacy of the collateral’s fair value and 3) if the collateral loan exceeds the audited equity valuation of the pledged collateral, then any excess amount shall be non-admitted. These guidance clarifications would limit potential RBC arbitrage opportunities by certifying the fair value of the collateral and ensure that the assets used as collateral are admissible under statutory rules where a collateral loan may be used as a conduit.

New Market Tax Credit Investments (Ref #2022-14)

During the 2022 Fall National Meeting, regulators detailed a plan to revise the rules regarding tax credits and expand the guidance for allowable tax credit programs under statutory accounting. Current NAIC guidance only specifically covers low-income housing tax credits (SSAP 93), but there are other tax credit programs, covering areas such as rehabilitation projects, clean energy production and activities aimed at reducing carbon emissions, that could benefit insurers. NAIC staff will draft new guidance, while also relying on industry input for next steps.

There are also two specific issues the industry has requested additional clarity on:

• Some have requested that amortization and tax credits from the investment be captured in the same income statement line, similar to U.S. GAAP, as a component of income tax expense. Current statutory rules amortize the investment as the tax credits are proportionately used and recognize tax credits used as a reduction in the related tax expense category.
• Tax credit investments issued in debt form are reported on Schedule BA instead of Schedule D-1. Regulators are likely to keep the Schedule BA treatment, but will provide more clarity as to why this is the appropriate approach.

Reference Rate Reform (Ref #2023-05, INT 20-01)

To prepare for the transition away from the London Interbank Offered Rate (LIBOR) and other interbank offered rates, regulators previously adopted guidance that granted temporary (optional) waivers from de-recognizing hedging transactions and provided some exceptions for assessing hedge effectiveness. The relief also included derivative instruments affected by changes to the rates used for discounting, margining or contract price alignment (regardless of whether they referenced LIBOR or another interbank rate that is expected to be discontinued). Regulators are proposing to extend these temporary waivers to December 31, 2024, which will allow for the continuation of existing hedge relationships and thus not require hedge de-designation due to reference rate reform.

¹ Valuation of Securities Task Force
² Securities Valuation Office
³ This adoption currently only covers broadly syndicated CLOs, leaving out middle market CLOs, commercial real estate CLOs and other types of ABS. Regulators have stated that their intention is to eventually model middle market CLOs, but they will be out of scope until specialized assumptions and additional data can be attained.
⁴ American Council of Life Insurers
⁵ Nationally Recognized Statistical Rating Organization
⁶ Under current SVO rules, all privately rated securities issued after December 31, 2017 are required to have a private letter rationale report submitted to the SVO. These rationale reports detail the transaction structure and methodology that the NRSRO uses to assign its rating to the security, which typically mirrors what the NRSROs produce for public ratings.
⁷ Structured notes are defined as an investment that is structured to resemble a debt instrument, where the contractual amount of the instrument to be paid at maturity is at risk for other than the failure of the borrower to pay the contractual amount due. These instruments incorporate both the credit risk of the issuer, as well as the risk of an underlying variable/interest, such as the performance of an equity index or the performance of an unrelated security. Due to the underlying variable that determines principal repayment, these structures (regardless of if it is in a trust/SPV) do not qualify as creditor relationships and do not qualify for Schedule D-1 reporting. Existing guidance specifies that structured notes shall be captured in SSAP No. 86 – Derivatives.

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