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  • August 12, 2022

Catching up with the NAIC: July Updates

The Statutory Accounting Principles Working Group (SAPWG), Health Risk-Based Capital Working Group (HRBC), and Financial Condition Committee of the NAIC all held meetings in July. The SAPWG exposed proposed D-1 reporting changes for comment. The other groups discussed topics including regulations for private equity-owned insurers and related party disclosures.

The following updates pertain to investment accounting.

Statutory Accounting Principles Working Group

Exposed item with a comment deadline of October 7, 2022

Ref #2019-21: Principles-Based Bond Definition, Draft Issue Paper and Proposed D-1 Reporting Lines

The proposed principles-based bond definition and draft issue paper were exposed on March 2, with a comment deadline of May 6. The working group received comments from interested parties, including the Lease-Backed Securities Working Group (LBSWG), which is not related to the NAIC.

The following are a few highlights of the comments received from the interested parties and the responses from the NAIC staff or regulators.

NAIC staff disagreed with the interested parties and doesn’t recommend including their proposed changes for the following reasons:

  • As the SVO-identified credit tenant loans (CTLs) are proposed to be captured in SSAP No. 26R and Schedule D-1 under the proposed bond definition, NAIC staff disagrees with adding these mortgage form CTLs to paragraph 2g of the proposed bond definition.
  • The interested parties proposed restricting all returns in excess of principal repayments considered as interest payments to equity-backed asset-backed securities (ABS) only. NAIC staff said any securities that include stated interest and the potential for additional returns, shall be assessed under the proposed bond definition and thus, they don’t recommend incorporating the interested parties’ proposed change.
  • The interested parties disagreed with excluding the ABS from the scope of SSAP No. 2R and from being reported as short-term investments or cash equivalents on Schedule DA and E-2. They proposed discussing that in a separate agenda item because it is out of scope for the proposed bond definition project. The NAIC staff explained this is to avoid ABS securities to be designed with shortened maturity dates to permit DA or E-2 reporting that does not provide the transparency the regulators have been looking for. Currently shorter-term investments have minimal RBC factors without the need to obtain an NAIC designation or credit rating. The NAIC staff emphasized the ABS should not be allowed to be reported as short-term or cash equivalent investments regardless of how close the maturity date is at the acquisition. ABS, which are unrated and undesignated by the NAIC SVO, shall be reported as long-term bonds with an NAIC 6 on D-1. The proposed report for ABS (Schedule D Part 1 Section 2) will include columns that are specific to ABS structure, e.g., balloon payment percentage, overcollateralization, etc.
  • The Lease-Backed Securities Working Group explained their concerns:
    • The current proposal about the simple unstructured single-borrower securities backed by secured loans would be reported as 26R “Issuer Credit Obligations,” 43R “Asset-backed Securities,” or BA assets. They believe this will result in inconsistent filing by the insurers. For example, project finance loans or municipal lease-revenue bonds that were issued through a trust or special purpose vehicle (SPV) would be reclassified as 26R securities, whereas loans secured by leases to corporate entities, equipment trust certificates, and funding agreement notes would either be classified as 26R, 43R, or BA assets depending on the residual asset risk, e.g., they would be qualified as 26R if the residual risk is less than 5%, 43R if the residual risk is higher than 5%, or BA assets if the residual risk is too high.
    • Currently, some insurers file the simple single credit-based transactions under SSAP No. 26R, but some also file under SSAP No. 43R. The LBSWG said the cashflows from those simple unstructured debt transactions are simply passed-through unaltered to the investors and thus, the credit risk of the securities is identical to that of the underlying loan. They also believe the ABS should refer to structured securities only and the credit of each ABS is determined by the structure which fundamentally alters the cashflows to the investors.
    • If the unstructured securities would be classified as 43R under the new guidance, they would most likely be moved from D-1 to BA as the investor is in the same position as if they owned the underlying asset directly. They also disagreed that simple unstructured single borrower securities would be subject to the same two tests (substantive credit enhancement and meaningful cashflow) as other 43R securities. They proposed all single-credit payor/obligor transactions to be in the scope of SSAP No. 26R, while 43R would be used exclusively for true structured securities. NAIC staff said some comments from the LBSWG are related to a fundamental reconsideration of key aspects of the principles-based bond definition, are deemed not in line with the intent of the bond definition. If they incorporated the proposed changes from the LBSWG, some investment structures would be treated as issuer credit obligations in the scope of SSAP No. 26R without further assessment, e.g., securitization with underlying non-admitted assets, ten-year debt issuance backed by a 5-year lease, structures with significant balloon payments at maturity, lease-backed structure regardless of how many payers there are.
    • Inequities between non-municipal project finance bonds and simple unstructured single-borrower securities. The former would be classified as issuer obligation as long as the issuer is an operating entity. The latter would be classified as ABS regardless. As detailed in the draft issue paper, it was already acknowledged that project finance bonds issued by operating entities have characteristics of both issuer credit obligations and ABS. NAIC staff proposed to retain the existing proposed guidance which allows project finance bonds issued by operating entities to be qualified as issuer credit obligations. She emphasized that lease-backed securities are permitted as issuer credit obligations if they are fully backed by a single obligor.

NAIC staff agreed with language that was proposed by the interested parties, and included that language with edits in the bond definition, issue paper, and draft SSAP edits for subsequent exposure at the Summer National Meeting:

  • Instead of removing the US TIPs footnote from the proposed bond definition per interested parties’ comments, the NAIC staff recommended revising both the footnote and paragraph 3b for clarification. The securities that involve either leverage or an inverse adjustment relationship, are intentionally precluded from being classified as bonds under the proposed bond definition. US TIPs are securities with plain vanilla inflation adjustment and are not excluded from bond classification.
  • A proposed change to the Substantive Credit Enhancement Language included within the glossary of the Proposed Bond Definition with modifications that the first loss positions are required to have contractual principal and interest payments along with substantive credit enhancements to qualify for bond reporting, or they shall be reported on Schedule BA.
  • Adding a new paragraph to the draft issue paper for the feeder fund structure after paragraph 26. NAIC staff agreed that the feeder fund has an equity interest in another fund which only holds debt instruments and passes those fixed income cashflows to the ultimate debt holder, may be qualified to have bond treatment as long as the feeder fund structure passes through fixed income like cashflows to the investors in a timely manner and pass the substantive credit enhancement test.

The NAIC staff were directed to work on:

  • Integrating the Appendix I content into the bond definition, SSAPs and issue paper.
  • A separate agenda item to consider New Market Tax Credit Investments.
  • The proposed statutory accounting treatment and admittance criteria for assets that will be moved from D-1 to BA.

The proposed reporting changes are exposed with a comment deadline of October 7, 2022.

NAIC Health Risk-Based Capital Working Group

The Health Risk-Based Capital Working Group of the NAIC held a meeting in lieu of the Summer National Meeting on July 21, 2022, and discussed affiliated investment instructions and blank XR002-XR004, XR010, XR024-25, XR026.

This item was exposed on May 4 for a 61-day comment period ending July 5, and no comments were received. The working group will forward this item to Capital Adequacy for discussions at the Summer National Meeting.

NAIC Financial Condition Committee

The Financial Condition Committee of the NAIC held a meeting on July 21, 2022. The committee discussed regulatory considerations applicable (but not exclusive) to private equity-owned insurers.

This item was exposed by the Macroprudential Working Group (MWG) on April 27 for 45 days with a comment deadline of June 13. Five comment letters were received.

The Chair of the Financial Stability Task Force previously charged the working group with coordinating all NAIC efforts related to PE ownership of insurers. The working group quickly put together a list of 13 considerations the regulators need to address. Some NAIC committee groups were already working on the issues listed. Although the considerations include activities frequently attributed to PE firms, the working group emphasized that the considerations are applicable to any ownership structure and not limited to PE firms only. For more details on this discussion, read our previous Clear Insights post here.

The committee adopted the “Plan for List of MWG Considerations.”

Other Items

Update on Related Party Disclosures

The Chairman of the SAPWG provided an update to the Committee on the new related party disclosures requirement. Both the SAPWG and Blanks Working Group (BWG) recently adopted new disclosures for related party reporting on the detail investment schedules, except for Schedule A. The SAPWG adopted clarifying language within SSAP No. 25 to be consistent with Model Act#440 and #450 on the definitions of affiliate and control.

It is expected there will be an increase in reporting of affiliated investments by the insurers. The primary goal is to provide transparency into the involvement of related parties, e.g., actual credit exposure to related parties or if an investment involves a related party in the origination, servicing, or other involvements. The Chairman said an affiliate is a related party relationship for which there is either direct or indirect control. Model Act#440 is explicit that control can exist through arrangements besides voting interests.

Update on Proposed Bond Definition

The Chairman of the SAPWG provided an overview of the two categories for bond classification, i.e., issuer obligations and asset-backed securities (ABS). A bond must have a creditor relationship in substance. An issuer obligation where repayment is primarily supported by the general creditworthiness of an operating entity. ABS is backed by collateral that provides cash flows to service the debt and must have a substantive credit enhancement which would put the investor in a different economic position than holding the collateral directly, e.g., overcollateralization. The collateral may be a financial or non-financial asset. If the collateral is a non-financial asset, it requires the meaningful cash flows to service the debt.

He said both the state insurance regulators and industry are aligned with key concepts, and the NAIC staff is working on proposed changes to SSAP No. 26R & 43R for exposure at the Summer National Meeting. He also said the working group exposed the proposed changes to Schedule D Part 1 on July 18 with a comment deadline of October 7.

The proposal is to split the Schedule D Part 1 into two separate schedules – Schedule D Part 1 Section 1 to report issuer obligations and Schedule D Part 1 Section 2 to report ABS. It will provide valuable information to the regulators with additional columns. He emphasized that there is no grandfathering planned for investments to continue to be reported as bonds if they do not comply with the new guidance. However, some practical transition assessments will be considered.