How New Corporate Bond Factors Could Impact Insurers

In August 2014, the Investment Risk-Based Capital Working Group (IRBCWG) released a new set of Corporate Bond Factors specific to life insurers (also known as C1 Base Risk Factors). However, as there is currently no differentiation in RBC factors between life and non-Life insurers, these factors would likely impact P&C insurers as well. The factors were recommended by the American Academy of Actuaries (AAA).

The new factors were met with strong opposition by Industry. There were two major reasons why Industry opposed the change:

1. The AAA proposed changing from six designation classes to 14, using a system of 1+,1,1-, etc. This change would take months, as most insurers would need to update their systems.
2. The new factors, on average, would produce a 33% increase in the C1 factor for an average life insurer.

Shortly before the NAIC Summer 2015 National Meeting, the AAA released extensive documentation in response to this Industry opposition. The documentation detailed how the AAA arrived at their proposed factors and the reasons for the proposed changes. Industry replied with several new concerns about the project, as well as comments on the assumptions used in the AAA’s model to determine the new proposed factors.

New Industry Concerns And Questions

The American Council of Life Insurers (ACLI) released a comment letter on September 29, listing the most extensive concerns about the modeling process used by the AAA. Concerns include:

• Lack of Asset Class Analysis—Public Corporate Bonds only account for about 50% of assets that C-1 Factors cover; Industry was concerned that analysis should be done on other asset classes, especially municipal bonds. Related to this, the National Association of Mutual Insurance Companies (NAMIC) provided data detailing default rates for municipal bonds that shows significant differences from corporate bond factors, and asked that more analysis be done on municipal bonds. The lack of other asset class analysis was the most prevalent concern from Interested Parties.
• Discount Rate of 3.25%—The ACLI had issues with the discount rate using an after-tax rate, as well as using a risk-free rate. They believe an appropriate rate would be “significantly higher” than the proposed rate of 3.25%. Principal Financial expressed this concern in their comment letter as well.
• Risk Premium Offset—The model currently uses the mean expected rates, where the ACLI believes it should use a more conservative provision. Principal Financial expressed this concern in their formal letter, as well as concern about the discount rate used.
• Use of a “Greatest Loss” Construct—This construct is not conducive to the purpose of the C1 factors, which is to measure long-term performance of a single asset class, not to measure the survival of the firm as a whole.

The ACLI also requested more information about certain topics, including a sensitivity analysis, more information about recovery and default rates used, and why the proposed factors were significantly different than those used by S&P in rating insurance companies.

The ACLI also questioned the necessity for a change in the number of rating classes. Other parties, such as Principal, have expressed support for the change to 14 classes in the long-term, and multiple parties expressed that an implementation period of several years would be necessary.

NAMIC, in addition to asking for more analysis on municipal bonds, also raised concerns with using the same factors for P&C companies. They pointed to differences between the Life and P&C RBC formulas, and noted that the factors used for Life are not necessarily appropriate due to these differences. NAMIC also expressed concerns about upcoming regulatory changes that are already expected to affect P&C companies, and asked that the IRBCWG consider those upcoming challenges when making decisions.

The North American CRO Council (NACRO) addressed concerns with the incentives that the new factors could provide. There could be unintended consequences of insurers shifting from high-rated bonds, especially Single A, to lower-rated bonds, increasing the risk of insolvency across the industry as a whole. The NACRO supported the ACLI and NAMIC in concerns pertaining to using corporate bond experience across other types of fixed income.

Next Steps

During the most recent conference call, the IRBCWG received the comment letters, but did not discuss any at length. Most of the technical questions and concerns will be addressed by the AAA, but no specific timeline has been set for when the AAA will respond to Interested Party questions. More discussion will come from the working group at the NAIC Fall National Meeting. This will continue to be a topic to watch as Industry, the AAA, and the IRBCWG try to come to a solution that works for all parties.