NAIC Latest: CLOs, SCAs, and Mortgage RBC Factors

Two NAIC working groups – the Valuation of Securities Task Force and the Life Risk-Based Capital Working Group – held virtual meetings in October. The VOSTF discussed and exposed several proposed amendments to the SVO Purposes and Procedures (P&P) Manual, and The LRBCWG discussed proposed revisions to mortgage RBC factors and formulas.

The following updates pertain to investment accounting.

Valuation of Securities Task Force Updates

Adopted Item 

2023 Proposed Charges

The task force will work on two new charges in 2023:

1. Establish criteria to permit staff’s discretion over the assignment of NAIC designations for filing exempt securities to ensure greater consistency, uniformity, and appropriateness to achieve the NAIC’s financial solvency objectives.
2. Implement additional and alternative ways to measure and report investment risk.

Items Exposed for 45 days with Comment Deadline of December 5, 2022

Proposed P&P Manual Amendment to Add Instructions for the Financial Modeling of CLOs

It was noted in the Investment Analysis Office’s (IAO) memo, “Risk Assessment of Structured Securities – CLOs,” on May 25, 2022, that it is currently possible to significantly reduce capital charges by securitizing a pool of assets. Eric Kolchinsky, Director of the NAIC’s Structured Securities Group (SSG), said the aggregate risk-based capital (RBC) factor for owning all of the CLO tranches should be the same as that required for owning all of the underlying loan collateral. To eliminate this loophole, the IAO proposes:

1. Assigning the SSG the responsibility of financially modeling CLOs. The SSG can model CLOs and evaluate all losses across both debt and equity tranches under a series of calibrated and weighted collateral stress scenarios to assign NAIC designations that create equivalency between securitization and debit holdings. This will resolve the RBC arbitrage.
2. Sending a referral to both the Capital Adequacy Task Force and RBC Investment Risk and Evaluation Working Group requesting they consider adding two new RBC factors.
3. Adding NAIC modifiers to NAIC designation 6 with possible interim RBC factors of 30% (6.A), 75% (6.B) and 100% (6.C) until those groups can study structured securities.
4. Drafting a Blanks proposal for the new NAIC designation Categories – 6.A, 6.B & 6.C.

It also proposes adding the definition of collateralized loan obligation (CLO) to the SVO P&P Manual Part Four, paragraph 1, and CLOs would be assigned an NAIC designation category by the SSG without an administrative symbol if they can be financially modeled to the SVO P&P Manual Part Four, paragraph 2.  For those CLOs that cannot be financially modeled, they are filing exempt if rated by a credit rating provider, otherwise the insurers will have to file them with the SSG for the NAIC designation category.

The SSG will begin modeling CLOs and evaluate all tranche-level losses across all debt and equity tranches under a series of calibrated and weighted collateral stress scenarios to assign an NAIC designation category for a specific CLO tranche for 2023 annual.

Eric Kolchinsky said the proposed guidance will allow them to go through the process of modeling CLOs.  His team is running ahead of schedule and will discuss their methodology as well as scenarios which he believes will be the most controversial. This discussion is also necessary for them to plan the budgetary items.

The plan is to model broadly syndicated CLOs first because the collateral data is available from a third-party data provider. They will model the middle market CLOs when they can source the data from the data provider.

Proposed P&P Manual Amendment to Update Instructions for Related Party and Subsidiary, Controlled and Affiliated Investments

This proposed item stems from the SAPWG’s referral letter on June 10. The SAPWG adopted revisions to both SSAP No. 25 and 43R on May 24, but the amendment raised interested parties’ concerns about eligibility for filing exemptions for various affiliated structures.

This item proposes adding the related party bond and preferred stock to the SCA investments throughout the SVO P&P Manual. SVO staff clarified that the SCA investments in the SVO P&P Manual have always referred not only to affiliated transactions in which there is either direct or indirect control between the reporting entity and the issuer, but also referred to related parties with relationships other than control as listed in SSAP No. 25. Staff gave an example that the SVO reviewed a transaction in which there was no control between the reporting entity and the issuer, but the owner of the issuer and the CEO of the reporting entity have a father-and-son relationship which poses a risk of abuse, unfairness, or unreasonableness.

The SCA and related party bond and preferred stock investments include both non-control relationships, in which the issuer is not related to the reporting entity, and structures in which the non-issuer underlying credit exposure would qualify as a related party pursuant to paragraph 4.a in SSAP No. 43R.

This item proposes creating a new category of SCA and related party filing exempt investments in Part Three, paragraph 247. It includes the investments that are issued by an affiliated or related party special purpose entity (SPE), which is not an obligor or ultimate source of the investment repayment, or the originator, sponsor, manager, servicer, other influential transaction party is an affiliate or related party of the reporting entity. They would remain eligible for filing exemption unless otherwise ineligible for reasons other than their SCA or related party status. It clarifies that state regulators are permitted to require an insurance company to file with the SVO for NAIC designation categories, and they will be ineligible for future filing exemption.

Proposed P&P Manual Amendment to Clarify the Definition of an NAIC Designation in Part One and Part Two

This proposed amendment would add clarifying language to the SVO P&P Manual Part One, paragraph 37 and Part Two, paragraph 18 to clearly articulate that the assignment of an NAIC designation to a security reflects the likelihood of timely payment of principal and interest, the probability of principal and interest payment default, and the appropriateness and consistency of its use in the NAIC Policy Statement and Financial Regulation Standards (SFRS), including the risk-based capital model factor that will be applied to the security given its level of risk.

The SVO staff said it would provide people clarity into how the NAIC designations should be interpreted and explains why NAIC designations differ from credit rating provider (CRP) ratings.

Life Risk-Based Capital Working Group Updates

Discussion Item

Proposed Revisions to CM6 and CM7 Mortgage RBC Factors and Formula

Both the Mortgage Bankers Association (MBA) and the American Council of Life Insurers (ACLI) proposed the working group consider changing the RBC factors for CM6 and CM7 mortgage loans so that they would align with the RBC factors that were reduced in 2021 for Schedule A and BA real estate investments.

As the real estate RBC factors were reduced last year, the RBC charges are higher for mortgages now.  They recommended lowering the CM6 mortgage RBC factor from 18% to 11%, and the CM7 mortgage RBC factor from 23% to 13%.  As the working group members need more information to consider this request, NAIC staff will find out how the existing RBC factors were developed, and a representative from the MBA will see what data his group can pull.