The Statutory Accounting Principles Working Group (SAPWG) of the NAIC held a virtual meeting on November 16, 2022, where they continued discussions on the principles-based bond definition initiative. The proposed effective date for these changes was moved from January 1, 2024, to January 1, 2025.
What is the NAIC’s Principles-Based Bond Definition Project?
The SAPWG has worked on this bond project with NAIC staff, the Iowa Department of Insurance, and interested parties since October 2020. The intent of this project is to establish principles-based guidance for determining bonds in this increasingly dynamic financial market. The goal is to provide transparency into insurers’ investment portfolios for regulators and other financial statement users.
The proposed statutory accounting and reporting changes were exposed in July and August 2022, and the working group discussed comments received from the interested parties. Part of the interested parties’ comments are incorporated into the revisions to various SSAPs.
NAIC staff are revising an issue paper and D-1 reporting changes and will present them at the upcoming fall national meeting for exposure. The meeting takes place Dec. 12-16 in Tampa, Florida.
Proposed Revisions to Various SSAPs
There are numerous proposed revisions to various SSAPs resulting from the interested parties’ comments and NAIC staff’s recommendations. The SAPWG exposed these revisions for comment with a deadline of February 10, 2023. The following summarizes the proposed changes and some of the reasoning for these changes.
- Bond definitions will be centrally located in SSAP No. 26R.
- This will prevent duplication and potential inconsistencies in the language between SSAP No. 26R and 43R. Users would use SSAP No. 43R for the accounting and reporting guidance if the securities are determined to be asset-backed securities (ABS).
- Reference to “structure” will be replaced with “investments” in both SSAP No. 26R and 43R as the “structure” could cover all tranches of an ABS.
- This will prevent unintended consequences, e.g., one of the tranches, that is not eligible for bond classification, may ruin the eligibility of other tranches to be qualified as bonds.
- Clarification will be added that investments with specific guidance and reporting lines, e.g., surplus notes, WCFI, and structured settlements, shall follow the respective SSAPs even though they may meet the proposed principles-based bond definition.
- The glossary, other than the definition of bank loans from the old exhibit A, will be removed. The bank loans definition will be brought into a footnote to SSAP No. 26R paragraph 2b.
- “Loan-backed and structured security” is replaced with “asset-backed security” throughout the SSAP guidance, e.g., SSAP No. 26R, 43R, 2R, 7, 95, etc.
Highlights of the Proposed Revisions to Bond Definitions in SSAP No. 26R
- To determine if a security represents a creditor relationship, it should consider all other investments the insurer owns in the investee and any other contractual arrangements.
- For debt instruments collateralized by equity interests and dependent on cash flow distributions that are not contractually required to be made and are not controlled by the issuer of the debt it requires significant judgment, analysis, and documentation by the insurer at the time of acquisition. To prove the debt instruments are bonds, there should be predictable cash flows and the underlying equity risks should have been sufficiently redistributed through the capital structure of the issuer (For details see SSAP No. 26R Paragraph 6a).
- The level of documentation and analysis required will vary based on the characteristics of the individual debt instrument. For example, a debt instrument collateralized by fewer, less diversified equity interests would require more extensive and persuasive documented analysis than one collateralized by a larger diversified portfolio of equity interests.
- Bonds must have pre-determined principal and fixed or variable interest payments with contractual amounts that do not vary based on the appreciation or depreciation of any underlying collateral value or other non-debt variable, e.g., referenced equity, equity, real estate, etc. US treasury inflation protected securities (TIPs) and secured overnight financing rate (SOFT)-linked coupons are considered as bonds. However, structured notes and principal-protected securities (PPS) are not considered as bonds. The structured notes are in the scope of SSAP No. 86, and the PPS are in the scope of SSAP No. 21.
- A bond is either an issuer credit obligation or asset backed security.
- Issuer credit obligation is backed by the cash flows of an operating entity. The proposed revisions would clarify the general creditworthiness of an issuer is the primary repayment source, that can be through direct or indirect recourse in paragraph 7.
- ABS is backed by financial assets or cash generating non-financial assets that are owned by the ABS issuer. It adds new language to clarify that the issuer may not own the underlying collateral but has legal recourse to the underlying collateral pursuant to exhibit A paragraph 4.
- For ABS that have real property as the collateral, the loan-to-value at origination is revised to 100% from 70%.
- Cash-generating non-financial assets are expected at origination of the ABS to generate a meaningful level of cash flows toward the repayment of the bond through use, licensing, leasing, servicing or management fees, right to future cash flows, or other similar cash flow generation, other than through the sale or refinancing of the non-financial assets. As a practical expedient, the cash generating non-financial asset is considered to be able to produce meaningful cash flows if less than 50% of the original principal repayment relies on sale or refinancing. Complete or full analysis is required when more than 50% of the original principal repayment relies on sale or refinancing.
- The ABS holder must be in a different economic position than if they owned the collateral directly. To be qualified as an ABS, there must be substantive credit enhancement through guarantees, subordination and/or overcollateralization at origination. Substantive credit enhancement is used to distinguish bonds from instruments with equity-like characteristics or where the substance of the transaction is more closely aligned with that of the underlying collateral. The first loss position that lacks contractual principal and interest payments along with a substantive credit enhancement does not qualify for bond treatment and should be in the scope of SSAP No. 21R.
- Securities issued by a bankruptcy-remote entity and backed by a single asset or project, are considered as issuer credit obligations. It represents a stand-alone business producing its own operating revenues and expenses and the primary purpose is to finance an operating project.
Proposed Changes to SSAP No. 43R
- It clarifies if an ABS complies with the bond definition in SSAP No. 26R in paragraph 1.
- It includes Freddie-Mac When-Issued Trust Certificates that are fully guaranteed by Freddie Mac and not initially reported as a derivative forward contract are in the scope of 43R.
- It clarifies ABS that are of high credit quality, e.g., AA or better ratings (equivalent to NAIC Designation Categories 1.A or 1.B) at acquisition, can utilize the retrospective adjustment methodology for valuation until it is other-than-temporarily impaired (OTTI) in paragraph 18.
Proposed Transition Language to Both SSAP No. 26R and 43R
- For securities held at the time of transition, insurers may utilize current information in determining that a security qualifies for reporting as an issuer obligation or ABS as they may not have the means to complete historical assessments.
- For securities that do not qualify as bonds under the new SSAP No. 26R, they shall be reported as a disposal on Schedule D Part 4 with a reacquisition on the appropriate reporting schedule, e.g., Schedule BA Part 2 in 2025 Q1.
- For securities held at amortized cost as of December 31, 2024, no realized gain or loss shall be recognized at the time of reclassification on January 1, 2025, because the book adjusted carrying value and amortized cost shall be the same amount.
- For securities held at fair value under the lower of amortized cost or fair value measurement method as of December 31, 2024, they will be remeasured at amortized cost prior to the disposal on January 1, 2025. This will prevent realized loss recognition at the time of reclassification.
- The acquisition cost on Schedule BA Part 2 shall be the amortized cost.
- No unrealized gains but unrealized losses shall be recognized for securities that no longer qualify as bonds on Schedule D-1 due to the reclassification because book adjusted carrying value should never exceed amortized cost. A disclosure on the surplus impact at transition is required for Q1 2025:
- Aggregate BACV for securities reclassified off Schedule D-1.
- Aggregate BACV after transition for securities reclassified off Schedule D-1 that resulted with a change in measurement method, e.g., from amortized cost to a fair value measurement method.
- Aggregate surplus impact (the difference between BACV as of December 31, 2024, and BACV after transition) for securities reclassified off Schedule D-1.
Proposed Transition Language to SSAP No. 43R Only
ABS that were previously reported as short-term bonds on Schedule DA or cash equivalents on Schedule E Part 2 shall be reclassified and reported on Schedule D Part 1 Section 2 on January 1, 2025, pursuant to paragraph 51.
Proposed Changes to Other SSAPs
SSAP No. 2 – Cash, Cash Equivalents, Draft and Short-Term Investments
This proposed change disallows the following investments from being reported as cash equivalents in paragraph 6 or as short-term investments in paragraph 14:
- ABS captured in scope of SSAP No. 43R.
- All debt securities that do not qualify as bonds, captured in scope of SSAP No. 21R.
- Derivatives in scope of SSAP No. 86 or 108.
- Working capital finance investments in scope of SSAP No. 105R.
SSAP No. 21R – Other Admitted Assets
This proposed change adds all debt securities that do not qualify as bonds under the new bond definitions, in the scope of SSAP No. 21R:
- Debt securities do not reflect a creditor relationship in substance.
- Debt securities do not qualify for bond reporting due to a lack of substantive credit enhancement.
- Debt securities do not qualify for bond reporting due solely to a lack of meaningful cashflows.
The accounting and measurement method for those debt securities that do not qualify for bond treatment, due solely to a lack of meaningful cashflows, shall follow SSAP No. 43R, i.e., the book adjusted carrying value is determined by NAIC Designation. The other debt securities shall be reported at cost at acquisition and measured at lower of amortized cost or fair value.
Other statutory accounting guidance, e.g., amortized cost calculations, OTTI, bifurcation of unrealized and realized gains and losses between AVR and interest maintenance reserve (IMR), shall follow the guidance in SSAP No. 43R.
This change clarifies that the securities captured in SSAP No. 26R or 43R that are also secured with collateral shall continue to be captured in scope of those two standards in footnote 1 to paragraph 4.
It adds a new paragraph 15 for guaranteed investment contracts (GICs) acquired in a security structure that qualify as an issuer credit obligation or ABS shall follow SSAP No. 26R or 43R as applicable.
Debt securities are admitted if they are secured by admitted invested assets and any amounts in excess of the fair value of the underlying admitted invested assets shall be non-admitted.
SSAP No. 86 – Derivatives
This proposed change moves part of the footnote 5 to paragraph 5g – structured notes are instruments in which the amount of principal repayment is contingent on an underlying variable or interest where the terms and conditions make it possible that the insurer could lose all or part of its original investment amount.
SSAP No. 103R – Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
It adds that a security that doesn’t qualify for bond treatment shall be reported as a debt security in scope of SSAP No. 21R, to paragraph 2 and 18.
INT 07-01: Application of the scientific (constant yield) method in situations of reverse amortizations
This change removes quoted guidance from SSAP No. 26R and 43R.
The next SAPWG meeting will be held in Tampa, FL on December 13, 2022.
NAIC Blanks Working Group Update
The Blanks Working Group of the NAIC held a virtual meeting on November 17, 2022. The following updates pertain to investment accounting.
Exposed Items with comment deadline of February 1, 2023
Ref #2022-17BWG – Add new disclosure paragraph for Note 8 and illustration to new disclosure to be data captured. Add electronic only columns related to derivatives with excluded components to Schedule DB, Part A and Part B for both Section 1 and Section 2. Add new code column instructions for Schedule DB, Part A and B (SAPWG 2021-20)
This item proposes adding disclosure requirements for aggregate excluded components to Notes to Financial Statements 8 – Derivative Instruments. They should be reported in four categories (e.g., Time Value, Intrinsic Value, Cross Current Basis Spread, and Forward Points) with current fair value, recognized unrealized gain/loss, fair value reflected in book adjusted carrying value. For the excluded forward points (e.g., forward spot rate), three additional values – aggregate amount owed at maturity, current year amortization, and remaining amortization, are required.
Ref #2022-18BWG – For the life, accident, and health/fraternal blank, instructional corrections on the handling of Exchange Traded Funds and/or SVO Identified Funds within the Interest Maintenance Reserve (IMR) and the Asset Valuation Reserve (AVR).
Bond mutual funds were removed from statutory accounting principles (SAP) by the SAPWG and SVO P&P Manual from the Valuation of Securities Task Force. However, they haven’t been removed from the blank instructions.
This item proposes removing the bond mutual funds from both the interest maintenance reserve (IMR) and asset valuation reserve (AVR) – Default Component report and adding mutual funds, unit investment trusts, and closed-end funds to the AVR – Equity and Other Invested Asset Component report.