NAIC Summer 2015 National Meeting Updates

The NAIC Summer 2015 National Meeting took place on August 15 – 18, in Chicago, Illinois.

Relevant investment accounting items are examined below, including updates on corporate bond factors, mortgage-backed securities, the Investment Classification Project, and more. Read this entire post for a full recap, or click below to jump to the section that most interests you.

1. The Investment Risk-Based Capital Working Group (IRBCWG)
2. The Valuation of Securities Task Force (VOSTF)
3. The Statutory Accounting Principles Working Group (SAPWG)

C-1 FACTORS FOR CORPORATE BONDS UPDATE

Shortly before the NAIC summer meeting, the AAA released documentation detailing how they arrived at their proposed C-1 factors for corporate bonds, and went over the documentation in the IRBCWG meeting. Currently, this is only proposed for Life and Fraternal companies. This has been a standing item for the IRBCWG for four years, and is now starting to pick up steam as a proposal.

Impact of Proposed Changes

The AAA’s proposed factors, before covariance and adjustments, would increase the average industry C-1 charge from 1.16% to 1.56% on a before-tax basis, for an overall increase of 33%.

Deciding the number of RBC charge categories is now a pressing issue. The AAA has proposed increasing the number of categories from six to 14. Given that their analysis had to be done based on NRSRO ratings, the AAA calculated factors for each of the 19 rating categories (excluding those in or near default) and recommended a compression. The compression was proposed due to the insignificant differences between rating classes, and to maintain consistency with the current NAIC designation structure found in state laws (plus, equal, or minus would be added to ratings of NAIC 1-4.)

Industry Reaction

Industry, especially the ACLI, has expressed concern with the proposed expansion of classes. They point to the high cost of implementation, argue that the current number is working, and express concern that the number of categories could change again the next time the factors are reviewed (likely in 5-10 years). Industry also expressed the need to keep the number consistent across insurance segments.

The IRBCWG doesn’t agree with Industry on several concerns. Mainly, they disagree that the current number is working; given the pervasiveness of corporate bonds in the life insurance industry, they consider it imperative to include additional granularity. An interested party proposed the possible compromise of a two-step transition: first, implementing new factors across the current six categories, then expanding the number of categories.

The AAA recommended that due to the lack of publicly available data, the relative size of other classes of fixed income securities compared to public corporate bonds, and the global ratings scales used by NRSROs, the proposed corporate bond factors be used for other fixed income asset classes such as municipals, hybrids, sovereign debt, and private placement corporate bonds. Industry does not want to dismiss this concept at this point, since other asset classes would likely end up with a lower charge.

The main sticking point between Industry and the IRBCWG is municipal bonds. According to the AAA, the rating agencies use a “global ratings scale,” calibrated such that an A-rated municipal bond has the same default risk as a corporate bond publicly rated as any other fixed income class. However, the ACLI brought up evidence concerning the number of municipal bond defaults and argued that while the rating agencies may theoretically assert that municipal bonds have the same default risk as a corporate bond, historical experience does not back that up, and instead suggests that municipals have much less default risk.

The possibility of a carrying value adjustment was also discussed. This has been on the table since the end of 2013, but there’s been little indication that it will actually be incorporated. Theoretically, there is a case for such an adjustment (a premium bond stands to lose more than a discount, so a premium should have a higher charge). As 73% of corporate bonds are held within 2.5% of par (although those outside that range are held at a premium by a two-to-one ratio) most are of the opinion that such an adjustment would not have a material impact on RBC.

The AAA’s Corporate Bond Report also included proposed AVR factors that are consistent with the new RBC factors. No comments have been received from Industry on those yet.

Next Steps

The topic of proposed C-1 factors for corporate bonds will continue to be hotly debated in the coming months. Although the final result will likely not go into effect until 2017 or later, Life, Health, and P&C insurers should be aware of possible changes now, so they can plan for necessary system and process changes, and perhaps even adjustments to investment strategies.

The AAA’s report was exposed for a 45-day comment period ending October 7. The comments will be discussed at the NAIC Fall 2015 National Meeting. The IRBCWG stands behind the AAA’s work and their recommendations, so it will be interesting to see if compromises or other changes are made to the proposal. Once IRBCWG settles on a recommendation, they will then have to involve the other RBC working groups, the Capital Adequacy Task Force, the Valuation of Securities Task Force (VOSTF), and the Statutory Accounting Principles Working Group (SAPWG) to implement the final proposal.

During the remainder of Q3 and Q4, the AAA will also respond to regulator and interested party questions. They will evaluate current adjustments to investment RBC, such as the additional charge for top 10 concentration and the size factor. Their current opinion is that those adjustments are already accounted for in the model used to arrive at standard factors, and having an additional adjustment for them is unnecessary. They then plan to review the current factors for structured securities.

REAL ESTATE RBC DOCUMENTS – EXPOSED

The IRBCWG also exposed for comment the recommendation to revise the real estate RBC factor for Life and Fraternal companies. The proposal cuts the real estate RBC factor to a base factor of 8.5%, revises the factor for encumbrances, and adds an adjustment for unrealized gains/losses.

The factor for Schedule BA real estate would be 12.75%, remaining 50% higher than the standard real estate factor. The comment period ends September 29.

RESIDENTIAL MORTGAGE-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES FINANCIAL MODELING VENDORS

In Spring 2015, the NAIC requested proposals from vendors on the financial modeling of residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). The NAIC has announced that starting this year-end, all financial models will now be supplied by BlackRock.

This is a change from previous years, where PIMCO supplied the RMBS models and BlackRock provided the CMBS models. To minimize potential impacts, the Securities Valuation Office (SVO) has completed an extensive testing process. In the fall, the SVO will notify any insurance companies holding securities that will be greatly impacted.

FOREIGN ACCOUNTING STANDARDS UPDATES

The ACLI continues to research recent changes to UK GAAP and assess if UK GAAP should continue to be a recognized Financial Presentation Standard in The NAIC Purposes and Procedures Manual (P&P Manual).

UK GAAP was recently updated to better align with companies that choose to use International Financial Reporting Standards (IFRS). This caused some issues with smaller UK businesses. The SVO’s internal Credit Assessment and Valuation Group has expressed similar concerns that the new Financial Reporting Standard (FRS 102) allows companies to retain historic valuation methods.

The ACLI has also started to research the process of adding the Netherlands and Italy to the P&P Manual’s National Financial Presentation Standards.

HR RATING DE MEXICO

HR Rating de Mexico has applied to be added to the list of NAIC Credit Rating Providers.

HR Rating de Mexico (HR Ratings) is based in Mexico City and rates Mexican and South American securities valuing over $30 billion. In 2012, HR Ratings received approval from the SEC to act as a NRSRO for public finance securities. More information about HR Ratings can be found at: http://www.hrratings.com/en/index.

DERIVATIVES MODEL LAW PROJECT

The VOSTF also received an update on a review of the Derivatives Model Law Project, which was last reviewed in 2007.

The VOSTF has heard several presentations over the past two months detailing the derivatives market, insurer use of derivatives, and current derivatives regulation. More presentations may be coming if members of the VOSTF request more information about certain topics, or from certain parties. Major changes have occurred in the derivatives market since the last review, many of them brought about by the Dodd-Frank Act.

Definite proposed changes to the model law are unlikely to occur in the near future.

PRIVATE LETTER RULING

The VOSTF heard an update from the SVO on the Private Letter Rating Project.

The Private Letter Rating Project’s focus is to determine the cause of, and reduce the number of, Jumpstart exceptions, and to identify common situations where securities are being filed with the incorrect SVO.

The Project completed an analysis of every security assigned an FE designation from an insurer without first matching the SVO’s credit rating feeds with the NRSRO’s credit rating feeds. Securities identified that shouldnot be filed include CDs and Government Agencies filed with an FE, and non-modeled Structured Securities.

The current population of remaining exceptions leaves a total of 4,889 securities that might need to be filed with the SVO. The majority of the securities are private placements, sovereign debt, corporate bonds, and lottery bonds.

The SVO did not discuss next steps on the project.

INVESTMENT CLASSIFICATION PROJECT UPDATES

The NAIC Investment Classification Project (REF#2013-36) has four primary goals:

1. Clarify the definitions of certain security types in the market where Industry is treating them differently than stated guidance.
2. Clarify the look-through accounting requirements for certain types of securities.
3. Clarify inconsistencies regarding the reporting of items within Schedule D and BA.
4. Provide additional guidance on a subset of investments where Industry is inconsistent in their treatment.

During the NAIC Spring 2015 National Meeting, the SAPWG exposed proposals for Industry comment. During the August meetings, the NAIC discussed the comments received on those proposals, and identified the next steps, as detailed below.

INCLUSION OF SECURITY DEFINITION FOUND IN US GAAP WITHIN SSAP NO. 26

Industry supported this proposal, so the NAIC will be drafting up a proposal to insert the GAAP definition within SSAP No. 26. In addition, NAIC staff will further evaluate if this security definition should be added to the master glossary.

REQUIREMENT FOR “CONTRACTUAL AMOUNT OF PRINCIPAL DUE” FOR SSAP NO. 26 INVESTMENTS

This item would effectively move bond ETFs from Schedule D – Part 1 to a new schedule for all mutual funds and ETFs. The NAIC has further clarified that the accounting treatment of placing these funds on a new investment schedule has not yet been studied or identified.

Interested parties commented that the language in the proposal could have unintended downstream consequences by inadvertently moving something from an admitted asset to a non-admitted asset. They have asked that the NAIC move slowly and cautiously with this proposal.

BlackRock Investment Management, Inc., submitted a comment letter that contained a proposal to keep the bond ETFs that have been approved by the SVO for bond-like treatment on the Schedule D – Part 1. In summary, their proposal asks that the bond ETFs be broken out into a new separate sub-section and that the NAIC consider an amortized cost valuation method on the ETFs, using a look-through/weighted average approach. BlackRock suggested that, based on the individual holdings of each ETF, the bond use a weighted average approach to capture the bond-like fields, including Maturity, Book Yield, and Par Value, as well as the IMR gain and loss at point of sale of the underlying assts. The BlackRock comment letter and proposal, which is available on the NAIC website, lists numerous reasons why they have reached their rationale (Clearwater makes no claims regarding the accuracy or merits of those arguments).

The NAIC exposed the BlackRock proposal with a shortened comment period through September 11.

These changes will potentially have a strong impact on Industry. Read additional Clearwater commentary on potential challenges and downstream issues.

Discussion of Non-Bond Items

In conjunction with comments received from interested parties, NAIC staff will be inserting definitions for debt-like investments that should be included within the issue paper revising SSAP No. 26. These definitions will cover:

• Yankee Bonds
• American Depository Receipts (ADRs)
• Zero Coupon Bond
• Loan Participation
• Loan Syndications
• Convertible Securities

In addition to the above security types, NAIC staff will be updating the following terms in the issue paper, and will eventually suggest changes to the Annual Statement Instructions:

• To Be Announced (TBA) securities
• Hybrids
• Loan Participations
• Loan Syndications

Adopted Items

The NAIC adopted REF# 2015-20: a Non-substantive Revision to Remove Issue Papers from the PrintedAccounting Practices and Procedures (AP&P) Manual. Going forward, issue papers will only be available on the NAIC website. While Industry supported this change, they did remind the NAIC of the importance of issue papers, and ask that they be easily accessible on the NAIC website.

Exposed Items

2015-04: CLARIFYING GUIDANCE FOR CALLABLE BONDS — COMMENT PERIOD ENDING OCTOBER 5

This proposal is to modify SSAP No. 26 – Prepayment Penalties and Amortization on Callable Bond, to state that, “Bonds with Make Whole Calls shall NOT be considered in determining the timeframe for amortizing a bond over unless the reporting entity has information that the issuer is expected to invoke the call.” In addition, clarification will be added explaining that for callable bonds without a lockout period (excluding Make Whole Calls), the BACV at time of acquisition shall equal the lesser of the next call price, or cost. The remaining premium from that method shall then be amortized yield-to-worst (which essentially expenses the premium immediately).

Additional footnotes to SSAP No. 26 would clarify that only call dates after the acquisition of the bond shall be considered, and call dates/prices shall be continuously reviewed by the reporting entity to ensure that a yield-to-worst methodology is being followed throughout the period the entity holds the bond.

2015-23: ACCOUNTING FOR PREPAYMENT PENALTIES — COMMENT PERIOD ENDING OCTOBER 7

Currently, prepayment penalties are treated as interest income under SSAP 26 – Bonds. Item 2015-23: Accounting for Prepayment Penalties proposes moving prepayment penalties to be reported as either capital gains included in IMR or capital gains excluded from IMR.

A prepayment penalty represents an issuer compensating the investor for lost interest payments. The payment should fall under interest income, as it does not arise from a market decision by an investor to sell a security, which is the usual source for capital gains. The amount of prepayment penalties is immaterial to reporting entities as a whole. GAAP does not specify how prepayment penalties should be recorded.

A review of 21 entities’ Schedule D – Part 4 showed that of the entities that held a particular CUSIP, 15 of them reported the prepayment penalty as a realized gain/loss on their annual statements, and no interest income as a result of the penalty. Because of this, even if the accounting for prepayment penalties is not changed with this exposed item, clarification or new requirements might be added to the “Annual Statement Instructions” or to the SSAPs.

Industry’s position on this item is mixed. New York Life argues that prepayment penalties should go into capital gains, because gains on calls are typically interest-related based on current interest rates and therefore should be deferred into IMR. Deferring into IMR would also more closely mirror the way interest would have been recorded if the bond had been held to maturity.

2015-18: POLICY STATEMENT REVISIONS — COMMENT PERIOD ENDING OCTOBER 2

This proposal would disband the Emerging Accounting Issues Working Group (EAIWG). SAPWG will increase its membership by including the current members from the EAIWG that aren’t on SAPWG, and will incorporate a process to issue interpretations, which has been the responsibility of the EAIWG.

The purpose of this proposal is to cut back on the time taken to issue NAIC INTs, as items are often referred back-and-forth between EAIWG and SAPWG for revisions, and the delays have made the whole process inefficient. The Accounting Practices and Procedures Task Force will ultimately decide if the EAIWG will be disbanded.

2015-19: QUARTERLY REPORTING OF RESTRICTED ASSETS — COMMENT PERIOD ENDING OCTOBER 2

During the June conference call, 2015-19 was moved to the non-substantive active listing. The proposal exposed is for revisions to SSAP No. 1 to require the disclosure of restricted assets in all interim and annual financial statements, as well as require information on admitted and nonadmitted restricted assets, including information on equity restrictions. In addition, the second part of this agenda item—quarterly reporting of the investment schedules—will not be referenced under REF 2015-27.

There has been discussion about eliminating General Interrogatories 25.2 and 25.3 concerning restricted assets, and feeding the RBC charges currently using those interrogatories from Note 5H. Industry expressed concern with this change, citing the broad definition of restricted assets under Note 5H. It was originally implemented as a way for regulators to collect very broad information about restricted assets without changing any accounting treatment or RBC charges. Industry argues that more specific definitions and categories are needed on Note 5H before the interrogatories can be eliminated. The working group is asking for more specific information on what the differences are between Note 5H and the interrogatories.

The working group will also clarify if restricted asset disclosures are required quarterly, annually, or annually with quarterly updates on any material change.

2015-27: QUARTERLY REPORTING OF INVESTMENT SCHEDULES — COMMENT PERIOD ENDING OCTOBER 2

This is very early in the discussion stage. The NAIC wants to be able to view the different insurance market segments at an industry-wide level on a quarterly (rather than yearly) basis, and monitor solvency more frequently. Ed Toy from the Securities Valuations Office (SVO) brought up the recent events in Greece and Puerto Rico, oil prices, and other similar examples as evidence that markets are now more volatile than ever, and to emphasize the importance of monitoring solvency on a quarterly basis.

The NAIC is asking how they can get this data, and is open to suggestions for the best methodology. Industry expressed a lot of concern about the amount of work it would take to supply full Investment Schedules (such as the D-1), especially in the shortened time period allowed for quarterly filings.

Possible solutions include additional disclosures on a quarterly basis, partial schedules, changes on the NAIC’s end, or additional footnotes. Regulators and interested parties are welcome to propose a process or format for submitting quarterly investment information to the NAIC.

The NAIC currently has a way to roll-up information on a quarterly basis, but it is very inefficient, time consuming, and manual.

Clearwater runs fully automated Schedule D reconciliation on a daily basis, so our clients would not be as impacted by this change.

Exposed For Comment

2015-17: MEASUREMENT METHOD FOR NAIC 5 DESIGNATIONS — MOVED TO NON-SUBSTANTIVE ACTING LISTING

Currently insurers who file an AVR are allowed to carry NAIC 5-rated bonds at amortized cost. This agenda item proposes requiring a lower-of amortized cost or fair value approach. The proposal may be further revised to also require a lower-of approach for NAIC 4-rated securities.

The proposed change to NAIC 5 securities would impact 1,574 securities (5,945 if it was moved to NAIC 4 to mirror SSAP No. 32). No study has been done on the carrying value or RBC impact if such a change is made.

Currently, preferred stock under SSAP No. 32 allows amortized cost valuation for AVR filers only for NAIC 1-3-rated securities.

2015-31: NON-RECOURSE CHARITY NOTES (REFERRAL FROM VOSTF)

With both of these items, SAPWG is looking for information from insurers and interested parties on the structure and use of these types of transactions and the current accounting and reporting of these items.

Charity Notes: These are welcome in either a formal comment letter, or submitted to NAIC staff confidentially.

Insurance Linked: The purpose is to develop a disclosure for insurance-linked securities that would capture information such as the risks covered, the financial statement impact of such an item, the terms of each agreement, etc.

2014-25: HOLDERS OF SURPLUS NOTES (SUBSTANTIVE AND ACTIVE, EXPOSED)

This issue paper on accounting for surplus notes was directed for drafting back on June 17. It is now exposed for comment. The paper would specify that NAIC 1-rated notes would be reported at amortized cost, and all other notes would receive a lower of amortized cost or fair value approach. This would eliminate reporting notes at either outstanding face value, or a calculated amount based on the statement factor. Certain criteria such as the issuer being under regulatory action would result in non-admission of the note.