New CLO Updates from the NAIC

New CLO Updates from the NAIC

Three NAIC working groups held meetings in February and March: The Risk-Based Capital (RBC) Investment Risk and Evaluation Working Group, the Valuation of Securities Task Force (VOSTF), and the Blanks Working Group (BWG). Many of the updates pertained to collateralized loan obligations (CLOs).

The following updates pertain to investment accounting.

NAIC Risk-Based Capital Investment Risk and Evaluation Working Group

American Academy of Actuaries’ Follow Up to Presentation on CLOs

The American Academy of Actuaries said the RBC working group asked for both short- and long-term solutions for CLOs. They think short-term solutions may not be needed, which would mean they could focus on a long-term solution instead. Some interested parties said the current CLO investments are not material to the overall life insurance industry, and they don’t see the urgency to update the RBC factors for CLOs. The working group understands the CLO investment risk is not material to the overall life insurance industry, but it is material to some life insurers now. CLO investments in life insurers’ portfolios are growing and are expected to continue growing. Regulators want to have the right solution for the CLOs and want the Academy to do diligent work on the CLOs as quickly as possible. This work is separate from the interim solution for residual tranches, which are not limited to the CLOs but are for all asset-backed securities. The working group doesn’t expect the Academy to work on the C-3 structure.

The current C-1 bond factors are set at the 96th percentile over a 10-year period. To measure the risk of the CLOs, the Academy recommends replacing the 96th percentile with Conditional Tail Expectation (CTE), which embeds cliff effects for the fat tail risks of the CLOs. Most of the regulators are supportive of this recommendation, but some regulators are concerned it may not be appropriate to use the CTE historical for RBC and if it adds more complexity to the C-1 factor methodology. Eric Kolchinsky, Structured Securities Group Director, said he would align their modeling work with the new RBC factor methodology, and this alignment is fairly easily done. The Academy said they would provide the working group with the reconciliation between CTE and percentile and make it comparable for the regulators to decide which one is desirable. The Academy agreed to continue the discussion to hear feedback from the working group while working on the C-1 factor methodology.

The working group is concerned that some active managers shift the risks between tranches. Eric Kolchinsky said there are plenty of examples of CLO managers who favor the tranches that they own, and his team can compensate for those behaviors.

The Academy asked if the working group wants them to apply “no RBC arbitrage” to the C-1 factor methodology. Bonds and loans have different recovery rates and time horizons. The reason they have been sharing the same RBC factor is because the regulators believed the loan investments were not material enough to warrant a different RBC factor methodology back then. Philip Barlow, Chair of the RBC working group, said the working group wants to use a no arbitrage approach, and Carrie Mears, the Chair of the Valuation of Securities Task Force, said adjusting the RBC framework will eliminate RBC arbitrage.

Interested parties recommend the use of only one factor (30% or 45%) for residual tranches, and the new factor should not be materially more conservative than complete non-admittance of the asset. They also recommend additional sensitivity testing on LR038 and LR039 that should help the regulators identify which insurers have a material risk from their CLO and residual tranches investments. Eric Kolchinsky said he was fine with the single RBC factor approach as long as the new factor is high enough. Carrie Mears said they believe the year-end 2022 reports that the NAIC will receive in a couple days may not reflect the entire residual tranches investments held by the insurers. They will send a referral to the Statutory Accounting Principles Working Group for the definition of residual tranches, which should be for all asset-backed securities and not be limited to CLOs only.

The working group said the effective date will be December 31, 2023, once this item is adopted.

NAIC Valuation of Securities Task Force

Adopted Items

Add Instructions for the Financial Modeling of Collateralized Loan Obligations (CLOs) 

The task force added CLOs to the list of securities that are subject to financial modeling, other than residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS), to the SVO P&P Manual Part One through Four.

CLOs would be assigned an NAIC designation and designation category by the Structured Securities Group (SSG) without an administrative symbol pursuant to SVO P&P Manual Part Four Paragraph 2.

CLOs can be financially modeled and are exempt from filing with the SVO. The SSG will produce probability weighted net present values using its financial model with defined analytical inputs selected by the SSG.

For CLOs that cannot be financially modeled but are rated by a credit rating provider (CRP), the NAIC designations are determined by application of the filing exemption procedures, i.e., using the second-lowest rating methodology. For those that cannot be financially modeled but are not rated by a CRP, the insurers are required to file them with the SSG. For initial sufficiency information filing, the insurers shall provide the SSG with indenture, prospectus, offering memorandum, accountant’s comfort letter if obtained in connection with the transaction, International Swaps and Derivatives Association (ISDA) schedules and confirmation, legal opinions given in connection with the transaction, all available eligible CRP ratings for underlying loan portfolio. The insurers shall provide the prospectus, offering memorandum, and three years of the issuer’s audited financial statements for each unrated underlying loan.

The SSG will model CLO investments and evaluate all tranche-level losses across all debt and equity tranches to assign NAIC designation categories for each CLO tranche effective January 1, 2024. The insurers shall begin receiving the NAIC designation categories in mid-December 2024.

Update References to 5GI

This item replaces NAIC Designation 5GI with 5.B GI throughout the SVO P&P Manual Guidance (e.g., Part Two paragraph 7, Part Three paragraph 27 through 32, and 290) for consistency purposes.

It is effective immediately.

Referral Items

Proposed Amendment to Define and Add Guidance for Structured Equity and Fund Investments

The VOSTF sent this referral item to the Capital Adequacy Task Force, Life Actuarial Task Force, and RBC working group on February 3, 2023. This is an informational referral, and no direct action is expected from these three groups.

The SVO became aware of some notes issued by Special Purpose Vehicles (SPVs) or other legal entities that operate as feeder funds which invest in one or more funds or other equity investments directly or indirectly when they processed several private letter rating filings. These structures are often named generically as a senior note or term loan, and these structures can invest in any assets, e.g., affiliated investments, non-fixed income investments, derivatives, borrowings for the purpose of leverage, and non-admitted assets. However, they are reported as bonds and receiving bond RBC factors based on the NAIC Designations that derived from the CRP ratings through the filing exempt process. It allows better RBC treatment than would otherwise be received if they had been directly reported and the insurers to hold more underlying equity or fund investments than would be permitted under state investment law. As these notes use multiple interconnected private entities in the structure, it is hard for the regulators and investors to dig into the true underlying risks, credit exposure, and nature of the investment.

According to the current SVO P&P Manual, equity and fund investments are ineligible for filing exemption. For fund investments, the SVO is the only one authorized to determine if the ultimate underlying collateral of a fund produces fixed income like cash flows and designate them. Besides, all non-SEC registered funds are required to be reported on Schedule BA, and the life insurers are allowed to file those investments with the SVO for specific classification on Schedule BA. Most of the transactions the SVO has processed would not qualify as bonds eligible for Schedule D-1 reporting according to the upcoming principles-based bond definition guidance (SAPWG 2019-21, 2023-06 BWG), but some will qualify. The use of a fund intermediary has the potential to be abused and requires significant judgment to understand the substance and nature of the ultimate underlying risk. The SVO proposes defining these investments as Structured Equity and Fund investments and removing them from filing exemption.

Proposed In-House Calculation of Additional Market and Analytical Information for Bond Investments

The VOSTF sent this referral item to multiple committees and working groups on February 13, 2023. The VOSTF asked if these groups are supportive of creating an in-house calculation of additional market and analytical information for bonds within the SVO by utilizing commercially available data sources and investment models, any investment analytical measures and projections that would help their work, e.g., how they would utilize the data and why it would be of value. The VOSTF requested their responses by May 15, 2023.

This referral item stems from the Investment Analysis Office staff memorandum to the VOSTF on February 25, 2022, when it proposed adding market-data fields to the bond investments reporting, as privately issued and rated complex structured finance transactions are hard identify without additional market-data fields, e.g., market yield, market price, purchase yield, weighted average life, spread to average life UST, option adjusted spread, effective duration, convexity, and VISION issue ID. As each individual insurance company would incur the costs to implement system changes, the interested parties asked if the SVO would consider the NAIC to be responsible for calculating these fields by utilizing commercially available data sources and investment models. Having this capability within the SVO will allow more analytic values to be calculated for the regulators in the future, e.g., key rate duration, sensitivity to interest rate volatility, principal and interest cash flow projections for any security or portfolio for any given interest rate projection, loss estimates for any security for any given scenario, and probabilities.

NAIC Blanks Working Group

Adopted Items Effective December 31, 2023

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 by the VOSTF. However, they haven’t been removed from the blank instructions.

This item removes 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, closed-end funds to AVR – Equity and Other Invested Asset Component report.

NAIC staff agrees with the interested parties’ recommendation for minor edits and incorporated them into the instructions for AVR – Equity and Other Invested Asset Component report, e.g., adding instructions to line 1 to exclude money market mutual funds from Unaffiliated Common Stocks – Public and add instruction to line 2 to include privately issued mutual funds, unit investment trusts, closed-end funds, and ETFs in Unaffiliated Common Stocks – Private.

Exposed Items with Comment Deadline of April 28, 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 a new disclosure for derivative instruments. The purpose is to reflect changes adopted by the SAPWG in agenda item 2021-20 which allowed early adoption last year. NAIC staff agreed with several recommendations from the interested parties and incorporated them into the instructions for Note 8A(9), e.g., replacing intrinsic value with volatility value and stating the unrealized gain/(loss) is not applicable to foreign currency forwards and currency swaps for Schedule DB Parts A and B because the forward points or cross currency basis, respectively, are the excluded component.

The Chair of the SAPWG said NAIC staff is comfortable with re-exposure and that it will allow the interested parties to provide further comment.

Ref #2023‐07BWG – Update the code column and delete the Legal Entity Identifier (LEI) column for the following investment schedules: Schedules A, B, BA, D Part 2, D Part 6, and E Part 1.

This item proposes changing the column name from Code to Restricted Asset Code and removing six character codes from the closed option list. It also proposes removing the LEI column from Schedules A, B, BA, D Part 2, D Part 6, and E Part 1.

The proposed effective date is January 1, 2025.

Ref #2023‐08BWG – Add clarifying language for mutual insurance companies on Schedule Y, Part 3.

This item proposes adding clarifying language to the instruction that mutual insurance companies should be included in Schedule Y, Part 3.

The proposed effective date is December 31, 2023.

Editorial Change – Adding clarifying language to Notes to Financial Statements 11A to include FHLB borrowings per SSAP No. 15

This item proposes adding clarifying language to the instruction for Note 11A that includes the FHLB borrowings accounted for under SSAP No. 15 in the debt disclosure.

The proposed effective date is December 31, 2023.

Exposed Item with Comment Deadline of June 30, 2023

Ref #2023-06BWG – Split the Schedule D Part 1 into two sections: one for Issuer Credit Obligations (ICO) and the other for Asset-Backed Securities (ABS). Update the other parts of the Annual Statement that reference the bond lines of business. (SAPWG 2019-21)

This item proposes updating the blank and blank instructions including Investment Schedules General Instructions to reflect the current proposal from the SAPWG 2019-21 (Principles-Based Bond Project).

The Chair of the SAPWG said this proposal will increase the transparency for bond reporting and allows the insurers to assess their current investment holdings. Details of the proposed changes include eliminating Schedule D Part 1A Section 2; renaming Schedule D Part 1A Section 1 as Schedule D Part 1A; removing ABS from both Schedule DA and E Part 2 reporting; and making multiple changes for Schedule D Parts 1 through 5.

The proposed effective date is January 1, 2025.