Staying Up-To-Date with the NAIC’s changes to Principles Based Bond Definitions

The National Association of Insurance Commissioners recently put out new guidance regarding its Principles Based Bond Definitions (PBBD) within statutory accounting. They want to ensure that only securities embodying true creditor relationships are reported as such. This impacts how investments are reported, valued and regulated and can impact capital requirements, financial reporting, regulatory compliance and even risk management.

These changes can be difficult to spot, and as difficult to implement, and the impact can be easily missed.

A big deal or a storm in a teacup?

The obvious first question is why do these specific changes matter? In this case, it comes in two parts. The first is that debt instruments that can no longer be classified as bonds may result in an increased capital charge against that asset in the portfolio. Understanding which assets may need to change and which can remain is therefore crucially important to ensure the portfolio is accounted for correctly and the correct capital charges applied.

The second impact of these changes is that because of their importance to asset accounting, these classifications must now be included in audited financial statements. It’s not enough to make the changes – external auditors must also review and comment on their accuracy. If it’s not done right, this will introduce unnecessary and unwelcome audit risk.

Classifying assets that are no longer bonds

Where assets do not meet the new bond definition, they should be moved to be classified as Schedule BA assets – i.e., assets that don’t fit traditional asset classifications. This is when the higher capital charge may take effect. Life insurers will have to file them with the Securities Valuation Office (SVO) for NAIC Designation (Credit Quality assigned by the SVO) to benefit from the lower capital charge. Unfortunately, P&C and Health insurers do not have this avenue for getting lower capital charge.

Too good to be true?

Asset backed securities (ABS) could be classified as issuer credit obligations (ICOs) if they are backed predominantly by a single entity, and with underlying collateral sufficient to serve all interest payments and at least 95% of the original principal payment.

The benefit of ICO classification is in the way they are accounted for, namely:

• No need to apply additional tests such as substantive credit enhancement and/or meaningful cashflow tests, simplifying accounting for them
• The option to report these assets as short-term investments. Regular asset backed securities cannot be reported in this way.
• The capital charge for ICO and ABS is currently the same, but it is expected that this may change as the NAIC has been working on capital charge reform for ABS, with ABS likely to be liable for a higher capital charge in the future.

What’s In and What’s Out?

One of the most significant impacts of the reclassification may be on municipal bonds. Often an important element of an insurer’s portfolio, some municipal bonds, such as those linked to housing bonds, may not be eligible for ICO classification, and may need to be reflected as asset-backed securities. At high volume this may have a notable impact on insurers’ risk-based capital charges and, as a result, their investment strategies.

Another major impact is that only hard and saleable assets can be taken into consideration when calculating the overcollaterization percentage on ABS in the portfolio (for disclosure on Schedule D Part 1 Section 2).

Overcollaterization provides a cushion against potential losses as a result of default within the underlying assets. Expected cashflow excluded from this calculation could distort the quality of some ABS and result in changes, impacting regulatory compliance.

The devil is in the detail

These are some of the more noteworthy changes but there are plenty of additional changes to consider. We’ve created a table for ease of use or, join us at our Webinar with the NAIC’s Julie Gann and Clearwater’s Sabrina Wilson on March 20 to discuss the intricacies, and impacts, of the changes to PBBDs.

Accounting Changes

Reporting Changes