What No One Has Told You About the Proposed Bond ETF Changes

One of the key issues discussed during the NAIC Summer National Meeting was a comment letter submitted by BlackRock Investment Management, Inc.

As previously outlined in the summary of the Statutory Accounting Principles Working Group (SAPWG) national meeting updates, this comment letter contained a proposal to keep Bond ETFs on the Schedule D — Part 1.

Proposal Background

In 2013, the SAPWG added the Investment Classification Project to their agenda. This project 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.

As NAIC staff works on this project, the NAIC released a memo expressing a proposal for all SSAP No. 26 investments to have a “contractual amount of principal due.” Adding this statement within the SSAP would exclude certain bond funds that currently receive bond treatment on Schedule D Part 1. The NAIC memo proposes that all funds (including those with underlying characteristics of equity) be moved to a new Schedule D Part 7.

Naturally, the concept of a new reporting schedule has gained a lot of attention. It should be noted that if the NAIC proposal to create a new Schedule D Part 7 proceeds, RBC treatment may or may not be affected. During the Spring 2015 National Meeting, the NAIC asked for Industry to comment on the memorandum. During the Summer 2015 National Meeting, BlackRock responded with the proposal detailed below.

BlackRock Proposal

As a large issuer of Bond ETF funds, BlackRock is concerned with the impact of moving these assets to a new Schedule D Part 7. Their rationale is:

• Bonds ETFs are essentially a basket of high performing bonds and should be treated as other fixed income instruments.
• A change to a fair value valuation would impact an insurance company’s ability to invest in Bond ETFs.
• Bond ETFs are a cheap way to gain access to the bond market without the full startup cost of a separately managed account. There is concern that moving to a fair value approach could hinder this market.

As an alternative, BlackRock has submitted 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:

• Bond ETFs be broken out into a new separate sub-section.
• The NAIC consider an amortized cost valuation method on the ETFs.
• Bonds ETFs use 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 (proposal) is available on the NAIC website. The NAIC exposed the BlackRock proposal with a shortened comment period of September 11.

Clearwater Commentary on the BlackRock Proposal

Clearwater has been asked if we support the BlackRock Proposal. At this point in time, we believe there are simply too many unknowns, and until the details are identified and documented it is difficult to be supportive of this proposal.

From an accounting policy and regulation perspective, arguments can be made in both support and non-support of the BlackRock proposal. Clearwater’s (and other vendors’) primary function is to support NAIC-mandated regulation and Industry direction. It is not in any vendors’ best interest to oppose regulation supported by Industry. However, while Clearwater does not intend to stop or modify accounting regulatory guidance, as an investment and accounting solution vendor with more than 400 insurance clients, it is our responsibility to provide insights into possible implementations issues, for both Industry and regulators alike.

Clearwater sees several possible issues with the Bond ETF proposal. We have shared these concerns with BlackRock, interested parties, and regulators alike. It must be emphasized that our goal is to not stop the BlackRock proposal, but to get answers. A “win” here is to get everything documented so Industry has a clear understanding of not only the benefits of weighted average cost, but how it would be implemented.

The following issues should be carefully considered by Industry before supporting, or withdrawing support, for the proposed weighted average approach to the Bond ETFs. Clearwater is actively collaborating with BlackRock and other investment accounting vendors to solve the challenges identified below.

Implementation Challenges

BlackRock’s proposal states: “Each NAIC designed fixed-income ETF holding shall be revalued each quarter using the current underlying bond portfolio’s projected cash flows and using the prospective adjustment methodology.” While this language is in-line with other statutory requirements, the reality is most insurance companies report on a monthly basis. As Industry considers the proposal, the daily workflow of calculating a weighted average book value should be carefully considered.

In order to perform the calculations proposed by BlackRock, Industry will need to adhere to a look-through accounting approach. Is the data required to do this analysis readily available to Industry? In addition, in order to comply with these requirements, some companies may choose to perform shadow accounting at the ETF (fund) level. Will insurance companies have the required data on a daily basis to make this feasible? Furthermore, what happens if two insurance companies perform look-through accounting but come up with different values? Again, the workflow needs to be properly considered.

BlackRock has made public presentations stating they would be providing these values to insurance companies in order to comply, but no similar representation has been made by other issuers of bond-like ETFs. While 90% of Bond ETFs are reported by a few issuers (including BlackRock), consistency needs to be maintained from all issuers of Bond ETFs. Prior to any adoption of this proposal, it is recommended that every issuer of the bond-like ETFs be required to publically support or reject the proposal.

These concerns have been mentioned to BlackRock and they are open to resolving these items and working with Industry to supply the values. One idea is to put a “calculator” on their website that will provide insurance companies a way to input their holdings and generate the required values. BlackRock has even suggested they go one step further and build an interface to the accounting providers. While we applaud BlackRock for their willingness to provide these calculations, this does bring up several other challenges:

• Who will audit the BlackRock calculator? Will an independent CPA firm audit the data on a timely basis? Will that audit be completed in time for insurance companies to file annual reports?
• Will the other issuers of Bond ETFs adhere to the same calculation and audit quality?

Scalability

As stated, BlackRock and other issuers of ETFs state that smaller insurance companies benefit from the ETF market. However, will these smaller insurance companies have the infrastructure in place to properly adhere to these guidelines?

Cost

BlackRock and State Street Bank have implied that if the proposal is supported, no new costs will be passed through to insurance companies. In fact, most of the data needed to provide these calculations are already public and free to Industry. However, there are always direct cost and indirect costs with new changes. In order to implement this proposal, insurance companies will have some indirect cost, including system updates, process changes, and resource constraints. While this is true with every new piece of insurance regulation, this impact could be larger due to the unknown potential issues with downstream systems and processes.

System Limitations

At the end of the day, many assume the crux of Clearwater’s commentary involves system limitations. But the reality is not as straightforward. Generally speaking, investment accounting systems treat ETFs as an equity type investment and use tools in the background to ensure proper reporting treatment. Currently, the concept of an amortized cost methodology does not exist. Changes requiring the concept of amortization on an ETF could be a substantive change to the underlying technology and reporting structure. The fact is we do not have enough detail at this point to understand the impact. Think of it like building a brand new house. Seldom do you have a finite deadline on day one. The house construction starts with the foundation, then the walls, electrical, plumbing, etc, and evolves as it proceeds. In our opinion, with this proposal we are still determining the type of cement used in the foundation. There are so many questions left to understand, we do not know if this is a simple change or a complex change requiring a year to implement fully.

Final Thoughts

Clearwater, BlackRock, other vendors, Interested Parties, and the ACLI continue to work in the background to answer these questions. All parties have a vested interest to support Industry. Industry in general has neither supported nor rejected this proposal. Industry, along with Clearwater, is simply in the initial data gathering phase of this proposal. We will continue to work with the mentioned parties to bring more clarity into this proposal and other future proposals.

This commentary is not an opinion on the BlackRock proposal, but a clarification on the proposal’s potential impacts. Clearwater has no stance on the Bond ETFs reporting schedule.