US NAIC Spring 2023 National Meeting Highlights: Valuation of Securities (E) Task Force

At the Spring 2023 National Meeting of the US National Association of Insurance Commissioners (“NAIC”), the NAIC Valuation of Securities (E) Task Force (“VOS TF”) held its meeting on March 23, 2023. Below are updates from the VOS TF meeting.

New Direction for the “Structured Equity and Funds” Proposal

After approving minutes of prior meetings, the VOS TF discussed proposed amendments to the Purposes and Procedures Manual of the NAIC Investment Analysis Office (the “P&P Manual”), which had been exposed for comment on December 14, 2022, at the Fall 2022 National Meeting for a period that ended on February 13, 2023. The proposed amendments, which were set out in a November 28, 2022 memo from the NAIC Securities Valuation Office (“SVO”), would have removed the filing exemption for “Structured Equity and Fund” investments (a term that would have included, among other things, collateralized fund obligations and rated feeder notes), thereby requiring such investments to be filed with the SVO for assessment and assignment of a designation, instead of automatically receiving the designation equivalent to their rating by an NAIC-recognized credit rating provider (“CRP”).

Marc Perlman, SVO Investment Counsel, and Charles Therriault, SVO Director, explained the “Structured Equity and Funds” proposal and its rationale in some detail, noting that it was designed to prevent an insurer from circumventing regulatory guidance by inserting an SPV debt issuer between the insurer and underlying equity investments, and was also designed to provide transparency into the nature of the underlying investments.

The SVO proposal had engendered strong opposition from the industry, expressed in three comment letters, one of which was a joint letter from the American Council of Life Insurers, the Private Placement Investors Association and the North American Securities Valuation Association (the “Joint Letter”). The Joint Letter pointed out that the concerns expressed by the SVO in its proposal are actually being addressed by other units of the NAIC—specifically that the Risk-Based Capital Investment Risk and Evaluation (E) Working Group is addressing risk-based capital charges for structured investments, and that the Statutory Accounting Principles (E) Working Group (“SAP WG”) is nearing completion of its project to define what investments qualify for bond treatment. The Joint Letter also noted that the SVO now has access to the rationale reports for privately rated securities and can use those reports to obtain information about fund structures and their underlying investments. Additionally, the Joint Letter expressed concern about the lack of transparency and the potential for inconsistency regarding methodologies used by the SVO, as well as the significant cost and time involved in filing securities with the SVO.

In the end, the VOS TF did not advance the SVO proposal in the form in which it had been proposed. Instead, it took a number of other actions:

• Directed staff to send a referral to the SAP WG to request that it consider the definition of structured equity and funds in its guidance regarding the treatment of residual tranches of structured securities; and
• Directed the SVO staff to draft proposed amendments to the P&P Manual outlining (i) procedural steps that the SVO could take, after reviewing the rationale letter for a security with a private letter rating, to challenge the NAIC designation that would be assigned based on the filing exemption, and (ii) procedural steps that insurers could take to clarify and rebut the SVO’s concerns.

One of the members of the VOS TF commented that transparency needs to go both ways: the SVO needs transparency into these types of structured securities, and insurers need transparency into the factors that could be used by the SVO to challenge the filing exemption and seek to override the private letter rating. 

The chair of the VOS TF, Carrie Mears of the Iowa Division of Insurance, offered an analogy to describe the need for the new process and criteria that the SVO staff is being asked to develop for the VOS TF’s consideration. Currently, she said, there is only a green light (filing exempt) and a red light (not filing exempt), and what needs to be added is a yellow light (slow down, take a closer look and decide based on transparent criteria and due process whether or not the security is filing exempt). 

In our view, one of the benefits of this proposed new approach is that it will enable the SVO’s ability to challenge a CRP rating to be coordinated with the principles-based definition of what constitutes a bond that is being carefully developed by the SAP WG, including, in particular, the criteria that have been developed for when a rated feeder note can qualify as a bond. 

Next, the SVO staff will come back with a proposed process and criteria that the SVO could use to challenge filing exemptions, on a case-by-case basis, for securities with a private letter rating. That proposal will be presented to and discussed by the VOS TF, and eventually exposed for comment, potentially multiple rounds of comments and revisions, before being considered for adoption by the VOS TF.

Also discussed was the extent to which the 2022 annual statements filed by insurers adequately identified investments in residual tranches of structured securities. Some members of the VOS TF felt that there had been underreporting of such investments. It was agreed to follow up on this concern in a regulator-only session in coordination with the SAP WG.

Next Steps Outlined for Collateralized Loan Obligation Modeling Project

Eric Kolchinsky, Director of the NAIC Structured Securities Group and Capital Markets Bureau, discussed the next steps in the development of a modeling process for collateralized loan obligations (“CLOs”). He explained that an ad-hoc group would be convened to work on the following tasks over a period of about two months:

• analyze the effects of pre-payments and discount purchases on CLO structures, using three or four actual CLO deals as examples; and
• tie out the cash flows on three “dummy” stress Scenarios A, B and C.

Mr. Kolchinsky indicated that meetings of the ad-hoc group would be open to all, but asked that interested parties designate one participant from each interest group who would be their spokesperson at the meetings. He also suggested that non-regulator participants have a technical background for discussion, such as actuarial, credit modeling or CLOs, and that CLO participants would ideally have a background in running software, tying out numbers and rating agency methodologies.

Exposure of Proposed Questions for CRPs

The VOS TF reviewed a document from the SVO, outlining 22 questions to be posed to NAIC-recognized CRPs, as part of the ongoing effort of the VOS TF to evaluate the role of CRPs in relation to insurer financial solvency regulation. Chair Mears requested that any recommendations on this topic be sent to SVO staff.

Short Exposure of Proposed Amendment to the P&P Manual Regarding Financial Institutions

The SVO maintains a list of Qualified US Financial Institutions (“QUSFIs”), which indicates the financial institutions that are eligible to issue letters of credit which, pursuant to Section 3 of the NAIC Credit for Reinsurance Model Law (“Model #785”), can be used to enable a US ceding insurer to take credit for reinsurance ceded to certain reinsurers (primarily offshore reinsurers that are not licensed in the US and do not qualify as certified reinsurers or reciprocal jurisdiction reinsurers).

The P&P Manual includes provisions for the SVO to monitor changes in the credit quality of financial institutions on the QUSFI list, including providing notice of credit deterioration to the NAIC Reinsurance (E) Task Force and state insurance regulators more generally.

Marc Perlman of the SVO addressed the meeting and referred to recent situations in which a financial institution on the QUSFI list had undergone such a rapid deterioration that events outstripped the usual process for the SVO to provide a notice of credit deterioration. To address this situation, he recommended on behalf of the SVO that the P&P Manual be amended to provide that, if a financial institution on the QUSFI list is closed by and/or placed in receivership or conservatorship, or notice is given of such action, by its primary regulator(s), the SVO shall promptly remove the name of the financial institution from the QUSFI list.

The VOS TF exposed the proposed amendment for a 15-day public comment period which ended on April 10, 2023, to be followed by an e-vote of the VOS TF. The VOS TF also directed staff to refer the amendment to the Reinsurance (E) Task Force.

To view additional updates from the US NAIC Spring 2023 National Meeting, visit our meeting highlights page.