August 21. 2024

US NAIC Summer 2024 National Meeting Highlights: Investment-Related Initiatives

Authors:

The US National Association of Insurance Commissioners (“NAIC”) held its Summer National Meeting in Chicago from August 12 to 15, 2024. This Legal Update reports on some highlights of the meetings of the Valuation of Securities (E) Task Force (“VOSTF”) on August 13, the Financial Condition (E) Committee (“E Committee”) on August 15, and the Risk-Based Capital Investment Risk and Evaluation (E) Working Group (“RBC IRE WG”) on August 14. Actions taken at the August 13 meeting of the Statutory Accounting Principles (E) Working Group will be reported on in a separate Legal Update.

The VOSTF voted to amend the definition of an NAIC designation.

NAIC designations are important because they are generally used to determine the risk-based capital (“RBC”) factors associated with the fixed-income investments of insurers, and also because many states’ insurance codes set quantitative limitations on insurers’ investments in securities with designations below NAIC-3.

Historically, NAIC designations have been considered as similar to credit ratings, and a significant majority of fixed-income securities held by insurers are filing-exempt, meaning that the Purposes and Procedures Manual (“P&P Manual”) of the NAIC Investment Analysis Office (“IAO”) allows those securities to automatically receive an NAIC designation equivalent to the rating assigned by an NAIC-recognized credit rating provider (“CRP”). Securities that are not filing-exempt must be filed with the NAIC’s Securities Valuation Office (“SVO”) for analysis and the assignment of an NAIC designation. The SVO is part of the IAO, along with the NAIC’s Structured Securities Group (“SSG”) and Capital Markets Bureau.

The amended definition of an NAIC designation in the P&P Manual largely reflects the text of the proposal that was previously exposed for comment. However, there was an important addition to the previously exposed text (in paragraphs 89 and 90) to clarify that an NAIC designation focuses on “investment risk,” which is distinguished from “credit risk.” “Investment risk” is defined as “the likelihood that an insurer will receive full and timely principal and expected interest.” “Credit risk,” by contrast, “traditionally focuses on the ability of an issuer to make payments in accordance with contractual terms.”

The new text points to principal protected securities (“PPS”) and SVO-designated funds as examples of where “focusing on credit risk alone would limit the SVO’s ability to appropriately assess certain risks.” For example, a PPS with an interest component based on the performance of a non-debt variable could pay no interest without causing an event of default by the issuer. That is an example of what the SVO means by focusing on investment risk, and not just credit risk. That example also sheds light, in retrospect, on the VOSTF’s 2020 decision to remove the filing exemption from PPS and require PPS to be filed with the SVO for the assignment of an NAIC designation—which was explained at the time by saying that PPS posed “other non-payment risks” that were not necessarily captured in CRP ratings.

The VOSTF voted to establish a process for the NAIC to remove an eligible CRP rating of a specific security from filing exemption and assign an NAIC designation determined by the IAO to that security.

Background

An initial version of this proposal was exposed for comment by the VOSTF on May 15, 2023, and was described as a way to grant the SVO “some level of discretion” over the filing-exempt process to address what the SVO called a “blind reliance on credit ratings.” The proposal was revised repeatedly over the ensuing 15 months, with exposures for public comment at each iteration, and with modifications being made right up to the time of the August 13, 2024 VOSTF meeting. It would be fair to say that the main thrust of the comments, and the resulting revisions to the proposal (which were worked out by the IAO and members of the VOSTF in consultation with trade groups), was to add “checks and balances” that would ensure “due process” for insurers, where insurers would have the ability to make their case for maintaining the CRP rating—first to the IAO, and ultimately to a subgroup of the VOSTF, which would make the final decision.

Summary of the Adopted Proposal

The new provisions in the P&P Manual for the removal of an eligible CRP rating of a specific security from filing exemption (which generally refer to the IAO, of which the SVO is a part) include the following procedural steps:

How the process is initiated – The review of a security may be initiated by either a state insurance regulator or the IAO staff if they believe that the NAIC designation category assigned through the filing exemption based on a CRP rating “may not be a reasonable assessment of investment risk of the security for regulatory purposes.”
Who decides whether to proceed with a full review – The IAO Credit Committee will convene to determine whether, in its opinion, the NAIC designation category assigned through the filing exemption based on a CRP rating is a “reasonable assessment of investment risk of the security for regulatory purposes.” The Credit Committee may consider (i) a comparison to peers rated by different CRPs; (ii) consistency of the security’s yield at issuance or current market yield to securities with equivalently calculated NAIC designations rated by different CRPs; (iii) the IAO’s assessment of the security applying available methodologies; and (iv) any other factors it deems relevant. If the Credit Committee’s opinion is that the NAIC designation category assigned through the filing exemption based on a CRP rating is not a “reasonable assessment of investment risk of the security for regulatory purposes,” then the security will be placed under review and designated in NAIC systems (though not in insurers’ statutory reporting schedules) with the symbol “UR.”
How the IAO gets information for the full review – The IAO staff will issue an information request to each insurer that holds the security, asking them to provide the information that would be required if they were filing the security with the SVO, including each insurer’s internal analysis. Insurers must respond within 45 days, but can request an extension of up to 45 additional days. If the requested information is not provided to the IAO within 90 days, then the security will be removed from filing exemption.
How insurers can provide additional information to assist in the IAO’s full review – At any time during the information request submission period or during the IAO’s subsequent analysis of the security, insurers who hold the security are encouraged to provide additional information to the IAO, such as their internal analysis, presentations from the issuer, and meetings with the issuer’s management team. The IAO will provide the insurers with a written summary of its analysis as to why it believes the CRP’s risk assessment is an unreasonable assessment of investment risk of the security for regulatory purposes, and the insurers will have an opportunity to respond and to ask questions about the IAO’s analysis. The insurers may also invite other authorized parties that have agreed to the NAIC’s confidentiality provisions (including CRP representatives) to participate in these discussions with the IAO.
What is the materiality threshold for proceeding to the next step – Upon completion of the IAO’s analysis, the IAO Credit Committee will reconvene to determine its own opinion of the NAIC designation category. The IAO may proceed with the process only if the Credit Committee determines, based on its review, that the IAO’s assessment is three or more notches different from the NAIC designation category determined by the eligible CRP credit rating.
How the final decision is made – If the Credit Committee determines that the three-notch materiality threshold is met, then a call will be scheduled with a subgroup of the VOSTF, at which both the IAO and the insurers who hold the security will be able to make their case. The IAO is required to submit its position in writing and its supporting rationale in advance of that meeting. The domestic state regulators of the insurers will be invited to participate in that meeting. The insurers may also invite other authorized parties that have agreed to the NAIC’s confidentiality provisions (including CRP representatives) to participate. After hearing both sides, the VOSTF subgroup will decide whether or not it agrees with the Credit Committee’s opinion.
What happens if the IAO’s view prevails – If the VOSTF subgroup agrees with the Credit Committee’s opinion, the security will be removed from filing exemption, and the IAO’s determination of the NAIC designation category will be entered in the NAIC’s systems with an analytical symbol of “ER.” However, if the security has (or subsequently receives) one or more other eligible NAIC CRP ratings that have not been removed, then it can receive its NAIC designation category through the filing exemption process based on those other NAIC CRP ratings that have not been removed. An insurer can also ask the IAO to reevaluate an eligible NAIC CRP rating that was removed from filing exemption eligibility for possible reinstatement in a subsequent filing year by following the SVO’s appeal process.
How decisions will be published – Within 45 days of a security being removed from filing exemption, the IAO will publish an anonymized summary of “each unique situation encountered” on an insurer-accessible web location. The anonymized summary will not include references to specific securities, CRPs, or impacted insurers. The IAO will also publish an annual anonymized summary of actions taken to remove filing exemption during the prior calendar year.

Other Important Considerations

In prior discussions, the VOSTF Chair has indicated that the process to remove filing exemption from a specific security was intended to be used sparingly and was not directed against any specific CRP or against an entire asset class. Accordingly, the text that was adopted on August 13 includes the following statement: “The process in this section will be consistently applied to all CRPs without favor to any individual CRP or class of CRPs, and is not expected to be used often.”

There is also a provision in the adopted text that states that if the IAO Credit Committee identifies a recurring analytical pattern or concern, it is to inform the VOSTF Chair, and they will decide whether to bring the concern to the attention of the full VOSTF to decide if an issue paper, referral, amendment to the P&P Manual, or some other action is needed to address that concern.

The effective date of the P&P Manual amendments will be January 1, 2026, to allow time for the NAIC systems to be modified to handle the IAO review process and the potential removal of filing exemption and substitution of an IAO-determined NAIC designation category.

Comments and VOSTF Chair’s Responses

At the beginning of the VOSTF’s consideration of this agenda item, VOSTF Chair Carrie Mears addressed a number of the comments received on the proposal, including the following key comments:

Methodology – Concerns have been expressed throughout the process about the fact that the IAO is not required to use any published methodology in the way that rating agencies are required to do. In response, Chair Mears stated that the SVO considers multiple published rating agency methodologies and uses the methodology (or methodologies) that it believes will produce a reasonable assessment of investment risk for regulatory purposes.
Relationship between the SVO and rating agencies – Concerns have been expressed throughout the process that the SVO is trying to compete with or replace rating agencies. In response, Chair Mears stated that the SVO is not a rating agency, but rather a consumer of rating agency ratings, and that the goal is for the NAIC to use CRP ratings responsibly. She said that the process for removal of an eligible CRP rating of a specific security from filing exemption would not be overruling a particular CRP rating, but rather choosing not to use a particular CRP rating for regulatory purposes. (The distinction discussed above between “credit risk” and “investment risk” is relevant here because it makes it possible for the NAIC to say that a CRP rating of a security may be a reasonable assessment of “credit risk” but not a reasonable of “investment risk” when it removes the CRP rating from filing exemption.)
Time frames for the IAO process – Commenters have noted that there are strict time frames for insurers to respond to the IAO’s information requests, but no time frames for the IAO to act on the information provided, and have suggested that there should also be time frames specified for the IAO, given the uncertainties created for an insurer when a security in its investment portfolio is placed under IAO review. Chair Mears stated that it is difficult to set deadlines for the IAO, but that the IAO would perform its work expeditiously once information is provided to it.
Role of CRPs in the IAO process – Commenters have noted that CRPs do not have any independent right to participate in discussions with the IAO or in the final hearing before the VOSTF subgroup. Chair Mears stated that insurance regulators have authority over insurers, but not over CRPs, and that is why the process focuses on the insurers and allows the insurers to invite external parties (including CRPs) who agree to the NAIC’s confidentiality provisions to participate in both the discussions with the IAO and the hearing before the VOSTF subgroup.

The full text of the comment letters is available in pages 110 to 134 of the VOSTF meeting materials.

Oral Comment at the Meeting from a Former State Legislator

One of the CRPs had submitted a comment letter, urging that the participation of CRPs should not be at the discretion of the insurers, but that CRPs should be informed at the outset of the IAO review process, should be provided all materials generated by the IAO, and should have a right to participate in the review process whether or not requested by the insurers. The comment letter gave several reasons in support of that position. As noted above, the drafters did not adopt the approach urged in the comment letter, and the VOSTF Chair offered an explanation for that decision in her opening remarks.

At the August 13 meeting, there was an oral presentation by a consultant representing the same CRP that may turn out to have a greater impact (as discussed below). The consultant was Jason Rapert, a former member of the Arkansas State Senate, where he chaired the Insurance and Commerce Committee, and a former president of the National Conference of Insurance Legislators (“NCOIL”). He provided a further reason for allowing CRPs an independent right to participate in the IAO review process. He pointed out that an insurer could decide not to participate in or contest an IAO review, and to simply allow the IAO’s assessment to replace the CRP rating if it felt that the impact of the change was not sufficiently material to warrant the time and expense involved and that, if the insurer made such a decision, then the CRP would have no opportunity to present its case in defense of its rating.

The NAIC’s E Committee deferred action on the process for the NAIC to remove an eligible CRP rating of a specific security from filing exemption and assign an NAIC designation determined by the IAO to that security.

The E Committee is the parent committee of the VOSTF and typically routinely approves the actions of the VOSTF (and the other E Committee sub-units). Accordingly, it was quite surprising when the E Committee, at its August 15, 2024 meeting, passed a motion to adopt the actions of all of its other sub-units but did not adopt this specific VOSTF action. Instead, the E Committee Chair announced that there was insufficient time in the meeting agenda to discuss this agenda item and that there would be a separate open meeting of the E Committee to consider its adoption. That E Committee meeting has been scheduled for August 29, 2024.

This deferral of action by the E Committee has caused speculation as to what it might mean. Some sources have expressed the view that the E Committee just felt that this particular action was more substantive than most of the actions it routinely approves and that it warranted a separate discussion before being adopted. If that view is correct, the two-week delay will have no real impact and the proposal will be adopted by the E Committee without change.

On the other hand, the E Committee Chair’s decision to defer action for two weeks could indicate that he believes an additional aspect of the process may need to be addressed. That additional aspect might be the concern expressed by Senator Rapert at the August 13 meeting that if an insurer decides for reasons of its own not to participate in or contest an IAO review, then the CRP will have no opportunity to participate. What the VOSTF Chair focused on in her opening remarks was that the NAIC has no authority to compel a CRP to participate in the process, but what Senator Rapert is questioning is whether it is appropriate for a CRP to be excluded when it very much wishes to participate in a process in which it may have a material interest. In addition to the merits of Senator Rapert’s argument, on which there may be a difference of opinion, the fact that he is a former state insurance legislator and a former president of NCOIL means that his views need to be taken seriously, even if only as a matter of courtesy.

Accordingly, it is possible that the August 29 meeting of the E Committee may include the consideration of a revision to the IAO review process that will offer the CRP that provided the eligible filing-exempt rating an opportunity to participate that is not contingent on an insurer’s invitation.

The NAIC’s E Committee exposed two documents for a 60-day comment period ending October 14, 2024.

At its August 15 meeting, the E Committee advanced two other initiatives that originated at the last NAIC Summer National Meeting in August 2023:

The E Committee exposed for comment a draft request for proposal (“RFP”) for a consultant to design and help implement a new process under which the NAIC would develop “a strong due diligence program” over the ongoing use of CRPs. The concept of developing such a due diligence program was proposed in the August 2023 document entitled “Framework for Regulation of Insurer Investments—A Holistic Review” (the “Holistic Review Document”). In the Holistic Review Document, developing such a due diligence program was actually proposed as an alternative to developing a process for the IAO to remove the filing exemption from CRP ratings for specific securities, but the E Committee decided to pursue both initiatives rather than to choose between them. In March 2024, the NAIC’s Executive (EX) Committee authorized the E Committee to proceed with the development of an RFP, and this exposure draft is the next step in the process.
The E Committee also exposed for comment a written response to the comments it received on the Holistic Review Document and a related workplan, which the E Committee had exposed for comment on February 15, 2024. The E Committee released its response to those comments.
The VOSTF received an update on the treatment of investments that will move from Schedule D to Schedule BA on January 1, 2025.

SVO Director Charles Therriault noted that the January 1, 2025 changes to Statement of Statutory Accounting Principles (SSAP) No. 26 and SSAP No. 43 relating to the new principles-based bond definition (“PPBD”) will cause certain debt securities that are currently reported as bonds on Schedule D of the statutory investment schedules to become non-bond debt securities reportable on Schedule BA. He pointed out that Schedule BA includes a column for indicating the NAIC designation if an investment has an NAIC designation. He noted that some investments that will move to Schedule BA as non-bond debt securities already have NAIC designations assigned by the SVO; however, investments that do not have NAIC designations assigned by the SVO but are eligible to receive NAIC designations will need to be filed with the SVO to obtain such designations. This would include certain investments that are currently filing-exempt but that cease to qualify as bonds under the PPBD after January 1, 2025.

The VOSTF received an update from the Structured Securities Group on the CLO modeling project.

At its August 14 meeting, the VOSTF also received a report from Eric Kolchinsky, Director of the SSG, on the Ad Hoc Working Group’s efforts to develop a modeling methodology for collateralized loan obligations (“CLOs”). Mr. Kolchinsky stated that the SSG has completed running 10 scenarios for each of the CLOs owned by insurance companies, and that the results will be posted on the Ad Hoc Working Group’s website and sent to the American Academy of Actuaries (the “Academy”) for analysis. He also stated that the Ad Hoc Working Group has completed the analysis of the methodology adjustments that were previously proposed by interested parties and expects to present the analysis at its next meeting in September.

The RBC IRE WG received an update from the American Academy of Actuaries on its risk analysis project relating to CLOs.

As we have previously reported, the RBC IRE WG has been engaged since 2022 in developing an RBC framework for asset-backed securities, starting with CLOs. At the NAIC’s Spring National Meeting in March 2024, Stephen Smith, Chair of the Academy’s C1 Subcommittee, described the Academy’s plan to identify “comparable attributes” that can be used to differentiate risk (e.g., CRP rating, thickness of residual tranche, and credit support) and to analyze whether or not a small set of identifiable attributes explain most of the tail risk of CLOs.
At the RBC IRE WG meeting on August 14, Mr. Smith provided an update on the Academy’s work on this project. He explained that it has taken longer than expected to clear certain legal hurdles and gain access to the data for the analysis, but that the software for analyzing the data is in place and ready to start work as soon as the data is received. Mr. Smith said that the Academy expects to complete its analysis and present its findings and recommendations at the NAIC’s Spring National Meeting in March 2025, and that he would provide a further status update at the NAIC Fall National Meeting in November 2024.

The RBC IRE WG launched a project to develop a comprehensive fund proposal.

The RBC IRE WG voted to add to its 2024 working agenda several ongoing referrals from the Capital Adequacy (E) Task Force relating to the RBC factors for investments in various fund structures. The working group’s goal is to address such referrals by developing a comprehensive proposal (the “Comprehensive Fund Proposal”) to ensure the consistent treatment of funds that have underlying characteristics of debt rather than equity, and to qualify such funds to receive NAIC designations and be eligible to receive bond RBC factors. Chair Philip Barlow invited interested parties to participate in this project, and Brian Bayerle, Chief Life Actuary at the American Council of Life Insurers, volunteered to assist.

To view additional updates from the US NAIC Summer 2024 National Meeting, visit our meeting highlights page.