US NAIC Summer 2022 National Meeting Key Takeaways: Investment-Related Initiatives

A number of sessions held during the Summer National Meeting of the US National Association of Insurance Commissioners (“NAIC”) focused on initiatives relating to insurance company investments. We have been focusing on these initiatives for some time and summarize below the latest developments from the Summer National Meeting.

August 10 – Statutory Accounting Principles (E) Working Group

• Since early 2021, the Statutory Accounting Principles (E) Working Group (“SAP WG”) has been working on changes to the definition of what counts as a “bond” for statutory accounting principles. Bond treatment is highly advantageous for insurance company investors because they can generally carry bond investments at amortized cost (rather than marking them to market) and the risk-based capital (“RBC”) charges for bond investments are markedly lower than for equity investments. 
• As expected, at the August 10 meeting, the SAP WG received a revised draft of the “principles-based” bond definition and exposed it for a comment period ending October 7, 2022. The SAP WG also received a draft “statutory issue paper” on the principles-based bond definition and exposed it for the same comment period. A “statutory issue paper” provides a detailed rationale for the SAP WG’s adoption of a new or revised statement of statutory accounting principles (“SSAP”). To complete the package, the SAP WG also exposed draft amendments to SSAP No. 26R – Bonds and SSAP No. 43R – Loan-backed and Structured Securities for the same comment period, ending October 7, 2022.
• October 7 is the same date when comments are due on proposals previously exposed by the SAP WG, providing for changes to insurers’ statutory financial statements that would split Schedule D into two separate sub-schedules—one for issuer obligations and one for asset-backed securities (“ABS”)—with different data columns tailored to each type and more granular visibility for the investments underlying ABS. 
• Of particular interest is language in the draft issue paper addressing rated debt issued from “feeder funds,” which have been an increasingly popular investment for insurance companies. Prompted by input from industry representatives, the draft issue paper states that if the underlying fund holds only debt instruments and passes those fixed income cash flows through the structure to the ultimate debt holder, the rated note issued by the feeder fund may have substance aligned with a debt investment rather than an equity investment. This willingness to “look through” the structure to the underlying debt exposures is a promising development since insurance regulators have traditionally focused almost exclusively on the nature of the instrument that an insurance company directly holds. 
• NAIC staff also mentioned that revisions would be forthcoming to SSAP No. 2R – Cash, Cash Equivalents, Drafts and Short-Term Investments (to exclude ABS from being classified as short-term investments) and to SSAP No. 103R – Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (because it contains some cross-references to SSAP No. 43R that may need revisions to reflect changes to that statement).
• The chair of the SAP WG stated that, due to the amount of work still to be done on the operative documents, the likely effective date of the proposed statutory accounting changes is January 1, 2025. He also reiterated that once the new rules are in effect, they will apply to all investments in an insurance company’s portfolio (i.e., there will be no “grandfathering” of previously acquired investments).
• All of the exposed draft documents are available at the webpage of the Statutory Accounting Principles (E) Working Group (under the Exposure Drafts tab).
• For more background on the NAIC’s “what is a bond” initiative, see “Major NAIC Investment-Related Initiatives” in our Global Insurance Industry Year in Review 2021 and a subsequent Legal Update, “Latest Exposure Draft from NAIC Working Group May Facilitate Rated Feeders, CFOs and Other Structured Investments for US Insurers.”

August 11 – Valuation of Securities (E) Task Force

• At its August 11 meeting, the Valuation of Securities (E) Task Force (“VOS TF”) advanced a number of initiatives that will affect the credit quality designations assigned to insurance company investments and will indirectly affect the RBC charges that are tied to those credit quality designations. 
• Historically, the great majority of fixed-income securities owned by insurance companies have been “filing exempt”—meaning that they automatically receive a credit quality designation equivalent to their external rating by an NAIC-recognized credit rating provider (“CRP”). Securities that are not filing-exempt must be filed with and assigned a designation by the NAIC’s Securities Valuation Office (“SVO”). In either case, the credit quality designation determines the applicable RBC charge associated with investment in that security.
• On August 11, the VOS TF adopted a previously exposed amendment to the Purposes and Procedures Manual (“P&P Manual”) of the NAIC Investment Analysis Office (“IAO”), clarifying that the SVO has the discretion to notify state regulators of an insurer’s investment that it considers ineligible for reporting on Schedule D or BA, but that the SVO can still assign an NAIC designation to that investment provided that its credit quality can be assessed consistently with the policies and methodologies specified in the P&P Manual.
• The VOS TF also adopted a previously exposed amendment to the P&P Manual to update the definition of “principal protected securities” (“PPS”) to also include structured notes issued by an operating entity that synthetically replicate notes issued by an SPV that holds underlying assets with both a principal protection component and a performance component. As discussed in “Major NAIC-Investment Related Initiatives” in our Global Insurance Year in Review 2021 and in more detail in our Legal Update “Major Change in Capital Treatment for Insurer Investments in ‘Principal Protected Securities’,” PPS are no longer filing-exempt but must be filed with and assigned a designation by the SVO.
• The VOS TF received a referral from the SAP WG relating to ABS that are classified as affiliate investments because the issuer is controlled by an affiliate of the insurer even though the underlying credit exposures are unaffiliated with the insurer. Currently, affiliate investments are not filing-exempt, but the SAP WG has asked the VOS TF to consider amending the P&P Manual to grant a filing exemption if the underlying credit exposures are unaffiliated. 
• The VOS TF also exposed the following documents for a 30-day comment period ending September 12, 2022 (documents are available at the webpage of the Valuation of Securities (E) Task Force, under the Exposure Drafts tab):
  • Proposed Task Force charges for 2023, including two newly added charges:
    1. Establish criteria to permit staff’s discretion over the assignment of NAIC designations for securities subject to the filing-exempt process (the use of credit rating provider ratings to determine an NAIC designation) to ensure greater consistency, uniformity, and appropriateness to achieve the NAIC’s financial solvency objectives.
    2. Implement additional and alternative ways to measure and report investment risk.
  • A revised SVO memorandum (dated July 14, 2022) outlining possible options for adding market data fields for bond investments to the statutory financial statements to enable the SVO to independently assess investment risk. The revised memorandum is intended to address industry comments on the SVO’s February 25, 2022, memorandum on the subject.
  • A proposed amendment to the P&P Manual to provide more detail regarding securities to which the SVO assigns a “Subscript S” symbol based on a determination that the security contains “other non-payment risk” (i.e., risks of non-payment other than credit risk).
  • Slides containing the NAIC staff’s response to industry comments received on a previously exposed issue paper calling for collateralized loan obligation (“CLO”) investments to be assigned designations based on a modeling process (rather than on CRP ratings) and a previously published briefing paper from the NAIC Capital Markets Bureau on the NAIC’s CLO stress test methodology.
• Carrie Mears, chair of the VOS TF, clarified that the project to develop a modeling process, under which the IAO would assign designations to CLO investments, will be handled through an iterative process, with full transparency, deliberation, and opportunity for industry input on the fine tuning of the methodology, and done in collaboration with the Risk-Based Capital Investment Risk and Evaluation (E) Working Group (“RBC IR&E WG”).
• Chair Mears also clarified that the goal of addressing RBC factors for residual tranches is to eliminate RBC arbitrage.
  • This arbitrage is believed to exist when the sum of the RBC charges borne by an insurance company that holds all of the tranches of a securitization is lower than the RBC charge it would have borne if it held the underlying securitized assets directly.
  • Chair Mears stated that increasing the RBC charges on residual tranches was a shorter-term project than the longer-term development of a modeling process for assigning credit quality designations to CLOs and asked staff of the IAO to start working with the RBC IR&E WG on that shorter-term project.
• Chair Mears also reported that the ad hoc study group looking at CRPs and the use of CRP ratings was still in the early stages and that this would be a multi-year process.

August 11 – Risk-Based Capital Investment Risk and Evaluation (E) Working Group 

• The RBC IR&E WG was created in early 2022 as a working group of the Capital Adequacy (E) Task Force (“CapAd TF”). The CapAd TF has overall responsibility for establishing RBC factors for insurance company investments, and it charged the RBC IR&E WG with performing a comprehensive review of the RBC investment framework. (See our discussion of RBC factors in our Global Insurance Industry Year in Review 2021.)
• On August 11, prompted by the VOS TF, the RBC IR&E WG added to its working agenda an item to evaluate the appropriate RBC treatment of residual tranches of ABS, with CLOs as the first priority. 
• Phil Barlow, chair of the RBC IR&E WG, emphasized that the RBC IR&E WG and VOS TF need to collaborate on both of the current initiatives—the longer-term project to model NAIC designations for CLOs and the shorter-term project to address the RBC treatment of residual tranches to eliminate RBC arbitrage.
• Chair Barlow stated the following as objectives:
  • It should be possible to easily determine from looking at an insurer’s annual statutory statement how an investment is classified for RBC purposes.
  • It should be clear what risk criteria are included in and excluded from the SVO’s analysis when the SVO assigns a designation so that the RBC IR&E WG can assess whether the designation should directly translate to an RBC factor (as is currently the case) or whether more inputs are needed.
  • There needs to be a way to assign an RBC charge to new types of assets during the time period before the SAP WG and VOS TF have determined where to classify them.
• Chair Barlow reiterated that there are two distinct projects relating to CLOs:
  1. Developing a framework for assigning RBC charges to CLOs (namely, the CLO modeling project); and
  2. Addressing an interim issue with CLOs (i.e., determining how to increase RBC on the residual tranches to address RBC arbitrage).
     • Chair Mears commented that these projects were starting with CLOs but would need to look beyond CLOs, especially with regard to treatment of the residual tranches of other types of ABS.
     • She noted that the SAP WG, in its bond project, had expressly articulated an expectation that RBC arbitrage would be addressed by the RBC IR&E WG and she would welcome input from industry as to solutions that would not be “overly punitive.”
     • Chair Barlow asked whether residual tranches are clearly identifiable in an insurer’s annual statement. Dale Bruggeman, chair of the SAP WG, responded that this information was not necessarily available previously but will be available in the 2022 annual statements.
• Chair Barlow announced that he has reached out to the American Academy of Actuaries (“AAA”) and requested their assistance with the CLO project. He called on Steve Smith, chair of the C1 Working Group of the AAA, who said his working group was standing ready to assist both the RBC IR&E WG and the VOS TF.
• Chair Barlow asked whether the RBC IR&E WG needs to be concerned with RBC arbitrage in tranches besides the residual tranche.
  • Dale Bruggeman responded that the SVO’s analysis has shown that even a 100 percent RBC charge on residual tranches will not necessarily cure arbitrage, so it may be necessary to look at the lower-rated mezzanine tranches.
  • Carrie Mears stated that she would prefer that the interim solution be limited to the residual tranche and that other tranches be addressed as part of the longer-term modeling project.
  • Charles Therriault, director of the SVO, said that the goal is to look at the entire structure (i.e., all tranches) but to focus on the residual tranche in the short term.
  • Tom Botsko, chair of the CapAd TF, suggested giving consideration to increasing RBC by 5 percentage points for the lower-rated mezzanine tranches as part of an interim solution. There was no immediate response to that suggestion.
• Chair Barlow mentioned that the RBC IR&E WG had received a referral from the Financial Stability (E) Task Force and its Macroprudential (E) Working Group expressing concern about the risks posed by privately structured securities. He expressed the view that the interim solution would address this concern.