US NAIC Fall 2024 National Meeting Highlights: Investment-related Highlights

The US National Association of Insurance Commissioners (NAIC) held its Fall National Meeting in Denver, CO on November 16-19, 2024. This article reports on some highlights of the November 17 meetings of the Statutory Accounting Principles (E) Working Group (SAPWG) and Valuation of Securities (E) Task Force (VOSTF) and also reflects on some of their implications.

The SAPWG adopted the previously exposed Q&A Guide relating to the new PPBD

As readers are likely aware, the new principles-based bond definition (PPBD) will become effective on January 1, 2025—with no “grandfathering.” Beginning on that date, all debt securities owned by insurance companies will need to satisfy the PPBD in order to be treated as bonds for statutory accounting purposes and reported on Schedule D of the statutory investment schedules.

By way of background, on August 13, at the NAIC Summer National meeting, the SAPWG exposed for comment a Question-and-Answer Implementation Guide (the “Q&A Guide”), providing responses to eight questions about how the PPBD should be applied to specific situations. On October 6, the SAPWG exposed for comment three additional Q&As plus edits to one of the original Q&As. On November 17, the SAPWG adopted the enlarged Q&A Guide (with minor editorial changes suggested in one of the comment letters) and designated it as a new statutory interpretation captioned INT 24-01. Statutory interpretations are Level 2 of the statutory accounting hierarchy, ranking just below Statements of Statutory Accounting Principles (SSAPs), which are Level 1.

The adopted version of the Q&A Guide is available here and includes responses to the following questions:

1. When assessing whether a security has substantive credit enhancement, how should future cash flows be considered? Should future expected cash flows be incorporated into the overcollateralization disclosure?
2. Are securities issued by foreign governments or foreign government agencies considered Issuer Credit Obligations?
3. Are “Municipals” always Issuer Credit Obligations (ICO)?
4. Should common types of “Sports Deals” be classified as ICO or asset-backed securities (ABS)?
5. Do cashflows produced by non-financial assets backing an ABS have to actually be used to make interest and principal payments throughout the life of the debt security for an investment to qualify as a non-financial backed ABS under the meaningful cash flow test?
6. How should CMBS Interest Only (IO) strips be assessed under the PBBD?
7. How should debt securities that reflect Single Asset Single Borrower (SASB) Commercial Mortgage Loan (CML) securitizations be assessed under the PBBD?
8. Do synthetic or referenced pool structures within an ABS disqualify the ABS for reporting on Schedule D-2-1?
9. Can expected but non-contractual cash flows (e.g. from future leases) be considered in determining the meaningful cash flow practical expedient for non-financial ABS?
10. How should hybrid securities be accounted and reported?
11. When do non-bond debt securities need to be assessed for admittance based on underlying collateral?

We examine Q&As 7, 10 and 11 in more detail below.

Q&A 7: SASB CML securitizations must be assessed as ABS under the PPBD and will generally fail to qualify as bonds if they have a uni-tranche structure

Q&A 7 addresses SASB commercial mortgage-backed security (CMBS) structures that securitize a single mortgage loan collateralized by one property owned by a single borrower. SASB CMBS structures can issue multiple tranches with different priorities of payment, or they can issue a single tranche (a “uni-tranche structure”) that simply passes through the cash flows of the underlying CML. It had been suggested by some observers that SASB structures where the underlying CML was fully amortizing could qualify as ICOs under subparagraph 7.g. of SSAP No. 26—Bonds; i.e., as “securities for which repayment is fully supported by an underlying contractual obligation of a single operating entity.”

However, Q&A 7 rejects the foregoing analysis and requires SASB CMBS structures to be analyzed under the ABS side of the PPBD. The main reason is that, even though the CML has a single borrower, the ultimate cash flows for repayment of the CML and the CMBS are the lease cash flows, which are typically derived from multiple lessees. Under the ABS criteria, an ABS must have substantive credit enhancement that puts the holder of the debt security in an economically better position than if it held the underlying collateral directly. If the CMBS has a multi-tranche structure, then the senior tranche(s) receive credit enhancement from the subordinate tranche(s). But if the CMBS has a uni-tranche structure, there is no substantive credit enhancement for the single CMBS tranche (absent some other form of credit support such as an external guarantee), with the result that the uni-tranche CMBS will fail to qualify as an ABS and will be a “non-bond debt security” (NBDS). There are a number of consequences of NBDS classification. In the case of life insurers, NBDSs do not qualify for filing exemption and need to be filed with the NAIC’s Securities Valuation Office (SVO) in order to be assigned an NAIC designation. See the VOSTF discussion below for a description of steps the NAIC staff is taking to facilitate the assignment of NAIC designations to uni-tranche SASB CMBS.

One aspect of Q&A 7 that merits particular attention is its focus on the source of the ultimate cash flows for repayment of the debt security. While at first glance it might appear that the single borrower under the SASB CML could be regarded as the source of repayment of the CMBS in order to qualify the CMBS as an ICO under subparagraph 7.g. of SSAP No. 26, that is not how the NAIC analyzes the structure, because that single borrower is a landlord who depends on the cash flows from its tenants to repay the mortgage loan. The key takeaway is that unless repayment is based on the general creditworthiness of an operating entity (the hallmark of an ICO), the PPBD analysis needs to focus not on an immediate or intermediate source of cash flows, but rather on the ultimate source of cash flows for repayment.

Q&A 10: Hybrid securities will need to be analyzed under the PPBD. If a hybrid security is determined to be a non-bond debt security, the RBC charge for P&C and health insurers that hold that security will increase significantly

Q&A 10 explains that under the old, pre-PPBD version of SSAP No. 26, hybrid securities—which have characteristics of both debt and equity—were automatically “scoped into” the bond definition. However, the new SSAP No. 26 will require hybrid securities to satisfy the PPBD in order to be classified as bonds, and hybrid securities that fail to satisfy the PPBD will be classified as either NBDS or surplus notes. A comment letter submitted to the SAPWG by an asset-management firm (see pages 101 to 104 of the meeting materials) pointed out the risk-based capital (RBC) impact that an NBDS classification would have on a P&C or health insurer. While a life insurer can file an NBDS with the SVO to obtain an NAIC designation and receive the RBC charge associated with that designation, a P&C or health insurer does not currently have that ability. The RBC factor for “other invested assets” for a P&C or health insurer is 20%, which would be a dramatic increase from the RBC factors of 1.5% or 1.9%, respectively, for a bond rated A−.

The SAPWG responded to the above concern by formally referring this topic to two other NAIC working groups—the P&C Risk-Based Capital (E) Working Group and the Health Risk-Based Capital (E) Working Group—to consider whether to provide for more granular RBC factors for P&C and health insurers for (i) NBDS based on SVO-assigned NAIC designations and (ii) surplus notes based on NRSRO ratings.

Q&A 11: If a debt security fails to qualify as a bond under the PPBD, the underlying collateral must qualify as an admitted asset in order for the debt security to qualify as an admitted asset

There are multiple disadvantages of a life insurer of having to classify a debt security as an NBDS rather than a bond. An NBDS is reported on Schedule BA of the investment schedules, rather than Schedule D. An NBDS is reported at the lower of cost or fair value (in contrast to a bond, which is reported at amortized cost so long as its designation is above NAIC-6). An NBDS must be filed with the SVO in order to be assigned an NAIC designation, rather than receiving a designation based on an NRSRO rating. And, as Q&A 11 makes clear, there is a potentially more serious consequence: if the underlying collateral would not be an admitted asset if held by the insurer directly, then the NBDS will be a nonadmitted asset. (The concept of a nonadmitted asset is a distinctive feature of statutory accounting and refers to an asset that is charged against an insurer’s surplus because it is generally considered unusable to satisfy the insurer’s obligations to policyholders.) For example, if a mortgage-backed security fails to qualify as a bond—such as the uni-tranche SASB CML securitization in Q&A 7—it will be an NBDS but still an admitted asset, because the SASB CML is an admitted asset that the insurer could have invested in directly. By contrast, if a debt security backed by railcar leases fails to qualify as a bond under the PPBD, that debt security would be nonadmitted, because railcars are not admitted assets that an insurer could have invested in directly. Other examples of collateral that would not be admitted assets if held directly by an insurer are consumer loans and student loans. Q&A 11 underscores the point emphasized in our discussion of Q&A 7—the importance of looking to the ultimate source of repayment when applying the PPBD.

The SAPWG directed NAIC staff to prepare an agenda item to classify issue papers in Level 5 of the statutory hierarchy

NAIC staff has often pointed out that NAIC issue papers—unlike SSAPs and statutory interpretations—do not provide authoritative guidance. Rather, they provide historical documentation of the discussions behind the development of new or revised SSAPs. However, that may be about to change. A comment letter on the first exposure of the Q&A Guide urged that issue papers be added to the statutory hierarchy, as they often include interpretive guidance that is not found elsewhere. An example cited was the discussion of feeder funds under the PPBD in Issue Paper No. 169. In response, the SAPWG directed NAIC staff to prepare an agenda item to classify issue papers in Level 5 of the statutory hierarchy. As such, issue papers would still be subordinate to SSAPs (which are Level 1) and to statutory interpretations (Level 2), but it would no longer be true that they do not provide authoritative guidance.

The SAPWG abandoned the proposal it had exposed at the Summer National Meeting to require bifurcated reporting of “credit repacks” and other derivative wrapper structures

As discussed in our report on the NAIC Summer National Meeting, on August 13, the SAPWG exposed for comment (until September 27, 2024) proposed revisions to SSAP No. 86—Derivatives that would have addressed, not just “credit repacks,” but all debt security investments with derivative wrappers/components. The proposed revisions would have required bifurcation—separate accounting for the derivative and the underlying debt security—in contrast to current statutory accounting guidance, which explicitly precludes the separation of embedded derivatives.

The comment letter submitted by interested parties (see pages 95 to 97 of the meeting materials) was rather critical of the bifurcation proposal and, among other things, pointed out significant obstacles to an insurer even being able to report the derivative on Schedule DB or to apply the requisite hedge accounting requirements, since the insurer would not control or own the embedded derivative directly. The letter also pointed out that bifurcating the derivative and the bond would potentially cause the bond to be reported as a restricted asset. The letter concluded its comment on this topic by recommending that insurers should simply be required to evaluate the repacked instrument in its entirety under the PPBD.

In response to the comments, the SAPWG decided not to pursue the bifurcation proposal and limited its action to sponsoring blanks revisions to clarify that if an insurer already holds a bond that is “dropped” into an SPV to create a repacked security, then the insurer must account for that transaction as a disposal of the bond and an acquisition of the repacked security.

Some readers may be aware that in informal conversations earlier in 2024, the NAIC staff seemed at least receptive to the idea that simpler types of credit repacks (e.g., repacks that convert the payment currency or convert fixed to floating interest payments or vice versa) could potentially be analyzed as ICOs under subparagraph 7.g. of SSAP No. 26—Bonds, i.e., as “securities for which repayment is fully supported by an underlying contractual obligation of a single operating entity.” However, that is no longer the case in the wake of the abandonment of the bifurcation proposal. In a private communication subsequent to the Fall National Meeting, senior statutory accounting staff stated that all credit repacks will need to be analyzed as ABS and, if they lack substantive credit enhancement, will be classified as NBDS.

The SAPWG exposed for comment (until January 31, 2025) a new agenda item (Ref. #2024-21) to clarify statutory accounting guidance for investment subsidiaries of insurance companies, with resulting implications for statutory reporting and RBC

The term “investment subsidiary” is defined in Section 2TT of the NAIC Investments of Insurers Model Act (Model 280) as “a subsidiary of an insurer engaged or organized to engage exclusively in the ownership and management of assets authorized as investments for the insurer.” For purposes of compliance with any investment limitations applicable to the insurer, the insurer’s direct investments are aggregated with any indirect investments that are made through its investment subsidiaries. A similar description of an investment subsidiary is found in Section 2B(2) of the NAIC Insurance Holding Company System Regulatory Act (Model 440), although the term “investment subsidiary” is not used.

In the realm of statutory accounting, the concept of investment subsidiary appeared in a now-superseded SSAP No. 46—Investments in Subsidiary, Controlled and Affiliated Entities, which referred to “investments in noninsurance subsidiary, controlled or affiliated entities (SCAs) that have no significant ongoing operations other than to hold assets that are primarily for the direct or indirect benefit or use of the reporting entity or its affiliates.” For these SCAs, SSAP No. 46 required an equity measurement method adjusted to be consistent with the accumulated measurement of the underlying assets if they had been held by the insurer directly, i.e., a “look through.” However, when SSAP No. 46 was superseded by SSAP No. 88 as of January 1, 2005, the concept of an investment subsidiary was eliminated from statutory accounting guidance for SCAs, and the concept is similarly absent from SSAP No. 97, which superseded SSAP No. 88 as of December 31, 2007, and is the current authoritative guidance for SCAs. The concept of investment subsidiary is still found in SSAP No. 25—Affiliates and Related Parties, which has a number of parallels to the NAIC Insurance Holding Company System Regulatory Act.

Under current guidance in SSAP No. 97, unless the SCA is itself an insurer or engages in specific transactions on behalf of the parent insurer, the SCA will be captured under paragraph 8.b.iii of SSAP No. 97 and reported based on the audited US GAAP equity value—which may not be the same as the value of the underlying assets on a “look through” basis. Based on SSAP No. 97, the audited US GAAP equity value is used when reporting the investment subsidiary on Schedule D-2-2, Common Stocks. The valuation in Schedule D-2-2 is to then be carried over onto Schedule D-6-1, Valuation of Shares of Subsidiary, Controlled or Affiliated Companies.

The 2005 removal of the investment subsidiary concept from the SSAP guidance for SCAs has led to a number of disconnects. The annual statement instructions for Schedule D-6-1 limit the value reported for an investment subsidiary to the “imputed value on a statutory basis” of the underlying assets held by the investment subsidiary, which harks back to the “look through” methodology of the now superseded SSAP No. 46. Similarly, the Life RBC LR044 instruction for Affiliate Type 4 states: “The risk-based capital charge for the ownership of an investment subsidiary is based on the risk-based capital of the underlying assets, pro-rated for the degree of ownership. The basis for this calculation is the assumption that the charge should be the same as it would be if the life insurer held the assets directly.” Both of those approaches differ from the valuation guidance in SSAP No. 97, which is based on the audited US GAAP equity value of the subsidiary.

To address these disconnects, the NAIC staff has recommended that the SAPWG consider the following measures:

1. Revisions to SSAP No. 97 that would provide for SCAs that are investment subsidiaries to be valued using a “look through” to the underlying assets (similar to the long-superseded SSAP No. 46), potentially excluding any underlying assets that would be nonadmitted if held by the insurer directly.
2. Revisions to the statutory reporting blanks to capture new investment schedules—or perhaps expansions to existing investment schedules—to detail the underlying assets held within an investment subsidiary.
3. Referrals to the Capital Adequacy (E) Task Force and related RBC Working Groups to incorporate details that allow regulators to verify the RBC calculation for the underlying assets in investment subsidiaries.

NAIC staff made an additional noteworthy observation in the SAPWG meeting materials for this agenda item, noting that situations have been identified in which insurers have reported Schedule BA items (in scope of SSAP No. 48—Joint Ventures, Partnerships and Limited Liability Companies) as investment subsidiaries for RBC “look through” purposes. Staff commented that SSAP No. 48 Schedule BA investments should not be captured within the “investment subsidiary” classification, which is limited to common and preferred stock investments reported as SCAs in scope of SSAP No. 97. This raises the question of whether insurers can use trusts as investment subsidiaries to hold underlying assets. The current status of trusts for statutory accounting purposes is not entirely clear. SSAP No. 30—Unaffiliated Common Stock generally limits the term “common stock” to the common stock of a corporation, while “scoping in” a limited number of additional types of investments, e.g., master limited partnerships, common stock warrants and shares of registered investment companies (which in some cases are organized as trusts rather than as corporations). That said, we are not aware of statutory guidance relating to investments in trusts that are not registered investment companies, although we have noticed that some insurers do report investments in trusts as common stocks on Schedule D-2-2, and as investment subsidiaries on Schedule D-6-1.

We also note that under the NAIC model acts cited above, an investment subsidiary does not need to be organized as a corporation. The NAIC Insurance Holding Company System Regulatory Act defines a “subsidiary” of a person as “an affiliate controlled by such person directly or indirectly through one or more intermediaries.” That model act defines a “person” as “an individual, a corporation, a limited liability company, a partnership, an association, a joint stock company, a trust, an unincorporated organization, any similar entity or any combination of the foregoing acting in concert.” So under the NAIC model acts (and state statutes that follow the model acts), a subsidiary—and thus an investment subsidiary—could be organized as a corporation (subject to SSAP No. 97), or a partnership or limited liability company (subject to SSAP No. 48) or a trust (unclear as to what SSAP it is subject to). Whatever the SAPWG ultimately determines to be the appropriate valuation method for investment subsidiaries (audited GAAP equity or “look through”)—and whatever the Capital Adequacy (E) Task Force decides is the appropriate methodology for the RBC calculation (carrying value of the investment subsidiary or “look through”)—we do not see any principles-based reason for those outcomes to differ based on whether the investment subsidiary is organized as a corporation, a partnership, a limited liability company or a trust, when the function is the same regardless of entity structure, namely, to engage exclusively in the ownership and management of assets authorized as investments for the insurer.

The SAPWG Chair and Vice-Chair offered informal advice regarding the use of third-party vendors and checklists when implementing the PPBD

Toward the end of the SAPWG meeting, SAPWG Chair Dale Bruggeman said he was aware that some insurance companies are using third-party vendors and checklists to analyze the classification of their fixed-income investments under the PPBD. He and SAPWG Vice-Chair Kevin Clark each commented that insurance companies should use such tools with caution and not “blindly accept the results” because (i) the PPBD is principles-based rather than rules-based, so there are limitations on how well an algorithm can do in performing a principles-based analysis; and (ii) the insurance company itself is responsible for the classification, and if it uses such third-party tools, it must verify and “own” the results of the analysis.

The VOSTF adopted an amendment to the P&P Manual to clarify the ability of CRPs to provide ratings on specific classes of securities

Because “ABS” is a key term used in the PPBD, the adoption of the PPBD created a potential ambiguity as to whether a credit rating provider’s (CRP) NRSRO registration status with the SEC needs to include the ability to provide credit ratings for issuers of asset-backed securities in order for the CRP’s rating to qualify a bond that is classified as an ABS under the PPBD to be eligible for filing-exemption. The VOSTF resolved that ambiguity on November 17by adopting an amendment to the P&P Manual to add the following sentence to paragraph 57 of Part One of the Purposes and Procedures Manual (P&P Manual):

The NAIC only recognizes NAIC Credit Rating Provider ratings for those classes of credit ratings (each as defined by the SEC) for which an NAIC Credit Rating Provider is registered with the SEC as an NRSRO. For the avoidance of doubt, SEC definitions are distinct from those used for statutory accounting asset classification purposes in the Statements of Statutory Accounting Principles.

The added text clarifies that a CRP that is not registered with the SEC to provide credit ratings for issuers of ABS is not precluded from rating securities that fall within the PPBD’s definition of ABS unless those securities also fall within the SEC’s definition of ABS.

The NAIC’s SSG Providing Expedited CMBS Modeling for SASB CMBS Uni-Tranche Deals in Advance of January 1, 2025

As discussed above in our report on the SAPWG meeting, SASB CML securitizations will need to be assessed as ABS under the PPBD, and will generally fail to qualify as bonds if they have a uni-tranche structure. That means that they will no longer qualify for filing exemption as of January 1, 2025, and will need to be filed with the NAIC in order to be assigned an NAIC designation. At the VOSTF meeting, Eric Kolchinsky, Director of the Structured Securities Group (SSG), announced the SSG’s readiness to provide expedited modeling to assign NAIC designations to SASB SMBS uni-tranche deals before January 1, 2025. He asked that insurers start sending the SSG the specific CUSIPs involved to facilitate the process. There is a detailed process that insurers need to follow, which is summarized in a November 18, 2024 memo from the SSG.

The SVO Will Begin Deactivating the Filing Exemption of PL Securities Issued Since January 1, 2022 and for which a Private Letter Rating Rationale Report Has Not Been Filed

Effective January 1, 2022, the VOSTF amended the P&P Manual to require the filing of the private letter rating rationale report for Securities with a Private Letter Rating (PL Securities) with the SVO. The consequence that the P&P Manual prescribes for failure to file is deactivation of the PL Security’s filing exemption. At the November 17 VOSTF meeting, Charles Therriault, Director of the SVO, explained that, until now, the SVO has deferred enforcing this requirement while the NAIC’s technology was being updated, but that the SVO is planning to begin the deactivation process in 2025 for PL Securities issued on or after January 1, 2022. The consequence of deactivation is that the NAIC designation derived from the CRP rating will be removed from NAIC systems and an insurer that owns the PL Security will need to, within 120 days, either (i) file the PL Security with the SVO for the assignment of a designation; or (ii) self assign an NAIC-5.B GI designation to the PL Security and follow the General Interrogatory procedure in the statutory statements. Therriault also stated that the SVO had identified approximately 1,700 PL Securities issued since January 1, 2022 for which the private letter rating rationale report had not been filed, and that the SVO was reviewing the list with NASVA to confirm that this list is correct and that there are no data quality issues. He said that if it emerged that there are such issues, then the deactivation process would be deferred pending resolution of those issues. He added that if a PL Security is renewed at year-end, then a 120-day grace period would be provided for filing the private letter rating rationale report.

The SSG Continues to Develop a Modeling Methodology for CLOs

At the VOSTF meeting, Eric Kolchinsky provided a brief update on the Collateralized Loan Obligations (CLO) modeling project. He reported that, after analyzing data for approximately 1,800 CLOs held by insurers, the ad hoc group had selected a preliminary probability distribution designed to minimize the mean square error. He said that the ad hoc group would meet again in December, and would start posting monthly data in early 2025. He also reported that the C1 Subcommittee of the American Academy of Actuaries (which is working on a parallel project for the NAIC Risk-Based Capital Investment Risk and Evaluation (E) Working Group) is currently processing data received from Moody’s, and that the Academy’s results will be compared with the model the SSG is developing.

Following the VOSTF Meeting, a Special Session was Held on Impact Investing

Following the VOSTF meeting, Connecticut Insurance Commissioner Andrew Mais convened a special session on impact investing. He described the work that had been done by an ad hoc group of insurance regulatory staff from California, Connecticut, Iowa, New York and Wisconsin. He then introduced Joseph Pursley, from Nuveen, who gave a slide presentation describing five key criteria for impact investing, as well as a proposed structure for a pooled investment vehicle that would qualify as an ABS (and thus as a bond) under the PPBD.

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