United States: Treating Debt As Equity — Emerging Standards In Insurance Regulation

Recent efforts by the National Association of Insurance Commissioners (NAIC), the principal standard-setting body for insurance regulation in the U.S., to establish a "group capital" standard (that is, capital-adequacy rules for insurance companies and their affiliates as a whole) could change the circumstances under which debt instruments are treated as equity for regulatory-capital purposes.

After reviewing some of the basics of insurance company capital requirements and the features of certain "hybrid" debt instruments, this article will explore the NAIC's ongoing group capital project and its possible impact on the treatment of such instruments, including highlights of a recent paper from an NAIC working group.

RBC and Entity-Level Capital Requirements

Historically, capital of insurers has been regulated mainly at the statutory entity level. The principal regulatory tool that state insurance regulators have used for approximately the past 25 years is the NAIC's risk-based capital, or RBC, calculation. Under RBC, each insurance company performs an annual series of prescribed calculations, tailored to its distinct risk profile, product mix, investment portfolio, reinsurance program and other variables, designed to produce (i) a minimum amount of capital and surplus necessary for the entity to conduct its specific business and (ii) the actual amount of "total adjusted capital" residing in the entity. Total adjusted capital must exceed two times the minimum in order for the entity to be in full compliance with RBC requirements. If capital falls below two times the minimum, the regulator may take certain measures to restore the insurer to capital adequacy. Below 1.5 times the minimum, certain additional remedies become available to the regulator to address the capital deficiency, and still further measures can be taken when capital falls below 1.0 times the minimum. At 0.7 times the minimum level, the insurance regulator is required to place the insurer in receivership.

The entity-level determination of minimum capital is consistent with financial regulation of insurers generally, including the use by insurance regulators and companies of "statutory" accounting principles as opposed to generally accepted accounting principles (GAAP). "Stat" or "SAP" accounting operates at the entity level as well and does not consolidate multiple entities. (Of course, insurance companies that are part of a larger group can use GAAP on a consolidated basis and, when registering under U.S. securities laws, must do so.)

Surplus Notes

Under statutory accounting guidelines issued by the NAIC — and, in a number of states, specific insurance statutes — "surplus" notes issued by an insurer are recorded as capital rather than liabilities on the insurer's balance sheet. Surplus notes, generally, are deeply subordinated debt instruments, as to which prior approval of the state regulator is required for issuance, payment of any principal or interest, and any redemption or repurchase. Payments on the notes may be approved by the regulator only if he deems surplus to be sufficient to safely do so. Surplus notes may not be accelerated upon a default, rank senior only to equity, and are subordinated to all other liabilities — policy claims, general unsecured claims, all other debt instruments — except for other series of pari passu surplus notes.

Historically, surplus notes have been a key mechanism allowing non-stock insurers, such as mutual insurers (insurance companies essentially "owned" by policyholders), which cannot by definition issue shares to investors, to raise capital. Large mutual insurers such as Mass Mutual, New York Life and Nationwide have issued multiple investment-grade, Rule 144A-eligible surplus note tranches over the past 20 years or so, raising billions in capital for those carriers. In 2017, The Savings Bank Life Insurance Company of Massachusetts issued surplus notes in a Rule 144A-eligible offering in connection with its conversion from a stock carrier to a mutual carrier, in order to replace capital used to repurchase the company's shares.1

Shares and surplus notes issued by insurers ordinarily qualify for capital treatment even when issued to an upstream parent which has purchased the securities using proceeds from the parent's issuance of debt to third parties. In other words, the entity-level framework for insurance accounting and capital standards lacks a prescribed method for discounting the capital treatment of instruments where the issuance of the instrument has the effect of levering the insurer (insofar as the parent company relies on the insurer's profits for liquidity to pay debt service). A brief review of insurance holding company regulation is instructive in this regard.

Regulation of Insurance Groups

Because RBC is determined at the legal entity level, multiple insurance entities within a holding company group can and do have distinct RBC ratios. State regulators historically did not regulate minimum capital at the aggregate or holding company level. The main tool for regulating insurance groups has historically been the NAIC's model insurance holding company act, which regulates (i) acquisitions of control over insurance companies, (ii) relationships between insurers and their affiliates, and (iii) specific transactions (including dividends and other distributions) between insurers and affiliates, some of which require prior notice to and/or prior approval of the state insurance regulator. Insurance holding company acts have been adopted, with some variation, in all U.S. states.

The premise for the original insurance holding company act (whose legislative roots trace to the early 1970s), however, was the potential abuse or "looting" of insurers by parent companies, particularly diversified conglomerates. Policymakers were concerned that such firms, straddling multiple sectors, would have incentive to extract capital from insurers to the detriment of policyholders. The holding company act did not purport to regulate consolidated group capital as such.

One consequence of this holding company regulatory framework, coupled with entity-level accounting and capital standards, was that insurance regulators' tools for dealing with holding company leverage were somewhat blunt. A holding company could incur debt and contribute proceeds to a subsidiary insurance company as equity or as a surplus note, and the standard treatment of such transaction was to permit the insurer to record the proceeds as capital, just as if the insurer or its parent had issued new shares to third-party investors. By contrast, a more holistic view of the consolidated group (such as that of a rating agency or regulators in other sectors, including banking) might discount the capital treatment of the proceeds on the theory that the insurer is at least partially leveraged as a result of the transaction. This is particularly the case where the holding company has few or no other businesses and relies on the insurance subsidiary to generate profits that can become dividends upstream to service debt.

The lack of any prescriptive regulatory discounting of capital treatment is one of the key reasons that insurance companies did not embrace "hybrid" securities to the same extent that the banking sector historically did. Hybrid securities have characteristics of debt and equity and were designed to achieve capital treatment on the strength of their equity-like features such as deferral of interest, deep subordination and commitments to issue replacement capital upon a repayment. Rating agencies and bank regulators developed tools for calibrating the specific capital treatment that would be afforded to such instruments based on the strength of these various characteristics.

Toughening Insurance Group Regulation

In the years since the subprime crisis, the NAIC has sought to strengthen regulation of insurance groups by implementing stricter tools for overseeing insurers' relations with parent and other affiliate entities. Three principal developments exemplify this approach — amendments to the insurance holding company act itself in 2010 (now adopted in most states); adoption of the "Risk Management and Own Risk and Solvency Assessment Model Act" (ORSA) model law in 2012 (adopted widely); and the ongoing effort to develop a group capital standard at consolidated groups. The holding company act amendments, with their "enterprise risk" requirements, and ORSA, with its focus on group capital adequacy, were the NAIC's first forays into oversight of conditions beyond the insurance entity in order to capture enterprise-wide risks. However, they still mainly dealt with consolidated group risks qualitatively rather than quantitatively.

How the Group Capital Effort Is Different

The group capital calculation (GCC) project currently ongoing at an NAIC working group is directed more analytically at determining the appropriate amount of group capital for insurers and their affiliates as a whole. The initial efforts of the GCC project were aimed at determining whether group capital should be determined on a "consolidated" (measuring the group based on consolidated financial-accounting tools) or "aggregate" (tallying up the regulatory capital at the multiple entities) basis. For the time being, the NAIC has decided on an aggregate approach. Other initial topics that the GCC working group has attempted to tackle include the issue of scope (that is, which sectors within the insurance market will be covered by the standard, and whether any, such as health insurers, will be exempt) and the treatment of life insurance special-purpose captive insurers (limited-purpose insurers designed to finance excess reserving requirements). While these efforts have progressed, the working group has now turned to a newer issue — the treatment of surplus notes and "subordinated senior debt" in the group capital framework.

Recent Proposed Guidance and Discussion Points

A 2017 NAIC working group paper — discussed on a public April 19, 2018, conference call among interested parties and re-issued with revisions on April 24 — sets out some principles on treating surplus notes and subordinated notes under the emerging group capital framework. Among the NAIC's points:

  • Currently, when an insurer issues a surplus note to an affiliated insurer in which the first insurer has an existing investment, stat accounting permits the issuer to treat proceeds as equity but eliminates the value from the surplus of the purchaser, while RBC requires the purchaser to incur asset risk in respect of the note. This is intended to prevent double-counting (i.e., a result where an insurer (i) has an investment in an affiliate, (ii) issues securities to that affiliate and (iii) then seeks to increase the value of the investment accordingly).

    • In an aggregation model of group capital, however, this statutory accounting mechanism would not automatically apply. Each entity would be looked at distinctly, leading to possible double-counting when aggregated (the insurer could record surplus in respect of the surplus note, as well as an increase in the value of its investment in the affiliate). There would be no organic way to neutralize the duplicative effect. The paper indicates that this treatment "needs to be addressed."
  • The NAIC writes that another factor it traditionally relies on in addressing holding company leverage is structural, or effective, subordination. This refers to the super-senior ranking of policyholders in an insurer's capital structure relative to all debt holders in an insolvency.2 Because policy claims are payable prior to any surplus-note payments or dividends on shares, policyholders are substantively senior to holders of holding company debt. This mitigates somewhat the NAIC's historical lack of a discounting mechanism for capital treatment where holding company leverage is incurred.

    • In other words, the fact that policyholders have a senior claim arguably justifies treating funds as capital even where those funds must support debt service at the parent level.
    • The NAIC notes that, by the same token, it may be appropriate to impose a cap on such capital treatment, inasmuch as this type of transaction may cause outflows of group assets (i.e., for debt service) that could otherwise be used to absorb future losses.
  • From the standpoint of the issuer, surplus notes "shall" be reported as surplus, and not as debt, only if the surplus note contains the following features (these are not novel and reflect the traditional characteristics of surplus notes):

    • subordination to policyholders;

    • subordination to "claimant and beneficiary" claims;

    • subordination to all other creditors; and

    • prior approval of the domiciliary regulator required for interest and principal repayments.

  • As noted above, the NAIC confirms that under stat accounting there is no distinction in capital treatment, such as "tiering," for assets that qualify as surplus, such as surplus notes. It is noteworthy, however, that the NAIC writes, "However, there is a distinction under U.S. banking rules and there may be under other sectoral rules. So it seems logical to respect the available calculations of the regulators in those sectors" in an aggregation group capital approach (where an insurer's affiliates include banking or other financial entities).

The NAIC memorandum sets forth the following recommendations for treating these types of transactions in determining group capital:

  • Surplus Notes — "In all cases treat the assets transferred to the issuer of the surplus note as available capital."

    • If the purchaser is an affiliated insurer, eliminate the investment value from the affiliated purchaser of the surplus note (treat as zero surplus) and eliminate the purchaser's capital, or RBC, charge on the surplus-note investment.

  • "Subordinated Senior Debt Issued" — Recognize structurally subordinated debt as available capital "to some degree" but only to the extent funded (any receivables for non-paid-in amounts would not be included for purposes of calculating the allowance). For purposes of recognition these criteria must be met:

    • The instrument has a fixed term (e.g., a minimum of five years including any call options).

    • An earlier draft had stipulated that "there is not an expectation, either implied or through the terms of the instrument, that supervisory approval will not be withheld upon request for the repurchase or redemption of the instrument." This prong was revised in March 2018 and, as it appears in the current draft, now clarifies that regulatory approval is required for any repurchase or redemption, and that there is no expectation that such "approval ... will be granted without supervisory review." This prong implies that ordinary interest and principal payments may be made without prior regulatory approval, a sensible distinction from surplus notes, which do require such approval.

    • A formal requirement that the note not contain an acceleration remedy has been stricken from the current draft of the paper. Again, contrast this with the near-universal practice of structuring surplus notes such that they cannot be accelerated on a default.

  • As the NAIC approaches its "field testing" of the group capital standard with selected pilot insurers, explore a cap on the amount of total capital that can be represented by subordinated debt (e.g., the NAIC could specify that subordinate debt is allowed as capital but subject to, say, 20% of total capital).

The paper's April re-issue concludes with recommendations to (i) review hybrid securities to determine the extent to which they should be admitted to capital and (ii) "continue discussion, in consultation with [the] NAIC international team, to maintain consistency on the boundaries of what constitutes structural subordination and how it should be measured."


1 Kramer Levin represented the initial purchasers in the offering.

2 Insurance company insolvency is governed by state laws on insurance company liquidation and rehabilitation. Insurance companies are statutorily ineligible to be debtors under the U.S. Bankruptcy Code.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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