At the Summer 2024 National Meeting of the US National Association of Insurance Commissioners ("NAIC"), the NAIC Statutory Accounting Principles (E) Working Group ("SAPWG") met on August 13, 2024. The SAPWG agenda included many more items than are discussed here; this update highlights specific agenda items of particular relevance to insurer investments. Meeting materials and exposure drafts are available at the SAPWG web page.
Issue paper adopted relating to principles-based bond definition
When the SAPWG makes substantive revisions to statements of statutory accounting principles ("SSAPs"), the NAIC staff develops an "issue paper" that sets out the history of the SAPWG's discussions and the detailed rationale for its decisions. Unlike SSAPs, statutory issue papers are not authoritative, but they provide important context for understanding the SSAPs to which they relate.
On August 13, the SAPWG adopted Statutory Issue Paper No. 169, which details the conceptual background for the revisions made to SSAP No. 26—Bonds, SSAP No. 43—Loan-backed and Structured Securities (renamed Asset-Backed Securities), SSAP No. 21—Other Admitted Assets, and certain other SSAPs in connection with the principles-based bond definition ("PPBD") that will become effective on January 1, 2025. The issue paper is 45 pages long, but is worth reading in order to gain a fuller understanding of how the PPBD will narrow the range of debt securities that will be treated as bonds, how all bonds will need to qualify as either issuer credit obligations ("ICOs") or asset-backed securities ("ABS"), and how debt securities that fail to qualify as bonds will be treated, beginning on January 1, 2025.
Q&A implementation guide exposed for comment
NAIC staff reported at the meeting that subsequent to the adoption of the PPBD in August 2023, a number of specific questions have arisen regarding the details of its implementation. Accordingly, the staff presented an Implementation Question and Answer Guide dated August 7, 2024 (the "Q&A Guide"), detailing responses to eight questions that have been discussed by a Bond / AICPA small group. The SAPWG voted to expose the Q&A guide for a comment period ending September 27, 2024. It was also noted that the Q&A guide is expected to be expanded over time as new questions arise.
PPBD revisions exposed for comment to allow debt securities issued by certain unregistered funds to qualify as ICOs
Under the PPBD as adopted in August 2023, debt securities issued by business development corporations, closed-end funds, or similar operating entities are treated as ICOs (and thus as bonds) only if the issuer is registered under the Investment Company Act of 1940 (the "1940 Act"). In order for debt securities issued by unregistered funds to be treated as bonds, they must qualify as ABS, which means they need to satisfy additional tests that ICOs do not need to satisfy: they must have substantive credit enhancement, and they must have underlying collateral that consists of either financial assets or cash-generating non-financial assets.
Prompted by interested parties' comments suggesting that using 1940 Act registration as the determining factor for bond treatment was inconsistent with the principles-based approach of the new bond definition, on January 10, 2024, the SAPWG exposed for comment a proposed revision to the PPBD that would permit debt securities issued by unregistered funds to be classified as ICOs, rather than ABS, if the fund qualifies as an "operating entity." The intent of the proposal was to put debt leverage issued by unregistered funds on the same footing as debt leverage issued by 1940 Act-registered funds.
After the January 10, 2024 proposal was exposed for comment, the desirability of ICO treatment led some people to suggest that rated feeder notes and collateralized fund obligations could qualify as ICOs under the proposed revisions. Reacting negatively to that suggestion, the SAPWG decided not to adopt the proposed revisions at the Spring National Meeting and directed NAIC staff to work with interested parties to further refine the definition of an operating entity and to better define the amount of debt that operating entities could issue and have the debt be treated as an ICO.
At the August 13 SAPWG meeting, NAIC staff presented a revised proposal for revisions to SSAP No. 26 (and the related issue paper). The revised proposal retains the basic concept that debt securities issued by funds that qualify as operating entities will be treated as ICOs, regardless of whether or not the fund is registered under the 1940 Act. The following text is proposed to be added to SSAP No. 26 to distinguish funds that are operating entities from ABS issuers:
- A fund representing an operating entity has a primary purpose of raising equity capital and generating returns to its equity investors. Ancillary debt may be issued to fund operations or produce levered returns to equity holders. However, this is in service to meeting the fund's primary equity-investor objective. As a practical safe harbor, 1940-Act registered closed-end funds (CEFs) and business development corporations (BDCs), debt securities issued from the fund in accordance with permitted leverage ratios represent debt issued by operating entities and qualify as issuer credit obligations. This safe harbor for SEC-registered funds should not be viewed to extend to funds that are not SEC-registered by analogy, through comparison of leverage levels for example. All other funds should be classified in accordance with the determination of the issuer's primary purpose.
- In contrast, an ABS Issuer has a primary purpose of raising debt capital and its structural terms and features serve to support this purpose. Perhaps most distinctively, . . . the contractual terms of the structure generally define how each cash flow generated by the collateral is to be applied. There is generally little discretion afforded to the manager/servicer of the vehicle and any discretion that is allowed is narrowly defined in the contractual agreements. This hardwiring of debtholder protections allows for the issuance of higher amounts of leverage than would be possible for a fund representing an operating entity, further supporting the entity's primary purpose of raising debt capital.
While 1940 Act-registered funds are automatically considered operating entities and are allowed to issue debt up to the limits permitted by the 1940 Act, there is no comparable safe harbor for unregistered funds. Unregistered funds can only qualify as operating entities if they have "a primary purpose of raising equity capital and generating returns to equity investors."
Because interested parties are supportive of the proposed revisions and indeed participated in the drafting process, the SAPWG has set a short deadline of September 6, 2024 for comments on this exposure and has noted that it intends to adopt the revisions shortly thereafter.
Proposal exposed to require asset-level reporting of funds withheld and modco assets
In 2023, the SAPWG formed an Interest Maintenance Reserve ("IMR") Ad Hoc Group to address the issue of net negative interest maintenance reserves for life insurers. During the IMR Ad Hoc Group's discussions, it was noted that it is difficult to identify assets that are subject to funds withheld or modified coinsurance ("modco") arrangements within insurers' financial statements and reporting schedules. That observation sparked a new SAPWG agenda item aimed at making it easier to identify assets that are subject to a funds withheld or modco arrangements through updated reporting in insurers' financial statements. Moreover, because funds withheld arrangements also pertain to property and casualty insurers, this proposal would add reporting to the annual statement blanks for all types of insurers, not just life insurers.
At the August 13 meeting, the SAPWG voted to expose for comment (until September 27, 2024) a proposal to add a new part to Schedule S in the Life/Fraternal and Health annual statement blanks and a new part to Schedule F in the Property/Casualty (P/C) and Title annual statement blanks that insurers would use to report all assets held under a funds withheld arrangement and a separate signifier for modified coinsurance assets. Such assets would be reported at the CUSIP-level, but would not be tied to specific reinsurance treaties, in acknowledgement of industry concerns regarding the potential disclosure of proprietary information.
Proposed revisions to SSAP No. 86 exposed to require bifurcation for credit repacks and other derivative wrapper investments
At the August 13 meeting, NAIC staff reported that they had received a number of inquiries regarding the statutory accounting treatment under the PPBD of "credit repack" structures, where a special purpose vehicle acquires a debt security and reprofiles the cash flows by entering into a derivative transaction with a derivative counterparty. The staff expressed the view that when "repack" transactions are evaluated under the PPBD they could constitute a type of ICO if the impact of the repacking is merely to convert fixed payments to floating or to change the currency denomination of payments, but that if the timing or extent of cash flows is altered in other ways, then in order to receive bond treatment, the repack would need to qualify as an ABS, which it would fail to do given the lack of substantive credit enhancement (e.g., no subordination, over-collateralization, or guarantee).
On the staff's recommendation, the SAPWG exposed for comment (until September 27, 2024) proposed revisions to SSAP No. 86—Derivatives that would address, not just "credit repacks," but all debt security investments with derivative wrappers / components. The proposed revisions would require 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 proposed revisions reflect the staff's view that bifurcation is preferable to an outcome that would preclude bond treatment altogether for certain types of repacks.
Under the proposal, debt security repack structures would be treated similarly to investments where the bond and derivative are not combined. The debt portion of the repacked security would be assessed under the PPBD to determine whether it qualifies as a bond, and the derivative would be assessed in accordance with SSAP No. 86 and reported on Schedule DA. Consequently, there would be no capital benefit or detriment due to the repack structure. Additionally, this proposal is designed to provide greater transparency to state insurance regulators regarding the derivatives that insurers are using and to facilitate monitoring insurers' compliance with their derivative use plans.
Notably, the only look-through to the underlying debt security is for the purpose of analyzing whether the repack note will be treated as an ICO, ABS, or non-bond debt security. Everything else (including a new CUSIP, name of issuer, NAIC credit designation, investment yield, and other investment characteristics) will be tied to the repacked security.
Structured notes (which do not provide principal protection) would be excluded from the proposed bifurcated treatment, since they do not qualify as bonds and are treated purely as derivatives under SSAP No. 86.
The SAPWG has set a set a deadline of September 27, 2024 for comments on this exposure in order to allow for discussions at the NAIC's Fall National Meeting.
To view additional updates from the US NAIC Summer 2024 National Meeting, visit our meeting highlights page.
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