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US NAIC Summer 2022 National Meeting Key Takeaways: Investment-Related Initiatives – Insurance Laws and Products

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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
    (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
    (under the Exposure Drafts tab).

  • For more background on the NAIC’s “what is a
    bond” initiative, see “Major NAIC Investment-Related
    ” 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

  • 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

  • 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
    ” in our Global Insurance Year in Review
    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

      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

  • 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

    • 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

  • 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

  • Chair Barlow asked whether the RBC IR&E WG needs to be
    concerned with RBC arbitrage in tranches besides the residual

    • 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.

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