Regulatory Update: National Association of Insurance Commissioners Summer 2023 National Meeting

1. NAIC Progresses Revisions to Statements of Statutory Accounting Principles Relating to Investments

At the Summer Meeting, the Statutory Accounting Principles (E) Working Group (SAP Working Group) adopted revisions to Statement of Statutory Accounting Principles (SSAP) No. 26R — Bonds, SSAP No. 43R — Loan-Backed and Structured Securities, and other related SSAPs in connection with its principle-based bond definition project (Bond Project). The SAP Working Group also adopted a limited-time interpretation to allow insurers to admit up to a specified percentage of negative interest maintenance reserve (IMR) under SSAP No. 7 — Asset Valuation Reserve and Interest Maintenance Reserve. The SAP Working Group also reexposed changes to SSAP No. 21R — Other Admitted Assets with respect to accounting for debt securities that do not qualify as bonds under the new bond definition and revisions to clarify that any pledged collateral must qualify as an admitted invested asset in order for a collateral loan to be admitted and to require the use of net equity value for valuation assessments when the pledged collateral is in the form of partnerships, limited liability companies, or joint ventures.

a. NAIC Adopts Revisions to Statements of Statutory Accounting Principles as Work Continues on Principle-Based Bond Definition Project

At the Summer Meeting, SAP Working Group adopted revisions to SSAP No. 26R, SSAP No. 43R, and other related SSAPs in connection with the Bond Project but reexposed for comment the revisions to SSAP No. 21R with respect to accounting for debt securities that do not qualify as bonds under the new bond definition.

The adoption of these revisions marks a significant milestone in the SAP Working Group’s Bond Project, which began in October 2020 through the development of a principle-based bond definition to be used for all securities in determining whether they qualify for reporting on Schedule D-1. Within the bond definition, bonds are classified as an “issuer credit obligation” or an “asset backed security.” An “issuer credit obligation” is defined as a bond where repayment is supported by the general creditworthiness of an operating entity, and an “asset backed security” is defined as a bond issued by an entity created for the primary purpose of raising capital through debt backed by financial assets. The revisions to SSAP No. 26R reflect the principle-based bond definition, and SSAP No. 43R provides revised accounting and reporting guidance for investments that qualify as asset-backed securities under the revised bond definition.

NAIC staff have drafted updates to a proposed statutory issue paper entitled “Principles-Based Bond Definition” that details the discussions and directions in developing the bond definition and resulting guidance to date, which the SAP Working Group exposed for comment until September 29, 2023.

In connection with above changes, the SAP Working Group has also proposed revisions to SSAP No. 21R that provide guidance for the accounting for debt securities that do not qualify as bonds as well as proposed measurement guidance for residual tranches. For debt securities that do not qualify as bonds, the revisions clarify that if the primary source of repayment is derived through underlying collateral, the investment will be admitted only if the underlying collateral itself qualifies as admitted invested assets. For residual tranches, if the reporting entity holds a debt tranche from the same securitization, and the debt tranche does not qualify as a bond (i.e., either an issuer credit obligation or asset-backed security), and the debt security does not qualify as an admitted asset under SSAP No. 21R, then the residual tranche also will not qualify as an admitted asset. The revisions to SSAP No. 21R also include a proposed new measurement method for residual tranches, which requires all cash flows received to be treated as a return of principal until the book-adjusted carrying value is zero. At that point, further cashflows received would be treated as interest income. The SAP Working Group has requested comments on the proposed measurement method for residual tranches in general and also for individual types of residual tranches. Comments on the revisions to SSAP No. 21R are also due September 29, 2023.

The revisions to SSAP Nos. 26R and 43R, as well as the proposed revisions to SSAP No. 21R (once adopted), will be effective January 1, 2025. As the SAP Working Group has noted, investments that do not qualify as bonds after such revisions are adopted will not be permitted to be reported as bonds on Schedule D-1 thereafter as there will be no grandfathering for existing investments that do not qualify under the revised SSAPs. However, certain accommodations may be made to prevent undue hardship for reporting entities complying with the new guidance.

b. NAIC Adopts Interim Guidance to Permit the Admittance of Negative Interest Maintenance Reserve

The SAP Working Group adopted INT 23-01T — Net Negative (Disallowed) Interest Maintenance Reserve, an interpretation of statutory accounting principles that provides optional, limited-term guidance for the admittance of net negative (disallowed) IMR under SSAP No. 7 for up to 10% of adjusted general account capital and surplus. An insurer’s capital and surplus must first be adjusted to exclude certain “soft assets” including net positive goodwill, electronic data processing equipment and operating system software, net deferred tax assets and admitted net negative (disallowed) IMR. An insurer will only be permitted to admit the negative IMR if the insurer’s risk-based capital (RBC) is over 300% authorized control level after adjustment to remove the assets described above.

As adopted, negative IMR may be admitted first in the insurer’s general account and then, if all disallowed IMR in the general account is admitted and the percentage limit is not reached, to the separate account proportionately between insulated and noninsulated accounts. There is no exclusion for derivatives losses included in negative IMR if the insurer can demonstrate historical practice in which realized gains from derivatives were also reversed to IMR (as liabilities) and amortized.

INT 23-01T will be effective through December 31, 2025, but may be nullified earlier or extended based on actions by the SAP Working Group to establish specific accounting guidance on net negative (disallowed) IMR to serve as a long-term solution. In connection therewith, the SAP Working Group also voted to form an ad hoc subgroup to work on developing such guidance.

c. NAIC Working Group Continues Discussion on SSAP Changes Related to Collateral for Loans

The SAP Working Group agreed to extend the exposure of proposed revisions to SSAP No. 21R, which require audits of investments governed by SSAP No. 48 — Joint Ventures, Partnerships, and Limited Liability Companies and SSAP No. 97 — Investments in Subsidiary, Controlled, and Affiliated Entities if pledged for collateral loans to specifically consider whether fair value or book value should be used for purposes of determining the collateral coverage.

The SAP Working Group initially exposed revisions to SSAP No. 21R in December 2022 to clarify that invested assets pledged as collateral for admitted collateral loans must themselves qualify as admitted invested assets. Under the proposed revisions, when the collateral pledged to secure a collateral loan would be in the scope of SSAP No. 48 or SSAP No. 97 if held directly by the reporting entity, such as a joint venture, partnership, or limited liability company or a subsidiary controlled or affiliated entity, audited financial statements are required for the collateral (and thus the collateral loan) to qualify as an admitted asset. The proportionate audited equity valuation (or “book value”) must be used for the determination of the adequacy of pledged collateral. If the collateral loan exceeds the audited book value of these pledged investments, then the excess must be nonadmitted.

While interested parties were generally in support of the changes as most recently exposed by the SAP Working Group, one interested party provided comments specifically with respect to the portion of the guidance that would require insurers to use book value when testing the sufficiency of the collateral, asking the SAP Working Group to revise the exposure to allow reporting entities to make an accounting policy election, applied consistently and across all applicable collateral loans, to use either fair value or book value when performing the collateral test.

Although members of the SAP Working Group disagreed with the proposal to allow insurers to make an accounting policy election and were eager to finalize the proposed revisions to SSAP No. 21R, the SAP Working Group did agree to extend the exposure for an additional 30 days to allow industry members additional time to submit comments regarding the measurement of collateral pledged from SSAP No. 48 and SSAP No. 97 entities. Comments are due by September 12, 2023.

2. NAIC Continues Progress on its Review of Ratings for Insurer Investments

a. NAIC Discusses Proposed Amendment to Update Definition of NAIC Designation

The Valuation of Securities (E) Task Force (VOS Task Force) continued its discussion on a proposed amendment to the Purposes and Procedures Manual of the NAIC Investment Analysis Office (P&P Manual) that would, if adopted, consolidate the instructions defining an NAIC designation (NAIC Designation) and address questions and concerns raised over the years as to the purpose of an NAIC Designation versus credit rating provider (CRP) ratings.

The NAIC has stated that the reason for these clarifications is that the P&P Manual, as currently formatted, has led to the interpretation that there are two different meanings of an NAIC Designation, one of which is applicable to all securities whether assigned an NAIC Designation pursuant to the filing exemption (FE) process or by the Securities Valuation Office (SVO) and the second of which is applicable only to securities assigned NAIC Designations by the SVO. The SVO intends to clarify that there is only one definition of an NAIC Designation and that it is applicable however the NAIC Designation is assigned.

The amendment, as initially exposed, also stated that an NAIC Designation should reflect the likelihood of timely and full payment of principal and scheduled periodic interest, as appropriate, and the probability of principal and interest payment default. It will also reflect consideration to potential “tail risks” (e.g., the probability that a security’s payment default will be more than three standard deviations from the mean is greater than what is shown by a normal distribution).

The amendment also included a recommendation to include NAIC Designation subscript “S” for other nonpayment risks in the consolidated definition of NAIC Designation. The VOS Task Force has expressly assigned to the SVO the responsibility for assessing other nonpayment risks and the authority to notch NAIC Designations pursuant to the P&P Manual and assign the Subscript S symbol, accordingly. During an interim conference call held on July 13, 2023, the VOS Task Force heard a number of comments on the P&P Manual amendment regarding the amendments on the NAIC Designation definition, many of which specifically addressed the inclusion of the tail risk component and the use of subscript “S.”

The VOS Task Force did not take any specific action on this item at the Summer Meeting but directed the SVO to continue to work with industry members on the amendment, specifically with respect to the need to understand how tail risk analysis will be used. A revised amendment is expected to be presented to the VOS Task Force for consideration on a future date.

b. NAIC Continues Discussion on a Proposed Amendment to Authorize Procedures for the SVO’s Discretion Over NAIC Designations Assigned Through the Filing Exempt Process

The VOS Task Force spent the majority of its time at the Summer Meeting discussing comments received to the VOS Task Force’s exposure of a proposed amendment to the P&P Manual that would set forth procedures for the exercise of the SVO’s discretion over NAIC Designations assigned through the FE process.

By way of background, at the 2023 Spring National Meeting, the VOS Task Force exposed a proposed amendment to the P&P Manual that would remove a new category of investment, defined as “Structured Equity and Funds,” from the FE process, based on the SVO’s review of private letter rating rationale reports. As part of that review, the VOS Task Force noted that when the SVO finds a significant potential issue with the CRP rating for an investment, the SVO should bring that issue to the VOS Task Force, along with a proposed solution, which may include a change to the NAIC Designation.

In response to industry comments to that exposure, the VOS Task Force directed NAIC staff to draft a distinct process for the SVO’s challenge of an NAIC Designation assigned from a CRP rating in the FE process that the SVO believes does not represent a reasonable assessment of risk for regulatory purposes. The proposed amendment to the P&P Manual outlining this process was initially exposed in May 2023.

The process, as initially proposed, would permit either a state insurance regulator (subject to confirmation by the SVO) or the SVO itself to identify any FE-eligible security for which a determination has been made that the NAIC Designation equivalent is not a reasonable assessment of risk of the security for regulatory purposes. The process includes a materiality threshold wherein the difference between the CRP rating used in the FE process and the SVO’s own assessment of the risk must be three or more notches different than the SVO’s assessment based on the SVO’s review (e.g., NAIC Designation Category 1.G versus 2.C). Once a security has been identified as being subject to the SVO’s analytical review, the SVO will have 120 days to make a final determination, during which time the insurer will have the option to submit an appeal. Following this 120-day notice period and optional appeal by the insurer, the CRP rating or the security’s filing exemption eligibility could be maintained or revoked. If revoked, the insurer would then have the option of filing the security with the SVO for assignment of an NAIC Designation. An insurer can appeal revocation in subsequent filing years.

Several members of the U.S. House of Representatives submitted a joint letter dated July 13, 2023, to the NAIC noting that the proposed amendment has the potential to provide RBC uncertainty for all FE investments held by U.S. insurance companies, creating liquidity and market disruption, and urging the NAIC to withdraw the proposed changes to the P&P Manual. In a July 25, 2023, response letter, the NAIC stated that it believes the process “is an appropriate approach to ensure that insurers are holding sufficient capital based on the risk they are taking with their investments,” noting that the materiality thresholds included in the proposal “ensure that challenging a CRP will only commence when a significant red flag occurs, and even then, the notice and appeal process ensures fair treatment for all parties.”

Both the NAIC in its letter and the VOS Task Force have stated that the SVO does not have any intention of challenging the methodologies or opinions of CRPs or disrupting the important role they play in public markets but do not feel obligated to defer to them without judgment or exception as the de facto driver of the NAIC’s RBC framework.

During the Summer Meeting, the VOS Task Force heard comments from industry members to the proposed amendment, which (i) requested clarity as to whether the SVO’s review may be focused on a specific security or an entire class of securities, (ii) requested the opportunity for additional time in the process for insurers to provide information as the SVO would be making its decision based on incomplete information, and (iii) reiterated concerns regarding the uncertainty the process could impose on insurers and the financial markets. The VOS Task Force noted that it intends to move forward with the review process generally as currently outlined but would consider making revisions in response to industry comments that would increase transparency of the SVO’s review process and provide the ability for insurers to provide information prior to initiating an appeal process.

c. NAIC Progresses Collateralized Loan Obligation Modeling Project

During the Joint Meeting of Executive (EX) Committee and Plenary, the NAIC adopted the interim solution to address residual tranches, which was developed and adopted by the Risk-Based Capital Investment Risk and Evaluation (E) Working Group (Investment RBC Working Group) prior to the Summer Meeting. During the Summer Meeting, the Investment RBC Working Group heard a presentation from the American Academy of Actuaries (Academy) related to the long-term project to update C-1 factors for collateralized loan obligations (CLOs).

As adopted under the interim solution to address residual tranches, for reporting as of year-end 2023, the residual tranche base factor will be 30%, with a 15% sensitivity test factor. For reporting as of year-end 2024, the residual tranche base factor will increase to 45%, although the Investment RBC Working Group has agreed to hear additional information from industry that could support a factor other than 45% prior to that factor’s taking effect. For reporting as of year-end 2024, the sensitivity test factor would be reduced to 0%, although that may also be adjusted if the residual tranche base factor is set at an amount other than 45%. The interim solution will apply to all residual tranches, not just CLOs. As adopted, the factors are consistent with the compromise approach proposed in the June 9, 2023, comment letter submitted by the Texas Department of Insurance. Texas explained that the proposal is intended to address concern that changing the charge for year-end 2023 reporting may be too disruptive and may cause companies to divest assets at depressed prices, resulting in adverse effects to surplus.

In connection with updating the C-1 factors for CLOs, the Academy intends to develop a model specification document that takes a de novo look at how to model CLOs for RBC purposes. At the Summer Meeting, the Investment RBC Working Group heard a presentation from the Academy regarding principles for structured securities RBC. In the presentation, the Academy proposed a flowchart to determine whether (i) an asset class needs to be modeled and (ii) whether securities within an asset class need to be modeled individually to determine C-1 factors.

With respect to C-1 asset modeling, the Academy emphasized its preference for simpler solutions, meaning that if an existing factor can be used, it should be used, and that individual security modeling for C-1 determination should be a last resort. If the result of the flowchart is that an asset class requires modeling, then the Academy supports a principles-based approach to the derivation of C-1 factors. The Academy presented seven candidate-principles for further consideration and evaluation by regulators:

• • Candidate-Principle #1 (The RBC formula is a blunt filtering tool). “The purpose of RBC is to help regulators identify weakly capitalized insurers, therefore small inaccuracies in RBC formulaic requirements will seldom justify a change to the RBC formula.”
  • Candidate-Principle #2 (RBC is based on statutory accounting). “RBC measures the impact of risk on statutory surplus. Changes in accounting treatment will affect C-1 requirements.”
  • Candidate-Principle #3 (C-1 is established for underlying collateral). “RBC arbitrage can only be measured for asset-backed securities (ABS) where the underlying collateral has an established asset-class-specific C-1 requirement.”
  • Candidate-Principle #4 (Intentions don’t matter for C-1 requirements). “The motivation behind creating an ABS structure should have no bearing on its C-1 requirements.”
  • Candidate-Principle #5 (C-1 requirements reflect likely future trading activities). “C-1 requirements on ABS should treat the collateral as a dynamic pool of assets, incorporating future trading activity that is likely to occur based on historical data or mandated by the structure’s legal documents.”
  • Candidate-Principle #6 (C-1 requirement for each tranche is independent). “RBC is based on the holdings of an insurer; assets not owned by an insurer should not impact its RBC.”
  • Candidate-Principle #7 (Different risk measures). “C-1 requirements for ABS should be calibrated to different risk measures where appropriate.”

The Investment RBC Working Group plans to discuss the Academy’s presentation and the candidate-principles during an interim conference call before formally exposing the information for public comment.

During the Summer Meeting, the VOS Task Force also discussed the status of the CLO modeling project. The VOS Task Force previously adopted an amendment to the P&P Manual to add reporting instructions for the financial modeling of CLOs. Specifically, the P&P Manual amendment makes CLOs ineligible to use CRP ratings to determine an NAIC Designation if the NAIC’s Structured Securities Group can model the security. The P&P Manual amendment was introduced after the NAIC’s Investment Analysis Office (IAO) identified that NAIC Designations assigned to CLOs were inconsistent when relying on CRP ratings and had recommended this change to the VOS Task Force to ensure reporting equivalency for NAIC regulatory purposes. The amendment will become effective January 1, 2024, with insurers first reporting the financially modeled NAIC Designations for CLOs with their year-end 2024 financial statement filings. The VOS Task Force ad hoc group is in the process of finalizing the CLO modeling methodology and expects to hold its next meeting in early September.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.