May 28, 2020

Major Change in Capital Treatment for Insurer Investments in “Principal Protected Securities”


On May 14, 2020, the Valuation of Securities (E) Task Force (VOS Task Force) of the National Association of Insurance Commissioners (NAIC) adopted amendments to the Purposes and Procedures Manual of the NAIC Investment Analysis Office (P&P Manual) that will significantly change the way insurers treat investments in “principal protected securities” (PPS) for risk-based capital (RBC) purposes.1 When the amendments become effective in 2021, PPS investments will need to be filed with the NAIC’s Securities Valuation Office (SVO) for review and assignment of an NAIC designation, rather than automatically receiving the NAIC designation equivalent to their credit rating from an NAIC-recognized credit rating provider (CRP).2 Because the designations that the SVO will assign to PPS investments are generally expected to be lower than their CRP ratings, the result will be a significant increase in the RBC charges associated with holding these securities.

Background of the PPS Amendments

The SVO is responsible for assessing the credit quality of securities owned by insurers, under the framework established by the P&P Manual. One of the key elements of the P&P Manual is a procedure for insurers to file information about their bond and preferred stock investments with the SVO, so that the SVO can perform a credit quality assessment and assign a “designation” (essentially equivalent to a rating) between NAIC‑1 and NAIC-6, with NAIC-1 indicating the lowest credit risk and NAIC-6 the highest credit risk.

The RBC factors associated with insurers’ investments in fixed-income securities are highly sensitive to the NAIC designations assigned to those securities. Currently, the pre-tax RBC factors for a life insurer are 40 basis points for an NAIC-1 investment, 130 basis points for an NAIC-2 investment, 460 basis points for an NAIC-3 investment and 1,000 basis points for an NAIC-4 investment.

In 2004, the P&P Manual was amended to include a filing exemption rule, granting an exemption from filing with the SVO for certain bond and preferred stock investments that have been assigned a current, monitored rating by a CRP. Under the filing exemption rule, the CRP rating of a bond or preferred stock investment is converted to the equivalent NAIC designation for statutory reporting and RBC purposes. The vast majority of fixed-income investments of insurers benefit from this filing exemption.

In July 2019, the SVO released a memo to the VOS Task Force that proposed a new definition of “principal protected securities” that would be removed from the filing exempt category and would need to be filed with the SVO for analysis and the assignment of an NAIC designation, rather than automatically receiving a designation based on a CRP rating. Right from the start, it was assumed that the NAIC designation that the SVO would assign to such filed securities as a result of its analysis would be lower than the CRP-equivalent designation the securities would have received under the filing exemption system.

The SVO’s PPS proposal was received by the VOS Task Force at the NAIC Summer National Meeting in August 2019 and was exposed for a 45-day comment period that ended on September 20, 2019. At its October 31, 2019, telephonic meeting, the VOS Task Force considered the comments received and directed the SVO to work with insurance industry representatives to refine the proposal. Following a series of four meetings with industry representatives in November and December, the SVO released an updated proposal on January 27, 2020, which the VOS Task Force discussed on February 4, 2020, and exposed for a 30-day comment period that ended on March 5, 2020. At that time, SVO staff expressed the view that the updated proposal had appropriately addressed the concerns raised by industry representatives and had arrived at the correct scope for the PPS definition. It was anticipated that the VOS Task Force would be in a position to adopt the proposal when it met at the NAIC Spring National Meeting on March 22, 2020.

The timetable envisioned at the February meeting of the VOS Task Force did not anticipate the arrival of the COVID-19 pandemic, which caused the cancellation of the NAIC Spring National Meeting. Because of the pandemic, there was speculation that action on the PPS proposal would be delayed—especially since another unit of the NAIC, the Statutory Accounting Principles (E) Working Group, had deferred taking action on a somewhat parallel proposal to clarify the statutory accounting principles applicable to collateralized fund obligations, and had exposed an issue paper on the topic for a comment period ending on July 31, 2020.

As it turned out, however, the SVO staff was determined to see the PPS initiative through to completion, and the chair of the VOS Task Force called a telephonic meeting for May 14, 2020. At that meeting, at the urging of the SVO staff, and with support expressed by the American Council of Life Insurers (ACLI) and the North American Securities Valuation Association (NASVA), the VOS Task Force unanimously adopted the January 27, 2020, proposed amendments to the P&P Manual, with minor revisions.

How a PPS Is Defined

As adopted, the amendments to the P&P Manual define a PPS as “a type of security that repackages one or more underlying investments and for which contractually promised payments according to a fixed schedule are satisfied by proceeds from an underlying bond(s) (including principal and, if applicable, interest, make whole payments and fees thereon) that if purchased by an insurance company on a stand-alone basis would be eligible for Filing Exemption” and for which two additional conditions are satisfied:

  1. The insurer would obtain a more favorable RBC charge or regulatory treatment for the PPS through filing exemption than it would if it were to separately file the underlying investments in accordance with the P&P Manual; and
  2. Either:
    1. The repackaged security structure enables potential returns from the underlying investments in addition to the contractually promised cash flows paid to such repackaged security according to a fixed schedule; or
    2. the contractual interest rate paid by the PPS is zero, below market or, in any case, equal to or below the comparable risk-free rate.

The amendments provide three illustrative examples of transactions that fall within the definition of a PPS:

  • A note issued by a special purpose vehicle (SPV) that holds two underlying investments: (i) a US Treasury zero coupon bond purchased at a discount with a face value equal to the principal amount of the note at maturity and (ii) a return linked to any positive performance of call options on the S&P 500 Index.
  • A note issued by an SPV that holds multiple underlying components: (i) a corporate bond paying a fixed coupon with a stated maturity date and (ii) additional undisclosed and unrated “performance assets.”
  • A repackaging of collateralized loan obligations (CLOs) into a CLO combination note (often called a “combo note”).

The amendments also include the following exclusions from the definition of PPS:

  • Defeased or pre-refunded securities which have separate instructions in the P&P Manual;
  • Broadly syndicated securitizations, such as CLOs (including middle market CLOs) and asset backed securities (ABS)—but excluding the examples listed above (e.g., CLO combo notes); and
  • CLO or ABS issuances held for purposes of risk retention as required by a governing law or regulation.

Consequences of PPS Status

As noted above, when the amendments become effective, insurers’ PPS investments will need to be filed with the SVO for analysis and the assignment of an NAIC designation by the SVO, rather than automatically receiving a designation based on a CRP rating.

One of the primary objectives of insurance regulation—and central to the mission of the VOS Task Force and the SVO—is monitoring insurer solvency, which is understood specifically as the financial ability of insurers to pay policyholders’ claims. Accordingly, the P&P Manual includes a concept of “other non-payment risk,” which it explains (in paragraph 90) as follows:

For example, the regulatory assumption is that a fixed income instrument called debt by its originator or issuer requires that the issuer make scheduled payments of interest and fully repay the principal amount to the insurer on a date certain. A contractual modification that is inconsistent with this assumption creates a rebuttable inference that the security or instrument contains an additional or other non-payment risk created by the contract that may result in the insurer not being paid in accordance with the underlying regulatory assumption. The SVO is required to identify securities that contain such contractual modifications and quantify the possibility that such contracts will result in a diminution in payment to the insurer, so this can be reflected in the NAIC Designation assigned to the security through the application of the notching process.

An SVO determination that a security contains “other non-payment risk” is indicated by assigning a “Subscript S” to that security’s CUSIP, which gives the SVO discretion to notch the NAIC designation of the security downwards as it deems appropriate to reflect its assessment of that “other non-payment risk.”

What the May 14, 2020, amendments to the P&P Manual have done is graft the new concept of PPS onto the pre-existing concept of “other non-payment risk.” If an investment meets the new PPS definition, it must be filed with the SVO, so that the SVO can assess whether it possesses “other non-payment risks” and exercise its broad discretion to assign the PPS an NAIC designation pursuant to the “Subscript S” authority outlined in the P&P Manual. Only if the SVO determines in its judgment that there are not any “other non-payment risks,” will the SVO permit the security to benefit from the filing exemption, assuming it is otherwise eligible.

When a PPS is filed with the SVO, the following information will need to be submitted, in addition to the usual package of information and documents required to be submitted for all filings:

  • Disclosure of any “subsidiary, controlled or affiliated” relationship between the PPS or any of the underlying investments and the insurer; including, how the underlying investments were acquired; and
  • Prior four quarterly financial statements, if produced, trustee or collateral agent reports from the entity issuing the PPS sufficient to identify: security specific details of each underlying investment (security identifier, descriptive information, all eligible NAIC CRP credit ratings (if any), par value, market value, and explanation as to how the market value was determined).

Given the SVO’s view that PPS investments possess “other non-payment risks,” it is to be expected that the designation assigned to a PPS by the SVO would be lower than a designation based solely on a CRP rating. That is certainly the case for the three illustrative examples mentioned above:

  • The PPS with the underlying US Treasury zero coupon bond and the S&P 500 Index-linked return would have a CRP rating of AAA/AA+ or an NAIC 1.A, based solely on the risk of the US Treasury bond. In contrast, the Weighted Average Ratings Factor (WARF) methodology applied by the SVO would result in an NAIC 4.B when it includes the exposure to the call options on the S&P 500 Index.
  • The PPS with the underlying corporate bond and the other “performance assets” would have a CRP rating of BBB or NAIC 2.B, based solely on the corporate bonds. In contrast, the WARF methodology would result in an NAIC 4.C when the exposure to all of the underlying investments is included.
  • The “combo note” would have a BBB– rating or NAIC 2.C on the notional based on payments from the underlying investment grade tranches. By contrast, the WARF methodology would result in an NAIC 4.B when the exposure to the below investment grade and unrated tranches is included.

To illustrate the impact on an insurer’s RBC calculations: the pre-tax RBC factors for a life insurer are currently 40 basis points for an NAIC-1 investment, 130 basis points for an NAIC-2 investment and 1,000 basis points for an NAIC-4 investment. That means that receiving a designation of NAIC-4 instead of NAIC-1 (as in the first illustrative example above) will increase the RBC charge to 2500 percent of what it used to be, and even receiving a designation of NAIC-4 instead of NAIC-2 (as in the other two examples) will increase the RBC charge to 769 percent of what it used to be.

In our view, the grafting of the new concept of PPS onto the pre-existing concept of “other non-payment risks” represents an expansion of the concept of “other non-payment risks” beyond its original meaning. As quoted above, the P&P Manual originally defined “other non-payment risks” as pertaining to debt securities with contractual features that are inconsistent with the requirement that the issuer make scheduled payments of interest and fully repay the principal amount to the insurer on a date certain. The characteristics of PPS investments that will henceforth make them subject to SVO scrutiny for “other non-payment risks” are different, because the terms of PPS investments are consistent with the requirement that the issuer make scheduled payments of interest and fully repay the principal amount to the insurer on a date certain. There is something else about PPS investments that has raised the SVO’s and the VOS Task Force’s concern, which is that the traditional CRP methodology is not accurately reflecting an assessment of the risks of these investments from a regulatory, as distinct from a credit, perspective. So while the new treatment of PPS does represent an expansion of the concept of “other non-payment risks,” it is an expansion that the SVO and the VOS Task Force view as integral to their mission of protecting insurer solvency—by ensuring that insurer investments are evaluated in a manner that accurately reflects the ability of insurers to use those investments to pay policyholders’ claims.

Transition Period for Implementation of the Amendments

One of the most frequently asked questions since the PPS initiative was first proposed in July 2019 has been whether existing investments of insurers would be “grandfathered” and could retain the equivalent NAIC designations to their CRP ratings. However, the SVO staff have consistently opposed the “grandfathering” of already-owned securities because they believe the “other non-payment risks” they have identified need to be addressed with respect to insurers’ entire portfolios of PPS investments, regardless of when they were acquired. Instead, the SVO has advocated for a transition period to allow insurers to adjust their portfolios before the new PPS filing regime becomes effective, and that is the approach that the VOS Task Force adopted on May 14, 2020.

The new PPS filing regime will become effective in 2021 for the December 31, 2021, statutory financial statements. Any PPS acquired on January 1, 2021, or later will need to be filed with the SVO within 120 days after acquisition. That is the standard filing schedule for securities that are not filing exempt. Any PPS owned prior to January 1, 2021, will need to be filed with the SVO by July 1, 2021.

The Road Ahead

Another of the most frequently asked questions since the PPS initiative was first proposed has been a request for more specifics about the methodology that the SVO will use to analyze PPS investments and assign the designation that will drive the capital treatment of those investments. In response, the SVO staff have repeatedly stated that they cannot be confined to a single prescribed methodology, but need to have the discretion to tailor their methodology to the variety of possible investment structures and the differing nature of the risks presented by each.

However, the industry’s request for more specifics on the SVO’s analytical methodology is not going away. In their March 5, 2020, comment letter, the ACLI and NASVA made the point that insurers need to have visibility into the key dynamics and assumptions that will drive the results of the WARF methodology in order to be able to assess the feasibility of allocations to PPS investments in their investment portfolios. As the comment letter put it:

We understand that any general NAIC rating methodology must afford a measure of leeway for analytical discretion to address the diversity of structural features of a given investment vehicle. However, insurance companies should understand the capital implications of investment decisions before a purchase.

Accordingly, the ACLI/NASVA comment letter requested that the SVO provide a “walk-through” of its WARF methodology, using the specific illustrative examples discussed above, so that industry participants will understand the key dynamics and assumptions that will drive the NAIC designations resulting from the application of that methodology. That request was reiterated by the ACLI’s representative at the May 14, 2020, meeting of the VOS Task Force.

We strongly agree with that request. While we recognize the need for the SVO to have the discretion to make the assessments required to protect insurer solvency without being confined to a single approach, nevertheless, the methodology for assigning designations to PPNs should not be a “black box.” We note that in other contexts—for example, underwriting algorithms and the use of artificial intelligence by insurers—the NAIC is very opposed to “black boxes.” We therefore hope that a middle ground can be found that both honors the need for the SVO to use all tools at its disposal and provides sufficient transparency to enable insurers to make informed, capital-efficient decisions about their portfolio investments.

Also Coming Down the Pike

At its May 14, 2020, meeting, the VOS Task Force also advanced another proposal that has been percolating for some time. The Task Force voted to expose for comment an issue paper written by the staff of the NAIC Investment Analysis Office (IAO) (which includes the SVO as well as the NAIC’s Structured Securities Group) expressing concerns about “bespoke securities” and CRP ratings.

The IAO issue paper had its origin in a May 2019 educational session provided by the IAO to the VOS Task Force, in which the IAO staff expressed the following concerns:

  • A concern about “bespoke securities,” defined as “financial instruments typically constructed by or for a small group of investors, which, due to their private nature, are not subject to or constrained by market forces and competition. As such, their visible characteristics may substantially underrepresent actual risks”; and
  • A concern about what the IAO staff deem to be the NAIC’s excessive reliance on CRP ratings to assess investment risk for regulatory purposes. The IAO staff does not believe that every CRP’s methodology is appropriate for, or consistent with, the assessment of investment risk for statutory (i.e., regulatory) purposes.

The issue paper identifies six “red flags” that indicate the presence of a “bespoke security”:

  1. Rating from a single CRP;
  2. Private letter rating;
  3. Assets backing the security were primarily owned by the insurer or its affiliates before the transaction and were reported differently (i.e., regulatory arbitrage);
  4. Assets backing the security do not generate bond-like cash flows (i.e., contractual requirements to pay periodic principal and interest);
  5. The insurer or members of its affiliated group are the sole investors in the security; or
  6. An affiliate of the insurer is the underwriter or sponsor of the security.

Under the IAO’s proposal, the SVO would review the legal agreements underlying “bespoke securities” and make a decision on whether the CRP’s rating is acceptable for determining the NAIC designation or whether the security needs to be filed for an SVO-determined designation. The analysis supporting the assignment of any private letter rating would also need to be submitted to the SVO for review at least annually. The SVO would have the authority to determine if it would rely upon the private rating or require the security to be filed.

In addition, the IAO proposes that at least two independent CRP ratings be required for any NAIC designation to be derived from CRP ratings, and that the lower of the ratings be applied. In the absence of two CRP ratings, the security would need to be filed for analysis by the SVO.

With regard to CRPs, the IAO proposes that the SVO be tasked with monitoring CRP ratings and methodologies on a case-by-case basis and determining how they are used in the filing exemption process—with a goal of achieving “the greatest consistency and uniformity in the production of NAIC designations while maximizing the alignment between the assessment of investment risk to the NAIC’s statutory objectives.”

At the May 14, 2020, meeting of the VOS Task Force, the Task Force voted to expose the IAO issue paper for a 90-day comment period ending on August 16, 2020. The lengthy comment period indicates a recognition by the Task Force that the IAO’s proposals would represent a significant change to the status quo—especially given that (by the IAO’s estimate) approximately 82 percent of all securities owned by insurers are currently assigned their NAIC designations based on CRP ratings through the filing exemption process.


Both of these developments—the PPS amendments that have now been adopted and will become effective in 2021 and the IAO issue paper that has just been exposed for a 90-day comment period— could potentially have a major impact on the investments of US insurers—particularly life insurers who have made long-term commitments in anticipation of achieving a certain level of investment returns. And coming in the midst of the COVID-19 pandemic, these developments will certainly add to the unprecedented challenges that insurers are already facing.

1 During the proposal stage of the amendments, these investments were referred to as “principal protected notes” or “PPNs.” However, the decision was made at the time of final adoption to use the term “principal protected securities” or “PPS” instead, in order to avoid confusion with the pre-existing use of the abbreviation “PPN” to refer to the “private placement number” issued by S&P and reported in the CUSIP field of various NAIC filings.

2 A CRP is an SEC-registered nationally recognized statistical rating organization that has been approved by the VOS Task Force to provide credit rating services to the NAIC.

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