The US National Association of Insurance Commissioners (“NAIC”) held its Summer National Meeting in Seattle on August 12-16, 2023. This Legal Update discusses several key investment-related initiatives that were addressed in sessions of that meeting. We will also be discussing those initiatives during our REVERSEinquiries webinar on August 22, 2023 (webinar details, including registration).1
Statutory Accounting Principles (E) Working Group (meeting materials):
The Statutory Accounting Principles (E) Working Group (“SAP WG”) met on August 13, 2023, and, as expected, it adopted the principles-based bond definition that represents the culmination of a more than three-year project to redefine what investments are entitled to be treated as bonds for statutory accounting purposes. The adoption includes major revisions to SSAP No. 26R – Bonds and SSAP No. 43R – Asset-Backed Securities (note the change in title), as well as conforming changes to several other SSAPs, notably SSAP No. 21R – Other Admitted Assets. The effective date of the new definition will be January 1, 2025.
The SAP WG also exposed for a comment period ending September 12, 2023, revisions to SSAP No. 43R, SSAP No. 48 – Joint Ventures, Partnerships and Limited Liability Companies and the Schedule BA Annual Statement Instructions that are designed to clarify the scope and reporting for investment structures that represent residual interests or a residual security tranche. The short exposure period was motivated by a desire to make the revisions effective on December 31, 2023, in light of the recent NAIC action (originated by the Risk-Based Capital Investment Risk and Evaluation (E) Working Group) to increase the risk-based capital (“RBC”) charge on residuals from 30% to 45% in 2024 and to add a 15% sensitivity factor to the 30% RBC charge for 2023. Given the new treatment of residuals, it is critically important to define what a residual is, i.e., “who gets whacked” under the new system. And because “the devil is in the details,” we quote the proposed definition in full here:
A residual interest or a residual security tranche (collectively referred to as residuals) exists in investment structures that issue one or more classes of debt securities created for the primary purpose of raising debt capital backed by collateral assets. The primary source of debt repayment is derived through rights to the cash flows of a discrete pool of collateral assets. These designs could be backed directly or indirectly through a feeder fund. The collateral assets generate cash flows that provide interest and principal payments to debt holders through a contractually prescribed distribution methodology (e.g., waterfall dictating the order and application of all collateral cash flows). Once those contractual requirements are met, the remaining cash flows generated by (or with the sale of) the collateral assets are provided to the holder of the residual security / residual interest holder. When an asset within the discrete pool of assets does not perform as expected, it impacts the extent to which cash flows will be generated and distributed. The residual holders in the structure continue to receive payments from the collateral so long as there are cash flows in excess of the debt obligations. The payments to the residual holder may vary significantly, both in timing and amount, based on the underlying collateral performance.
The structural design of a residual interest or residual security tranche can vary, but the overall concept is that they receive the remaining cash flows after all debt holders receive contractual interest and principal payments. Determining whether an investment in a structure reflects a residual interest or tranche shall be based on the substance of the investment held rather than its legal form.
Common characteristics of residual interests / residual security tranches include the items noted below, but the presence or absence of any of these factors should not be definitive in determination. Classification as a residual should be based on the substance of the investment and how cash flows to the holder are determined.
- Residuals often do not have contractual principal or interest.
- Residuals may be structured with terms that appear to be stated principal or interest but that lack substance, and result in receiving the residual cash flows of the underlying collateral. The terms allow for significant variation in the timing and amount of cash flows without triggering a default of the structure.
- Residuals do not have credit ratings or NAIC assigned designations. Rather, they are first loss positions that provide subordination to support the credit quality of the typically rated debt tranches.
- Residuals may provide payment throughout the investment duration (and not just at maturity), but the payments received continue to reflect the residual amount permitted after debt tranche holders receive contractual principal and interest payments.
- Frequently, there are contractual triggers that divert cash flows from the residual holders to the debt tranches if the structure becomes stressed.
The SAP WG meeting addressed many other statutory accounting items besides the foregoing. (See the NAIC staff’s meeting summary.)
Risk-Based Capital Investment Risk and Evaluation (E) Working Group (meeting materials):
The Risk-Based Capital Investment Risk and Evaluation (E) Working Group (“RBC IRE WG”) met on August 13, 2023. Most of the meeting was devoted to a presentation titled “Principles for Structured Securities RBC” given by Steve Smith, who chairs the C-1 Subcommittee of the American Academy of Actuaries (the “Academy”). The slides from the presentation are included in the RBC IRE WG meeting materials and are well worth reading. Smith’s presentation outlined the Academy’s proposal to use a flowchart to determine whether (a) an asset class needs to be modeled and (b) securities within an asset class need to be modeled individually to determine C-1 factors. (The C-1 factor is the investment risk component of the life RBC calculation.) Smith expressed a preference on behalf of the Academy for simpler solutions, i.e., if an existing factor can be used, it should be used, and individual security modeling should be a last resort. However, if the result of the flowchart is that an asset class requires modeling, then the Academy would support a principles-based approach to the derivation of C-1 factors. A principles-based approach will provide regulators flexibility in responding to new investment structures as they emerge. The presentation then laid out seven “candidate” principles for consideration by regulators. It also grappled with the concept of “RBC arbitrage” that has recently been cited as a basis for a number of initiatives by the NAIC Investment Analysis Office and called for all parties to first collectively agree on a definition of “RBC arbitrage” before discussing its implications for RBC requirements.
Members of the RBC IRE WG expressed appreciation to Smith for the Academy’s presentation. We hope that its recommendations will be taken seriously in the future deliberations of the RBC IRE WG as it pursues its broad mandate to review the RBC treatment of all asset-backed securities. Whether that will, in fact, be the case remains to be seen.
(See the NAIC staff's meeting summary.)
Valuation of Securities (E) Task Force (meeting materials):
The Valuation of Securities (E) Task Force (“VOS TF”) met on August 14, 2023. The primary focus of the meeting was on two SVO proposals that had been exposed for comment.
- SVO proposal to update the definition of an NAIC designation. The VOS TF chair (Carrie Mears of the Iowa Insurance Division) called on Marc Perlman, SVO investment counsel, to discuss this proposal. Perlman quoted from the proposal that “NAIC Designations 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.” He said the SVO agrees with the suggestion by some commenters that an NAIC designation should also consider loss given default and tail risk. He said the SVO is planning to come back to the VOS TF with “a minimally revised proposal.” Interested parties also commented. The representative of the American Council of Life Insurers (“ACLI”) noted that ACLI representatives had also met with the SVO staff on July 28, 2023, to discuss their comments.
- SVO proposal to establish a process for the SVO to override an NAIC designation derived from an NRSRO rating of a security and assign a different NAIC designation when the SVO’s assessment differs by more than three notches from the NRSRO rating. The discussion of this proposal occupied the bulk of the 1-1/2 hour VOS TF meeting.
The discussion began with prepared remarks by the VOS TF chair. Mears pointed out that the genesis of the proposal was a charge from the NAIC’s Financial Condition (E) Committee to address the use of NRSRO ratings in the SVO’s filing-exempt system. She referred to the request by the SVO in 2020 to require the filing of private letter rating rationale reports and to grant the SVO discretion to override a private rating based on its review of that document. In 2021, the VOS TF had granted the first request (effective in 2022), but not the second request, and had asked the SVO staff to come back to the VOS TF with thematic observations that could potentially justify providing it with such discretionary authority. Mears then referred to the proposal by the SVO in 2022 to define a category of “structured equity and fund” investments that would no longer be entitled to filing exemption and would have their NAIC designations assigned in all cases by the SVO. She noted that the reaction to this proposal had been that it was over-inclusive and that, in March 2023, the VOS TF had asked the SVO to develop a security-by-security process for challenging the use of the NRSRO rating for specific securities, with due process allowing an insurer holding the security to appeal the SVO’s challenge. Mears said that there was no intention for the SVO to replace or compete with rating agencies but that a process for allowing the SVO to challenge rating agency ratings is needed in order for regulators to be responsible users of NRSRO ratings. With regard to comments calling for a third party to make the ultimate decision on insurer appeals of SVO challenges, she expressed the view that it would not be cost-effective to do so but that a third-party consultant could be engaged to review the processes used by the SVO. She concluded by expressing “a sincere thank you” to those who had commented on the proposal.
Charles Therriault, SVO director, then addressed some of the comments that had been received. He cited the fact that the SVO has previously reported on divergencies between rating agencies with respect to privately rated securities. With regard to concerns that had been expressed about the transparency of the SVO’s process, he stated that the SVO is limited by confidentiality obligations when dealing with privately issued and privately rated securities. He said that the SVO could only publish high-level anonymized information and could share more detailed information only with the insurer that owns a security. With regard to methodology, he said that the SVO generally uses Moody’s and S&P methodologies because they are clear, reasonable and widely accepted.
Perlman suggested that some people treat the NRSROs as if they have a seal of approval from the US Securities and Exchange Commission (“SEC”), which he considers incorrect. He pointed out that the Credit Rating Agency Reform Act prohibits the SEC from regulating ratings, methodologies or procedures of rating agencies. He said it is, therefore, up to consumers of credit ratings, like the NAIC, to evaluate the rating agencies. He said that NRSRO ratings are not sacrosanct and that the SVO proposal is designed to fill the NAIC’s need as a consumer of NRSRO ratings for a mechanism to decide how and whether to use NRSRO ratings. (We would comment editorially that this framing of the issue appears to be a response to comments that have been expressed to the effect that the SVO is seeking to replace or compete with the NRSROs. “Not at all,” the SVO is saying in effect. “We are consumers of NRSRO ratings. All we are trying to do is be intelligent and responsible consumers of NRSRO ratings.”)
Therriault then summarized some of the aspects of the SVO’s proposed process. He pointed out that there would need to be a three-notch difference between the SVO’s assessment and the NRSRO rating to initiate a challenge. He said that the insurer owning the security would be notified and would have an opportunity to introduce data, a right to appeal the SVO’s decision and, in the event of an adverse decision by the SVO, an option to either file the security or obtain another NRSRO rating. He said that other insurers who owned the security could join in the process and that the relevant state regulators would also have a key role. He said that the SVO had compared its proposed process to the processes used internally by insurers and found it to be reasonable. That said, he stated that there were a number of actionable recommendations from the comment letters that the SVO would be incorporating into a revised proposal, such as that the SVO would publish a generic summary of individual actions, would produce an annual report summarizing the actions taken during the year and would engage an independent third-party consultant to prepare an analysis of the SVO’s process for review by the NAIC’s Executive Committee.
One of the state regulators on the VOS TF then commented that the purpose of the proposal was to provide a way for the SVO to continue to rely on NRSRO ratings where appropriate, while also providing a “relief valve” for cases where reliance on a particular rating is not appropriate.
Interested parties then commented. Among the key comments:
- The SVO would be making its decision to challenge a rating based on incomplete information (the private letter rating rationale report). The SVO needs to request and review additional documents, such as the private placement memorandum and legal documentation for the security, before it issues the rating challenge that the insurer has to try to rebut.
- There needs to be a way to notify all insurers who hold the security and their respective state regulators at the outset of the review process so that they can participate in the process.
- For there to be true due process, the ultimate decision on an appeal needs to be made by a neutral party.
- Clarity is needed as to whether an SVO challenge and override decision are limited to a specific security or potentially applicable to an entire asset class.
- Override decisions, and the uncertainty surrounding override decisions, have the potential to freeze the market for an asset class, and some insurers have already established a moratorium on certain asset classes.
- Insurers who own securities that are undergoing a challenge will be in a bind because the existence of the challenge will be material information, and they are precluded by law from selling the security while in possession of material non-public information.
After the interested parties’ comments, a number of regulators on the VOS TF made statements encouraging the SVO to take the comments into account. Two VOS TF members expressed the view that when an insurer appeals the SVO’s decision, the ultimate decision-maker should be the relevant state regulator or regulators.
Mears concluded the discussion by stating that every suggestion made would be reviewed in good faith. She also made reference to a document called “Framework for Regulation of Insurer Investments – A Holistic Review” that the Financial Condition (E) Committee would be considering for exposure on August 15, 2023. However, to the surprise and disappointment of many of those in attendance, it appeared from that small mention that the VOS TF does not intend to alter its course on the current SVO initiative based on that holistic review document.
At this point, our view is that the proposal to grant the SVO the discretion to override an NAIC designation based on an NRSRO rating is going to be adopted by the VOS TF in some form. The only question is what kinds of checks and balances will be incorporated into the proposal before it is adopted by the VOS TF. Checks and balances are critical because it is hard to overstate the potential disruption to an insurer’s investment process that will result when a security that was priced based on an indicative NRSRO rating turns out to have a different capital treatment after the insurer has purchased it. It does appear that the VOS TF members are willing to add some checks and balances, so the question is “Which ones?” In this regard, we think that the trade association commenters, particularly the ACLI and those organizations that commented jointly with it, will be the most influential.
(See the NAIC staff's meeting summary.)
Financial Condition (E) Committee (meeting materials):
The Financial Condition (E) Committee (“’E’ Committee”) met on August 15, 2023. It is the parent committee of the SAP WG, RBC IRE WG and VOS TF (among many other subunits). Accordingly, when the “E” Committee agenda was posted on August 3, 2023, with item 16 being the “Framework for Regulation of Insurer Investments – A Holistic Review”—which included numerous references to NAIC designations, the role of the SVO and the ongoing project of reviewing RBC factors—it was widely anticipated that the VOS TF would at least pause and consider the implications of this thoughtful and well-drafted document in connection with its consideration of the SVO proposal for rating overrides.
The first indication that such was not the case was the VOS TF meeting on August 14, 2023, when the holistic review document received only a brief mention at the end. This was confirmed during the discussion of this document at the “E” Committee meeting on August 15, 2023, when the chair (Elizabeth Dwyer, Director of the Rhode Island Department of Business Regulation) stated that there was no plan to stop the ongoing work of the three key workstreams: (i) the RBC IRE WG’s review of RBC for all asset-backed securities, (ii) the VOS TF implementation of financial modeling for CLO investments and (iii) the SVO proposal for rating overrides.
We believe the holistic framework document, which is included in the meeting materials and exposure draft tab at the “E” Committee’s web page, is well worth reading, and we hope that ways will be found to reflect the insights it expresses in the work of the “E” Committee, the RBC IRE WG and the VOS TF. That seems to be most likely to occur with the RBC IRE WG, which is still in the early stages of its review of RBC for asset-backed securities. However, it appears that a decision was made behind the scenes, and a consensus of “deciders” reached before the meeting, that the VOS TF implementation of financial modeling for CLO investments and the SVO proposal for rating overrides were too far advanced, and that too much work had been put into them, for these initiatives to be fundamentally reconsidered.
(See the NAIC staff’s summary of the meeting (which included many other agenda items).)
As always, if you have any questions or want to discuss, just let any of us at Mayer Brown know.
1 We assume the reader is generally familiar with the NAIC investment-related initiatives that we have been discussing for some time, including in our earlier REVERSEinquiries webinar.