Insurance Regulators’ Working Group Adopts Key Bond Definition, Providing Guidance for Equity-Based ABS

Culminating a four-year-long process, a key working group of insurance regulators has adopted new standards for determining whether an investment held by an insurance company should be characterized as a “bond” evidencing a “creditor relationship.” This “principle-based” bond definition will have broad implications for insurance company statutory reporting and Risk-Based Capital calculations. The action is of particular relevance for asset-backed securities (ABS) that are based on underlying equity interests, such as collateralized fund obligations (CFOs).

On Aug. 13, the Statutory Accounting Principles Working Group (SAPWG) of the National Association of Insurance Commissioners (NAIC) adopted revisions to Statement of Statutory Accounting Principles (SSAP) No. 26R (Bonds) and SSAP No. 43R (Asset-Backed Securities). The adoption, with an effective date of Jan. 1, 2025, occurred at SAPWG’s session as part of the NAIC’s Summer National Meeting in Seattle. The revisions give effect to a criteria-based definition of “bond.” Key guidance for securities backed by equity interests, such as CFOs, is provided in new SSAP No. 26R:

a. Determining whether a debt instrument represents a creditor relationship in substance when the source of cash flows for repayment is derived from underlying equity interests inherently requires significant judgment and analysis. . . . [D]ebt instruments collateralized by equity interests are dependent on cash flow distributions that are not contractually required to be made and are not controlled by the issuer of the debt. As a result, there is a rebuttable presumption that a debt instrument collateralized by equity interests does not represent a creditor relationship in substance. Notwithstanding this rebuttable presumption, it is possible for such a debt instrument to represent a creditor relationship if the characteristics of the underlying equity interests lend themselves to the production of predictable cash flows and the underlying equity risks have been sufficiently redistributed through the capital structure of the issuer. Factors to consider in making this determination include but are not limited to:

i. Number and diversification of the underlying equity interests

ii. Characteristics of the underlying equity interests (vintage, asset-types, etc.)

iii. Liquidity facilities

iv. Overcollateralization

v. Waiting period for distributions/paydowns to begin

vi. Capitalization of interest

vii. Covenants (e.g., loan-to-value trigger provisions)

viii. Reliance on ongoing sponsor commitments 

b. While reliance of the debt instrument on sale of underlying equity interests or refinancing at maturity does not preclude the rebuttable presumption from being overcome, it does require that the other characteristics mitigate the inherent reliance on equity valuation risk to support the transformation of underlying equity risk to bond risk. As reliance on sale or refinancing increases, the more compelling the other factors needed to overcome the rebuttable presumption become.

c. Analysis of whether the rebuttable presumption for underlying equity interests is overcome shall be conducted and documented by a reporting entity at the time such an investment is acquired . . .

(emphasis added). Based on the criteria laid out in the principle-based approach that SAPWG has now adopted, CFOs that include a diversified pool of fund interests by fund strategy and fund sponsor, preferably including a reasonable percentage of debt funds, as well as a liquidity facility and a structure that does not depend on sales or refinancings for repayment, should qualify as creating a creditor relationship between the note purchaser and the issuer. However, such treatment must be considered on a case-by-case basis.