NAIC’s ‘Bond’ Definition — Latest Developments

Insurers and others are closely following efforts by the National Association of Insurance Commissioners (NAIC) to develop a new, comprehensive, “principles-based” definition of debt securities for purposes of insurers’ reporting requirements. Interested parties should consider developments on this front, including draft guidance, from the NAIC’s Fall National Meeting, at which the Statutory Accounting Procedures Working Group (SAPWG) met on Dec. 11. The guidance that SAPWG has voted to expose for public comment relates to reporting of various types of debt instruments and assessing credit enhancement for purposes of classifying asset-backed securities (ABS) as debt.

By way of brief background, this project began in the summer of 2019, when the NAIC announced that it would classify “collateralized fund obligations,” or CFOs (ABS in which the underlying collateral consists of private equity fund interests), as equity securities for purposes of risk-based capital (RBC). RBC is the system of state insurance laws requiring insurers to hold capital against, among other things, the risk of investment losses. Under the RBC regime, equity investments require considerably more capital to be set aside than debt. Over the two-plus years following the NAIC’s July 2019 move, the project evolved into a broader look at ABS generally. (The precise treatment of CFOs will be included in this broader effort.) The project specifically involves revisiting two key statutory accounting pronouncements, SSAP No. 26R (Bonds) and SSAP No. 43R (Loan-Backed and Structured Securities), in order to harmonize them further and to articulate principles by which an investment could be classified as debt.

At Fall National, SAPWG voted to expose for public comment two items, available here, pertinent to this bond definition project. The first sets out proposed, more granular reporting changes for insurers’ disclosures to state regulators on bond holdings. Under these changes, certain existing categories of holdings would be eliminated, such as various subtypes of sovereign obligations, and the reporting schedule would generally require distinct reporting for “issuer credit obligations” and “asset-backed securities” (the two categories of bonds that the bond definition project is considering). Examples of reporting line items in the ABS category would include “self-liquidating financial asset-backed securities,” which in turn would encompass asset classes such as RMBS and CMBS, and “cash-generating non-financial asset backed securities.” Examples of line items in the “issuer credit obligation” category include “corporate bonds,” “U.S. government obligations” and “mandatory convertible bonds.”

The other item exposed for comment explains the “sufficient” (now “substantive”) credit enhancement requirement that has been proposed by the bond definition project. Under guidance from SAPWG in May 2021, the two defining characteristics of ABS are (i) that the collateral comprise either financial assets or “cash-generating non-financial assets” and (ii) that the holder be placed in a different economic position as compared with holding the underlying collateral directly, i.e., that there be sufficient credit enhancement to put the investor in such a different position. The December 2021 release uses the terminology “substantive” rather than “sufficient” credit enhancement and alters some of the language on credit enhancement present in the May 2021 paper. The new guidance moves away from concepts of comparing a putative ABS with “other debt instruments of similar quality” and stress-testing these.

In addition, language relating to the types of losses that would be absorbed is deleted. Instead, the new release focuses on loss absorption that occurs “before the debt instrument [i.e., the putative ABS] being evaluated would be expected to absorb losses.” In other words, the guidance is now focusing more specifically on tranching, distinguishing ownership of equity in an operating business (in which the investor is exposed to the business’s losses) and ownership of an ABS (in which an investor expects a more subordinated tranche to bear losses earlier than the investor). The December 2021 guidance notes that “if substantive credit enhancement did not exist, the substance of the debt instrument being evaluated would be more closely aligned with that of the underlying collateral than that of a bond.”

Comments on these two items are due from any interested parties by Feb. 18, 2022.