Insurance Solutions

North America Insurance Regulatory Update — Principles-Based Bond Definition

In our November regulatory update email, we detailed how typical rated note feeder funds are likely to qualify as bonds when evaluated as ABS. We further outlined how CFOs may also qualify. We believe this analysis stands—the update below confirms that the ABS framework we applied is the appropriate framework.

In language exposed for public comment, SAPWG clarifies that rated note feeder funds and CFOs must be evaluated as ABS (instead of Issuer Credit Obligations (“ICO”), e.g. corporate bonds) for purposes of determining whether they qualify as bonds. This matters for two reasons:

• Qualification as an ABS requires a thorough evaluation of the security, creating more work and a potential for some to fail to qualify as bonds
• Because the debt tranches are considered ABS, the residual tranche will be reported as such and draw a higher capital charge for life insurers

A key sign that a security is an ABS instead of an ICO is if the cash flows produced by the collateral are contractually required to follow a waterfall to one or multiple debt tranches. Alternatively, a structure where the equity tranche retains discretion over when to pay down the debt may potentially qualify as an ICO.

North America Insurance Regulatory Update — Life insurance 45% RBC requirement for residual tranches

Three updates relating to residual tranches came out of the NAIC’s 2024 Spring National Meeting: 1. Life insurance RBC requirement for residual tranches appears more likely to be 45%; 2. P&C and Health appear likely to also set a 45% RBC requirement for residual tranches; and 3. Mark-to-model accounting guidance for residual tranches was adopted.

Life insurance 45% RBC requirement for residual tranches

In the “Texas compromise” adopted in May 2023, the RBC requirement for residual tranches was set to 45% beginning in 2024. The Alternative Investment Management Association (AIMA) presented an Oliver Wyman study claiming that CLO residual tranche risk is similar to S&P 500 risk and that residual tranches of other ABS are less risky. AIMA suggested that this study provided evidence for not increasing the residual tranche RBC requirement higher than the 30% requirement for equity. The ACLI also requested that the residual tranche RBC requirement be kept at 30% for one more year.
Regulators responded with skepticism. None voiced support for delaying the 45% requirement, while multiple regulators disagreed with these interested parties. While no decision was taken at this meeting, it seems likely that the 45% requirement will go into effect this year. We should know more following a scheduled NAIC call on April 12.

North America Insurance Regulatory Update — P&C and Health moving towards a 45% RBC requirement for residual tranches

Three updates relating to residual tranches came out of the NAIC’s 2024 Spring National Meeting: 1. Life insurance RBC requirement for residual tranches appears more likely to be 45%; 2. P&C and Health appear likely to also set a 45% RBC requirement for residual tranches; and 3. Mark-to-model accounting guidance for residual tranches was adopted.

P&C and Health moving towards a 45% RBC requirement for residual tranches

NAIC had previously requested comments on how to appropriately set the RBC requirement for residual tranches held by P&C and Health companies. After receiving no comments, regulators proposed to align the requirement with life insurers by setting it to 45%. There was effectively no pushback at this meeting. Interested parties have until April 16 to comment on the proposed 45% requirement. Given the lack of engagement so far and the brevity of the discussion on the topic, it seems likely that this 45% requirement will be adopted.

North America Insurance Regulatory Update — Mark-to-model accounting for residual tranches

Three updates relating to residual tranches came out of the NAIC’s 2024 Spring National Meeting: 1. Life insurance RBC requirement for residual tranches appears more likely to be 45%; 2. P&C and Health appear likely to also set a 45% RBC requirement for residual tranches; and 3. Mark-to-model accounting guidance for residual tranches was adopted.

Mark-to-model accounting for residual tranches

SSAP 21R was updated to incorporate a mark-to-model accounting approach for residual tranches, working as follows:
1. At purchase, an insurer models best-estimate cash flows of the residual tranche.
2. Yield is set to make the present value of estimated cash flows equal to the purchase price.
3. periods
4. When actual cash flows exceed the yield, the excess can be applied to the interest carryforwards generated in step #3 above. Any excess cash flows after all interest carryforwards are recognized is applied to basis (in other words, the excess is treated as return of capital).
5. If the present value of projected cash flows, discounted at the purchase yield, is ever less than book value then an impairment must be taken. After this impairment, the original yield is retained and the process for income recognition outlined above continues.
6. If excess cash flows cause the book value to hit zero, then all future cash flows are recognized as income. The residual tranche will continue to be listed on Schedule BA at zero book value.
Using the method outlined above, a residual tranche can only produce an income greater than its yield after its book value has been reduced to zero. It is also never possible for a residual tranche book value to increase unless an additional purchase is made.
For insurers who wish not to perform the cash flow modeling required for this accounting methodology, a conservative practical expedient is available. Yield is set to zero so that all cash flows simply reduce basis. Once the book value has been driven to zero, all future cash flows are recognized as income.

North America Insurance Regulatory Update — Principles-Based Bond Definition

The Blanks Working Group of the NAIC adopted a proposal for more granularity on Schedule D, dividing asset-backed securities (ABS) from issuer credit obligations (ICO). This move is part of the larger bond project and follows the adoption of the principles-based bond definition in August. The updated bond definition and corresponding blanks structures are both effective January 2025. But, importantly, the rules are finalized. It will be important for insurers to analyze any new structure for compliance with the new bond definition. For further detail on what’s required for rated feeder funds and CLOs to qualify as bonds, please reach out to your local NB Insurance Solutions contact.

Brief Summary of the Principles-Based Bond Definition: To be classified as a bond, an investment must be either an ICO or an ABS. ICOs include Treasuries, corporate bonds, municipal bonds, etc., while ABSs include structured credit.

S&P Insurance Regulatory Update

After an almost two-year development, S&P is finally implementing its updated capital model to rate insurance companies. This final version maintains most of the changes shared at the end of 2021, while removing the most controversial aspects of the original proposal. Overall, the quantum of change versus the current capital model remains significant, as S&P has entirely overhauled both the method and assumptions underpinning the quantitative aspect of ratings. On the investment front, one significant innovation is the differentiation of credit risk charges based on the seniority/nature of the obligation and a recalibration that results in lower charges for senior secured debts and the sub-investment-grade universe compared to the previous model.

APAC Insurance Regulatory Update

To better reflect the risk embedded in their balance sheet and enhance policyholder protection, regions across Asia are examining and updating the insurance solvency regimes. The underlying philosophy tends to share similarities of regulations in Europe Solvency II. In addition, increasing consideration is being given to consistency with the new International Reporting Standard 17 (IFRS 17) and International Capital Standards (ICS). The framework details and implementation pace of the new capital regimes differ among countries. In China the CBIRC unveiled the new rules of C-ROSS Phase II on 30 December 2021. In January 2023 South Korea has implemented K-ICS, an economic value-based capital framework similar to ICS. The new rules are effective in 2024 for Hong Kong, in 2025 for Japan and in 2026 for Taiwan. Most of the solvency regimes have moved to an economic balance sheet framework, with an objective to assess assets and liabilities on a fair-value basis, which highlights the importance of better asset liability management and duration matching. Matching adjustments are adopted by some regimes such as HK RBC and Singapore RBC2, which aims to reduce the impact from short-term fluctuation in asset values and enhance asset liability cash flows matching. Neuberger Berman has worked with insurers across different Asia regions for more effective asset liability management under the new rules and portfolio optimization under the matching adjustments.

North America Insurance Regulatory Update — Residual Tranches

On today’s RBCIRE call (June 14, 2023), the C-1 factor and RBC sensitivity test for residual tranches were updated. 2023 C-1 factor will remain at 30%, and there will be a 15% sensitivity test. 2024 C-1 factor will increase to 45% and the sensitivity test will be removed.

The 2023 sensitivity test will allow regulators to assess the impact of a 45% factor (30% base factor + 15% sensitivity test = 45%) before it is imposed next year. The sensitivity test is a what-if scenario, not an actual RBC requirement.

The change applies to all residual tranches that are recorded in Schedule BA. There is a parallel project ongoing at SAPWG to update the definition of residual tranches—this new 45% factor in 2024 will apply to anything captured by this updated residual tranche definition.

Regulators on RBCIRE expressed that before the 45% factor comes into effect in 2024, they would like to revisit the issue and consider additional information. But in the absence of additional information, the default result would be for a 45% factor beginning in 2024.

North America Insurance Regulatory Update — Residual Tranches

On the NAIC’s RBC Investment Risk and Evaluation Work Group conference call Thursday, a specific C1 factor for residual tranches was formally exposed for the first time—45% pre-tax. Adoption of a structural change to RBC that allows for a separate residual tranche C1 factor was on the agenda and passed unanimously, but at the end of the call during the “any other matters” section the specific 45% factor was proposed for an exposure.

Debate amongst regulators ensued, mostly around whether to expose a specific number or a range. 30–45% was mentioned as a range. A regulator expressed concern that 45% may lead to insurers effectively being required to hold more than a dollar of capital per dollar of residual tranche investment if they are targeting a high enough RBC ratio. While regulators focused on ranges capped at 45%, the industry letter where the 45% factor was first seen had recommended a factor of “at least” 45%. The 45% number is still up for debate—the reason given for exposing this particular number is that it’s a number that interested parties are already familiar with due to the industry letter.

In summary: 45% pre-tax residual tranche factor exposed; This would be an interim factor that applies to all residual tranches identified on Schedule BA regardless of underlying collateral, LTV, or other characteristics of the securitization (CLO residual tranches are likely to be the first to get a new factor distinct from this interim factor); Comment period is 21 days (through May 12, 2023).

North America Insurance Regulatory Update — CLOs

Also during the NAIC Spring National Meeting:

CLOs

CLOs continue to be discussed on parallel tracks at VOSTF and RBCIREWG. Capital regulators (RBCIREWG and CATF) plan to have a conceptual discussion around the concept of RBC arbitrage. SSG staff will form an ad hoc group of interested parties to hold technical modeling discussions as SSG builds out the model that would replace NRSRO ratings. Overall, not much new on CLOs at this meeting, but more to come later this year.

North America Insurance Regulatory Update — Structured Equity and Fund

Also during the NAIC Spring National Meeting:

Structured Equity and Fund

Industry submitted extensive comments on the SVO’s proposal to disregard NRSRO ratings on feeder funds and CFOs. However, SVO did not provide any edits to their proposal addressing these comments. Instead, regulators instructed SVO staff to draft a process by which they could challenge specific ratings that they find objectionable. For the time being, this means that the proposal to disregard ratings on this entire class of investments is tabled. However, we should expect it to resurface later in the year after the ratings challenge process is drafted. With this delay, 2023 adoption of any changes is unlikely.

North America Insurance Regulatory Update — Residual Tranches

Also during the NAIC Spring National Meeting:

Residual Tranches

Beginning with 2022 reporting, insurers are required to hold residual tranches on Schedule BA and tag them as residual tranches. RBCIREWG (RBC Investment Risk and Evaluation Working Group) proposed a new RBC category for these residual tranches. RBCIREWG intends to adopt an increased interim capital charge for 2023 for all residual tranches captured by this new reporting on Schedule BA. A specific number should be proposed soon—it will need to be adopted by June 30 to be effective for 2023.

Regulators expressed concern that based on initial year-end filings they’re seeing, assets that they expected to fall into this the new Schedule BA category of Residual Tranche are not in fact being reported there. As more year-end filings become available, if this concern persists we should expect regulators to clean up the definition so that more assets are included as residual tranches. For example, regulators suggested that they would want all feeder fund residual tranches to be captured by this new category, but they observed that when the residual tranche is structured as an LP interest it is not always being recorded as a residual tranche on Schedule BA.

North America Insurance Regulatory Update — Negative IMR

Last week, the NAIC held its Spring National Meeting. There was minimal activity in terms of newly adopted investment rules, but several important proposals evolved and advanced towards adoption.

Negative IMR

The regulatory process to potentially allow for negative IMR is becoming more complicated, and with that 2023 adoption is unlikely. The current set of proposals and referrals would allow negative IMR in surplus but not in TAC. This means that selling bonds at a loss would not reduce distributable earnings (which drives the cap on allowable dividends) but would reduce an insurer’s RBC ratio. We’ll continue to monitor the parallel conversations across SAPWG (Statutory Accounting Principles Working Group), LATF (Life Actuarial Task Force), and CATF (Capital Adequacy Task Force).