In this newsletter, we provide an update on the NAIC Fall National Meeting from November 29–December 4, 2023 in Orlando, FL, as well as recent developments. In anticipation of the Spring National meeting in mid-March, we summarize the latest regulatory developments and highlight what to expect in Phoenix, AZ. In summary:
- The principles-based bond definition project is near completion. Expect the adoption of SSAP No.21R in March.
- The Current Expected Credit Loss (CECL) concept was rejected for statutory accounting.
- Work continues on various Schedule BA revisions (SSAP No.48 reporting categories, collateral loan reporting).
Principles-Based Bond Definition Nearly Done, but Fine-Tuning Continues
The new principles-based bond definition goes live in less than a year, on January 1, 2025. However, not all of its components have been finalized: SSAP No.26 (bonds) and SSAP No.43 (asset-backed securities) were recently adopted, but SSAP No. 21R hasn’t yet been ratified. Below are a few updates on this initiative that have received attention.
Gaining traction on accounting guidance for residuals: Last December, the Statutory Accounting Principles Working Group (SAPWG) discussed proposed revisions to SSAP No. 21R, revolving around two alternative measurement approaches: 1) the effective yield method with a cap and; 2) the return-of-cost-basis method. In the first approach, the Allowable Earned Yield (AEY) is established when the residual is acquired; the AEY is the discount rate that equates the initial best estimate of the residual’s cash flows to its acquisition cost. Subsequent cash distributions below the AEY are treated as interest, while any excess distributions above AEY are treated as return of principal, reducing the book adjusted carrying value (BACV). AEY is only calculated once, at the residual’s acquisition. In the second measurement approach, cash distributions are applied as principal until the BACV reaches zero and treated as interest thereafter. This approach is more conservative and less operationally intensive, given that the AEY wouldn’t need to be calculated. The residual’s BACV is never accrued above the original value at purchase for either method.
Reporting entities can’t “mix and match” the two measurement methods. If a reporting entity decides to use the return-ofcost-basis method, it must apply this method to all residuals in its portfolio. However, if a reporting entity decides to switch back to the effective yield method, it must document the explicit transition date, and the method will only be applied prospectively, i.e. to residuals acquired after that date. Residuals already in the portfolio by the transition date will continue to use the cost-recovery method until they are unwound, mature, are terminated, or no longer meet the definition of a residual. Residuals no longer meeting the definition would previously have required reclassification unless unwound withi 12 months. However, an update in the SAPWG’s recent February call removed the reclassification paragraph because it’s an infrequent occurrence, not reclassifying a residual is more conservative, and removing the requirement spares insurers the burden of creating, monitoring and enforcing additional policies.
Another update made at the February call remediated a discrepancy regarding other than temporary impairment (OTTI) events for residuals under the return-of-cost-basis method. In the original proposal, OTTI under either method required the calculation of AEY, but an insurer would choose the return-of-cost-basis method precisely to avoid calculating AEY and the operational complexities that come with it. The SAPWG picked up on this issue and provided a simple, yet elegant, solution: use fair value. Under the return-of-cost-basis method, OTTI would occur when the fair value falls below BACV, which is then adjusted down, with the fair value becoming the new BACV.
Early adoption of the residual guidance in 2024 would be permitted. This allowance applies to residual guidance only—not the entirety of SSAP No. 21R. The entire SSAP, when adopted, would be effective January 1, 2025, concurrent with the rest of the bond-definition project. Finally, the revised SSAP No.21R is now exposed for comments until March 7, 2024, with the goal of adopting it at the Spring National Meeting the following week.
Revisions continue for Schedule BA collateral loans reporting: Currently, regulators lack information on the type of collateral used for collateral loans in scope of SSAP No. 21R, preventing them from quickly determining admittance status of these loans. At its December 2023 meeting, the SAPWG exposed proposed revisions to SSAP No. 21R and Schedule BA that would address the issue. The revisions called for new disclosure requirements in SSAP No. 21R and for expanded reporting on Schedule BA, where collateral loans are to be categorized by type of collateral. Then, at the February meeting, the SAPWG circulated updates to the proposal, which included combining Schedule BA reporting categories as a way to reduce reporting volumes. The NAIC still prefers to retain more granularity in the SSAP No. 21R disclosures, though, sponsoring a parallel blanks proposal to reflect any expected data capture, disclosure and reporting changes.
In addition, industry feedback was requested on whether collateral loans should flow through AVR—which has not been the case historically. NAIC staff recommended a referral to the Life Risk-Based Capital Working Group (LRBC WG) on the suggested reporting lines and AVR mapping for RBC, which is exposed for comments until April 19, 2024.
Inconsistent treatment of registered and unregistered funds addressed: During its January meeting, the SAPWG discussed the fact that bonds issued by SEC-registered business development corporations (BDCs), closed-end funds (CEFs), or similar operating entities are automatically considered issuer credit obligations (ICOs) in SSAP No. 26, as opposed to consideration as asset-backed securities (ABS). This is a departure from the principles-based nature of the new bond definition, because the ICO classification is the result of registration status and not principles-based.
The current proposal to revise SSAP No. 26 seeks to remediate this discrepancy by classifying fund-issued debt as ICOs for funds that 1) represent operating entities and 2) are not issuing securities primarily for raising debt capital. The proposed revision would create better alignment with residual tranche definitions and consistent treatment, regardless of SEC registration status. To that end, the SEC registration requirement was removed and guidance on distinguishing between an operating entity and a securitization vehicle was proposed. To make this distinction, one has to look at the substance of the entity and its primary purpose: an operating-entity fund’s primary purpose is to raise equity capital, whereas an ABS vehicle’s primary purpose is to raise debt capital.
The comment period for this proposal ended on February 9, 2024, and we expect full adoption of the revised SSAP No. 26R at the Spring National Meeting in March.
Jury still out on Schedule BA reporting categories: Investments in the scope of SSAP No. 48 (Joint Ventures, Partnerships and Limited Liability Companies) are supposed to be categorized and reported based on the characteristics of their underlying assets. However, the current guidance on assigning investment types to categories is lacking. The NAIC proposed more consistent definitions and reporting of these investments. In particular, the NAIC recommended folding non-registered private funds into the reporting category for joint ventures (JV), partnerships and limited liability companies (LLC). The industry countered that the non-registered private-funds section is the only place where certain investments can be reported. After additional research, the NAIC determined that most of the investments reported as non-registered private funds are collateral loans. The regulator continues to advocate for keeping non-registered private funds in the scope of SSAP No. 48 and for combining them with JVs, partnerships, and LLCs. The proposal has been modified to clarify that any investments reported in the JV, LLC, and partnership categories must be in the scope of SSAP No. 48, and to make it unambiguous that all residuals must be in scope of SSAP No. 21R starting January 1, 2025. The proposal has been re-exposed for comments through April 19, 2024.
In other developments related to the bond definition, we note two adoptions at the December meeting:
- The proposal to modify SSAP No. 2R (cash, cash equivalents, drafts, and short-term investments) to exclude all Schedule BA investments and mortgage loans from being reported as cash-equivalent or short-term investments was adopted. The effective date is January 1, 2025, not coincidentally the same date when the principles-based bond definitions kicks in.
- Minor revisions to SSAPs No. 30R (unaffiliated common stock) and No. 32R (preferred stock) were adopted, clarifying that structures that are residuals in substance should be reported as residuals on Schedule BA. The effective date is January 1, 2024—essentially, the revisions are effective immediately for 2023 year-end reporting, which would be in line with the residual guidance already adopted.
Current Expected Credit Loss (CECL) Concept Rejected for Statutory Accounting
Another recent development isn’t an adopted proposal—ironically, it’s a rejected one. Current Expected Credit Loss, or CECL (pronounced “SEE-sil”), is a GAAP concept introduced on the heels of the global financial crisis. Officially, it’s known as Accounting Standards Update (ASU) 2016-13, issued by FASB in June of 2016. In a nutshell, the concept switches from incurred to expected losses—in other words, from a retrospective loss recognition to a prospective one. We’ve wondered for a while if this concept would make its way into the statutory accounting, too. The answer is finally in: CECL was rejected.
A number of considerations played a role in the decision to reject CECL for statutory accounting; we won’t discuss them all here. But most importantly, regulators reasoned that, unlike the old GAAP incurred-loss methodology, the statutory framework already has mechanisms that take a prospective view of credit risk. These include AVR for life insurers as well as fair-value reporting for high-yield bonds for property and casualty (P&C) insurers. Another consideration is that riskbased capital’s C1 bond factors are a direct incorporation of credit-risk expectations into the capital calculation. If CECL were adopted, it would have to be coordinated with RBC to avoid double-counting the same credit risk.
The consideration to adapt CECL for statutory accounting had been on the agenda from 2016 until the 2023 Fall National Meeting, when it was disposed of and replaced with a new and revised agenda item—a proposal to reject ASU 2016-13 and a host of peripheral documents, collectively known as CECL. After a shortened comment period that ended December 29, 2023, the SAPWG officially rejected CECL at its January 10, 2024 call, effective December 31, 2023.
Other Fall 2023 Agenda Items on Interest Maintenance Reserve and Asset Valuation Reserve
- Addressing ”low-hanging fruit”: This item has been adopted by the SAPWG to correct the issue of allocating noninterest rate-related losses to the Interest Maintenance Reserve (IMR) rather than the Asset Valuation Reserve (AVR). Realized gains or losses on debt securities with credit events not yet reflected in their credit ratings or NAIC designations must still go into the AVR. In other words, if a downgrade is pending but the bond is sold at a loss before the downgrade occurs, the loss still belongs to the AVR and not the IMR, because it isn’t interest rate-related but credit-related. And for mortgage loans, any gain or loss realized on the sale of a mortgage loan with an established valuation allowance has to be reported in AVR now. This change became effective January 1, 2024.
- Clarifying treatment of realized gains/losses on the sale of perpetual preferred stock: The second proposal clarifies that realized gains and losses on the sale of perpetual preferred stock should be reported in the AVR, just as realized gains and losses on the sale of common stock would be reported in the AVR. The goal is to align the AVR/IMR guidance with the measurement method for perpetual preferred stock, which in 2021 changed to fair value—regardless of NAIC designation. The fairly straightforward proposal’s comment period ended February 9, 2024, and we expect full adoption at the Spring National Meeting. For now, there’s no change in the treatment of redeemable preferred stock, which is more similar to debt than to equity. Thus, realized gains/losses will continue to flow to either the AVR or IMR, depending on the NAIC designation during the holding period. But expect the discussion about the treatment of redeemable preferred stock to be a part of the long-term IMR/AVR project, which we cover in the next item.
- Moving AVR/IMR accounting guidance under SSAP No.7—Asset Valuation Reserve and Interest Maintenance Reserve: The third proposal will be more involved—a long-term project to move AVR/IMR accounting guidance under the SSAP No.7—Asset Valuation Reserve and Interest Maintenance Reserve. We can’t add much more at the moment, because the project is still in its infancy. The ACLI has pledged its support, and the IMR ad hoc group has been formed to tackle the issue. Expect continued discussions and a steady trickle of updates on this workstream throughout 2024 and probably beyond.
Conclusion
The Spring National Meeting is just around the corner. We look forward to a productive event, with a number of proposals either being finalized or advanced. We highlighted some of these above, but the major breakthrough we expect is likely adoption of SSAP No.21R. This would wrap up the development of the three major SSAPs comprising the principlesbased bond definition. Note that a host of peripheral documents still need to be finalized, but we expect progress in due course before January 1, 2025, when the bond definition officially becomes effective.
At the Spring National Meeting, we’ll also look for more updates on several important workstreams:
- The academy’s continued work on the principles for structured securities RBC: It seems like a smooth sailing so far, but are there choppy waters ahead?
- Residual tranches’ capital charge of 45%: To be or not to be? Will we see compelling research prompting a drive toward a lower factor, or has the industry all but resigned itself to 45% as the new normal?
- Filing exemption (FE) and SVO discretion over CRP-based designations: Are we witnessing the end of the FE era, or will the new and better FE rise out of all this like a Phoenix? (Pun intended.)
- CLO modeling: there aren’t too many updates so far; we’re eagerly awaiting numeric results to estimate the impact of the new modeling methodology on various CLO tranches.
- Last but not least, the all-important E-Committee’s initiative on holistic framework for insurer investments regulation: Where will this yellow brick road lead us?
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