Summer Meeting Reveals NAIC Is Thinking Big and Getting Things Done

The National Association of Insurance Commissioners (NAIC) 2023 Summer National meeting in Seattle Washington wrapped up August 16. It included significant strategic discussions and approvals on several important decisions, with others still in comment periods. Among the highlights:

• Partial adoption of the principles-based bond definition, specifically Statements of Statutory Accounting Principles 26R–Bonds and 43R–Asset-Backed Securities
• Adoption of a temporary solution for the Net Negative Interest Maintenance Reserve (IMR) allowing insurers to admit net negative IMR up to 10% of the adjusted capital and surplus
• An ACLI proposal on the RBC treatment of repurchase agreements by creating a conforming repo category that would provide insurers with better diversification to short-term funding sources and counterparty exposures, among other benefits
• The American Academy of Actuaries proposal for new structured securities RBC principles, an approach to determining when an asset class—or individual securities in an asset class—must be modeled to determine C1 factors.
• Reexamining aspects of proposed changes to the definition of an NAIC designation, though no decision has been reached yet; a revised version will go back to the Valuation of Securities Task Force (VOSTF) for more consideration
• The Financial Condition Committee’s discussion of a concept framework for regulating insurance investments, in an effort to find the most effective ways to use the NAIC’s resources in regulating insurance investments.

Principles-Based Bond Definition Partially Adopted

The principles-based bond definition project consists of a series of revisions to various SSAPs (Statements of Statutory Accounting Principles) and other documents, which flow through to other SSAPs, requiring updates. At its August 13 hearing, the Statutory Accounting Principles Working Group (SAPWG) partially adopted the definition while exposing or reexposing other parts for comments. Specifically adopted were SSAPs 26R–Bonds and 43R–Asset-Backed Securities, along with revisions to other SSAPs affected by the updates.

The adoptions become effective January 1, 2025. In the meantime, insurers will have an opportunity to reevaluate their investment portfolios, and the NAIC will have time to develop training and education materials on the subject. The following have not yet been adopted:

• Revisions to SSAP No. 21R–Other Admitted Assets, which cover debt securities that do not qualify as bonds, as well as residuals’ treatment
• Proposed changes to reporting lines on Schedule BA (to incorporate debt securities that do not qualify as bonds; moreover, reporting them on separate lines according to the rationale for their failure to qualify)

Temporary Fix for Net Negative Interest Maintenance Reserve (IMR)

In the same August 13 session, SAPWG achieved another milestone—adopting a temporary solution to the net negative IMR problem, a proposal we reported on in April. It’s a limited-time exception to SSAP No. 7, the current statutoryaccounting guidance on IMR and Asset Valuation Reserve (AVR). The exception allows the reporting entity to admit net negative IMR up to 10% of the adjusted capital and surplus (up from 5% in earlier drafts).

To qualify, an entity must have an authorized control level risk-based capital (ACL RBC) ratio over 300%. For the RBC ratio test and for applying the 10% limit, the capital must first be adjusted by removing the so-called “soft” assets: goodwill, hardware and software, deferred taxes, and admitted IMR. Of a number of safeguards discussed earlier, these are the only ones that made it into the final version of the document. For example, a proposed mandatory inclusion of admitted net negative IMR into the asset adequacy testing has been dropped, as has the proposal to ensure that fixed-income sales that generated the negative IMR are reinvested in fixed-income securities.

Losses from interest-rate hedging derivatives can also be included in admitted net-negative IMR if the firm can demonstrate consistent and symmetric derivatives treatment. So, if gains from derivatives were historically placed in and amortized as part of the IMR, the company can do the same with derivatives losses. It’s not entirely clear how an insurer would start doing this without the historical evidence of treating derivatives gains through the IMR. It seems that the only way is to establish a history first, although the adopted guidance is silent on how long this history needs to be.

The IMR seems like a straightforward mechanism to align assets and liabilities, but it touches a surprisingly wide array of other statutory items. In addition to having balance-sheet and income-statement implications, it may affect asset-adequacy analysis, reserve calculations, risk-based capital (both total adjusted capital and the C3 Phase 1 calculation), and liquidity stress testing. So, the logical next step would be to develop a well-though-out permanent solution incorporating these dependencies. SAPWG seems up to the task. The working group has already launched this effort, which will most likely result in the creation of a new Ad Hoc Technical Working Group involving contributors from the SAPWG, Life Actuarial Task Force (LATF), Academy and insurance industry.

The temporary solution will be in place until December 31, 2025 and will be automatically nullified on January 1, 2026, unless the SAPWG nullifies it earlier or extends the effective date.

ACLI Proposal on RBC Treatment of Repurchase Agreements

The Life Risk-Based Capital Working Group (Life RBC WG), in its August 13 session, discussed the proposal by the American Council of Life Insurers (ACLI) on the RBC treatment of repurchase agreements (repos). The goal: align the RBC repo treatment with that of conforming securities-lending programs by creating the conforming-repo category. Conforming securities-lending has existed since 2006, with a current C0 RBC charge of 0.2%. Repos, in contrast, have received a 1.26% charge since the 1990s.

Securities lending and repos are similar in many ways, and both enable insurers to earn additional returns and access short-term funding. Among the benefits of this initiative would be better diversification of short-term funding sources and counterparty exposures, non-punitive access to alternative funding options, and a reduction of exposure to primary dealers (especially during market stresses, when activity tends to shift away from sec lending into the repo market).

The proposal calls for establishing the conforming-program option for repo agreements by enhancing General Interrogatories and RBC instructions. The enhancements include a written plan approved by the Board of Directors, written operational procedures, documented investment and risk guidelines, and collateral requirements. These requirements are nearly identical to sec lending conforming programs. Conforming repo assets would get a 0.2% charge, with an added RBC charge (a BBB bond factor) applied to the overcollateralization amount—a net counterparty exposure typically about 2%. All other (non-conforming) repos would still receive a 1.26% C0 RBC charge.

The proposal is exposed for comments for 45 days.

Academy Proposes New Principles for Structured Securities RBC

On August 13, 2023, the American Academy of Actuaries (AAA), a strategic thought leader for the industry, presented to the Risk-Based Capital Investment Risk and Evaluation Working Group (RBCIRE WG), outlining a proposed structured approach to deciding whether an asset class needs to be modeled to determine its C1 factors or whether securities in an asset class must be modeled individually to determine their C1 factors.

The AAA’s approach features a two-step process.

First, an asset class being considered for new C1 modeling should pass three hurdles:

1. Materiality--or likely future materiality--of the asset class
2. The risk in question should lend itself to be representable by a C1 factor
3. The benefits of a more precise calculation should outweigh the costs of building the model and the added complexity

Second, if the answer is “yes” to all three threshold questions, the user proceeds through the decision tree for considering a new C1 model for an asset class:

1. Are there similar risk-category differences versus existing C1 asset models? If “yes”, stop and use existing C1 factors; if “no”, continue.
2. Is sufficient data available for modeling? If “no”, stop and use existing C1 factors; if “yes”, continue.
3. Do individual assets within the asset class possess attributes allowing them to be sorted into risk buckets? If “yes”, stop and develop new C1 factors; if “no”, continue.
4. Is it practical to model assets individually? If “yes”, stop and model assets individually; if “no”, stop and use existing C1 factors.

The decision tree can clearly produce three outcomes:

1. Use existing C1 factors, either directly or with some adjustments
2. Create new asset class C1 factors
3. Model the assets individually

The decision tree is built so that outcome 1 is the default in many situations and outcome 3, typically the most laborintense and complex, is the last resort. The entire process emphasized simplicity and prudence.

AAA believes in a principles-based approach for deriving C1 factors. As for structured securities, the AAA formulated seven guiding candidate-principles:

1. RBC is a blunt reporting tool, so small inaccuracies are OK.
2. RBC is based on statutory accounting, so changes in accounting treatment will affect C1.
3. RBC arbitrage can only be measured for asset-backed securities (ABS), where the underlying collateral itself has well-defined C1 charges.
4. The motivation for creating an ABS structure doesn’t matter for establishing C1 charges, which only quantify risk.
5. C1 charges should reflect the collateral-management practices for a given type of ABS.
6. The C1 requirement for each tranche is independent. RBC is based on what an insurer holds; the tranches it doesn’t hold should not impact its RBC.
7. The risk profile of ABS, in principle, differs from that of bonds, so their C1 charges should be calibrated differently.

The Academy realizes that more principles may need to be added to the list, and regulators are unlikely to support all of the above principles equally. It welcomes a productive dialog on this topic.

Aspects of an NAIC Designation Are Being Re-examined

On August 14, the Valuation of Securities Task Force (VOSTF) held a two-part discussion of NAIC designations, including the definition of an NAIC designation itself and the proposed procedures for the SVO to challenge designations assigned through the filing exemption (FE) process.

The definition of a designation is more of a technical correction to the Purposes and Procedures Manual of the NAIC Investment Analysis Office (P&P Manual), consolidating definitions found in Part 1 and Part 2 and clarifying the meaning, purpose and use of an NAIC designation. The three comment letters received included criticism of aspects of the proposal. No decision has been reached on its adoption; instead, a revised version will be returned to the Task Force for more consideration.

The other proposal, covering procedures for the SVO’s discretion over FE-assigned designations, was drafted after the Spring National meeting in March, where VOSTF tasked the SVO with creating a process detailing how credit-rating providers’ (CRP) ratings can be reviewed and challenged. As outlined in the current proposal, the process includes the following elements:

• Identifying an FE-calculated NAIC Designation of concern and notifying insurance company holders of this security
• A sufficient notice period, allowing insurers time to appeal (120 days)
• A formal analytical review process by the SVO and involving state insurance regulators
• A materiality threshold (minimum three notches’ difference between the CRP credit rating and the SVO’s own risk assessment of the security)
• Final determination, involving either deactivating the analytical review notice or revoking FE eligibility
• If FE eligibility is revoked, the security either has to be filed with the SVO or receive another NAIC designation through the FE process, if it has another eligible CRP rating
• Steps for an insurer to appeal the SVO’s decision and potentially reinstate the FE eligibility of the CRP rating

The idea of the SVO’s broad discretion over FE-based designations generated a flurry of comment letters. The one getting the most attention—even national headlines—was signed by eight members of the US House of Representatives who expressed concern about the lack of a formal methodology, possible market disruptions and the SVO becoming a de facto unregulated NRSRO with an unfair competitive advantage. They urged that the proposal be withdrawn.

The NAIC’s response stressed that it has no intention to compete with CRPs, if for no other reason than the sheer volume of NRSRO-rated securities held by US insurers. But the NAIC isn’t willing to rely on CRPs unconditionally either. In recent years, regulators started seeing differences among CRP’s ratings for the same security. While the SEC views ratings variability as a healthy difference of opinion, the NAIC notes that it also could spur “rating shopping.” The historic precedent it cites is the discrepancy between mortgage-backed securities’ ratings and their true risks in the wake of the Global Financial Crisis, which led to the creation of the current modeling process for CMBS and RMBS.

The NAIC further highlighted that its work is for regulatory purposes only and not released to the public, so there won’t be competitive imbalances for NRSROs. The process of challenging FE-based designations will be very focused on specific assets, not broad, and most asset ratings will be unchallenged. In any case, no action will be taken until the insurer is notified and had a chance to respond.

Other comment letters presented at the session universally pushed back against the proposal, focusing on a variety of issues but with common themes:

• There are concerns over the lack of process oversight or transparency.
• The SVO will need to share the statistics for rating challenges regularly.
• Concerns exist about incomplete or lacking information, creating information asymmetry.
• An appeals process must be better defined, including the option for independent review or escalation.
• Uncertainty hurts securities markets: it can freeze, disrupt or unintentionally move certain segments.
• The proposals could impede the ability of smaller insurers to raise capital.
• It may take nearly a year for the process to play out before a given security moves out of FE or switches to another CRP rating—an unacceptably long time frame.
• The ultimate regulatory authority must rest with the states.
• The change in SVO responsibilities is too profound and overburdens its resources.
• Associated substantial costs will be borne by policyholders but are not specified in the proposal. No cost-benefit analysis has been performed.
• There’s a need for better governance and more “people on the ground,” possibly involving outside consultants.

As with the NAIC designation definition proposal, no specific action was taken and no decision made. Comments must be taken into account for the next draft; the Task Force will provide directions to the SVO staff on how to proceed from here. Perhaps not coincidentally, some of the above concerns—particularly the last three—were addressed at a more conceptual level the next day at the VOSTF’s parent E-Committee meeting, which we cover in the following section.

Framework for Insurer Investment Regulation

One of the last sessions at the conference was also one of its most anticipated. The Financial Condition Committee (the “E Committee”) presented for discussion a concept framework for regulating insurance investments. The E Committee is one of the most senior NAIC committees, with many working groups and task forces reporting into it, so a proposal that comes from the top is sure to be noticed—and its implications bound to ripple through the insurance regulatory fabric.

At the core of the proposal is the desire to find the most effective ways to use the NAIC’s resources to regulate insurance investments. While the NAIC has recently spearheaded important workstreams in this area, the report also acknowledges that these efforts may sometimes appear “piecemeal” and “disjointed” to industry participants. The organization’s limited regulatory resources are one factor contributing to this perception. The report proposes to step back and holistically reexamine potential areas for improvement in the regulatory framework itself.

The role and functions of the Securities Valuation Office (SVO) are among the main areas needing reform. The proposal attempts to strike a balance between two extremes: On the one hand is the SVO’s current “blind” reliance on ratings from credit-rating providers—the status quo. On the other hand is an equally untenable approach of the SVO taking things “in house,” performing modeling and credit assessment for diverse individual securities—essentially duplicating the CRPs work. The way out of this dilemma, according to the proposal, is robust governance of CRPs’ due diligence. There should be clear, well-documented mechanisms allowing the SVO to challenge individual CRP ratings and perform its own credit assessment if needed, but only as a “backstop.” Assuming the successful establishment of strong due diligence around CRP ratings for insurance use, this option would rarely have to be invoked, anyway. This would free up the SVO’s limited resources to pursue other, more strategic directions such as overseeing CRP usage; enhancing company-specific and industry-wide risk analytics and stress testing; identifying emerging risks; and building a policy-advisory function.

This redesign would require more investment in talent and tools. The proposal suggests more involvement by external consultants, investment and actuarial professionals, and risk-management specialists. The document lists many impacts the proposed framework would have on current initiatives overseen by VOSTF, LATF, SAPWG, and RBCIRE WG.

The feedback from session participants who spoke was uniformly positive. The draft of the proposed framework will be exposed for comments for 45 days, until October 2, 2023.

Summary: the Big Picture

After protracted debate, rapid progress is happening in several areas. Fundamental discussions have occurred and important solutions adopted at the summer meeting.

Regulators moved with resolve and adopted (albeit partially) the principles-based bond definition, effective January 1, 2025. It took 10 years to develop 20 C1 bond factors, so we’re very impressed that a foundational undertaking like this took shape in such a short time. (Depending on who you ask, the project was only launched in earnest in 2019 or 2020.) We look forward to the NAIC fleshing out the remaining Schedule BA details and entering implementation mode before the January 1, 2025 debut. There will be interesting Q&A and guidance letters issued before then, for sure.

Negative IMR is another to-do item that’s been on the back burner forever (since the early nineties, no less) that finally saw the light of day—another impressive move by the NAIC in adopting a temporary net-negative IMR solution. We hope a permanent one won’t be far behind. The fact that the temporary solution expires at the end of 2025 should be a hint.

In the novel thinking category, two presentations steal the spotlight: the Academy’s proposed principles for structured securities RBC and the important E Committee proposal on a holistic framework for insurer investment regulation. A framework that makes sense and is easy to understand. To borrow from Seinfeld’s George Costanza, “Finally, this is an ideology I can embrace!”

With these two initiatives, we clearly see the NAIC moving towards the “big picture” of simplification and parsimony. One can only hope that the Internal Revenue Service would take note and follow the same path.

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