A Regulatory Approach to an Evolving Market
Adopting the NAIC’s principles-based bond-definition guidance has proven to be among the most significant efforts for the insurance community since the NAIC codified statutory accounting principles in 2001. The guidance marks a major shift from the regulator’s previous prescriptive approach. It places responsibility on insurers to assess a security’s composition, focusing on the substance of an investment over its legal form, to substantiate whether it qualifies to be reported as a bond.
It takes a deep understanding of the NAIC’s guidance to complete a classification and fulfill the associated reporting and documentation requirements. The concepts within these criteria are likely familiar to insurance investors, but applying them through the lens of the bond-definition guidance is a far more novel concept. To do this effectively, insurers and their asset-management partners must make significant renovations to their investment operations and processes.
Several motives underly the NAIC’s guidance. Perhaps the most evident is the association’s desire to address approaches to structuring securities that seek favorable capital treatment,
which results in higher equity exposure on insurers’ balance sheets. In seeking to curtail this activity, the NAIC hasn’t been shy about broadcasting its desire for principles-based guidance and application. Such an approach brings a level of interpretation and subjectivity to any issue, and classifying investments through that lens is no different. It poses challenges—some controllable, others less so—based on an insurer’s proximity to the development of the guidance and the insight it gains from partnering with peers in similar situations.
The insurance industry has been in active discussions with the NAIC in an effort to gain clarity on the association’s guidance and develop an approach to applying the guidance that’s as consistent as possible. These engagements have been productive, but it’s challenging to reach consensus on such a large scale. Inevitably, different interpretations of the guidance and different approaches to applying it will be adopted across the industry, and these different approaches will ultimately face scrutiny from regulators. That’s why it’s vital for insurance investors to capitalize on this opportunity to develop sound processes and avoid challenges down the road.
Time is running out for insurance investors and asset managers to adapt to the new guidance. The regulation goes into effect January 1, 2025, and insurers must classify their year-end 2024 investment portfolios to ensure compliance by day one.
Determining When a Bond Is Really a Bond
A bond classification requires a security structure, a representation of a creditor relationship, and an attestation as to whether a security is an issuer credit obligation (ICO) or an asset-backed security (ABS).
Structure: The criteria for defining a security’s structure will continue to follow the definitions based on generally accepted accounting principles (GAAP) in the US.
Creditor Relationship: When assessing whether a creditor relationship exists, only the substance of a security’s structure matters—its legal form isn’t relevant. For example, a security with equity-like characteristics or that represents an ownership interest in the issuer does not signify a creditor relationship.
The filing entity that owns the security can rebut this presumption only through significant analysis and by applying its own judgment. For example, a debt instrument could be a creditor relationship if the characteristics of the underlying equity interests produce predictable cash flows, and if the underlying equity risks have been redistributed throughout the capital structure.
For the characteristics of the underlying equity interests to support the transformation of equity risk to bond risk, the guidance requires that these characteristics reduce the inherent reliance on equity valuation risk. The greater the reliance of the debt instrument on the sale of underlying equity interests or refinancing at maturity, the more compelling other factors must be to overcome the presumption that there is not a creditor relationship.
