4) Impact of Revised Bond Definitions on Private/Esoteric ABS
The NAIC intends to establish principles-based guidance for determining whether or not a security should be categorized as a bond. The intent is to address the increasing financial innovation by providing regulators and other financial statement users with more transparency on the risks in an insurer’s investment portfolio. A bond would be defined as any security that represents a creditor relationship with a fixed schedule for at least one future payment, and which qualifies as either an issuer credit obligation or an asset-backed security (ABS).
Our Assessment: This change would likely be gradual; the current target for implementing it is year-end 2024 or year-end 2025. However, we expect increased focus from regulators, industry participants and the media. According to the draft document released in June, securities backed by financial assets (CMBS, RMBS and CLOs) were specifically referred to as “Financial Asset-Backed” ABS. For these instruments, the NAIC bond definition is based on whether a security has a “substantive credit enhancement.” Securities that don’t meet the criteria would be treated as equities, not bonds. Overcollateralization and subordination both count as enhancements, but the NAIC hasn’t yet determined the threshold for enhancements to be considered “substantive.”
As for instruments not backed by financial assets, the proposal mostly targets private and esoteric ABS and, in our view, certain credit tenant lease securities. Bond classification would require securities to satisfy a “meaningful cash flows” test, defined as bonds for which less than 50% of the contracted principal and interest payments rely on refinancing or a sale of the collateral assets.
A one-size-fits-all definition of “substantive credit enhancement” might create unintended consequences for financial asset-backed instruments. For example, prime-auto ABS have meaningfully less subordination than subprime auto ABS, yet both would be categorized the same way. The test could also spur questions about the accounting of instruments backed by assets other than financial, including CMBS and corporate bonds, which rely on refinancing at maturity.
The Big Picture: What Could the Changes Mean for Insurers’ Portfolios?
The NAIC’s recent focus on securitized assets illustrates its desire to proactively review and regulate risk in insurers’ securitized-asset holdings. If the changes are partly or fully implemented, they would likely result in a net increase in RBC C1 charges.
For example, US life insurers were well capitalized heading into 2022, with an industry average Company Action Level RBC Ratio of 443%. That ratio could fall by 10–20 percentage points from the change in CLO capital treatment alone, depending on the NAIC’s ultimate approach. That’s a substantial amount for an asset class that generally comprises about 3% of the average life insurer’s portfolio. We wouldn’t be surprised if some life insurers, especially those more sensitive to RBC constraints, reconsider allocations to lower-rated CLO tranches ahead of the implementation.
What can insurers do as the NAIC changes move from proposal to ultimate implementation?
•Monitor and assess the proposed changes, provide comments and actively participate in the industry’s discussion. The changes are still in flux, with much more information to be presented and debated before final rules are issued, and modifications can substantially alter the playing field.
•Emphasize cross-sector, capital-adjusted relative value when optimizing insurance portfolios. Insurers need to build or acquire tools and models that enable them to be nimble in reevaluating “what if” scenarios and in re-optimizing portfolios under alternative capital-rule outcomes.
•Re-evaluate portfolio design as C1 charges shift, weighing the trade-off between deploying RBC into assets versus channeling them to other parts of the business or the balance sheet. Opportunities in the reinsurance market might also be another tool for capital management.
