Blog: Regulatory Update: NAIC Fall 2021 National Meeting | Insights – Sidley Austin LLP

a. NAIC to Evaluate Rating Information and Process for Privately Issued Securities 

The NAIC is concerned that private credit rating provider (CRP) ratings do not adequately represent the risks of privately issued securities purchased by insurers, which can affect an insurer’s RBC calculation, resulting in a lower RBC charge for higher-risk investments. The Valuation of Securities (E) Task Force (VOS Task Force) previously adopted an amendment to the P&P Manual requiring the submission of private rating letter rationale reports with certain private rating letters filed with the NAIC Securities Valuation Office (SVO). Beginning in January 2022, insurers are required to file such reports with the SVO to provide additional details regarding the private letter ratings obtained with respect to their ownership of privately issued securities. The report must provide an analytical review of the privately issued security that mirrors the work product that a CRP would produce for a similar publicly rated security, including an explanation of the transaction structure, methodology relied on and, as appropriate, analysis of the credit, legal and operational risks and mitigants supporting the assigned CRP rating.

Additionally, on November 9, 2021, the SVO issued a memorandum to the VOS Task Force expressing concern regarding the NAIC’s extensive reliance on CRP ratings to assess investment risk for regulatory purposes and proposing changes to the SVO’s “filing exempt” process, which grants an exemption from filing with the SVO for bonds and preferred stock that have been assigned a current, monitored rating by a nationally recognized statistical rating organization (NRSRO). The memorandum noted that the SVO staff conducted an in-depth review of a sample of 43 privately rated securities and found material differences between the private ratings and the SVO staff’s estimates, with the private ratings being three to six or more notches higher than the SVO staff’s estimates. The memorandum suggested four alternatives that the NAIC should consider in 2022 to begin the process of actively managing and overseeing its use of CRP ratings, which alternatives may be considered independently or may be combined or phased in over different time periods. The proposed alternatives include:

  • requiring at least two CRP ratings for every security and using the lowest rating to determine the NAIC designation; if a security has only one rating, then requiring it to be reviewed by the SVO to determine whether the SVO deems the rating reasonable (i) pursuant to its own analysis, (ii) when benchmarked to NRSRO peers and methodology, or (iii) compared to a spread implied rating, and, if not, to determine whether a full filing and SVO analysis would be appropriate
  • conducting an in-depth study of the NAIC’s use of CRP ratings and SVO-assigned NAIC designations as to their consistency and comparability for regulatory purposes, specifically the determination of RBC factors
  • offering NRSROs the opportunity to respond to a request for qualifications (RFQ), with the NAIC contracting only with those CRPs that adequately meet the RFQ criteria
  • having the SVO remove any rating agency from the CRP list at any time upon the request of the VOS Task Force

The VOS Task Force indicated that the memorandum provides a starting point to evaluate the rating process, and the VOS Task Force expects to form a subgroup charged with conducting such evaluation, which would include participation by CRPs, insurers and other stakeholders.   

b. NAIC Removes Residual Tranches From Receiving NAIC Designation

The VOS Task Force adopted an amendment to the P&P Manual to remove residual tranches and interests from receiving an NAIC designation. Specifically, the amendment provides that securities that are residual tranches or interests, as defined in Statement of Statutory Accounting Principles No. 43R–Loan Backed and Structured Securities, must be reported on Schedule BA (Other Long-Term Invested Assets) without an NAIC designation and are not eligible to be assigned an NAIC 5GI or NAIC 6* Designation. Residual tranches or interests generally refer to securitization tranches, beneficial interests and other structures that reflect loss layers without any contractual payments, whether principal, interest or both. Payments to investors in residual tranches or interests (i) occur after contractual interest and principal payments have been made to other tranches and interests and (ii) are based on any remaining available funds. For 2021 year-end reporting only, residual tranches or interests previously reported on Schedule D-1 (Long-Term Bonds) may be reported on Schedule D-1 with an NAIC 6* Designation but not an NAIC 5GI Designation. 

c. NAIC Exposes Amendment to Definition of Principal Protected Securities

The VOS Task Force exposed an amendment to the PPS definition in the P&P Manual to address alternate securities with “performance assets” that do not fit within the current PPS definition but nevertheless should be categorized as PPS. By way of background, in May 2020, the VOS Task Force adopted an amendment to the P&P Manual to include PPS as a new security type that is not eligible for the SVO’s “filing exempt” process. At that time, the types of PPS considered were combinations of (i) a typical bond or bonds and (ii) additional performance assets with various characteristics, including derivatives, common stock, and/or commodities and equity indices, that were intended to generate additional returns. The performance assets generally included undisclosed assets and were typically not securities that would otherwise be permitted on Schedule D, Part 1 as a bond. In each case, the private CRP rating was based solely on the component dedicated to the repayment of principal and ignored the risks and statutory prohibitions of reporting the performance asset on Schedule D, Part 1.

The impetus for the proposed amendment was the SVO’s receipt of a proposed security that had many of the same risks as PPS but was structured in a way that did not fit squarely within the PPS definition in the P&P Manual. The proposed security was not issued by a special purpose vehicle holding both the bond and the performance asset; rather, the security was the direct obligation of a large financial institution that was obligated to pay principal at maturity and any additional return based on the performance of certain referenced indices of equities, fixed-income instruments, futures and other financial assets. Although the financial institution issuing the security was the sole obligor under the security, such that there were no underlying bonds or performance assets, the structure posed the same risk of exposure to a performance asset because the amount of the issuing financial institution’s payment obligation depended directly on the performance of the referenced indices. Additionally, unlike a PPS transaction with an underlying bond and performance asset, the likelihood of payment of any performance asset return was linked directly to the creditworthiness of the issuing financial institution. The proposed amendment to the PPS definition is intended to address such alternate structures that pose similar risks, so that such structures would be covered under the PPS definition and ineligible for the SVO’s “filing exempt” process.

d. NAIC Forms New RBC Investment Risk and Evaluation (E) Working Group

The Financial Condition (E) Committee approved the formation of a new RBC Investment Risk and Evaluation (E) Working Group following a recommendation from the Capital Adequacy (E) Task Force. The new working group has been charged with performing a comprehensive review of the RBC investment framework for all business types and will coordinate with other NAIC groups in an effort to achieve a more holistic evaluation of investment-related proposals and their RBC impact.


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