New Subgroup Charge and Decision
The National Association of Insurance Commissioners (NAIC) Reinsurance Investment Security Subgroup (the Subgroup) was formed earlier this year with representatives from eight states: Connecticut, California, Colorado, Illinois, Maine, Missouri, New Jersey and New York. The Subgroup considered whether a specific investment product would qualify as investment security, thus “acceptable security” for reinsurance purposes or “primary security” under AG 48.
The Subgroup did not reach a unanimous position and declined to label the investment product in question as an “investment security,” thus qualifying for “acceptable collateral” or “primary security” for credit for reinsurance and AG 48 purposes. The Subgroup left these decisions to state commissioners when they are asked in the future to review those products in context. More interestingly, while reviewing the proposed investment product, the Subgroup found ambiguity or a lack of guidance in the current accounting and regulatory framework and made several referrals in that regard.
Proposed Investment Product
As background, the investment product in question is an interest-bearing debt security issued by a master trust for a varied period of one to 20 years. Due to the confidential nature of this product, only limited and generic information was provided. The security is supported by underlying assets which are to be invested and reinvested according to some investment policy. Redemption under the security is unconditional, and the security can be redeemed prior to its maturity. According to the memo provided by the Subgroup, the security could be acquired and utilized differently by various insurance entities, including:
As a stand-alone investment security with a sole motivation for profit;
As an investment that has some relation to a regulatory transaction (e.g., acquired from the proceeds of, or the cash flows from an issuer impacted by, a transaction that requires review and approval by a state under its regulatory framework, such as a surplus note); or
As part of a trust (such as a reinsurance trust) or other investment structure, where underlying assets are specifically defined.
Viewed on its own and in the abstract, the security looks very similar to a collateralized debt security. A collateralized debt obligation reported under SSAP No. 43R is typically purchased and held for profit and qualifies as an investment security, or an admitted asset, for an insurer. The Subgroup, however, looked beyond the apparent features of the proposed security, drilled down to the quality and investment of the underlying assets supporting the security, and examined the context in which this security would be acquired or used.
Focusing on these elements, the majority of the Subgroup noted that the asset quality supporting the security could not be immediately ascertained and that the security could be acquired in exchange for a surplus note and used as part of a financing transaction (in other words, a regulatory transaction). This group then reasoned that allowing the blanket inclusion of a specific investment as an investment security would take away the necessary review of the quality of the underlying assets and the overall transaction relating to the acquisition of the security. Because of its potential or intended usage in a regulatory transaction, the majority of the Subgroup felt it would be prudent not to preapprove it as “acceptable collateral” or “primary security” but rather let state insurance commissioners retain the discretion and authority in evaluating any new investment product, affording them the opportunity to examine the whole transaction.
In reaching this position, a few specific factors were noted. First, the quality of the assets underlying the security would be an important element. In the proposed structure, the characteristics and investment policy of those assets were not clear, which concerned the Subgroup. As a result, a referral was made to seek further guidance on the quality of assets supporting a collateralized debt obligation.
Second, the netting feature of the proposed security could disqualify it from being an investment security. When cash flows due from the investment issuer are netted in whole or in part with cash flows from the holder of the investment or such holder’s affiliate, the investment bears resemblance to a regulatory transaction and thus cannot be automatically approved as an investment security.
Third, it was clear that features similar to a letter of credit, or even an unconditional letter of credit, were not sufficient to make a security an investment security.
Further Considerations through Referrals
While the Subgroup’s decision is not surprising, perhaps the more notable results of this review were several referrals generated by the process. How these referrals are considered and deliberated by other groups warrant further monitoring.
First, the Subgroup asked the Statutory Accounting Principles Working Group (SAPWG) to consider whether there are particular elements in SSAP No. 43R or other guidance, such as the investment policy of the trust and/or the underlying quality of assets held in the trust structure, that, if not met, would disqualify a variation of the proposed security from being considered an admitted asset. Even if the security in question is acquired solely for profit by an insurer, such security, bearing the characteristics of a collateralized debt obligation, may not necessarily qualify as loan-backed and structured securities under SSAP No. 43R, and thus an admitted asset if the underlying assets lack certain quality.
Second, the Subgroup saw the potential usage of the security in possible multi-layer transactions with the exchange of a surplus note. A surplus note is afforded unique accounting treatment if it complies with the strict rules of SSAP No. 41R. However, it was noted that SSAP No. 41R may not fully consider the possibility of subsequent complex transactions that link obligations under the surplus note to a separate investment product. Therefore, the Subgroup requested that the SAPWG consider revisions to SSAP No. 41R to further elaborate the principles underlying the standard for surplus note accounting under such situations.
Third, the Subgroup noted that the determination of a regulatory transaction is open to interpretation. Accordingly, it was recommended that the Valuation of Securities Task Force provide guidance in determining whether a security (or other instrument) should be considered as part of a regulatory transaction. The Subgroup offered the following three general elements for initial consideration: (i) the transaction is designed to solve a regulatory issue; (ii) the transaction likely has a financing component; and (iii) the transaction requires review and/or approval by the domiciliary state regulator.
Fourth, the Subgroup noted the lack of statutory accounting and reporting guidance with respect to a regulatory transaction. It asked the SAPWG to consider whether an investment involved in a regulatory transaction should be considered a non-admitted asset, unless approved for admittance by the domiciliary state regulator as a permitted or prescribed practice.
Finally, the Subgroup noted that in connection with the XXX/AXXX Reinsurance Framework and AG 48, a new RBC charge was instituted focusing on the magnitude of a captive’s surplus and quality of assets backing the surplus. A surplus note qualified under SSAP No. 41R is typically treated as surplus for the issuing entity. The Subgroup sent a referral to the Capital Adequacy Task Force to alert it on the implications of allowing surplus notes issued by captives to be automatically included in total adjusted capital, particularly without an assessment of any “linked” transactions that transfer the consequences of deferral or denial of interest and/or principal payments to unaffiliated third-party investors.