Eversheds Sutherland (US) LLP

On August 26, 2021, the Statutory Accounting Principles (E) Working Group (SAPWG) of the National Association of Insurance Commissioners (NAIC) directed a new “43R study group” to continue work on a proposed principles-based bond definition made public on May 20, 2021 (Proposed Bond Definition). This group’s charge is to propose revisions to Statement of Statutory Accounting Principles (SSAP) No. 26R and SSAP No. 43R to incorporate the principles-based approach of the Proposed Bond Definition. The Proposed Bond Definition is part of a project whose aim is to clarify what should be considered a bond and reported on Schedule D-1: Long-Term Bonds. The project might lead to significant changes to the current Schedule D-1 reporting categories, potentially excluding from Schedule D-1 treatment certain investments currently reported on Schedule D-1.

Investments eligible for treatment as bonds on Schedule D-1 to an insurer’s statutory financial statements require a lower amount of risk-based capital (RBC) than do equity instruments that are categorized as Schedule BA assets. Further, certain investments eligible for Schedule D-1 bond treatment may be eligible to be valued at amortized cost.

The SAPWG agreed that the next steps for the project will be:

  • development of an issue paper and proposed SSAP revisions to incorporate the principles-based approach of the Proposed Bond Definition,
  • development of Statutory Accounting Principles (SAP) guidance that specifically details accounting and reporting requirements for investments that are currently permitted to be categorized as Schedule D-1 investments and that must be recategorized under such SAP guidance and
  • development of more granular Schedule D-1 reporting, which is expected to result in significant changes to the current Schedule D-1 reporting categories. For example, equity-backed bonds are expected to be separately identifiable.

The earliest effective date of the proposed SSAP revisions is expected to be January 1, 2024. Until revised guidance is adopted and effective, reporting entities can continue reporting as they have been for investments currently in scope of SSAP No. 26R—Bonds or SSAP No. 43R—Loan-Backed and Structured Securities.

During the SAPWG meeting, the NAIC’s Julie Gann and the Iowa Insurance Division’s Kevin Clark indicated that there would not be “total grandfathering” of existing structures. They acknowledged that there will have to be practical consideration of how the transition to the principles-based approach will occur.

Ms. Gann also indicated that the SAPWG may proceed with a separate project to require, prior to January 1, 2024, consistent reporting by insurers of equity tranches of securitizations, including CLO equity tranches. It is anticipated that CLO equity and other equity tranches will have to be reported on Schedule BA.

The chairman of SAPWG, Dale Bruggeman (OH), emphasized the need for ongoing collaboration with the Valuation of Securities Task Force and the Capital Adequacy Task Force as the project proceeds. Referrals to those task forces may be necessary related to credit quality/ratings and NAIC designations and RBC, respectively.

The rest of this alert summarizes potential issues raised under the Proposed Bond Definition with respect to “stapled investments” and collateralized fund obligation debt instruments (CFO debt), which issues are expected to be addressed by the 43R study group.

  1. Stapled investments

The Proposed Bond Definition addresses the following scenario involving a stapled investment: an insurer invests in a private equity fund in circumstances in which each fund investor is required to make 75% of its investment in the form of debt and 25% in the form of an equity interest. According to the Proposed Bond Definition, if the debt is required to be purchased with a pro rata share of an equity interest in the fund and there is a restriction on selling, assigning, or transferring the debt investment without also selling, assigning, or transferring the pro rata equity interest to the same party, the debt investment would not be categorized as a Schedule D-1 bond. The rationale offered for this conclusion is that the investor is in the same economic position as if it held its entire investment in the form of an equity interest in the private equity fund. While the “debt investment would have legal priority of payment over the equity interest, both interests are contractually required to be held in the same proportion by the reporting entity and cannot be independently sold, assigned, or transferred, which only gives the reporting entity priority of payment over itself.”

The working group members who participated in the August 26, 2021 call clarified that the Proposed Bond Definition’s treatment of stapled investments might be amended as a result of further discussions by the 43R study group. The 43R study group will discuss why stapling exists to make sure that the Proposed Bond Definition’s treatment of stapled investments will not have unforeseen consequences.

The 43R study group is expected to consider several questions relating to the Proposed Bond Definition’s treatment of stapled investments:

  • What will be the statutory accounting and reporting for and the RBC treatment of the portion of a stapled investment that is legal form debt?
  • Would such debt portion be categorized as a Schedule D-1 investment if the debt is not required to be purchased with a pro rata share of an equity interest in the private equity fund or if the stapling is temporary?
  • Would the debt portion be categorized as a Schedule D-1 bond if a general partner’s consent, not unreasonably to be withheld, is required for the sale, assignment, or transfer of the insurer’s investment?

CFO debt (see Appendix I, Example 3 of the Proposed Bond Definition)

The insurance industry has raised several questions about the Proposed Bond Definition’s treatment of CFO debt. According to the Proposed Bond Definition, “debt instruments collateralized by equity interests [e.g., CFO debt] are dependent on distributions that are not contractually required to be made and are not controlled by the issuer of the debt. As a result, there is a rebuttable presumption that a debt instrument collateralized by equity interests does not represent a creditor relationship in substance.” Further, the Proposed Bond Definition would exclude CFO debt from Schedule D-1 if the CFO “relies significantly upon the ability to refinance or sell the underlying equity interests at maturity.”

[A] debt instrument for which repayment relies significantly upon the ability to refinance or sell the underlying equity interests at maturity subjects the holder to a point-in-time equity valuation risk that is characteristic of the substance of an equity holder relationship rather than a creditor relationship. Therefore, such reliance would preclude the rebuttable presumption from being overcome.

A group of interested parties in the insurance industry submitted a comment letter on the Proposed Bond Definition that objected to the exclusion of CFO debt from Schedule D-1 if repayment of the CFO debt relied significantly on the ability to refinance or sell the underlying equity collateral. The interested parties pointed out that the phrase “relies significantly” may be interpreted to mean that only approximately 10%–20% of such repayment is allowed from refinancing or the sale of collateral and they commented that a failure by a CFO debt instrument to meet that test does not make the CFO debt equity-like. The interested parties support eliminating the relies-significantly rule in favor of an approach that evaluates whether the CFO debt qualifies for inclusion on Schedule D-1 on the basis of multiple factors, such as the diversification and characteristics of the underlying collateral, the amount of overcollateralization and the presence of a liquidity facility intended to ensure payment of contractual principal and interest.

During the meeting, Mr. Clark noted that there was room to have different opinions on the role of refinancing risk and he welcomed further discussion of the issue by regulators and insurers.

The Proposed Bond Definition’s treatment of CFO debt raises several questions that the 43R study group is expected to consider further, including the following:

  • whether CFO debt collateralized by a diversified pool of private equity investments can be categorized as a Schedule D-1 bond if repayment of the debt on the expected maturity date relies on refinancing but the CFO debt investors benefit from structural protections such as the following:
    • a maximum loan to value (LTV) limitation that requires a high-enough level of overcollateralization so that a reasonable investor would refinance at the expected maturity date, 
    • a coupon step-up if repayment of the debt is not made on the expected maturity date,
    • the sponsor receives no cash flow if the LTV limitation is breached or the repayment of the CFO debt does not occur on the expected maturity date and
    • a reserve account to cover debt service if necessary.
  • whether CFO debt collateralized by a diversified pool of private equity investments can be categorized as a Schedule D-1 bond if repayment of the debt is expected to be made from the cash flow of the collateral on the expected maturity date and is required to be made on the legal final maturity, provided that CFO debt investors benefit from structural protections such as the following:
    • a maximum LTV limitation that requires overcollateralization in an amount intended to ensure that losses on the underlying collateral would not be expected to affect the payment of interest and principal
    • a coupon step-up if repayment of the debt is not made on the expected maturity date,
    • the sponsor receives no cash flow if the LTV limitation is breached or if repayment of the CFO debt does not occur on the expected maturity date and
    • a reserve account to cover debt service if necessary.
  • whether debt collateralized by a diversified pool of large cap equities can be categorized as a Schedule D-1 bond if (1) the debt is 10x overcollateralized, (2) dividends are expected to cover interest payments but at most only 5% of principal at maturity and (3) investors will decide if they want to refinance or sell securities to pay the principal at maturity.

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