The standards-setting body for America’s insurance regulators has adopted new guidelines that will allow state regulators, or staff at the body, to change the risk calculus for insurance company investments, including collateralized fund obligations and private debt.
Since 2004, under the National Association of Insurance Commissioners guidelines, insurance companies that invested in collateralized fund obligations or similar asset-backed securities have used the NAIC’s “filing exempt” system to save time on paperwork. It has also allowed some of them to take advantage of relatively low, bond-rated, risk-based capital charges. The system requires a security to have a rating from a nationally recognized credit rating company, and then slots the investment into one of 20 categories, each with its own risk charges.
Under new guidance adopted at NAIC’s summer meeting in Chicago Tuesday, either NAIC staff or a state regulator can now ask for a review of an insurer’s filing exempt slot if they think the insurer’s credit rating does not capture the full risk of a given investment. Insurance companies will then have 45 days – with an additional 45 days if they ask for an extension – to make their case that the NAIC designation is proper.
“It is impressive how much the NAIC has taken on board industry concerns in this process”
If staff or a state regulator can show that there are “material” differences – defined as a three-or-more notch difference in the NAIC risk-based capital slot – they can change the investment’s designation. Under the new guidance, insurers can then “appeal” staff decisions to NAIC’s securities valuation task force, which is staffed by state insurance regulators, with a new round of arguments.
The task force’s decisions are final, but insurers can ask to have them reviewed every year. The proceedings are confidential, but NAIC will publish an anonymized summary explaining what happened.
Small changes can have big impacts
The NAIC designation can have a major impact on the attractiveness of potential investments for insurance companies, which are a critical investment base for many securitization asset classes, including the still nascent market for ABS of fund interests.
A filing exempt bond with NAIC designation 1.F (equivalent to a single-A rating) carries a 0.816 percent risk-based capital charge. If the designation was downgraded by three notches to 2.B (equivalent to a triple-B rating), the risk-based capital requirement would increase to 1.523 percent. An equity investment – outside of NAIC’s filing exempt system – carries a 30 percent risk charge.
As the private debt market has exploded in the last few years, NAIC staff and some state insurance regulators have begun to press for some kind of review of the filing exempt process, worried that the system wasn’t capturing the full scope of risk.
NAIC officials say they’ll use their new review powers rarely, but it’s an important tool to help them keep an eye on emerging threats to the insurance industry.
“They sure want to be reading these anonymized summaries to learn what are the things that are going to cause these things to be changed”
The new guidelines do not mention any asset class specifically, but they are clearly driven by staff worry about the uptick in securitizations of either GP or LP private fund interests, and especially private debt fund securitizations. The number of privately rated securities held by insurance companies since 2019 is expected to have tripled by years’ end, NAIC staff said in a staff memo published last year.
Small credit rating firms such as Egan Jones, the Kroll Bond Rating Agency and Morningstar accounted for 86 percent of insurers’ private letter ratings, but a staff review of the NAIC designations that resulted from those ratings found they were nearly three notches better, on average, than NAIC staff designations would have been, the memo claimed.
“Insurance company investment portfolios used to be a lot more boring,” says Larry Hamilton, a partner at Mayer, Brown’s Chicago office.
“And all of a sudden they’ve got these exotic new titles. Insurance companies must list every single investment on their investment schedule. Regulators know what they’re looking at when they see a corporate bond issued by an operating company on the investment schedule. Now they’re seeing these names that aren’t names of operating companies, they’re names that come from some kind of special purpose vehicle that has issued securitization notes. It started to concern insurance regulators generally: What are we looking at here?”
Enforcement criteria yet to come
NAIC’s new review system won’t take effect until at least 2026 and there may still be tweaks to it in the months ahead, says Lindsay Trapp, a partner at Dechert who concentrates her practice on fund formation, specializing in rated funds. Some industry voices, for instance, have called for NAIC to adopt and publish a single methodology for its risk analysis – something that ratings agencies are required to do.
“Ultimately, we’re entering another 18 months where we find the devils in the details,” Trapp says, adding that she’s cheered by how careful NAIC has been in this putting together this new guidance. “It is impressive how much the NAIC has taken on board industry concerns in this process. They haven’t just gone out and said, ‘This is what we’re doing.’”
Debt managers who covet the $8.5 trillion in cash and invested assets held by U.S. insurance companies will want to think carefully about how they structure their funds, Trapp says. The first question will be whether a firm “feels comfortable” that a given fund matches NAIC’s bond definition.
“If it gets reviewed,” she says to ask yourself, “would it stand up?”
Planning ahead
Key follow up questions include how and when the fund will have enough money to pay the underlying notes, Trapp says. A second question – and this is one where a fund may want to have close discussions with investors – is, what happens if NAIC changes the risk slot?
“These are rated securities, you can’t just agree to dispense with a rating at will,” Trapp says.
There is a potential fail-safe for insurance investors who get hit with an unexpectedly higher capital charge. If an investor can’t take on the adjusted capital charge resulting from a change in a bond’s ratings slot, they might be allowed, under a partnership agreement, to transfer the investment to someone who can take on the new charge.
“Insurance company investment portfolios used to be a lot more boring”
“Another thing that may make sense is to have an agreement to review and remove the rating. After that, there may be things like collapsing a structure, converting it to equity interest,” Trapp says.
Mayer Brown’s Hamilton says that, once NAIC overrides a risk designation, firms will want to read the case summary closely.
“They sure want to be reading these anonymized summaries to learn what are the things that are going to cause these things to be changed,” he says. “Study what the characteristics are of the ratings that the NAIC successfully overrode. It’s not completely closing the barn door after the horses have run away, because fund managers can use that information for future structuring. An ounce of prevention is worth a pound of cure.”
