Home Accounting principles Statutory Accounting Principles Working Group (E) to Develop SSAP Revisions Incorporating Definition of Principal-Based Obligations | Eversheds Sutherland (United States) LLP

Statutory Accounting Principles Working Group (E) to Develop SSAP Revisions Incorporating Definition of Principal-Based Obligations | Eversheds Sutherland (United States) LLP

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On August 26, 2021, the Statutory Accounting Principles Working Group (E) (SAP working group) of the National Association of Insurance Commissioners (NAIC) asked a new ’43R Study Group’ to continue work on a proposed principled obligation definition released on May 20, 2021 (Definition of proposed obligation). This group is responsible for proposing revisions to the Statement of statutory accounting principles (SSAP) # 26R and SSAP # 43R to incorporate the principles-based approach of the proposed obligation definition. The proposed definition of obligation is part of a project whose objective is to clarify what should be considered an obligation and Annex D-1: Long-term obligations. The project could result in significant changes to the current reporting categories in Schedule D-1, potentially excluding from the treatment of Schedule D-1 certain investments currently reported on Schedule D-1.

Investments eligible for treatment as bonds in Annex D-1 of an insurer’s statutory financial statements require a lower amount of risk capital (RBC) than equity instruments that are classified as assets in Annex BA. In addition, certain investments eligible for the treatment of obligations in Schedule D-1 may be eligible for valuation at amortized cost.

The SAPWG agreed that the next steps of the project will be as follows:

  • the development of a concept paper and the proposed revisions of the SSAP to incorporate the principle-based approach of the proposed definition of obligation,
  • development of statutory accounting principles (SAP) guidelines which specifically detail the accounting and reporting requirements for investments which are currently allowed to be classified as Annex D-1 investments and which are to be reclassified under these SAP guidelines and
  • development of more detailed reports on Annex D-1, which should result in significant changes to the current reporting categories in Annex D-1. For example, equity-backed bonds should be separately identifiable.

The first effective date of the proposed SSAP revisions is expected to be January 1, 2024. Until the adoption and entry into force of the revised guidelines, reporting entities may continue to report as they have been for investments currently within the scope of SSAP n ° 26R — Bonds Where SSAP n ° 43R – Loan-backed and structured securities.

During the SAPWG meeting, Julie Gann of the NAIC and Kevin Clark of the Iowa Division of Insurance indicated that there would be no “total grandfather” of the existing structures. They recognized that there will need to be a practical review of how the transition to the principled approach will happen.

Ms Gann also indicated that the SAPWG may proceed with a separate project to require, by January 1, 2024, consistent reporting by insurers of capital tranches of securitizations, including CLO capital tranches. It is expected that CLO equity and other equity tranches will need to be reported in Annex BA.

SAPWG Chairman Dale Bruggeman (OH) stressed the need for continued collaboration with the Securities Valuation Working Group and the Capital Adequacy Working Group as the project progresses. References to these working groups may be required with respect to credit quality / ratings and NAIC and RBC designations, respectively.

The remainder of this alert summarizes potential issues raised under the proposed bond definition with respect to “stapled investments” and debt securities backed by fund bonds (Debt of the chief financial officer), what questions should be addressed by the 43R Study Group.

  1. Stapled investments

The proposed bond definition addresses the following scenario involving a core investment: an insurer invests in a private equity fund under circumstances in which each fund investor is required to make 75% of its investment in debt and 25 % in the form of a share capital. According to the proposed definition of bond, if the debt is to be purchased with a proportional share of a stake in the fund and there is a restriction on the sale, disposal or transfer of the investment of the debt without also sell, cede or transfer the interest on a pro rata basis to the same party, the debt investment would not be classified as a Schedule D-1 obligation. The justification put forward for this conclusion is that the investor is in the same economic situation as if he held his entire investment in the form of a participation in the private equity fund. While “the debt investment would have legal priority of payment over the participation, the two interests must be contractually held in the same proportion by the reporting entity and cannot be sold, assigned or transferred independently, which does not give the priority that the reporting entity of payment over itself.

Working group members who participated in the August 26, 2021 call clarified that the treatment of stapled investments in the proposed bond definition could be changed following further discussion by the 43R Study Group. Study Group 43R will discuss the reasons why stapling exists to ensure that the treatment of stapled investments by the proposed bond definition will not have unintended consequences.

The 43R Study Group is expected to consider several issues relating to the treatment of investments stapled by the proposed bond definition:

  • What will be the statutory accounting and reporting and RBC processing of the portion of a stapled investment that is legal form debt?
  • Would such a portion of the debt be classified as a Schedule D-1 investment if the debt is not required to be purchased with a pro rata share of a stake in the private equity fund or if the debt is stapling is temporary?
  • Would the portion of the debt be classified as a Schedule D-1 obligation if the consent of a general partner, which should not be unreasonably withheld, is required for the sale, assignment or transfer of the business? investment of the insurer?

Debt of the CFO (see Annex I, example 3 of the proposed definition of obligation)

The insurance industry has raised several questions about the treatment of CFO debt in the proposed definition of obligation. According to the proposed definition of bonds, “debt securities guaranteed by equity [e.g., CFO debt] depend on distributions which are not contractually required and are not controlled by the issuer of the debt. Accordingly, there is a rebuttable presumption that a debt instrument secured by equity interests does not represent a creditor relationship in substance. In addition, the proposed definition of obligation would exclude CFO debt from Schedule D-1 if the CFO “relies significantly on the ability to refinance or sell the underlying holdings at maturity” .

[A] debt instrument the repayment of which depends significantly on the ability to refinance or sell the underlying holdings at maturity subjects the holder to a risk of valuation of the shares at a given point in time which is characteristic of the substance of the a relationship with shareholders rather than a relationship with creditors. Therefore, such an invocation would prevent the rebuttable presumption from being overcome.

A group of insurance industry stakeholders submitted a comment letter on the proposed definition of obligation that objected to excluding CFO debt from Schedule D-1 if debt repayment of the CFO depended significantly on the ability to refinance or sell the underlying collateral. . Interested parties pointed out that the phrase “significantly rests” can be interpreted to mean that only about 10% to 20% of such repayment is allowed from refinancing or the sale of collateral and they have done so. note that a failure of a CFO debt instrument to meet this test does not make the CFO classifiable as debt securities. Stakeholders support the elimination of the materiality rule in favor of an approach that assesses whether CFO debt qualifies for Schedule D-1 listing based on several factors, such as the diversification and characteristics of the underlying collateral, the amount of overcollateralisation and the presence of a liquidity facility intended to ensure payment of principal and contractual interest.

During the meeting, Mr. Clark noted that there was room for different views on the role of refinancing risk and he welcomed the continued discussions on the issue by regulators and regulators. insurers.

The treatment of CFO debt in the proposed definition of obligation raises several questions that Study Group 43R should consider further, including the following:

  • whether the debt of the CFO guaranteed by a diversified pool of private equity investments can be classified in the bond category of Annex D-1 if the repayment of the debt on the due date is based on refinancing but that CFO debt investors benefit from structural protections such as the following:
    • a maximum loan / value ratio (LTV) limitation which requires a sufficiently high level of overcollateralisation that a reasonable investor would refinance on the expected maturity date,
    • an increase in the coupon if the debt is not repaid on the due date,
    • the sponsor does not receive any cash flow if the LTV limit is exceeded or if the repayment of the CFO’s debt is not made on the due date and
    • a reserve account to cover debt service if necessary.
  • whether the debt of the CFO guaranteed by a diversified pool of private equity investments can be classified as a schedule D-1 obligation if the debt repayment is expected be constituted from the cash flows of the collateral at the expected maturity date and is obligatory to be made at the legal final maturity, provided that investors in CFO debt benefit from structural protections such as:
    • a maximum LTV limit which requires overcollateralisation by an amount intended to ensure that losses on the underlying collateral should not affect the payment of interest and principal
    • an increase in the coupon if the debt is not repaid on the due date,
    • the sponsor does not receive any cash flow if the LTV limit is not met or if the repayment of the CFO’s debt is not made on the due date and
    • a reserve account to cover debt service if necessary.
  • if the debt guaranteed by a diversified pool of large cap stocks can be classified in the bond category of Schedule D-1 if (1) the debt is 10 times oversized, (2) the dividends should cover the payments of interest but not more than 5% of the principal at maturity and (3) investors will decide whether they wish to refinance or sell securities to pay the principal at maturity.

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