The Principles-Based Bond Project — which originally appeared on the National Association of Insurance Commissioners (NAIC) 2019 agenda topics — was finalized on March 16, 2024, and will take effect on Jan. 1, 2025. The project began in response to evolving types of investments and investing strategies being adopted in insurers’ portfolios and aimed to increase transparency into investment securities for regulators and other financial statement users. Now that it’s finalized, the new guidance represents a significant revision to Statement of Statutory Accounting Principles (SSAP) No. 26R, Bonds, No. 43R, Asset-Back Securities, and No. 21R, Other Admitted Assets. Given the potential magnitude of the impacts, insurance companies should make sure they fully understand the new principles-based method of bond definition and prepare early.
The new definition of a bond
Under the new guidance, a bond is now defined as “any security representing a creditor relationship, whereby there’s a fixed schedule for one or more future payments, and which qualifies as either an issuer credit obligation or an asset-backed security.” A key point to note: If the security possesses “equity-like characteristics” or represents an ownership interest, it’s not a creditor relationship. The revised SSAP No. 26 paragraphs 6.a. – 6.d. describe the specific elements of equity-like securities.
The analysis
Based on this definition of a bond, insurance companies now need to analyze securities to determine whether a creditor relationship exists. To accomplish this, insurers must evaluate the security’s substance rather than focus solely on the name or legal form of the instrument. This analysis should also consider all other investments the reporting entity owns in the investee, as well as any other contractual agreements, to verify the existence of a creditor relationship.
Adding further complexity, the SSAP now defines two subsets of bonds:
Issuer credit obligations
Issuer credit obligations, which are defined as follows: “A bond, for which the general creditworthiness of an operating entity or entities through direct or indirect recourse, is the primary source of repayment.”
Examples include:
- U.S. Treasury securities, including U.S. Treasury inflation-indexed securities (TIIS).
- U.S. government agency securities.
- Corporate bonds issued by operating entities, including Yankee bonds and zero-coupon bonds.
Asset-backed securities
Asset-backed securities, which are defined as “bonds issued by an entity — an asset-backed security (ABS) issuer — created for the primary purpose of raising debt capital backed by financial assets or cash generating nonfinancial assets owned by the ABS issuer, for which the primary source of repayment is derived from the cash flows associated with the underlying defined collateral rather than the cash flows of an operating entity.”
Paragraphs 9 and 10 of the revised SSAP 26 detail the two key defining characteristics that must be present for a security to meet the definition of an asset-backed security:
- The assets owned by the ABS issuer are either financial assets or cash-generating nonfinancial assets that provide a meaningful level of cash flows toward repayment of the bond.
- The holder of the debt instrument issued by an ABS issuer is in a different economic position than they would otherwise be if the holder owned the ABS issuer’s assets directly.
Examples include:
- Residential mortgage-backed securities.
- Commercial mortgage-backed securities.
- Collateralized loan obligations.
Under the new definition, some securities previously reported as a bond on Schedule D Part 1 might no longer meet the definition of a bond. These securities will now fall under SSAP No. 21, Other Admitted Assets. These securities are split into three subcategories:
- Debt securities that don’t reflect a creditor relationship in substance.
- Debt securities that don’t qualify for bond reporting due to a lack of substantive credit enhancement.
- Debt securities that don’t qualify for bond reporting due solely to a lack of meaningful cash flows.
The accounting and measurement method for the bonds and debt securities are dependent on the category in which they belong.
The impact on insurers
Unpacking the new definitions and applying them to the securities portfolio is a significant undertaking. The SSAP updates resulting from the bond project impacts how insurers will summarize and disclose data to regulators, which will impact annual statement filings in several ways:
- Breaking out Schedule D – Part 1 into two sections (as discussed above).
- Modifications to Schedule BA to include new subcategories for debt securities that don’t qualify as bonds.
- Reclassifying securities to appropriate reporting locations based on the new definition of a bond.
Other factors to consider from these changes are the potential impacts on risk-based capital (RBC) calculations, asset valuation reserve, and admissibility considerations (depending on the investment).
Tips for a successful transition
Bond redefinition is a major undertaking, the scope of which won’t be entirely known until you begin the process. The following tips will help you prepare for a smooth transition.
- Start now: The classification process might take more time than you initially think. Depending on the type and quantity of investments held, research and data gathering might be required. The new definitions might require cash flow information that hasn’t historically been obtained or assessed. There may also be downstream impacts such as changes to RBC thresholds that require business modifications and additional time to resolve.
- Understand your staffing requirements: Don’t assume your investment manager will perform the analysis for you. Work with your investment manager or investment department to determine and secure the resources you’ll need.
- Segment your portfolio: Start with a high-level segmentation of your investments and group them in pools to assess. Separate out the obvious ones, such as Treasury securities that don’t require individual examination, or basic securities where you can assess one and all the others follow suit.
- Review the more challenging securities: Once the more subjective securities are identified, gather contracts, legal documents, and cash flow information to determine the appropriate classification. Investments designed and marketed to insurance companies to obtain favorable RBC treatment should be closely evaluated.
- Document your results: Establish supporting processes and resources to back up and document your choices so regulators and auditors can review your work.
Proactive and thorough planning is key
The bond classification process will require proactive planning and implementation of new processes. In most cases, solely relying on an investment manager or other third party won’t be sufficient — you’ll need to dedicate resources to review and validate the results of any external review. As you implement this change and perform the initial classification, think ahead to your process for categorizing acquired securities in future reporting periods. Significant changes to regulatory filings, such as this, require proper planning and execution. If your organization hasn’t kicked off the process, now is the time.
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