Background
Originally introduced at the Summer 2019 National Association of Insurance Commissioners (NAIC) meeting, the SSAP 26R principles-based bonds definition project (Bond Project) represents a significant shift in the classification and valuation of bond investments within the insurance industry. The project, initiated by the Statutory Accounting Principles Working Group (SAPWC), looks to provide a principles-based framework around the definition of a bond and enhanced clarity and consistency of bond reporting. The effective date of the updated guidance is January 1, 2025.
Classification of balances and transactions within the NAIC Statutory Annual Statement schedules are critical inputs to the NAIC Risk-Based Capital (RBC) model, which dictates the capital requirements of insurance entities. Due to the recent periods of prolonged low interest rates, some insurance carriers and the investment community developed investment vehicles that included both debt- and equity-like features to create more yield while still meeting the legacy classification requirements of a bond. As Schedule D (Bonds) assets carry a lower RBC charge than Schedule BA (other invested assets), the ability to classify these investments as bonds on Schedule D provided the added benefit of avoiding higher RBC charges, which also positively impacted other metrics critical to key stakeholders of an entity.
The Bond Project was initially created to prevent the structuring of investments with equity-like features into debt investments for NAIC annual statement reporting (originally centered around collateralized fund obligations (CFO) investments) through the implementation of a principles-based bond definition. However, the project subsequently developed into a more comprehensive review of investments made by insurers.
Principles-Based Bond Definition
“A bond shall be defined as any security representing a creditor relationship, whereby there is a fixed schedule for one or more future payments, and which qualifies as either an issuer credit obligation or an asset backed security.
Determining whether a security represents a creditor relationship should consider its substance, rather than solely the legal form of the instrument. The analysis of whether a security represents a creditor relationship should consider all other investments the reporting entity owns in the investee as well as any other contractual arrangements. A security that in substance possess equity-like characteristics or represents an ownership interest in the issuer does not represent a creditor relationship” – Source: SSAP 26R Paragraph 5
The new bond standard outlines three requirements that must be met to be classified as a bond:
- The instrument must be a security.
- The instrument must have a fixed schedule for one or more future payments.
- The instrument must qualify as either an:
- Issuer credit obligation (ICO)
- Asset-backed security (ABS)
If a security previously identified as a bond does not meet the new principles-based bond definition, it will need to be reclassified from the Schedule D to Schedule BA. An example of an asset previously classified as a bond that may no longer meet the classification requirements of a bond under the new guidance could include collateralized fund obligations, or CFOs, which would now follow guidance maintained in SSAP 21R, Other Admitted Assets, and be included in Schedule BA.
ICO Versus ABS Classification
The Bond Project also calls for the breakout of the Schedule D Part 1 into a Section 1 (ICO), and Section 2 (ABS). As such, reporting entities will need to perform an assessment to determine whether the instrument is classified as an ICO, ABS, or neither.
ICO
In general, ICOs are issued by operating entities with repayment primarily funded through the creditworthiness and income of an operating entity. These securities typically provide the holder either direct or indirect recourse against the issuing operating entity. Finally, the issuer of an ICO is expected to continue functioning beyond the final maturity of the debt, and all returns from the bond instrument in excess of the principal are required to be recognized as interest. Some common examples of ICOs include corporate bonds, U.S. treasuries, and municipal securities.
ABS
ABSs are typically issued by entities with the primary purpose of raising debt capital backed by collateral that provides cash flows to service the debt. These instruments are typically not expected to continue functioning beyond the final maturity of the debt initially raised by the ABS issuer. It is common for an ABS to be issued by a special purpose vehicle (SPV), but the presence or absence of an SPV does not determine the instrument’s classification.
Under the Bond Project, an ABS must meet the following criteria:
- The ABS must provide the security holder with substantive credit enhancement. Substantive credit enhancements are features or structures of the security that put the holder in a different economic position than if they held the underlying assets of the security directly. Common substantive enhancements include over-collateralization and subordination.
- The underlying assets held by the ABS must provide a meaningful level of cash flows toward repayment of the bond. While the concept of “meaningful level of cash flows” requires judgment, the NAIC has provided a practical expedient to assist entities in this determination. The practical expedient stipulates if less than 50% of the original principal of the instrument relies on the sale or refinancing of the underlying assets, the instrument meets the meaningful level of cash flows requirement. Otherwise, reporting entities must perform additional analysis and apply judgment to support their assertion.
Reporting & Additional Impacts
The Bond Project provides prescriptive guidance for reclassifying Schedule D assets that no longer meet the definition of a bond to other appropriate schedules such as Schedule BA. In general, the transition from Schedule D to Schedule BA will be at an amortized cost. For assets previously reported at fair value in Schedule D as of December 31, 2024, the entity will be required to reverse any unrealized adjustments on January 1, 2025 and dispose of the asset from Schedule D. There is no recognized gain or loss on the disposal of the asset from Schedule D. For Schedule BA acquisition, the asset will be reported at amortized cost, and then adjusted for correct Schedule BA valuation, which could result in unrealized losses (but should never have unrealized gains that result with a book adjusted carrying value exceeding amortized cost) as part of the transition. The process of derecognizing the instrument from Schedule D as a disposal and recognizing it as an acquisition on Schedule BA will help ensure the schedules appropriately roll from period to period.
Adoption Considerations
Effective January 1, 2025, insurers should begin reviewing their current Schedule D holdings and perform necessary assessments to report appropriately for both 2025 quarterly and annual statements. Companies should consider the data requirements necessary for evaluating Schedule D securities, as well as the time it will take to appropriately assess classification under the bond standard based on the nature and complexity of their holdings. Insurers that identify changes to classification between Schedule D and Schedule BA under the Bond Project should consider current and projected RBC impacts, as well as their future investment strategy to proactively avoid potential RBC issues.