Draft - Exposed for Comment Until Feb. 24, 2017

Draft - Exposed for Comment until Feb. 24, 2017

TO:Kevin Fry (IL), Chair, Investment Risk-Based Capital (E) Working Group

FROM: Dale Bruggeman (OH), Chair, Statutory Accounting Principles (E) Working Group

DATE:December 21, 2016

RE: Referral Regarding Increased Granularity in the Life RBC Formula

The Investment Risk-Based Capital (E) Working Group October 31, 2016 referral to the Statutory Accounting Principles (E) Working Group provided information on the proposed revisions to expand RBC categories for bonds. This referral identified that the proposed changes to bond granularity are not anticipated to have any impact on the Accounting Practices and Procedures Manual, but requested the Statutory Accounting Principles (E) Working Group review the proposal and provide confirmation. This memorandum has been drafted to respond to the IRBC referral.

Key Excerpts from IRBC Referral:

The life bond structure has been discussed by the Working Group on several occasions, and there is a general consensus that the number of RBC categories for bonds should be expanded from the current six categories (plus the exempt category) to 20categories (plus exempt.) The current RBC factors are based on the NAIC designations. The expansion would provide more robust and accurate results, primarily as it increases the granularity of the formula and reduces the “cliffs” between the different factors for the different NAIC designations. That is, an insurer may have an incentive to invest in lower-quality bonds within the same NAIC designation category and get the same RBC charge as a higher-quality bond within the same NAIC designation category.

The expansion to the 20 categories (plus exempt) would be accomplished by including a new electronic-only column in Schedule D. The Academy’s report suggests that these categories be based on the bond’s credit rating from a nationally recognized statistical rating organization (NRSRO). The electronic-only column would be used to accumulate bonds into the 20 bond categories for inclusion in the asset valuation reserve (AVR) default worksheet, and AVR would be calculated based on the new expanded categories. The bond amounts in the AVR default worksheet would be used to populate the information for bonds in the life RBC formula.

The current six NAIC designation categories would continue to be used for accounting and reporting purposes, as well as for state investment law purposes. The Working Group is not proposing any changes in the structure for other assets that received the bond treatment (e.g., Schedule BA) but may consider changes to these investments in the future. Regarding securities valued under Statement of Statutory Accounting Principles (SSAP) No.43R—Loan-Backed and Structured Securities, the breakpoints for both modeled and non-modeled securities would need to be updated to use the 20-category framework.

SAPWG Referral Response

The SAPWG agrees that the current IRBC proposal will not impact the measurement guidance in the Accounting Practices and Procedures Manual asthe current NAIC 1-6 designations will continue to be used for all measurement determinants (e.g., amortized cost or fair value) throughout the SSAPs. With the inclusion of this IRBC proposal, existing statutory accounting guidance thatutilizes NAIC designations to determine measurement methodwill not be impacted. Furthermore, reporting schedules that provide aggregations based on NAIC designation (such as Schedule D-Part 1) will not be impacted from this change. The SAPWG agrees that the retention of the existing guidance and reporting schedules, coupled with the expanded bond categories, will allow regulators to continue past practices for reporting entity assessments and comparisons, but also provide additional information regarding investment quality.

As identified by the IRBC, the guidance in SSAP No. 43R incorporates a “financial modeling” approach, which adjusts the “initial” NAIC designation to the “final” NAIC designation for statutory and accounting reporting purposes. One of the key reasons for incorporating this guidance was to properly determine RBC charges based on the risk of future loss of these investments. With the IRBC proposal, and the expansion of categories for RBC, consideration will need to occur on whether the financial modeling process should be retained, or if it should be modified to encompass the 20 categories detailed in the proposal. The SAPWG agrees that the impact to SSAP No. 43R will need to be considered, but as the financial modeling process is primarily driven by the work of the NAIC Structured Securities Group (SSG), recommends that the IRBC also consult with the SSG on this issue.

As an additional element, the SAPWG identifies that not all Schedule D investments are allowed to use aCRP rating as the basis for an NAIC designation. An investment must qualify to be “filing exempt” (FE) under the Purposes and Procedures Manual of the NAIC Investment Analysis Office in order for aCRP rating to be used as the basis for an NAIC designation. Although this process is specified by the Valuation of Securities (E) Task Force, improper use of “FE” has recently been identified by the SAPWG when reviewing specific investments and efforts have been taken to educate regulators and industry to reduce these occurrences. If NRSRO[1] ratings are permitted for RBC purposes, but NAIC designations are still required (investment does not qualify as FE), the SAPWG is concerned that improper use of “FE” ratings will increase. To mitigate improper use of NRSRO ratings, the SAPWG would recommend that the IRBC, perhaps in conjunction with the Valuation of Securities (E) Task Force, provide clear instruction on what should be used for RBC purposes for the following scenarios:

Investment is not permitted to use aCRP rating to determine NAIC designation (e.g., SVO-Identified bond ETF), but a CRP rating is acquired by the company. In this situation, would the reporting entity be allowed to use the CRP rating for RBC purposes, or would the NAIC designation acquired from the SVO be used for RBC purposes? If the NAIC designation is used, how would it be converted to the expanded RBC categories?

Investment is not permitted to use a CRP rating to determine NAIC designation, and reporting entity has not acquired a CRP rating for an investment. In this situation, would the NAIC designation acquired from the SVO be used for RBC purposes? How would it be converted to the expanded RBC categories?

The IRBC proposal specifically references use of NRSROs, however, if an NRSRO is not approved as a CRP (see footnote 1), would the NRSRO credit rating be permitted for RBC purposes?

Pursuant to the Statutory Accounting concept of Consistency, the SAPWG would recommend guidance ensuring that identical securities held by similar types of insurers (life, p/c, etc.,) are reported with the same RBC charge.(For example, all life companies holding the same CUSIP would incur the same RBC charge.) With this concept, the SAPWG recognizes that if a CRP rating for a security is not available to all reporting entities that own the security (such as in the case of an investment that is not permitted to be reported as FE, or if issued as a private-letter rating acquired by the single reporting entity), the CRP rating may not produce the most consistent determination of RBC.

Thank you for inquiring with the SAPWG when considering the RBC expansion proposal. Please contact Julie Gann (SAPWG staff), if you have any questions on this referral response.

Cc: Julie Gann/Robin Marcotte/ /Fatima Sediqzad/Julie Garber

[1] An NRSRO (Nationally Recognized Statistical Rating Organization) is a credit rating agency (CRA) that issues credit ratings that the U.S. SEC permits other financial firms to use for certain regulatory purposes. A CRP (Credit Rating Provider) is an NRSRO that has been approved for use by the Valuation of Securities (E) Task Force.