Rick Newman, CFA’s Post

Transcript

(upbeat music) - Hello, I'm Tim Antonelli, portfolio manager and the head of insurance multi-asset strategy at Wellington Management. And in our monthly insurance quick take series, we seek to identify emerging issues that exist at the intersection of our insurance clients business and the capital markets. So, a couple months ahead of the go live date of January 1st, 2025, I wanted to take a few moments to discuss the NAIC's Principles-Based Bond Definition Project and what the implications could be for you, our insurance clients. I know US insurers have been spending the last few months, thinking through the operational complexities that are caused by this rollout, how they're going to be classifying individual positions and also what data will be required for ongoing due diligence or reporting. I guess just taking a step back and understanding why the NAIC created this project, it was really in their words, in response to increased innovation in the portfolios of insurance companies. There was a real concern from their perspective that insurance companies were relying too much on the legal construct of what makes a bond and not enough about the substance of the underlying instrument. Said another way, they didn't view it appropriate to have a bond that has non-bond like characteristics, whether it's links to derivatives or links to the equity markets be treated as a bond when it comes to regulatory reporting and risk capital charges. Now, I don't think that there's going to be a major movement of assets from Schedule D bond reporting into schedule BA, other invested assets and I do think the major focus of the regulator has been on the most esoteric of vehicles in things where the insurance company is basically exposed to the underlying risk as if they held the assets directly on their balance sheet. So, what does this mean in terms of the impact? I think there's a couple different things. Number one, insurance companies bear the burden of maintaining the documentation around what their classification decision is. This is documentation that must be maintained to facilitate any sort of request that might occur from their auditors or from the individual state regulator during an examination. At this point, there won't be a feedback loop into a database to make sure the industry is synced up in terms of classification. Again, the burden's going to be with the insurance company themselves. Number two, there's very few bright line tests when it comes to this criteria. There's a meaningful cashflow expedient in which less than 50% of the principle at origination can come from sale or refinancing of the underlying assets. And there's also a test around variable interest adjustments where it must be less than 10% of the total yield for the interest rate adjustment criteria to be permissible. Number three, this in turn means the insurer and by extension, the asset manager needs to establish a view on what they deem to be substantive credit enhancement. So, what level of over-collateralization or what loan to value ratio is appropriate and what the meaningful cash flow tests would be in terms of the ability to service the debt from traditional cash flow sources. Four, based on these determinations, the asset will be either reported in Schedule D part one, which will be issuer credit obligations. Traditionally, like what we've seen in the past and now there's Schedule D, part one, two, that will be for asset backed securities only and come with a whole host of additional reporting requirements that insurance companies need to be prepared to handle. Number five, some structures were explicitly called out by the NAIC as no longer being permissible to be reported as bonds. These include principal protected notes, due to their lack of substantive credit enhancement and their links to non-bond like variable return streams and also structured notes, which now must be treated as derivatives. From a risk capital charge perspective, just because you reclassify a position from Schedule D to Schedule BA, doesn't mean you're going to incur a higher capital charge in the case of US life insurers. In that case, the NAAC specifically has said you should seek a rating from the security valuation office and you could use that rating to calculate your risk capital charge. It's important to note this is not available as of yet for P and C in health insurers. And finally, the implementation of this standard is not going to result in a day one P and L event. They're specifically saying no realized losses are going to be incurred when you reclass the position from Schedule D to Schedule BA. You are also not allowed to generate an unrealized gain as a result of that classification. However, you can generate an unrealized loss when you make that determination. So in my view, the vast majority of positions are likely to be okay and I think you're going to see in addition to the more complex vehicles I referenced earlier, a limited portion of the securitized universe. So, think first loss tranches or unitranche, CMBS, for example, that may move over to Schedule BA. And if you're not a life insurer, it could incur an additional capital charge. But for me, this really re underwrites the case of why an insurance company needs to partner with an asset manager who's focused on the insurance industry and can be a true thought partner here. You shouldn't have to face this change alone. As always, we'll be paying attention to these updates as they unfold and we'll pass along any changes in our views in due course. Thank you. (upbeat music)