US Insurance Regulators Ask: What Is A ‘Bond'? – Insurance Laws and Products & More Latest News Here – Up Jobs

Regulation of insurance company solvency is a key pillar of
insurance law worldwide, and in the United States no less than
elsewhere. In the US’s state-based regulatory system,
regulators have a number of tools designed to enable them to
monitor the financial condition of insurers. Two of these are
statutory accounting and risk-based capital (RBC), both of which
are related. Important developments in these areas could affect the
way in which insurer’s account for complicated financial
instruments in their portfolios and could consequently alter the
market for such institutional products.

Insurers in the US are required to maintain their accounts using
Statutory Accounting Principles (SAP) rather than more common
systems such as United States Generally Accepted Accounting
Principles (US GAAP) or International Financial Reporting Standards
(IFRS). Of course, many insurers and their holding companies also
maintain US GAAP or IFRS accounts, in addition to SAP, for
investor, rating agency or securities-law purposes. SAP is
published by the National Association of Insurance Commissioners
(NAIC), the principal standard-setting body for the 56 state and
territorial insurance regulators, and tends to emphasise an
insurer’s surplus at a given point in time. By contrast, US
GAAP and IFRS can be considered more income-statement oriented.

Historically, SAP pronouncements have governed how a bond or
asset-backed security (ABS) in an insurer’s portfolio would
be recorded, accounted for and disclosed to regulators. Accounting
treatment, in turn, would generally dictate treatment under the
second of these two regimes, the RBC framework. RBC requires each
US insurer annually to calculate a customised, unique amount of
capital that it is required to hold based on its particular risk
profile, taking into account investment, underwriting, corporate
and other risks. The results of the calculations (the amount of
required capital, amount of actual capital held and resulting
ratios) are then submitted to the NAIC and state regulators.

The investment risk prong of RBC ascribes a level of risk to
each asset held in the portfolio and requires the insurer to hold a
certain amount of redundant capital against that asset. As a
general rule, debt securities require less additional capital than
equity, as debt securities are considered less risky, all else
being equal. In fact, the greater capital charge associated with
equity securities is considered substantial and makes equity
securities generally unattractive to insurers.

Some ABS are based on non-debt instruments, such as
collateralised fund obligations (CFOs), which are ABS secured by
positions in private equity funds. These positions are memorialised
as limited partner or limited liability company units and
constitute equity instruments. In 2019 staff of the NAIC’s
Statutory Accounting Principles Working Group (SAPWG) expressed
concern with respect to insurance company CFOs, which the NAIC
perceived could be an abusive way of converting a position in
equity securities, carrying a high capital charge (the fund
positions), into rated notes that bear a much lower charge (the
resulting ABS). The NAIC indicated that it was prepared to
re-classify categorically all CFOs as equity securities because of
the equity nature of the underlying cash flows.

After extensive consultation with interested parties, the NAIC
backed away from this categorical position and agreed in principle
to consider CFOs on a case-by-case basis. If a CFO had
characteristics traditionally associated with a debt security (eg,
scheduled payments of principal and interest, events of default,
remedies), it would be possible for a CFO to attain debt status for
RBC purposes. Over the period 2020-2021, and continuing to the
present day, this effort by the NAIC to examine CFOs has expanded
to consider the characteristics of bonds more generally. In what is
now known as the ‘bond definition project’, the NAIC
has been working with interested parties to identify criteria which
would be used to determine if any investment – not just an
equity-backed ABS – should be characterised a debt or
equity.

This SAPWG project has crystallised into a draft paper (Proposed
Definition), the latest version of which was released in March 2022
for public review and comment by interested parties. (In a call
with interested parties in July 2022, SAPWG recommended revisions
to the guidance concerning three items: (1) classifying US
inflation-indexed Treasury notes under the bond definition, (2)
clarifying that first loss ‘tranche’ refers to
‘position’ and (3) addressing ‘feeder
funds’.) In the remainder of this article, we explain some of
the key points of the Proposed Definition, which is accompanied by
an extensive proposed SAP interpretive paper.

Under the Proposed Definition, a bond is 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.

The Proposed Definition adopts the GAAP definition of security,
namely, a share, participation or other interest or obligation
that: (1) is either in bearer or in registered form; (2) is of a
type commonly dealt in on securities exchanges; and (3) is one of a
class or series or divisible into classes or series.

Whether a transaction represents a creditor relationship
requires a subjective, substance-over-form analysis and must take
into account the other investments the insurer owns. An equity-like
instrument is not a creditor relationship.

The two types of bonds under the Proposed Definition are issuer
creditor obligations and ABS. An issuer credit obligation is a
bond, to which repayment is ‘supported primarily by the
creditworthiness of an operating entity.’ It also consists of
direct or indirect recourse to the issuer. An ABS issuer cannot be
an entity supporting an issuer credit obligation.

Two factors must be present for a security to be classified as
an ABS: (1) the assets owned by the ABS issuer are either financial
assets or cash-generating non-financial assets; (2) the holder is
in a different economic position as compared with owning the ABS
issuer’s assets directly.

A financial asset is cash, evidence of an ownership interest in
an entity or a contract that conveys a right to receive cash or
another financial instrument or to exchange other financial
instruments on potentially favourable terms. Cash-generating
non-financial assets are assets that are expected to generate a
meaningful level of cash flows toward repayment from sources
other than the sale or refinancing of the underlying
collateral. Such sources may include licensing, use, leasing,
servicing or management fees, or other similar cash flows.
Meaningful cash flows are deemed to exist where the contractual
cash flows of a non-financial asset service more than 50 per cent
of the original principal.

The holder of a debt instrument is in a different economic
position if such debt instrument benefits from substantive credit
enhancement through guarantees (or other similar forms of
recourse), subordination and/or overcollateralization. The purpose
of this requirement is to distinguish qualifying bonds from
instruments with equity-like characteristics. In instances where
the assets owned by the ABS issuer are equity interests, the debt
instrument must have predetermined principal and interest payments
(fixed or variable) with contractual amounts that do not vary based
on the appreciation or depreciation of the equity interests.
Substantive credit enhancements absorb losses before they are
passed to the debt instrument itself. Without such enhancements,
the substance of the debt instrument would be more closely aligned
with that of the underlying collateral than that of a bond. The
substantive credit enhancement required to put the holder in a
‘different economic position’ is specific to each
transaction, determined at origination, and refers to the level of
credit enhancement that a market participant would conclude is
substantive.

An issuer might appear to be an ABS issuer but in fact is an
operating entity, such as an entity that operates a single asset
(eg, a toll road or a power generation facility), which serves to
collateralise a debt issuance. Because such an asset would
constitute a standalone business, it is properly classified as an
operating entity.

In addition, the Proposed Definition provides examples of
securities that, despite their legal form, do not represent
creditor relationships in substance. In one of these, the issuing
SPV owns a ‘portfolio’ of equities. This creates a
‘rebuttable presumption’ that it is not a
bond, insofar as repayment of the security might be dependent on
non-contractual cash flow distributions and/or may not be
controlled by the issuer. In some instances, sale or refinancing of
the underlying equity interests may be the only means of generating
cash flows to service the debt instruments. However, this
presumption may be overcome if the characteristics of the
underlying equity interests lend themselves to the production of
predictable cash flows, and the underlying equity risks have been
sufficiently redistributed through the capital structure of the
issuer.

In other words, an instrument’s reliance on sale of
underlying equity interests or refinancing at maturity does not
preclude it from qualifying as a bond. However, it does require
that the other characteristics mitigate the inherent reliance on
equity valuation risk to support the transformation to bond risk.
An instrument collateralised by fewer, less-diversified equity
interests would require more extensive and persuasive documented
analysis than one collateralised by a larger diversified portfolio
of equity interests. Likewise, a debt instrument that has been
successfully marketed to unrelated and/or non-insurance company
investors may be more favourably treated than others.

An example given for ABS in the Proposed Definition involves an
instrument issued by an SPV that owns equipment which is leased to
an equipment operator. The equipment operator makes lease payments
to the SPV, which are passed through to service the SPV’s
debt obligation. While the debt is outstanding, the equipment and
lease are held in trust and pledged as collateral for the
debtholders. Should a default occur, the debtholders can foreclose
on and liquidate the equipment as well as submit an unsecured lease
claim in the lessee’s bankruptcy for any defaulted lease
payments.

The loan-to-value (LTV) at origination is 70 per cent. Payments
under the lease are expected to cover debt service on the
SPV’s obligation, but a balloon payment on maturity is not
matched by a similar balloon payment under the lease. Therefore,
the SPV will need to either refinance the debt or sell the
underlying equipment to service the final balloon payment. At the
same time, the equipment is expected to have a more-or-less
predictable market value such that the equipment could be
liquidated over a reasonable period of time, if necessary. LTV
falls to 40 per cent as a result of the principal amortisation, the
balloon payment and the value of the equipment.

This is treated as an ABS insofar as the equipment is a cash
generating non-financial asset expected to generate a meaningful
level of cash flows for the repayment of the bonds via the existing
lease that covers all interest payments and at least 50 per cent of
the principal payments. The cash flows are contractually fixed for
the life of the debt instrument. The cash flows needed to service
the obligation are recoverable by sale or refinancing.

The structure also provides substantive credit enhancement in
the form of overcollateralization, supporting the conclusion that
investors are in a different economic position as compared with
holding the equipment directly. In reaching this conclusion, the
example notes that the hypothetical debt instrument starts with a
70 per cent LTV, which continues to improve over the life of the
debt as the loan balance amortises more quickly than the expected
economic depreciation on the underlying equipment. Because of the
predictable nature of the cash flows and collateral value range
over time, this would be considered a level of
overcollateralization sufficient to put the investor in a
substantively different economic position as compared to if owning
the underlying equipment directly.

Originally published by International Bar
Association

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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