Accounting Standard Updates

SAPWG Conference Call 10/13/2020 – Defining Bonds – SSAP 26 vs SSAP 43R

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Hot Take:

Hot Take

On October 13, 2020, the NAIC Statutory Accounting Principles Working Group (SAPWG) met to address industry and regulator concerns regarding the proper classification of bonds on Schedule D-1 as “Issuer Obligations” versus loan-backed/structured instruments that rely on various underlying characteristics (cash flows from underlying collateral). Specifically, two key items in the recently exposed SSAP 43R issue paper have received the concentrated concern. On the surface, a solution would appear straightforward; however, inconsistencies in the application of definitions within the industry have brought about a complex conceptual discussion to achieve a level playing field in reporting. Furthermore, the inventiveness of institutions in developing investment products that skirt original definitional intent has led to the need to tighten down initial characterizations, affecting reporting classifications in the regulatory investment Schedule D.

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Background – SSAP 43R and SSAP No. 26R – Classification Issues:

In current statutory accounting practice, there are two standards for bonds. SSAP 26R – Bonds typically calls for regular amortized cost, and SSAP 43R – Loan-Backed and Structured Securities represents a modified amortized cost that adjusts for intermittent changes in prepayment assumptions. SSAP 26R covers all bonds, other than the special treatment provisions for those securities that qualify under SSAP 43R behavior. SSAP 43R encompasses all securities issued from a trust or Special Purpose Vehicle (SPV), established by a sponsoring parent obligation. The nature of SSAP 43R contemplates loan-backed/structured securities, and herein lies the issue.

So, what’s the rub?

SSAP 43R securities were originally carved out from SSAP 26R due to the uniqueness of periodic prepayment and extension risk issues. This created the need for special modified accounting techniques to accommodate those varying cash flows. This is an important distinction.

So, let’s first set out some definitions. Issuer obligations encompass securities backed by the credit quality of the operating entity, whereby this credit quality of the issuer has a direct impact on payment (SSAP 26R). This definition captures the majority of fixed income securities reported on Schedule D-1. A loan-backed or structured investment vehicle is reliant upon the pass-through of collateral cash flows from the underlying collateral and through the SPV (SSAP 43R).

There are securities being issued via trust or SPV vehicles that do not have prepayment or extension risk, and a number of industry constituents believe these securities are clearly within the scope of SSAP 26R rather than SSAP 43R. Interested parties hold the position that the cash flow patterns (i.e. prepayments) should be the distinguishing factor, not the fact that the security was issued via a trust or SPV. This latter point is highly important as it appears to have been a primary driving factor for qualification under SSAP 43R under the original 2009 NAIC interpretations when the revisions were adopted. Interested parties question why the presence of a trust or SPV should have anything to do with determining the accounting arrangement. The two terms (trust/SPV) can be ambiguous, to say the least. Couple this with the creativity of product design in the financial realm, and the use of these terms as primary classification determinants becomes highly questionable. Interested parties do, however, desire to keep the cash flow patterns as distinguishing keys in the final classification determinants.

Parting Comments:

SAPWG determined that the current definition of bonds for Schedule D reporting is too broad in light of the variety of vehicles now in the marketplace. Under the current definition, it was noted the possibility clearly exists for an insurer to acquire any asset through a debt-issuing trust or SPV and report it as a Schedule D-1 bond, even if that asset would be otherwise inadmissible if held directly, and even if there is no economic substance to the trust.

The second step of the SAPWG discussion involves formally defining an asset-backed security (ABS) that qualifies for Schedule D-1 reporting. NAIC staff recommended utilizing a principle-based approach to defining an ABS, rather than attempting to coordinate formal definitions incorporated by the Securities and Exchange Acts of 1933 and 1934 as updated by recent amendments.

SAPWG voted to expose the issues above to further comment with a response due date of December 4, 2020.