US insurance regulators ask: What is a ‘bond’?

Dan Rabinowitz
Kramer Levin Naftalis & Frankel, New York
drabinowitz@kramerlevin.com

Matthew Doyle
Kramer Levin Naftalis & Frankel, New York
mdoyle@kramerlevin.com

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.