June 2024: Updates on NAIC activities impacting investments

The National Association of Insurance Commissioners (“NAIC”) has been active over the past few weeks, engaging in a variety of initiatives that could impact insurer portfolios and investment strategy. Below are the latest updates.

Residual tranche capital charges adopted for 2024

For 2024, residual tranche capital charges have been established at 45% for Life insurers and 20% for P&C and Health insurers.

The first half of 2024 witnessed an intensive debate among regulators, the industry, and stakeholders, regarding the interim 45% residual capital charge implemented last year, which was due to take effect this year. A study by Oliver Wyman (link) provided some quantitative support for differing risk levels of residuals based on various characteristics such as collateral type and residual thickness. Additionally, a subsequent survey by the American Council of Life Insurers (“ACLI”) (link, p4-9) showed that the majority of residuals held by life insurers were middle-market Collateralized Loan Obligations (“CLOs”) and feeder funds. These new insights led to several comment letters and proposals from both industry and regulators (link), suggesting exemptions for certain residuals from the higher 45% charge based on certain criteria. Ultimately, the Risk Based Capital Investment Risk and Evaluation Working Group (“RBCIRE”) voted to uphold the 45% interim charge from last year, emphasizing that residual capital charges are a component to the broader effort to update capital charges for structured assets currently in progress.

On June 28^th, the Capital Adequacy Task Force decided not to implement the 45% charge for P&C and Health insurers for 2024, citing the lack of comprehensive research and discussion on the charge’s suitability given differences in each industry’s formula. However, the reporting structure will be updated to allow for a distinct capital charge for residuals in the future.

With the capital charges for 2024 now established, we present a comparative analysis on the effective capital charge on residuals for Life, P&C, and Health insurers, taking into account differences in their formulas and typical diversification benefits. Despite the headline charge of 45%, the estimated effective charge for Life insurers is significantly lower at approximately 20% driven by both the conversion to an after-tax basis and a strong diversification benefit from C1cs covariance in the RBC formula. While P&C and Health insurers both face a nominal charge of 20%, the effective charge is much lower for Health insurers, since investment risk in H1 generally receives a large diversification benefit.

Updated proposal for SVO discretion over NAIC designations in filing exempt process

The Valuation of Securities Task Force (“VOSTF”) has put forth a revised proposal that allows the Securities Valuation Office (“SVO”) to override the NAIC designation for filing-exempt securities where they estimate a 3+ notch difference in rating. The proposal (link) is exposed for public comment until July 18^th, and if approved would take one to two years to implement due to technological requirements.

The core discretion sought by the SVO remains unchanged, but there are two key changes to the process:

1. Insurers will now be directly involved in the SVO’s full analysis once a security has been placed under review. This change addresses concerns raised by the previous proposal's appeals process, particularly regarding the fairness of appeals.
2. The final decision to remove a security’s filing exemption and adopt the SVO’s designation will be made by a subgroup of VOSTF, rather than the SVO itself. This will include a joint meeting between the SVO, VOSTF subgroup, domiciliary regulators, authorized insurers, and other authorized parties who can present their own analyses.

The new proposal also clearly states that if at any time during this process a new credit rating from a recognized credit rating provider is received at any point during the process, it would re-qualify the security as filing exempt.

While any filing exempt security is subject to SVO’s discretionary override, we expect the SVO to focus their efforts on securities with certain risk factors such as those with a single private letter rating, inadequate rationale report, complex structures, limited investor base, and/or affiliate relationships within the deal. However, this proposal could create some uncertainty for insurers when making investment decisions considering how the investment will be treated, potentially impacting broader investment activities.

Separately, the NAIC published an analysis (link) of private letter ratings (“PLRs”) they received in 2023, which includes data on 109 securities that had previously received an SVO-assigned designation but now have a PLR-driven designation. They found that 106 of the 109 securities received an upgrade with designations averaging 2.74 notches higher. This was consistent across large and small CRPs, which were on average 1.9 and 3.01 notches higher, respectively, than the SVO-assigned designation. This included some securities that moved from high yield to investment grade, and some moves of over six notches. Although this dataset may not fully represent the universe of private assets in insurer portfolios, it is indicative of what is driving the SVO’s push for this discretion and how frequently the SVO may find 3+ notch differences in their credit assessment.

For more information on regulatory updates, please reach out to your BlackRock Relationship Manager and schedule a discussion with our Insurance Solutions team.