Amnon Levy, CEO at Bridgeway Analytics, considers the changes the NAIC's new bond definition could bring to the sector, and how they can be managed
Updated guidelines under the NAIC's bond project, which went into effect at the start of the year, marked a significant milestone in the evolution of investment risk oversight. In the coming years, there are plans for broader changes, including further refinement to classification, governance over the use of agency ratings in designations, NAIC model-based designations for CLOs, and revisions to the Risk-Based Capital (RBC) to more closely align with differentiated economic risks across investments.
But why do the rules need changing? A key aspect of supervision is measuring the risks of insurers' solvency and ability to pay future policy claims, which relies on consistent reporting and measurement. The shift in insurers' investments toward less traditional assets, often complex, higher-yielding, and illiquid, has made clear the need for more precise categorization and differentiation of their treatment to better align with regulatory needs.
Changes to insurer's investment strategies
Rulemaking bodies globally have paid close attention to the shifts in life companies' investment strategies over the last several years. In 2009, bonds and loans comprised 74% of cash and invested assets, dropping to 68% by 2023. Less traditional assets under Schedule BA and direct mortgage lending mostly filled the gap.
Digging deeper, we see the composition of life companies' debt investments, filed under Schedule D, shifting away from government, municipal, and agency mortgage-backed securities (MBS) (from 25% in 2011 to 14% in 2023) and toward asset-backed securities (ABS), which includes CLOs (from 7% in 2011 to 14% in 2023).
Despite life companies receiving the lion's share of attention, the shifts are more extreme for property and casualty companies by some measures.
Property & Casualty Schedule D Bond Holdingds (% of carrying value)
The Shifting Investment Strategies Helping Address The P&C Insurance Crisis: Implications For Investment Risk Oversight
The table above highlights the shift away from US government, municipal, and agency debt (in tan and brown) and toward corporate (in violet and purple) and structured credit (in light blue and lime) since 2009.
The income generated from these shifts has played a critical role in helping address the insurance crisis, benefiting life and property and casualty insurers and policyholders. In the case of property and casualty companies, shifting investment strategies have generated additional income, equating to an estimated 40% of industry net income in 2023.
Shifts of this magnitude are naturally flagged by regulators, who must assess the degree to which the rules are appropriate for the new landscape and revise them accordingly.
Significance of changes to classification guidelines
Q1 2025 schedule filings will provide the first snapshot under the new classification structure, and the vast majority of debt investments will most likely continue to qualify as bonds and receive favorable treatment under the current RBC framework.
Some investments will undoubtedly be classified as non-bond debt, complicating their treatment. In addition, there are important nuances with bond qualification under either an issuer credit obligation (ICO) of an operating entity or asset-backed security (ABS), with possible implications for reporting, designations, and capital. For example, equipment trust certificates (ETCs) or enhanced ETCs were often categorized as structured securities (i.e., an ABS) collateralized by lease transactions. Under the updated reporting guidelines, they are categorized as ICO and reported as a single-entity-backed obligation ETC or EETC. With efforts underway to differentiate RBC for CLOs and the broader set of ABS, classification guidelines can have significant downstream implications for investment strategies.
For example, when held by life companies, residual interest (i.e., equity) of ABS receives a 45% capital charge compared to equity of an operating entity, which receives a 30% charge.
Classification systems are necessary but limited
The act of categorizing inherently abstracts from nuances; thus, its value is use-case-specific. Rating agencies, financial institutions, and rulemaking bodies (e.g., the US Securities and Exchange Commission) each have their own classification hierarchies to suit their specific needs.
With no common standards suitable for overseeing insurers' investments, the NAIC and state insurance regulators initiated the bond project to heroically map out the wide-ranging characteristics that are embedded within insurers' investment portfolios and viewed as economically relevant when assessing risks of insurers' solvency and ability to pay future policy claims. The principles-based approach will necessarily result in varying opinions over classifications. Still, it is considered a critical step forward, given the wide range of investment characteristics and the context of evolving capital markets.
The classification structure under the bond project is unmistakably designed for regulatory oversight of insurers' investments. Under the bond definition, for example, feeder notes are classified as ABS, while rating agencies generally do not classify them as structured products. These sorts of classification incongruities are nothing new to the investment community. After all, insurers must maintain extensive separate records detailing their assessments and justifications to support compliance for each rulemaking body that may have different objectives (such as statutory accounting, US GAAP, or IFRS). In the context of the bond project, the level of nuance in each subclassification (e.g. assessment of self-liquidation for ABS backed by financial assets or meaningful cash flows for ABS backed by non-financial assets) can be significant.
Tools required
The challenges are magnified when the changes to guidelines are widespread and interdependent (e.g. changes in classification triggering changes to capital). As insurers adapt to these changes, leveraging tools that simplify classification and reporting can ensure alignment with updated guidelines, reducing the administrative burden on insurers. Automating and streamlining classification can mean the difference between compliance and costly missteps for those grappling with the nuances of the bond definition and other regulatory shifts.
The road ahead
Additional plans are underway to refine classification and broader changes to investment oversight in the coming years, including using agency ratings in designations, NAIC model-based designations for CLOs, and revisions to the RBC of ABS and investment funds.
The post-NAIC 2024 Fall National Meeting Update highlighted the scale of the changes. These initiatives will significantly impact the fiduciary processes endorsed by management and directors and portfolio asset allocation methodologies. While shifting regulatory requirements will require a shift in mindset, regulators have committed to an open and iterative process with multiple checkpoints for deliberation and input from industry stakeholders. Regulators are looking to the community for guidance on how to do this well and in a cost-effective way. This poses an incredible opportunity to design a new, effective, fair, and balanced framework that promotes competition and innovation.
Several developments to keep an eye on:
- Classification of investments: Although the bond definition is now effective, its principles-based framework inherently requires time for industry participants and regulators to establish precedents and align practices on consistent standards. As reporting standards converge, expect increased regulatory demands for granular reporting to address diverse risk exposures in investment segments viewed as material.
- Designations: To address concerns over the 'blind reliance' on agency ratings in NAIC Designations, which provide risk assessments of insurers' debt portfolios valued in the trillions, the NAIC recently adopted procedures extending staff discretion over designations, with a target rollout in 2026. NAIC staff have also been developing a CLO Designation Model targeted for 2025.
- Capital differentiation: The NAIC has initiated several efforts to differentiate capital requirements for asset classes, including investment funds possibly receiving look-through treatment and differentiated treatment for ABS to align with their economic risks more closely, initially focusing on CLOs.
- Modernizing investment oversight: The Financial Condition (E) Committee has taken on the long-term goal of modernizing the NAIC's Investment Risk Oversight Framework and is planning to develop a due diligence process for overseeing the use of agency ratings. While initially focusing on the prudent use of agency ratings, the Work Plan and Framework represent a comprehensive strategy that seeks to modernise the very foundation of how insurer investments are regulated. This shift is not merely an incremental adjustment—it is intended to revisit the rules that have long underpinned the industry, and its implications can be profound.