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The NAIC’s bond classification changes: Developing an implementation plan

September 10, 2024 / 5 min read

The principles-based bond definition will change the way insurance companies define their bonds starting Jan. 1, 2025. The undertaking will take time and resources to analyze, and an early start is recommended. Follow these tips for a smooth transition.

The Principles-Based Bond Project — which originally appeared on the National Association of Insurance Commissioners (NAIC) 2019 agenda topics — was finalized on March 16, 2024, and will take effect on Jan. 1, 2025. The project began in response to evolving types of investments and investing strategies being adopted in insurers’ portfolios and aimed to increase transparency into investment securities for regulators and other financial statement users. Now that it’s finalized, the new guidance represents a significant revision to Statement of Statutory Accounting Principles (SSAP) No. 26R, Bonds, No. 43R, Asset-Back Securities, and No. 21R, Other Admitted Assets. Given the potential magnitude of the impacts, insurance companies should make sure they fully understand the new principles-based method of bond definition and prepare early.

The new definition of a bond

Under the new guidance, a bond is now defined as “any security representing a creditor relationship, whereby there’s a fixed schedule for one or more future payments, and which qualifies as either an issuer credit obligation or an asset-backed security.” A key point to note: If the security possesses “equity-like characteristics” or represents an ownership interest, it’s not a creditor relationship. The revised SSAP No. 26 paragraphs 6.a. – 6.d. describe the specific elements of equity-like securities.

The analysis

Based on this definition of a bond, insurance companies now need to analyze securities to determine whether a creditor relationship exists. To accomplish this, insurers must evaluate the security’s substance rather than focus solely on the name or legal form of the instrument. This analysis should also consider all other investments the reporting entity owns in the investee, as well as any other contractual agreements, to verify the existence of a creditor relationship.

Adding further complexity, the SSAP now defines two subsets of bonds:

Issuer credit obligations

Issuer credit obligations, which are defined as follows: “A bond, for which the general creditworthiness of an operating entity or entities through direct or indirect recourse, is the primary source of repayment.”

Examples include:

Asset-backed securities

Asset-backed securities, which are defined as “bonds issued by an entity — an asset-backed security (ABS) issuer — created for the primary purpose of raising debt capital backed by financial assets or cash generating nonfinancial assets owned by the ABS issuer, for which the primary source of repayment is derived from the cash flows associated with the underlying defined collateral rather than the cash flows of an operating entity.”

Paragraphs 9 and 10 of the revised SSAP 26 detail the two key defining characteristics that must be present for a security to meet the definition of an asset-backed security:

Examples include:

Under the new definition, some securities previously reported as a bond on Schedule D Part 1 might no longer meet the definition of a bond. These securities will now fall under SSAP No. 21, Other Admitted Assets. These securities are split into three subcategories:

The accounting and measurement method for the bonds and debt securities are dependent on the category in which they belong.

The impact on insurers

Unpacking the new definitions and applying them to the securities portfolio is a significant undertaking. The SSAP updates resulting from the bond project impacts how insurers will summarize and disclose data to regulators, which will impact annual statement filings in several ways:

Other factors to consider from these changes are the potential impacts on risk-based capital (RBC) calculations, asset valuation reserve, and admissibility considerations (depending on the investment).

Tips for a successful transition

Bond redefinition is a major undertaking, the scope of which won’t be entirely known until you begin the process. The following tips will help you prepare for a smooth transition.

Proactive and thorough planning is key

The bond classification process will require proactive planning and implementation of new processes. In most cases, solely relying on an investment manager or other third party won’t be sufficient — you’ll need to dedicate resources to review and validate the results of any external review. As you implement this change and perform the initial classification, think ahead to your process for categorizing acquired securities in future reporting periods. Significant changes to regulatory filings, such as this, require proper planning and execution. If your organization hasn’t kicked off the process, now is the time.

Contact our authors

Want to learn more on how the PBBD Project will impact your organization? Reach out to our team to get started and stay ahead.

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