UPDATE: Fund ABS market comes to a crossroads

The National Association of Insurance Commissioners, which has already greenlit rules that could significantly impact the market for asset-backed securities tied to private fund interests, is mulling another big step towards determining its future.

The organization for state insurance regulators sets the rules for risk-based capital weights held by insurers who invest in capital markets securities.

The body is considering a rule that would make regulatory reporting of the instruments more time-consuming.

(Though the instruments are commonly referred to as collateralized fund obligations, or CFOs, Private Funds CFO does not use this term to avoid confusion with the acronym for chief financial officers).

The proposed regulation would allow the regulatory body’s Investment Analysis Office to essentially override credit ratings given to fund ABS tranches that underpin risk-based capital calculations and streamlined reporting. It would be effective on January 1, 2025.

The IAO is a joint body made up of the NAIC’s Securities Valuation Office and its Structured Securities Group.

The latest draft was a subject of the NAIC’s Valuation of Securities Task Force on March 16.

But the regulatory body tells Private Funds CFO that the proposed rule was not finalized. Instead, another draft for the rule will be issued and the task force will kick off a public comment period for it at a future meeting.

The draft that was released before the task force this month was itself a successor to an earlier one, which was subject to a comment period that ran through January.

Since 2004, insurers have been able to claim what is known as “filing exempt status” for certain holdings, which lets them skip filing with the SVO. Instead, they simply submit documentation to NAIC systems.

Filing exemption materially lowers the overall reporting workload, says Matthew Kerfoot, partner at Proskauer in New York.

But filing exempt securities must be supported with ratings issued by agencies that have a special recognition status from the SEC, such as Fitch or KBRA. These ratings are a basis for coming up with designations, which are assigned via an automated process for filing-exempt securities.

NAIC designations come from a list of its assessment scores that help to inform assigning risk-based capital charges.

The regulatory body’s Capital Adequacy Task Force comes up with the capital charges that correspond to those designations.

Not having filing exemption means insurers would have a material increase in their workloads, Kerfoot notes. Should insurers investing in fund ABS bonds have to report to the SVO, they could face a longer, more resource-intense process, he says. In this case, the NAIC determines whether to re-designate a given security to a more capital-intensive category.

The most recently published draft includes an appeal right to an outside third party if the regulatory body removes a credit rating. It also allows for the instruments to keep filing exemptions if they have an additional rating that hasn’t been removed.

While the proposal is significant, it’s also more lenient than an earlier one that would have completely stripped filing exemption eligibility for structured instruments.

The task force paused its consideration of the sweeping proposal when it met last March following a public comment period, records show. From there, the task force switched gears to opt for the ability to override filing exempt status in certain situations.

Keeping the market on tenterhooks

In August, the NAIC gave the market an unexpected regulatory boost when it determined that interests in the instruments could be counted as bonds for regulatory capital purposes – even if they are supported by private equity fund interests.

That is a crucial element toward making the asset class a viable one for potential insurance investors, whose broad-based entry into the market will help determine its success. Capital requirements for holding instruments deemed equity by the NAIC would destroy the economics of investing in them.

Insurers benefit in two ways from having assets that are counted as bonds.

Lawrence Hamilton, an attorney at Mayer Brown who focuses on insurance, says that investments treated as bonds get “much, much lower” regulatory capital charges than those treated as equity. He adds that the other upside for insurers is they can carry bonds “at the amortized cost on the balance sheet.”

This means that insurers don’t have to mark these investments to market, letting them avoid significant accounting losses. Indeed, this could make or break companies in a situation like the global financial crisis.

“If life insurance companies in 2008 had to mark their portfolio investments to market, there might have been some that on paper became insolvent at that point because of the tremendous decline in market value in a lot of types of structured securities, primarily mortgage-related securities,” Hamilton explains.

The bond definition was crafted with the goal of fighting regulatory arbitrage, Private Funds CFO has previously reported, where an insurer can get the same economic exposure with fund ABS as direct fund ownership but with more favorable capital treatment.

Rebuttable presumption

But the NAIC’s rule also includes a “rebuttable presumption,” meaning the instruments won’t get favorable treatment unless and until it can be demonstrated that they have predictable cashflows and there is a clear prioritization of payments within their ABS capital structures.

The NAIC lists several factors to review pertaining to the bond definition, including overcollateralization and the diversification of underlying assets.

The rule will take effect on January 1, 2025 and was reviewed and approved by the NAIC’s Statutory Accounting Principles Working Group.

The final rule’s reliance on this “rebuttable presumption” translates to uncertainty for the fund ABS space in the future, says Kerfoot. “There’s not a clear bright line test or a set of criteria.”

Plan B

But issuers and buyers may get a “Plan B” of sorts from the NAIC.

It is considering a path for certain securities that don’t meet the bond definition to get the same risk-based capital charges, per documents from its Statutory Accounting Principles Working Group.

This path would only be for instruments that are reviewed by the SVO and receive an NAIC designation.

The proposal aims to ensure that non-bond instruments that are reviewed by the SVO get charges that correspond to equivalent designations they would have otherwise received if they were reported as bonds, per a memo from the chair and vice-chair of the working group.

Eligible instruments would be reported on a form called Schedule BA, which is for instruments receiving heightened attention from the SVO.

“The nature of the investments on this schedule can vary widely and are often highly bespoke, which demands a higher level of regulatory scrutiny before being granted this favorable treatment,” states a memo from SVO representatives.

Mayer Brown’s Hamilton notes that Schedule BA debt would get the same charges as those that meet the bond definition – which are reportable on a form called Schedule D – but their reported valuations would differ.

“Schedule BA non-bond debt securities would be reported at the lower of cost or fair value, which is different from the treatment of Schedule D bonds, which are reported at amortized cost (so long as their NAIC designation is above NAIC-6),” he explains.

NAIC-6 is a designation for risky instruments that are in default or close to it.

And yet another NAIC body – the Capital Adequacy Task Force – which could revisit the matter in the future, according to another memo. In that case, it could decide whether to adopt its own process for assigning charges.

Equity charges

Another NAIC rule, announced in August, increases the capital charge on the residual tranches of fund ABS – the most junior tranches – from 30 percent in 2023 to 45 percent for 2024. The regulatory body’s Capital Adequacy Task Force and its Financial Condition Committee signed off on the increase.

This rule has the same purpose as the bond definition. Hamilton says the intent of the hike is to “try to discourage the regulatory arbitrage of setting up an asset-backed security in order to get lower overall RBC charges.”

But he warns that if the NAIC comes to believe that the most junior tranche lacks enough loss-absorbing capacity within a given deal, some non-residual tranches may be at risk of being treated by the regulatory body as residual pieces.

“To the extent that the residual tranche is not thick enough, it could be that regulators could take the position that some of the lower-rated tranches really ought to be considered residual and recharacterized as part of the residual layer,” Hamilton said.

The impact of the charge hike on prospective insurance investors in fund ABS may be uneven.

While Hamilton expects the rule will discourage insurers’ ownership of residual tranches, one exception may come from “more adventuresome” insurers that are owned by PE firms.

This rule is less likely to affect LP-led fund ABS than their GP-led counterparts because of differences in how the two types treat residual tranches.

Kerfoot says LPs tend to retain their equity portions even as they seek liquidity for other parts. This means that insurers are less likely to have access to the riskier instruments in the first place.

But the buyside for GP-leds could take a hit, Kerfoot says, since the rule may cause residual tranches, which the GP generally sells to third-party investors, to be smaller in those deals. That could also reduce the credit enhancement of more senior tranches, likely resulting in higher costs for the selling GP to compensate for the increased risk, and potentially make such deals more likely to be scrutinized by the NAIC.

This story has been updated to include the status of the credit ratings rule following the Valuation of Securities Task Force’s March 16 meeting.