Rated Note Fund Structures: The Impact of the NAIC’s SSAP 26

Podcast
November 30, 2023
11:30 minutes
Speakers:

On this Ropes & Gray podcast, asset management partners Jason Kolman and Jessica Marlin are joined by Daren Moreira, a partner at Eversheds Sutherland, to discuss the NAIC’s updated Statement of Statutory Accounting Principles No. 26 (SSAP 26). They discuss the background of and guidance in SSAP 26, and its potential impact on rated note fund structures.


Transcript:

Jason Kolman: Hello, I’m Jason Kolman, a partner in Ropes & Gray’s asset management group. I’m joined today by Daren Moreira, a partner in the insurance transactional and regulatory group at Eversheds Sutherland, as well as by my colleague, partner Jessica Marlin from Ropes’s asset management group. We’ll be discussing an important development impacting rated note fund products: the NAIC’s updated Statement of Statutory Accounting Principles No. 26, also known as SSAP 26.

Over the past few years, we have seen substantial interest among private fund sponsors and insurance company investors in rated note feeder products. These products effectively recast a typical credit fund product—which is usually structured entirely as equity or LP interests in a partnership or fund—into an investment that is primarily structured as a rated note, which results in more favorable regulatory capital for insurance investors.

Recently, the National Association of Insurance Commissioners (or NAIC) updated the statutory accounting rules governing what constitutes a bond—most notably, through amendments to SSAP 26. This is a significant development for rated note feeders, as it reflects important changes to the framework for thinking about how these and other similar products should be treated for regulatory capital purposes.

Daren, thanks for joining us today. Let’s start with an overview of SSAP 26. Can you summarize the basics of SSAP 26 and give us some background on the NAIC process that led to this point?

Daren Moreira: Hi, Jason—thanks for having me on. Over the past five years, state insurance regulators have become increasingly concerned that insurers have been investing in structured securities that are technically debt but have the risk profile of equity. In this context, it’s important to note that debt investments, which generally have more stable and predictable cash flows than equity, receive significantly better capital treatment under U.S. statutory accounting rules.

That concern gave rise to a multi-year project at the NAIC, known as the “principles-based bond definition project.” The project is headed up by the NAIC’s Statutory Accounting Principles Working Group (or SAPWG) and representatives from the Iowa Insurance Division, working with interested parties from industry. The goal of the project was to develop new statutory accounting rules that govern what constitutes a bond, and how bonds are reported and valued on insurers’ financial statements.

The bond project impacts a number of SSAPs, but SSAP 26 contains the new bond definition. The current definition of a bond under SSAP 26 is very broad—it’s essentially “any security representing a creditor relationship, where there is a fixed schedule for one or more payments. Under the new definition, a security must also qualify as “either an issuer credit obligation or an asset-backed security” to receive bond treatment.

SSAP 26 and a related Issue Paper include detailed guidance that should be used to determine whether a particular security meets the new definition of a bond. The guidance is fairly dense, so I’ll focus on what’s most relevant for rated note feeder products.

The guidance says that determining whether a security represents a creditor relationship should consider its substance, rather than solely the legal form of the instrument—so, even if an investment is structured as debt, you need to consider whether, in substance, the investment includes equity-like characteristics.

In order for a security to represent a creditor relationship, it must have pre-determined principal and interest payments—whether fixed or variable—with contractual amounts that do not vary based on the performance of the underlying collateral.

Where a debt investment is collateralized by an equity interest—which is the case with rated note feeder products—there is a rebuttable presumption that the investment does not represent a creditor relationship, and therefore, is not a bond. That presumption can be rebutted by showing that 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. Factors to consider include:

  • The number and diversification of the underlying equity interests
  • The characteristics of those underlying equity interests
  • Liquidity facilities
  • Overcollateralization… and others

With respect to asset-backed securities (or ABS), the holder of a debt instrument issued by an ABS issuer must be in a different economic position than if the holder owned the ABS issuer’s assets directly. This is achieved through substantive credit enhancements in the investment structure that absorb losses before the debt instrument would be expected to, such as guarantees (or other similar forms of recourse), subordination and/or overcollateralization.

For all of this, the burden is on the insurer investing in the security to conduct the required analysis and to document it—this documentation will be essential for insurers during future financial exams.

That’s probably the most important point for listeners to take away from the guidance: the new bond definition is principles-based and provides a fair amount of flexibility in how insurers’ bond investments are structured, but it’s critical that insurers evaluate and document how an investment meets the new standard, and that must done at the time the investment is made.

Jason Kolman: Thanks, Daren. Is there any guidance specific to rated noted feeder products?

Daren Moreira: Yes. As I mentioned, there is an Issue Paper that should be used to determine whether a particular security meets the new definition of a bond. The Paper is still being finalized but it addresses rated note feeder structures specifically. The Paper provides that:

Feeder fund structures are not automatically assumed to qualify as a bond (even if the ultimate collateral is fixed income), nor are they automatically precluded from being a bond. But like other ABS collateralized by an equity interest, there is a rebuttable presumption that the investment does not represent a creditor relationship, and therefore, is not a bond.

The Paper also says that an assessment of a feeder fund structure should evaluate whether the structure ensures the pass through of the underlying cash flows, or whether uncertainty as to the timing or amount of cash flows is introduced by the structure—this is a recurring theme throughout the guidance: the importance of predictability of cash flows. On this point, the Paper notes that a fund manager having discretion to withhold distributions of underlying cash flows could make a feeder fund product more like equity. On the other hand, provisions that simply dictate the order of payments or allow a fund manager to use proceeds to pay qualified expenses or establish reserves, should not.

Jason Kolman: Thanks for that overview. What is the timing for SSAP 26’s implementation, and is there any sort of grandfathering concept for existing products?

Daren Moreira: The revisions to SSAP 26 were adopted by the NAIC in August and they go into effect January 1, 2025. There is no grandfathering. In fact, SSAP 26 includes guidance on how insurers should reclassify investments that were previously reported as bonds but no longer qualify as of January 1, 2025.

Jason Kolman: Thanks for that. Do you expect there will be any additional guidance from the NAIC before the 2025 effective date that provides additional clarity?

Daren Moreira: The Issue Paper is still being finalized—it was most recently released for a six-week comment period during the Summer National Meeting of the NAIC. It’s certain to be a topic of discussion during SAPWG’s next meeting during the Fall National Meeting in Orlando on December 1, but most of the work is done. In October, the NAIC adopted new annual statement reporting forms for issuer credit obligations and ABS that qualify as bonds under the new definition—those new forms also go into effect January 1, 2025.

Jason Kolman: Thanks, Daren. Jess, let’s now turn to the potential impact of SSAP 26 on rated note feeder products. Do you think this will lead to diminished interest in these products?

Jessica Marlin: Thanks for that overview of the revisions to the Issue Paper. But, no, I don’t expect diminished interest in rated note feeders as the result of these revisions based on what we know now, and we have not seen sponsor clients or investors shying away from these products following SSAP 26’s issuance. I think this is for a few reasons:

First, the guidance is principles-based, as Daron discussed, and so, generally does not require or prohibit any specific features. So, there should be room for insurance investors to take reasonable interpretive positions based on the fund’s terms and the composition of the underlying debt portfolio.

The second reason I don’t think there will be diminished interest is that sponsors currently don’t typically guarantee or offer assurances that the regulatory capital treatment of the notes will be respected by insurance regulators and include disclosure in the rated note feeder documents to that effect already. This approach generally aligns with the revised SSAP 26, and specifically the requirement that each insurance company make its own determination as to the appropriate regulatory capital treatment based on the nature of the specific investment product.

The other reason that I don’t expect there to be diminished interest is that to the extent that SSAP 26 requires a tightening of the debt terms, this should dovetail with the ratings agency process, as many of the factors cited by the NAIC are already ones that ratings agencies often raise, and we’ve been seeing them raise more frequently over the past year. So, there should be a general alignment of interests in complying with SSAP 26 and working with the ratings agency to obtain the desired rating on the notes.

Jason Kolman: Thanks, Jess. With all that said, do you think we’ll start to see some rated note feeder terms change in response to SSAP 26?

Jessica Marlin: Yes, I think it is possible that the terms could change, especially given the regulators’ focus on substance and a creditor relationship. Some of the terms that could change based on statements in the guidance are:

  • Capping or eliminating the underlying fund’s ability to hold equity positions. This is something that we’ve already seen rating agents press on recently. You could see eliminating capital calls for the underlying equity investments to calls on the equity portion of the investment in order to meet that standard.
  • Another term that could change is to remove the ability of note interest to PIK (or pay-in-kind) and making interest payments in cash.
  • I could also see including liquidity mechanisms to facilitate cash on the notes, such as investing a portion of the commitment in a cash management vehicle to reserve it for payment on the notes.
  • I also think it will be important to ensure there is a meaningful equity tranche in the structure, to help ensure the debt is distinct and legitimate. This could lead to higher ratios of equity to debt. And, again, we’ve already seen rating agents put pressure on the ratio of equity to debt.
  • And, lastly, I think another term that could change would be including some form of LTV or overcollateralization test, which prioritizes payments to the debt if the test is exceeded.

Also, the rated note fund documents typically include—and we recommend—some form of ability to amend the terms to address NAIC requirements or other regulatory developments, which I think we’ll continue to see to provide some flexibility to adapt to any future developments, given the fluid nature of the regulatory landscape.

Jason Kolman: Thanks, Jess. That’s all the time we have for today. We appreciate you tuning in and thank Daren Moreira at Eversheds Sutherland for working with us on this update. Please visit our website, or feel free to reach out to me, to my colleague Jessica Marlin, or to Daren at Eversheds by email or phone for more information. You can also subscribe to this series wherever you typically listen to podcasts, including on Apple and Spotify. Thanks again for listening.

Daren Moreira
Partner, Eversheds Sutherland
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