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Summary of the Principles-Based Bond Project

Summary of the Principles-Based Bond Project

In August, the National Association of Insurance Commissioners (NAIC) Statutory Accounting Principles Working Group (SAPWG) implemented one of the most significant updates to statutory accounting principles in recent years by adopting the final portion of NAIC REF 2019-21. Known as the Principles-Based Bond Definition (PBBD) Project, the guidance is a comprehensive overhaul of the bond definition and classification process, utilizing a principles-based methodology. The guidance incorporates the most recent feedback received from industry stakeholders and significantly revises SSAP No. 26R, Bonds, SSAP No. 43R, Loan-Backed and Structured Securities, and other SSAPs (e.g., SSAP No. 86, Derivatives, for replication (synthetic asset) transactions). The adopted revisions go into effect January 1, 2025.

How is a Bond Classified?

According to SSAP No. 26R, a bond is defined as “any security representing a creditor relationship, whereby there is a fixed schedule for one or more future payments, and which qualifies as either an issuer credit obligation or an asset-back security.”

Whereas previously, insurers assessed a creditor relationship based strictly on legal form, the new guidance is explicit that insurers will need to consider the substance of the agreement, not just the legal form. A creditor relationship exists when a security has predetermined principal and interest payments (fixed or variable interest) with contractual amounts that do not vary based on depreciation or appreciation of underlying collateral or non-debt variables.

The revised SSAP No. 26R now specifies exclusions for securities that do not qualify as bonds pursuant to the principles-based bond definition, including first loss positions that lack contractual payments or substantive credit enhancement. Securities that represent an ownership interest or that possess equity-like characteristics will also be excluded under SSAP No. 26R and will now be considered under SSAP No. 21R, Other Admitted Assets, and reported on Schedule BA.

Changes to Schedule D

With the changes adopted in response to the principles-based bond definition, Schedule D will be broken out as follows:

  • Schedule D Part 1, Section 1: Bonds for issuer credit obligations in the scope of SSAP No. 26; and
  • Schedule D, Part 1, Section 2: Asset Backed Securities for asset-backed security investments under SSAP No. 26 that follow SSAP No. 43 – Asset-Backed Securities for accounting and reporting.

What Are Issuer Credit Obligations?

Bonds that are issuer credit obligations are covered in SSAP No. 26R, Bonds. Issuer credit obligations under the new guidance are defined as “a bond, for which the primary source of repayment is the general creditworthiness of an operating entity or entities.” Operating entities include business entities, nonprofit organizations, governmental units and other providers of goods or services. Issuer credit obligations will be reported on Schedule D, Part 1, Section 1.

What Are Asset-Backed Securities?

Bonds that are asset-backed securities are covered in SSAP No. 43R, Asset-Backed Securities. Asset-backed securities under the new guidance are defined as “a bond issued by an entity (an ‘ABS Issuer’) created for the primary purpose of raising debt capital backed by financial assets or cash generating non-financial 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.” Asset-backed securities include commercial and residential mortgage-backed securities, collateralized loan obligations and other asset-backed securities.

Asset-backed securities are classified as financial asset-backed and non-financial asset-backed. For a bond to qualify as a non-financial asset-backed security, the underlying financial or non-financial assets must generate a substantial portion of the cash flows, not primarily through the sale or refinancing of those assets by the ABS issuer. As a practical measure, this substantial cash flow criteria are considered met if less than 50% of the original principal relies on sale or refinancing to generate cash flows.

Both financial asset-backed and non-financial asset-backed securities must provide the holder with substantive credit enhancement. These are features that put the holder in a different position than if they directly held the underlying assets of the security. Examples of these are subordination, guarantees and overcollateralization. There is no practical expedient or threshold for these criteria. Asset-backed securities will be reported on Schedule D, Part 1, Section2.

Other Changes

Schedule BA

Securities that no longer meet the principles-based definition of a bond will be reported on Schedule BA. No gain or loss is recognized when transitioning a security from Schedule D, Part 1 to Schedule BA. Acquisitions recorded on Schedule BA should be reported at amortized cost and adjustments made to reflect the correct value. This process may result in unrealized losses but unrealized gains are not permitted.

Risk-Based Capital (RBC) Calculation

There have been no specific changes to the RBC calculation under the adopted revisions. However, transferring securities between Schedule D and Schedule BA may have implications for RBC. Assets that were previously reported on Schedule D Part 1 that no longer qualify as bonds may incur a higher RBC charge on Schedule BA.

How Should Insurance Companies Prepare?

Insurance companies should begin an internal assessment of their bond portfolio to identify complex structures that may need more scrutiny. They should also review their current categorization of each security currently classified as a bond and reassess whether the bond is an issuer obligation or an asset-backed security. For any security that a company is unsure of, they should consult with their fixed income investment advisor to make a final determination. If any securities are to be moved to Schedule BA, research the appropriate accounting treatment for those particular securities.

If you have any questions on the Principles-Based Bond Project, please reach out to the Brown Plus Insurance Team.

Posted In: Insurance | Insights

About the Author - Hank Straub, CPA

Hank is an Audit Principal and Shareholder with Brown Plus, specializing in accounting and audits of property and casualty (P&C) insurance companies, distributors and auto dealerships. Hank also serves as the Treasurer of Brown Plus.

With over 35 years of accounting and auditing experience, Hank is a valuable asset to the Brown Plus Insurance Practice. He is a founding partner of M&A Advisory Group, LLC, which merged with Brown Plus, effective January 1, 2014, a company that provided in-depth financial expertise to P&C insurance companies. In addition, Hank has served as Controller and Chief Financial Officer (CFO) for a publicly traded P&C insurance holding company and has over 12 years of experience working as a senior audit manager at a Big Four accounting firm.

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