The insurance industry faces its most significant accounting change in decades. Sabrina Wilson of Clearwater Analytics explores how the NAIC’s principles-based bond definition is forcing insurers to rethink asset classification, documentation practices and investment strategies while preparing for unprecedented regulatory examination.
Insurance industry accounting and compliance leaders, and, for that matter, chief investment officers (CIOs) and operations leaders, are tackling the single biggest National Association of Insurance Commissioners (NAIC) accounting guidance change in decades. The new principles-based bond definition (PBBD) became effective Jan. 1 — with no grandfathering. All debt securities owned by insurance companies, in all lines, from fraternal and life, to property and casualty and health, need to satisfy the PBBD to be treated as bonds for statutory accounting purposes and reported on Schedule D of the statutory investment schedules.
Ideally, insurance asset owners have spent the past couple of years installing new procedures and solutions to reorient toward a principles-based accounting paradigm. This sweeping change demands detailed asset classifications, robust documentation and collaboration with auditors to ensure compliance and avoid regulatory penalties.
NAIC compliance: no room for delays or do-overs
In our observations, most of the large insurers are ready, having modified their standard operating procedures and hiring more junior and senior roles. Of course, nobody could be 100% ready because the new guidance required a Day One understanding of the correct classifications of Section 1 issuer credit obligations (ICO) and Section 2 asset-backed securities (ABS). NAIC expects that all the documentation to be in place. When the external auditor or the department of insurance examiner performs reviews, CFOs will have no excuse. They won’t have the luxury of saying “OK, wait just a minute. Let me collect the data and get back to you.”
Third-party external asset managers may be well-versed in complying with SEC regulations, but they need to learn a new language and become fluent in NAIC rules. The NAIC is fully intending to put their foot down if they think an insurance company doesn’t understand the real risk of their investment strategy or grasp the more granular categories that allow regulators to better identify the important characteristics of bonds on Schedule D, Part 1 (D-1). This is not a time to postpone compliant accounting or try to retroactively get things in order.
Asset classification within the audit scope
One important change is the accounting guidance concerning the Statement of Statutory Accounting Principles (SSAP) 26, paragraph 39. Determining if an asset is ABS or ICO, NAIC states that, “Assessment on these aspects is investment specific, with determination at origination by the reporting entity based on the overall structure of the investment.” This is huge — necessitating an external auditor. Alternative investments, particularly private debt, have been booming for years: Bonds make up more than 60% of insurer investment portfolios.
Previously, within the existing schedule item (SI) asset classification on the Schedule D-1, long-term bonds never made it into the audit scope. The auditor that never used to have to touch the Schedule D-1 will now have to because asset classification is included in the audit scope. Principles-based means NAIC allows reporting entities to exercise their professional judgement. This is a surprising move. If you make an external auditor put a stamp on it, is it no longer principles-based?
Is Your Compliance Framework Ready for ISO20022?
How to handle new data elements and text-based tags in transaction screening systems
Read moreDetailsNAIC is not handing out freebies. You have to earn it.
The industry must be conscientious about understanding what category bucket an investment falls under. CFOs will have to re-bucket their Schedule D-1 investments and have clear transparency into which are ICO and which are ABS.
The NAIC states unequivocally that insurance companies must accurately differentiate between ICOs and ABS, as the classification determines the required assessments for credit enhancement and cash-flow generation, stating, “ICOs are primarily supported by the general creditworthiness of an operating entity, while ABS are backed by the cash flows of underlying collateral.” Misclassifying an investment as an ICO to avoid detailed assessments could result in noncompliance.
To properly categorize the complex instruments, data scientists and IT leaders will need to identify and collect new data points for categorizing D-1 assets correctly, such as full or partial government guarantees, issuer types, collateral details, waiting periods, covenants and cash-flow sources. The auditors, the NAIC and the regulators are all going to laser focus on ABS classifications.
New guidance enables some ABS to move into the ICO category. Certainly, it is beneficial to move any ABS from Section Two (ABS) to Section One (ICO). But, the NAIC will not hand out free passes; they will confirm if you meet the criteria for single entity-backed obligations on Schedule D-1 Section 1 (ICO). This is crucial. If you repackage an equity investment and make it look like ABS or a bond, you had better be precise in the structuring. I would urge against classifying assets into sensitive categories unless you are absolutely certain. The regulators will look closely at these three categories:
- Non-self-liquidating ABS, dependent on market conditions, like collateralized fund obligations and feeder funds with underlying equity.
- Non-financial ABS, from physical assets. You must prove they produce “meaningful cash flows to service the debt.” Accounting must have full documentation to prove that structures captured as a bond on Schedule D-1 actually reflect bond-like cash flows.
- Non-debt variables will have to go to Schedule BA as alternative investments. Whether an ICO or ABS, if the investment return can be linked to something S&P 500, collateralized by equity interests, it doesn’t represent a creditor relationship in substance.
People are going to change their investment strategies
The new rules will cause chief investment officers to adjust their portfolio strategies. As noted above, they will sometimes need to move investments from Schedule D-1 to Schedule BA because they fail to qualify as a bond. The NAIC uses Schedule BA to monitor insurance companies’ exposure to alternative investments, such as private equity, private credit, hedge funds and real estate, to ensure that insurers maintain sufficient reserves to cover potential risks with these investments.
However, all 50 states have a cap on how much you can invest on Schedule BA. If the insurer is at the limit, it must sell part or all of the fund. The returns may be fantastic, but because they failed a new bond definition, they don’t behave like a bond. Are they risky? They may not be. It will force the insurance company to drop that investment — even though they are not risky.
Open a dialogue with the auditor
It is sensible to always work with your auditor before the audit. They, of course, are not supposed to tell you their strategy for how they will audit. But given the widespread changes that NAIC PBBD compliance necessitates, there is nothing wrong with engaging with auditors to test certain classification tactics and discuss expectations.
Schedule D-1 is about 75%-80% of a total portfolio. PBBD will add seven new columns to Schedule D-1 Section 2 (ABS). The complexity of so many new columns can put a strain on legacy accounting and reporting processes and platforms. Insurers will need to manage the burden in reporting that spans varying accounting regimes, complex asset classes, global currencies, multiple portfolio types and external managers.
Sabrina Wilson, CPA, FLMI is a global regulatory policy expert at Clearwater Analytics, provider of portfolio accounting, reporting and reconciliation services for institutional investors. Before her time with Clearwater, she was a manager of investment accounting at United Heritage Insurance. 
