Regulatory Update: NAIC Summer 2021 National Meeting

Moody’s Analytics, in collaboration with the American Council of Life Insurers, developed the revised bond factors, which are based on more recent historical data, as the data on which the prior factors were based was approximately 30 years old. Among other matters, the revised bond factors establish a more granular rating analysis by expanding the number of bond designation categories from the previous six categories to 20 categories.

As reported in the July 2021 NAIC Life Risk-Based Capital Newsletter (a copy of which is available here), the expanded categories from a technical perspective include “factors on the Bonds page (LR002), Asset Concentration page (LR010), Hedged Asset Bond Schedule (LR014), Off Balance Sheet Collateral page (LR017), and Calculation of Tax Effect (LR030). In addition to the base factors on LR002, the bond size adjustment factors were modified.”

The revisions, which were classified as “non-substantive” by the Statutory Accounting Principles (E) Working Group (SAP Working Group), clarify that (a) a levelized commission arrangement (whether linked to traditional or nontraditional elements) requires the establishment of a liability for the full amount of the unpaid principal and accrued interest payable to a third party, such as a funding agent, at the time the policy is issued; and (b) persistency commissions must be accrued proportionately over the policy period to which the commissions relate and cannot be deferred until fully earned. While not typically required for “non-substantive” changes, due to the nature of the revisions and the continued debate by industry and members, the revisions to SSAP No. 71 ultimately required approval by the NAIC Executive (EX) Committee and Plenary, which voted to adopt the revisions during the Summer Meeting.

Prior to the final vote to approve the changes, New Mexico Superintendent of Insurance Russell Toal made a motion to delay the implementation of these proposed changes by one year to December 31, 2022. Industry members and certain regulators had previously voiced opposition to the December 31, 2021, effective date, noting that it would be difficult for affected companies to comply within the required timeframe. However, the motion by Superintendent Toal failed, and affected insurers concerned about the December 31, 2021, effective date were encouraged to seek a permitted accounting practice from their domiciliary insurance regulator.

In addition, during prior discussions on the revisions, industry members and other regulators voiced concerns over the classification of the revisions as “non-substantive,” noting that the revisions, as applied, would result in substantial changes for companies that have historically used levelized commission arrangements in reliance on existing guidance. As a result of such discussions, during the Summer Meeting, the Financial Condition (E) Committee adopted a referral to the SAP Working Group that requests consideration of changes to the SAP Working Group’s maintenance policy related to the use of the terms “substantive” and “non-substantive.” The referral requests that the SAP Working Group consider updating these terms to prevent future misunderstandings as a result of the perception that these terms (based on their common usage) may reflect the degree of financial impact to companies.

The P&P Manual currently grants the NAIC’s Securities Valuation Office (SVO) discretion when determining whether a fund’s use of derivatives is consistent with a fixed income-like security (i.e., whether it will generate predictable and periodic cash flows and is, therefore, eligible for an NAIC designation). The amendment adopted by the VOS Task Force is intended to provide greater clarity and predictability to fund sponsors and investors regarding the acceptable use of derivatives in funds and permit some funds to have greater flexibility in their use of derivatives. The amendment is consistent with Rule 18f-4 under the Securities and Exchange Commission (SEC) Investment Company Act of 1940 related to the use of derivatives by registered investment companies, including funds, which the SEC adopted in October 2020.

However, one difference between the P&P Manual amendment and the SEC rule is that the P&P Manual’s methodology requires a look-through assessment of all funds which, in turn, includes a requirement that a fund “predominantly hold” bonds or preferred stock, as applicable. As defined in the P&P Manual, “predominantly hold” means that a fund holds at least 80% of its assets in bonds or preferred stock, depending on the type of fund, in normal market conditions. 

Pursuant to the P&P Manual amendment, a fund’s exposure to the following is limited to 10% of the fund’s net assets in normal market conditions:

• derivatives under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payments or otherwise 
• short sale borrowings 
• reverse repurchase agreements or similar financing 

Exposure is calculated based on the gross notional amounts of derivatives, the value of assets sold short for short sale borrowings, and the proceeds received by the fund but not repaid for reverse repurchase agreements. 

Consistent with the SEC rule, under the P&P Manual amendment, interest rate derivatives and option contracts exposures are calculated with other defined methods consistent with market practice. In addition, certain currency and interest rate derivatives that hedge currency or interest rate risk associated with one or more specific equity or fixed-income investments of the fund are excluded from the 10% exposure calculation.

Among other charges, specific to workstream three (P/C Insurance) the Special Committee is to conduct research and analysis of insurance, legal, and regulatory approaches to address unfair discrimination, disparate impact, and proxy discrimination and make recommendations for statutory or regulatory changes, including developing analytical and regulatory tools to assist state insurance regulators in defining, identifying, and addressing unfair discrimination in P/C Insurance, including issues related to rating and underwriting variables, such as socioeconomic variables and criminal history. During the Summer Meeting, the Special Committee heard presentations regarding the use of credit scores as a proxy for discrimination in auto insurance underwriting. 

Certain states, including California and Washington, currently prohibit the use of credit scores in auto insurance underwriting and/or pricing. Most states, however, do not have such a prohibition, and the concern is that the use of credit scores in setting auto insurance rates results in higher premium rates for people of color and members of disadvantaged or underrepresented groups. Accordingly, the Special Committee has undertaken an evaluation of the use of credit scores in auto insurance pricing to determine whether any statutory or regulatory changes should be recommended. 

The exposure of the actuarial section of the LTCI multistate review framework built on previous exposures of the operational sections, which were exposed in April 2021. Points of contention in the comments included questions about the decision-making process of the multistate actuarial (MSA) team. Specifically, industry comments included concerns that the LTCI multistate rate review framework provides three potentially conflicting approaches to calculating a justified rate increase but does not specify how the results from the different approaches will generate a rate recommendation from the MSA team and leaves open questions as to what happens when the approaches are in conflict.

A second draft of the operational section of the LTCI multistate rate review framework addressing the issues identified in the comments received was released on September 10, 2021, for a comment period ending on October 11, 2021. A second draft of the actuarial section is also expected to be released for comment in September 2021.

The Revised CFR Model Laws eliminate reinsurance collateral requirements for certain reinsurers and limit the worldwide application of prudential group insurance measures on insurance groups that are domiciled in a “reciprocal jurisdiction.” A reciprocal jurisdiction includes a non-U.S. jurisdiction that has entered into a covered agreement with the United States (such as the European Union, or EU, and the United Kingdom, or UK) as well as “qualified jurisdictions” that meet certain additional requirements consistent with the terms and conditions of the covered agreements, including that the jurisdiction “recognizes the U.S. state regulatory approach to group supervision and group capital.” To date, Bermuda, Japan, and Switzerland have been approved as reciprocal jurisdictions.

The NAIC previously adopted the Process for Evaluating Qualified and Reciprocal Jurisdictions to specify how qualified jurisdictions that meet the requirements under the Revised CFR Model Laws are recognized as reciprocal jurisdictions. During the Summer Meeting, the NAIC adopted revisions to the Process for Evaluating Qualified and Reciprocal Jurisdictions that incorporate provisions for terminating the status of a qualified jurisdiction or reciprocal jurisdiction and create a passporting process for reciprocal jurisdictions, under which a state may defer to another state’s determination with respect to the requirements for reciprocal jurisdiction reinsurers. The passporting process is facilitated through the Reinsurance Financial Analysis (E) Working Group (ReFAWG). Ahead of the Summer Meeting, ReFAWG exposed its draft Review Process for Passporting Certified and Reciprocal Jurisdiction Reinsurers. Six comment letters were received in response to this exposure, which the Reinsurance (E) Task Force referred to ReFAWG to evaluate and recommend revisions. In response to the comment letters received, the revisions are expected to focus on eliminating the submission of duplicate information for reciprocal jurisdiction reinsurers that are also certified reinsurers and to make the filings for both certified and reciprocal jurisdiction reinsurers more consistent.

In addition, the Mutual Recognition of Jurisdictions (E) Working Group voted to expose the draft process for evaluating jurisdictions that recognize and accept the NAIC’s group capital calculation (GCC) (referred to as “Recognize and Accept” Jurisdictions), which process will be similar to the Process for Evaluating Qualified and Reciprocal Jurisdictions. A “recognize and accept” evaluation is already part of the reciprocal jurisdiction review process as all reciprocal jurisdictions designated by the NAIC through that review process are also automatically designated as “Recognize and Accept” Jurisdictions. Likewise, in accordance with the terms of the covered agreements with the EU and UK, all EU states and the UK are automatically designated “Recognize and Accept” Jurisdictions. The Mutual Recognition of Jurisdictions (E) Working Group will evaluate non-U.S. jurisdictions in accordance with this “Recognize and Accept” process, and a list of “Recognize and Accept” Jurisdictions will be published through the NAIC committee process.

As of July 16, 2021, 42 U.S. jurisdictions had adopted the 2019 revisions to the Credit for Reinsurance Model Law, while four jurisdictions had action under consideration. In addition, 15 states had adopted the revisions to the Credit for Reinsurance Model Regulation, and seven jurisdictions had action under consideration. The Revised CFR Model Laws must be adopted by the states prior to September 1, 2022, the date at which the Federal Insurance Office (FIO) must complete its federal preemption reviews under the covered agreements with the EU and the UK. The NAIC is encouraging all states and jurisdictions to adopt the Revised CFR Model Laws as soon as possible and no later than July 1, 2022, to give the FIO time for its federal preemption analysis.

The December 2020 revisions to Model 440 and Model 450 implement (i) the GCC, for the purpose of group solvency supervision for U.S. insurance groups, and (ii) the liquidity stress test (or LST), for macroprudential surveillance of certain large life insurance companies that meet the in-scope criteria outlined in Model 440. With respect to the GCC, the December 2020 revisions require that a group file an initial GCC before it is able to seek an exemption from further filings. However, the exposure by the Financial Regulation Standards and Accreditation (F) Committee was revised from the initial referral from the Financial Condition (E) Committee to allow GCC filing exemptions to qualifying groups meeting the standards set forth in Model 450, without the requirement to file the GCC at least once. The exposure must be approved by the Executive (EX) Committee and Plenary, which is expected at the next national meeting in December 2021.

The Pharmacy Benefit Manager Regulatory Issues (B) Subgroup (PBM Subgroup) began developing the PBM Model Act in 2019 to provide state insurance departments with direct authority to regulate pharmacy benefit managers (PBMs) rather than to regulate indirectly through the insurer. The PBM Model Act would have established standards and criteria for the licensing and regulation of PBMs providing claims processing services or other prescription drug or device services for health benefit plans. However, in the course of developing the PBM Model Act, members of the PBM Subgroup could not come to a consensus on a number of matters, including whether the model would focus only on PBM licensing and registration provisions or include substantive provisions addressing certain PBM business practices.

During the vote, a number of states abstained on the grounds that their state had already passed legislation regarding the licensure and registration of PBMs. Over the past year, more than 100 separate bills regulating PBMs have been introduced in 42 states following the December 10, 2020, unanimous decision by the Supreme Court in Rutledge vs. Pharmaceutical Care Management Association that backed an Arkansas state law that regulates PBMs and paved the way for state regulation of PBMs.

Following the failed vote on the PBM Model Act, the PBM Subgroup will continue work on a white paper that will explore existing and emerging state laws on PBM business practices (such as price transparency and reporting requirements, rebating, and spread pricing) and discuss the implications of the decision in the Rutledge case on such business practices.

The exposure was the result of several meetings since October 2020 between regulators from the Iowa Insurance Division, NAIC staff, and a small subset of interested parties who met regularly to draft the exposed bond definition to be used for all securities in determining whether they qualify for reporting on Schedule D-1. The exposure draft also included appendices setting forth several examples of securities that do, or do not, meet the definition of a “bond” under the proposed definition. The proposed definition reflects principle concepts for consideration as to whether a structure qualifies as either (1) an asset-backed security or (2) an issuer credit obligation prior to reporting as a bond, with a focus on substance over form. 

The bond definition concepts are not considered final, as further discussion and deliberation will occur during the remainder of this project. As a result, although the proposed bond definition has not been formally exposed, interested parties can submit comments or questions on it for consideration by the 43R study group during the issue paper development process.