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Regulatory Update - Schedule D Part 1 (Bonds)

September 16, 2022

Regulatory Update - Schedule D Part 1 (Bonds)

The National Association of Insurance Commissioners (NAIC) recently held its Summer National Meeting and provided updates regarding proposals related to insurance company investments.

Regulatory Update - Schedule D Part 1 (Bonds)

The National Association of Insurance Commissioners (NAIC) recently held its Summer National Meeting and provided updates regarding proposals related to insurance company investments. Two areas we highlight that are of high importance to insurers are:

  1. Updates to the NAIC’s proposed principles-based bond definition, which focuses on defining what qualifies as a bond and, in turn, what qualifies for inclusion on Schedule D – Part 1 and the resulting favorable capital treatment that comes with it.
  2. The proposal to split the statutory reporting schedule for bonds (Schedule D) into two sections from one in order to distinguish more traditional issuer obligation bonds from structured securities.

The new proposals are currently taking public comments until October 7, 2022. If the proposals are approved, the likely effective date of the new rules is January 1, 2025.

These changes will have material impact on U.S. insurers, by requiring additional filing information on existing holdings and potentially moving assets that now qualify as bonds to a different reporting schedule with more punitive capital treatment.

What is changing?

1. The NAIC is making structural changes to insurance investment reporting, by separating bonds into two separate schedules (currently all bonds are located on the same schedule):

a) Schedule D – Part 1-1

  • Issuer Obligation bonds (Corporates, Treasuries, Agencies, Municipals, etc.)

b) Schedule D – Part 1-2

  • Structured Securities (asset-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, collateralized loan obligations, etc.)

2. The NAIC is updating the definition of bond to be principle based:

“A bond shall be 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 backed security.”

 

  • Based on the updated bond definition, the guidance would relax the restriction on ABS collateralized with equity interests (examples would include debt issued by special purpose vehicles [SPV] and backed by private equity, hedge fund and/or limited partnership interests). Particularly, the updates include a revision to a key component of the definition of ABS, and would require that an issuer must have pre-determined and contractual principal and interest payments.

  • Similarly, the revised proposal adds guidance on the application of the bond principles to rated note structures. The guidance notes that no rated note feeder structure will automatically qualify for, or be automatically disqualified from, bond treatment. Rather, in classifying a feeder structure, regulators will assess the certainty of cash flows to the ultimate creditors. Cash flows (interest) that vary based on underlying holdings, varying principal payments based on performance on underlying holdings or required sales to meet principal requirements will disqualify such holdings as being categorized as a bond.

  • Regulators also require the rated note structures to have substantial credit enhancement over their equity-like characteristics. The ability to make interest and principal payments through only underlying interest and principal repayment is the key distinction. The core principle regulators will be scrutinizing is the ability of cash flow (interest or principal) to be paid without the sale of underlying assets, which would expose said flows to equity risk, and invalidate it as a bond.
     

3. In the proposal, regulators remove the restriction on stapled structures. If an insurer holds the entire capital stack of a securitization, the guidance amendment would allow the debt portion(s) to be a Schedule D bond, while the equity tranche would be a Schedule BA asset, unlike current standards which largely forces staple structures to entirely Schedule BA.

Insurance companies are responsible for interpreting the proposed bond definition guidance and for self-reporting financial instruments on the appropriate schedules. There will be no further guidance or evaluation of whether an investment is qualified as a bond from NAIC. However, if a financial instrument is reported inaccurately, the company might receive additional scrutiny from auditors or other external stakeholders.

Currently, the NAIC is not making further changes to the Risk Based Capital framework. If a bond is recategorized to a Schedule BA asset, it will receive the capital charge of Schedule BA assets.   

 

Why make these updates?

The current reporting structure has a limited scope for the definition of a bond and does not provide granularity on what could qualify. The NAIC intended to develop a more robust illustration of proposed reporting structures on Schedule D, helping to define what qualifies to ensure the more aggressive structuring of equity into debt-like structures no longer endangers policyholders.   

What does this mean for investment strategies?

The proposed changes should have minor practical impact on most insurers. Most insurance companies’ financial instruments reported on Schedule D will still fall within the scope of the proposed bond definition. However, the proposal will have a profound impact on certain investment managers/funds that will no longer qualify for Schedule D treatment, increasing the capital charge from roughly 1.0% to 30.0%.

Going forward, it will be paramount for insurers and their asset managers to vet current and future holdings, ensuring there are no surprise capital implications as additional regulatory updates are published.

The information in this paper is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this paper.

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility. Unless otherwise stated, all figures and estimates provided have been sourced internally and are current as at the date of the paper unless separately stated. All data is subject to change.

No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

© 2022, SLC Management

 

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About SLC Management

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate.

Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

BentallGreenOak, InfraRed Capital Partners (InfraRed) and Crescent Capital Group (Crescent)  are also part of SLC Management.

Bentall Green Oak is a global real estate investment management advisor and a provider of real estate services. In the U.S., real estate mandates are offered by BentallGreenOak (U.S.) Limited Partnership, who is registered with the SEC as an investment adviser, or Sun Life Institutional Distributors (U.S.) LLC, an SEC registered broker-dealer and a member of the Financial Industry Regulatory Authority (“FINRA”) . In Canada, real estate mandates are offered by BentallGreenOak (Canada) Limited Partnership, BGO Capital (Canada) Inc. or Sun Life Capital Management (Canada) Inc. BGO Capital (Canada) Inc. is a Canadian registered portfolio manager and exempt market dealer and is registered as an investment fund manager in British Columbia, Ontario and Quebec.

InfraRed Capital Partners is an international investment manager focused on infrastructure. Operating worldwide, InfraRed manages equity capital in multiple private and listed funds, primarily for institutional investors across the globe. InfraRed Capital Partners Ltd. is authorized and regulated in the UK by the Financial Conduct Authority.

Crescent Capital Group is a global alternative credit investment asset manager registered with the U.S. Securities and Exchange Commission as an investment adviser. Crescent provides private credit financing (including senior, unitranche and junior debt) to middle-market companies in the U.S. and Europe, and invests in high-yield bonds and broadly syndicated loans.

Securities will only be offered and sold in compliance with applicable securities laws.

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The content of this website is intended for institutional investors only. It is not for retail use or distribution to individual investors. All investments involve risk including the possible loss of capital. This website is for informational and educational purposes only. Past performance is not a guarantee of future results.

The information contained in this website is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained on this website. The assets under management (AUM) represent the combined AUM of Sun Life Capital Management (Canada) Inc., Sun Life Capital Management (U.S) LLC, BentallGreenOak and InfraRed Capital Partners.

AUM as of September 30, 2022. Total AUM includes approximately $7B in cash, other, and unfunded commitments.

Currency conversion rate: CAD$1.00 = US$1.3826 as of September 30, 2022.

SLC Management Newsroom: SLC-20221101-2566004

UK Tax Strategy - InfraRed (UK) Holdco 2020 Limited

InfraRed (UK) Holdco 2020 Ltd is the UK holding company of InfraRed Partners LLP and a subsidiary of Sun Life (U.S.) Holdco 2020 Inc, which has its headquarters in the U.S. The company was incorporated to purchase InfraRed Partners LLP and acts solely as a passive holding company. The Tax Strategy for the InfraRed Holdco Group sets out our approach to the management of InfraRed Holdco Group UK tax affairs in supporting business activities in the UK. 

This UK tax strategy is published in accordance with the requirements set out in Schedule 19 of Finance Act 2016. The strategy, which has been approved by the Board of Directors of InfraRed (UK) Holdco 2020 Ltd, is effective for the period ending 31 December 2022. It applies to InfraRed (UK) Holdco 2020 Ltd and its dormant subsidiary Sun Life (UK) Designated Member Ltd, referred to as the “InfraRed Holdco Group”. InfraRed Holdco Group.

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