Insurers and fund advisers should consider newly proposed
guidance from insurance regulators on funds’ use of derivatives
in the context of regulatory capital treatment of a fund’s
units, shares or interests. Once finalized, the guidance could have
an impact on whether a fund is a permissible or attractive
investment for insurance company balance sheets. Similarly, the
guidance could motivate a fund to balance its appetite for
derivatives with its need to market itself to investing
insurers.
The proposed guidance was adopted on Thursday, July 15, by the
Valuation of Securities Task Force (VOSTF) of the National
Association of Insurance Commissioners (NAIC). The guidance
modifies use of derivatives requirements for funds on the
NAIC’s “Fixed Income-Like SEC Registered Funds
List” (funds whose interests, when held by an insurer,
can be treated as debt securities for risk-based capital (RBC)
purposes).
By way of background, the NAIC may include on the fixed income
list a Securities and Exchange Commission (SEC) registered fund
(other than a money market fund) regarded as “fixed
income-like,” that is, one that generates predictable and
periodic cash flows similar to an investment in the underlying
bonds or preferred stock directly. The criteria governing whether a
fund is eligible for such listing are set forth in
the Purposes and Procedures Manual of the NAIC Investment
Analysis (the P&P Manual). Under
these criteria, the NAIC’s Securities Valuation Office
evaluates the extent to which the fund “predominantly”
holds bonds or preferred equity as well as the fund’s credit
risk and leverage.
The new guidance places additional restrictions on the use of
derivatives for funds on the list to conform more closely to
standards that will be required by newly promulgated Rule 18f-4
under the Investment Companies Act of 1940, adopted by the SEC in
October 2020. Registered fund compliance with new Rule 18f-4 is
required by August 2022.
Under Rule 18f-4, a fund is eligible to enter into derivative
transactions if it complies with certain governance, reporting and “value at risk” (VaR) requirements. However, a “limited derivative user” is exempt from some of these
requirements (specifically those relating to maintaining a
derivatives risk management program, VaR compliance and board
oversight and reporting). A limited derivatives user is a fund
whose derivatives exposure does not exceed 10% of the fund’s
net assets, excluding certain hedging instruments such as foreign
exchange or interest rate derivatives.
The new NAIC guidance would similarly permit fixed income funds
to be subject to a 10% exposure basket (that also excludes certain
hedging instruments). Similar to Rule 18f-4, the new VOSTF guidance
defines “derivative transaction” as:
“(1) any swap, security-based swap, futures contract,
forward contract, option, any combination of the foregoing, or any
similar instrument (‘derivatives instrument’), 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
payment or otherwise;
(2) any short sale borrowing; and
(3) any reverse repurchase agreement or similar financing
transaction.”
In turn, “derivatives exposure” is defined as “the sum of the gross notional amounts of the fund’s
derivatives transactions, . . . ; in the case of short sale
borrowings, the value of the assets sold short; and, in the case of
reverse repurchase agreements or similar financing transactions,
the fund’s derivatives exposure also includes, for each
transaction, the proceeds received but not yet repaid or returned,
or for which the associated liability has not been extinguished, in
connection with the transaction.”
If a fund exceeds the 10% basket, the fund would be ineligible
for inclusion on the NAIC fixed income fund list. Under preexisting
NAIC standards, a 10% or other fixed cap was not expressly stated,
and derivative exposure has been more of a subjective variable.
Since the SEC’s proposal of Rule 18f-4, the NAIC guidance
referred to the rule as proposed, but not in an explicitly
prescriptive way. Derivative exposure has been considered in tandem
with other factors such as exposure to other financial commitments
and leverage.
A fixed income fund not on the NAIC list will not automatically
be entitled to debt treatment for its shares, which could make
these funds much less attractive for insurers from an RBC
perspective, requiring the insurer to hold much more capital
against them. By the same token, registered funds included on the
list (and thus that would adhere to the new derivatives limits when
finalized) could more aggressively market to insurers with capital
looking for limited RBC exposure. The proposal comes at a time when
other NAIC bodies are examining the debt and equity characteristics
of various investment structures, such as the Statutory Accounting
Principles Working Group’s ongoing analysis of structured
securities for purposes of the statutory accounting guidance on
bonds (SSAP No. 23R) and loan-backed securities (SSAP No. 43R).
The full text of the new fixed income-like fund guidance can be
found within the VOSTF meeting materials located here.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
