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.