The National Association of Insurance Commissioners’ (NAIC’s) proposed changes to credit ratings for structured finance instruments aim to increase regulatory scrutiny and reduce risks tied to perceived arbitrage. These revisions may affect investment strategies and compliance for insurers using structured equity, rated note-feeders, and CFOs.
In a prior LawFlash, we discussed the NAIC’s August meeting, during which its members deliberated on changes to the proposal that would allow them to challenge the credit rating of structured finance instruments held by insurance companies. This is part of the NAIC’s wider scrutiny of insurance companies in the United States relating to perceived regulatory arbitrage in the structured equity and fund investment space, including CFOs and rated note feeders.
This LawFlash discusses such proposals further and their likely impact on insurance companies and credit rating providers (CRPs).
Under the discretion proposal, as currently revised, the Securities Valuation Office (SVO) could identify and question a rating provided by an approved CRP. The SVO must notify the insurance company holder(s) of the security and the domiciliary state regulator(s) of the insurance company holder(s). Additionally, it must provide an analysis explaining why it views the rating as flawed to a subcommittee of the Valuation of Securities (VOS) Task Force and the domiciliary state regulator(s) of the insurance company holder(s). The proposal is expected to rarely be used.
The SVO Credit committee and VOS Task Force subcommittee will then meet and decide whether it agrees with the SVO recommendation that the CRP rating be removed from the filing exempt process. If it is agreed, an anonymized summary of the credit issue identified will be published on an insurer-accessible location.
After the passage of the proposal by the VOS Task Force, it was not voted on by the (E) Committee (i.e., the senior committee that oversees the VOS Task Force).
Following the passing of the resolutions by the NAIC’s VOS Taskforce and the (E) Committee regarding the use of credit ratings, feedback from some market participants suggests these resolutions are likely to be workable for the industry.
Firstly, the provision for the questioning of ratings is to be “rarely used.” While there is little definition of the term “rarely used,” market expectation is that the process will be used in less than 5% of cases. Secondly, the SVO will be required to provide a written summary outlining the reasons it believes the rating is an unreasonable assessment of investment risk for regulatory capital purposes, as opposed to a private meeting where information is provided orally to a small set of regulators. Lastly, the CRP will be provided the opportunity to defend its rating, provided it is invited into the process by the firm holding the investment or the domiciliary regulator.
CRPs will likely welcome the opportunity to defend their ratings and be diligent in doing so. Arguably, a better approach may be to use a portfolio review to determine if, over time, there is a material difference between the probability of default implied by the various ratings in the portfolio and the realized defaults. A CRP that consistently issues ratings that understated the default risk might be questioned regarding the basis for such miscalculations.
Going forward, as previously highlighted, certain asset classes will undergo continued scrutiny, including collateralized fund obligations, where debt is issued against various fund strategies, including private equity holdings, as well as rated note feeder fund transactions which facilitate insurance company investments in private credit funds.
The proposed changes could have implications for insurance companies when they become effective January 1, 2026. As such, insurance companies should monitor the progress of the (E) Committee and its subgroups on matters relating to CRP ratings.