The National Association of Insurance Commissioners recently held its August 2024 meeting, which saw significant changes to the proposal pertaining to the Security Valuation Office's discretion authority over designations assigned through the filing-exempt process for certain types of investments. This LawFlash discusses what the changes might mean for structured equity and fund securities, such as collateralized fund obligations and related portfolio secondaries financing products (together, CFOs) and rated note funds/rated note feeder funds (RNFs).
The Security Valuation Office (SVO) has been challenging the reliance on credit rating provider (CRP) ratings for some time. The SVO had previously proposed defining “Structured Equity and Fund” investments, which would have included CFOs and RNFs and would have required such investments to be filed with the SVO for review and assignment of a National Association of Insurance Commissioners (NAIC)—the US standard-setting and regulatory support organization for the insurance industry—designation (i.e., an SVO rating) without reliance on a rating undertaken by an approved CRP.
This proposal was deferred by the Valuation of Securities Taskforce (VOSTF) in response to criticism from market participants. As an alternative, the VOSTF proposed a narrower process for the SVO to review a CRP rating for a specific filing-exempt investment, potentially challenging the CRP rating and resulting in the investment’s removal from filing exemption.
Currently CFOs and RNFs are exempt from the SVO filing process.
The revised proposal outlines the process for excluding an eligible CRP rating from filing exemption for a specific security. In essence, the SVO (directly, or at the behest of a state insurance regulator) could identify and question a rating provided by an approved CRP which it believes is not a reasonable assessment of investment risk of the security for regulatory purposes. The SVO may consider observable factors, including, but not limited to (1) a comparison to peers rated by different CRPs, (2) consistency of the security’s yield at issuance or current market yield to securities with equivalently calculated NAIC designations rated by different CRPs, (3) the SVO’s assessment of the security applying of the security applying applicable methodologies, and (4) any other factors deemed relevant.
The SVO must notify the insurance company holder of the security and the domiciliary state regulator of the insurance company holder. Additionally, it must provide an analysis of why it views the rating as flawed to a subcommittee of the VOSTF and the domiciliary state regulator of the insurance company holder. In light of such analysis, the SVO credit committee will reconvene to determine its own opinion of the filing-exempt designation. If the filing-exempt designation is three or more notches different to the SVO assessment, a meeting with regulators and interested parties could be convened to determine whether a security should be removed from the filing-exempt process. The SVO credit committee and VOSTF 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. The proposal also includes the prospect of insurers requesting that the SVO reevaluate a CRP rating that was removed from filing exemption for possible reinstatement in a subsequent filing year. The proposal is to take effect from January 1, 2026.
After the passage of the proposal by the VOSTF, it was not voted on by the (E) Committee (the senior committee that oversees the VOSTF). It is not clear why that is the case, although a number of comments were submitted that sought additional safeguards, including ensuring that the relevant CRP would have the opportunity to explain its ratings even if it were not invited to do so by the holder of the security. There is a concern that the holder of the security may not challenge the SVO’s findings or include the CRP in the process, thereby leaving the regulators without complete information in determining whether to accept the SVO credit committee's recommendation.
It is uncertain what the (E) Committee will do next, but we expect CRPs will be provided the opportunity to explain their rating so that the regulator has the benefit of more complete information. The (E) Committee has proposed a request for proposals to study a broader framework, which includes the role of the SVO and due diligence on the CRPs.
The ability to question credit ratings is entirely appropriate as credit ratings are merely opinions of the likelihood of future payment of interest and principal in relation to a given security, and CFOs and RNFs are no exception. That said, some CRPs have urged caution and for appropriate safeguards to be put in place in implementing the proposal. This is especially the case given the perceived conflict of interest at SVO level, as the SVO is both a market participant (by issuing designations/ratings) and a de facto regulator (by assisting regulators in overseeing the use of ratings). From the perspective of an insurance company investing in CFOs and RNFs, the rating aspect of these investments is crucial, as it determines the risk-based capital treatment for the insurer—so the proposal could have implications when it becomes effective January 1, 2026.
Although the proposal is not expected to be widely used, it highlights the ongoing scrutiny of the regulatory treatment of structured securities such as CFOs and RNFs, and insurers should monitor the progress of the (E) Committee and its subgroups on matters relating to CRP ratings.