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Updated Principles for
Structured Securities RBC
Follow-up to Presentation to NAIC’s RBCIRE
December 2, 2023
Steve Smith, MAAA, FSA, CFA
Chairperson, Academy C-1 Subcommittee
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Executive Summary: C-1 Asset Modeling
The American Academy of Actuaries proposes a flowchart to
determine whether
An asset class needs to be modeled, and
Securities within an asset class need to be modeled individually
to determine C-1 factors.
Simpler solutions are preferred—if an existing factor can be used, it
should be used.
Individual security modeling for C-1 determination is a last resort.
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Executive Summary: Principles-Based Approach for
Structured Securities
If the result of the flowchart is that an asset class requires modeling, we would
support a principles-based approach to the derivation of C-1 factors
A principles-based approach to RBC for structured securities (referred to
as “ABS” throughout this presentation) allows flexibility when adapting to
new structures as they emerge in the marketplace
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Discussion Topics
I. C-1 Modeling Flowchart
II. Structured Securities C-1 Principles
III. Appendices
a) Appendix A—RBC Arbitrage
b) Appendix B—Definitions of Terms
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C-1 Modeling Flowchart
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Threshold Questions
For an asset class to be considered using this flowchart, it should
first be verified as having all of the following attributes:
1. Materiality or likely materiality in the future across the industry.
Allocations from a small handful of companies would not justify
changes to the RBC formula.
2. The risk that would be modeled needs to be incorporated in C-1. For
example, illiquidity alone would not be a sufficient justification
because
C-1 does not measure illiquidity risk.
3. The expected benefits of a more precise calculation should outweigh
the expected costs of building and using a new model. Costs include
both time and energy spent to build the model as well as the
negative effect of added complexity within the RBC formula.
The burden to verify these attributes falls on the party asking for
a more exact determination of RBC.
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Considering
C-1 for an
asset class
Similar risk
vs. existing
C-1 asset
models?
Sufficient
data?
C-1 Modeling Flowchart
Comparable
attributes?
Practical to
model
individually?
Use existing
C-1 factors
Create new
C-1 factors
Model assets
individually
No
Yes
Yes
Yes
Yes No
No
No
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Decision—similar risk vs.
existing C-1 asset models
Answer “yes” if the relative risk differences between risk categories
(usually ratings or designations for fixed income) is similar to that of
an existing set of C-1 factors.
For example, municipal bonds and bank loans would each likely have an
answer of “yes,” because relative increase in risk as ratings decrease is
similar to that of corporate bonds.
CLOs and some other structured securities would likely have an
answer of “no,” because tail risk increases more quickly as the rating
decreases compared to corporate bonds.
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CLO = collateralized loan obligation.
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Decision—sufficient data
Answer “yes” if data exist to enable risk modeling, and in
particular tail risk modeling.
For example, CLOs would likely have an answer of “yes,” because their
bank loan collateral has ample historical loss data and the waterfall
structure is well documented.
Some esoteric ABS, especially residual tranches, may have an
answer of “no” if insufficient data are available.
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Decision—comparable attributes
Answer “yes” if most individual assets within this asset class have
an easily identifiable attribute that can be used to sort the assets
into risk buckets.
For example, CLOs would likely have an answer of “yes,” because most
CLOs are rated by CRPs and those ratings can reasonably sort each
individual CLO security into a risk bucket.
Asset classes that are typically not rated by CRPs may have an
answer of “no” here, but don’t automatically. For example,
commercial mortgage loans are also a likely “yes” because DSCR
and LTV substitute for CRP ratings as comparable attributes.
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CRP = credit rating provider. DSCR = debt service coverage ratio. LTV = loan-to-value.
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Decision—practical to model individually
Answer “yes” if individual assets within the asset class have several
attributes that differentiate individual assets and can be used for risk
modeling or if existing modeling software can be used.
For example, CLOs would likely have an answer of “yes” because off-the-shelf
software exists that can model individual CLOs (however, CLOs may never have
arrived at this decision point if they were deemed to have comparable
attributes).
If modeling cannot reasonably be done in a timely and cost-effective
manner for RBC filing, then the answer here must be “no.”
Some esoteric ABS may have an answer of “no” if the relevant risk is so
specific to each deal that a common modeling framework does not
apply across a reasonably large share of securities.
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Outcome—use existing C-1 factors
This outcome can either mean to use existing C-1 factors directly,
without adjustment, or it can mean to make slight adjustments to
existing C-1 factors.
For example, municipal bonds and bank loans currently use corporate
bond C-1 factors without adjustment.
Schedule BA real estate currently uses Schedule A real estate
C-1 factors, but with an upward adjustment resulting in a
proportionately higher C-1 factor for BA real estate.
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Outcome—create new C-1 factors
This outcome means that a new set of C-1 factors should be
developed for this asset class.
For example, CLOs may retain the 20 possible designations that they
are currently mapped into. But instead of those 20 designations
corresponding to the 20 corporate bond C-1 factors, CLOs may instead
have their own set of 20 C-1 factors.
Instead of just a slight adjustment to existing C-1 factors, this
outcome requires fundamental modeling work to derive new
factors.
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Outcome—model asset individually
This outcome means that each asset within this asset class needs to be
modeled individually in order to generate a C-1 factor.
In practice, this is currently how non-agency RMBS and CMBS are
treated. The modeling work is done by the Structured Securities Group
to determine the NAIC designation, after which point corporate bond
factors are used. This is functionally similar to modeling each RMBS
and CMBS security individually to determine its C-1 factor.
Because of the significant operational complexity involved, this
outcome is a last resort.
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Structured Securities C-1 Principles
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Glossary of Terms
ABS: bonds falling within the emerging definition of ABS in SSAP 26, most recently
exposed November 16, 2022
Vertical Slice: an investment in all tranches of an ABS in equal proportion to the
total outstanding
RBC-transformative ABS
1
: ABS where a vertical slice draws a lower aggregate C-1
requirement, considering only base factors (before portfolio adjustment and
covariance adjustment), than its underlying collateral would draw if held directly by
a life insurer
RBC Arbitrage (narrower): holding a vertical slice of an RBC-transformative ABS
RBC Arbitrage (broad): holding any part of an RBC-transformative ABS
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1. Conversely, one could then define RBC-neutral ABS as ABS where a vertical slice draws aggregate C1 equal to that which would be drawn by its underlying collateral.
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Principle #1.
The RBC Formula Is a Blunt Filtering Tool
The purpose of RBC is to help regulators identify potentially weakly
capitalized insurers, therefore changes that have a small impact on RBC
ratios may not justify a change to the RBC formula
The frequency of changes to the RBC formula is practically limited by
NAIC processes and stakeholders’ available time, therefore it is
important to prioritize the most material potential changes to the RBC
formula.
Small allocations to RBC-transformative ABS by a limited number of
insurers may not require a change in C-1 requirements across the
entire industry.
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Principle #2.
Emerging Risks Require Regulatory Scrutiny
Emerging investment risks create concerns for regulators, and existing regulatory tools can be
considered alongside RBC for addressing these newer risks—but RBC needs to be considered when
there are material solvency issues.
RBC should address solvency issues, but not every risk will create a material solvency concern.
Modifications to RBC may be necessary, but complementary regulatory tools should also be considered (e.g.,
ORSA, AAT/AG53, disclosures, examinations, etc.).
RBC-transformative ABS that are held by a small but growing number of insurers or with increased allocation
may justify changes to the RBC formula.
More responsive refinements to RBC may be justified in areas where an insurer can more easily adjust its
business model to optimize around the RBC formula.
Refinements that are made should generally be principle-driven and agnostic to specific market conditions.
Temporary relief may be warranted on occasion, even though it has the effect of contributing anti-cyclicality into
RBC.
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Principle #3.
RBC Is Based on Statutory Accounting
C-1 requirements should generally reflect the impact of risk on
statutory surplus. Changes in accounting treatment will affect RBC.
All else equal, assets that are marked to market (“MTM”) may have
higher C-1 requirements because C-1 on MTM assets incorporates
price fluctuations in addition to credit losses.
In practice, this means that C-1 for residual tranches would consider
price fluctuations, whereas C-1 for unimpaired rated debt tranches
only considers credit losses.
Impaired rated debt tranches are part of a broader issue that applies
beyond just structured securities and are therefore outside the scope
of this candidate-principle.
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Principle #4.
C-1 Aligns With Risk
C-1 requirements for a given tranche should align with that tranche’s risk, to the extent
practical.
If an ABS has a type of collateral that is not typically rated, the unrated status may not directly
factor into the appropriate way to determine the ABS’ appropriate C-1 requirement if similar
information is captured in the ABS debt tranches’ ratings
For example, if a CRP has assigned a rating to an ABS debt tranche that incorporates a granular
assessment of the underlying collateral, the lack of rating on the collateral per se is not necessarily
indicative of the level of risk
The existence of unrated collateral does not automatically imply that an ABS should have a higher C-
1 requirement.
The existence of unrated collateral also does not automatically imply that an ABS should not have a
higher C-1 requirement.
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Principle #5.
C-1 Requirements Reflect Likely Future Trading Activity
C-1 requirements on ABS should treat the collateral as a dynamic pool of assets,
incorporating future trading activities that are reasonable and vary appropriately by
economic scenario.
C-1 requirements should not be reduced by any amount due to an assumption of credit alpha.
This candidate-principle refers to the trading activity that is subject to or mandated by the structure’s legal
documents.
If C-1 requirements on ABS acknowledge the evolving nature of the collateral pool, the total C-1 of the
structure may not equal the C-1 of a snapshot of the collateral pool at any one point in time. A reasonable
relationship should exist between the C-1 requirements of the collateral pool and the ABS.
If designations are based on CRP ratings, then explicit recognition of trading activity may not be required
to the extent CRP ratings account for this.
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Principle #6.
Appropriate Risk Measures
Each C-1 factor is based on the asset class’s risk profile. However, the risk profile for
ABS differs from the risk profile for bonds. Therefore, C-1 requirements for ABS
should be calibrated to different risk measures where appropriate.
In our December 2022 report to RBCIRE WG, the Academy recommended adopting a different risk
measure for CLOs—Conditional Tail Expectation (“CTE”)—because CTE may better capture tail risk
inherent in CLOs.
While different risk measures may be appropriate, each asset’s C-1 factor aims for a similar
magnitude or level of risk.
This candidate-principle implies that not all ABS structures are necessarily RBC-neutral, because the
collateral and the ABS would have C-1 requirements set to different statistical safety levels. A
reasonable relationship should exist between the C-1 requirements of the collateral pool and the
ABS.
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Summary of Principles
1. The purpose of RBC is to help regulators identify potentially weakly capitalized insurers,
therefore changes that have a small impact on RBC ratios may not justify a change to
the RBC formula.
2. Emerging risks require regulatory scrutiny.
3. C-1 requirements reflect the impact of risk on statutory surplus. Changes in accounting
treatment will affect RBC.
4. C-1 requirements on a given tranche align with that tranche’s risk.
5. C-1 requirements on ABS should treat the collateral as a dynamic pool of assets.
6. C-1 requirements for ABS should be calibrated to different risk measures where
appropriate.
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Appendix A: RBC Arbitrage
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Impact of Principles on Definition of RBC Arbitrage
By discussing broader principles, this presentation seeks to spark conversation on the
definition of Risk-Based Capital (RBC) arbitrage in Asset Backed Securities (ABS) and
clarify the implications of conflicting RBC arbitrage definitions.
The NAIC’s Investment Analysis Office (IAO) has proposed a constraint in the model used
to determine designations, and therefore RBC requirements, for CLOs. This constraint
would eliminate RBC arbitrage, as defined by the IAO, that the IAO believes is present in
CLOs.
Competing definitions among interested parties and regulators have been used in some
formal and informal discussions, so far without a forum for being discussed directly.
This presentation attributes differences in RBC arbitrage definitions to underlying
principles of RBC. The Academy is requesting guidance from regulators on which
principles should be followed. Once the principles have been identified, RBC arbitrage
can be more clearly defined and more effectively mitigated. These principles will also
guide a broader effort around improving the C-1 framework for all ABS.
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Asset Classes With Greatest Potential
for RBC Arbitrage
Quantifying RBC arbitrage
is most direct when the
underlying collateral has an
explicit C-1 factor
Tranched structures are
more likely to produce RBC
arbitrage than pass-through
structures because
tranching transforms risk
RBC arbitrage discussions
should focus on tranched
structures with established
asset-class-specific C-1
CLO
Non-Agency RMBS/CMO
CMBS
CFO
Consumer Finance
Asset-based Lending
Credit feeder fund
Agency RMBS
Established
asset-class-
specific C-1
No established
asset-class-
specific C-1
Tranched Pass-Through
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Definitions of RBC Arbitrage
IAO has expressed its view that holding any tranche of a securitization
whose vertical slice carries a different aggregate C-1 requirement
compared to the underlying collateral constitutes RBC arbitrage—we term
this the broad
1
definition of RBC arbitrage
An alternative, narrower
1
definition of RBC arbitrage includes only
instances where an insurer holds a vertical slice
1
Many other possible definitions lie somewhere in between
1. Please see Appendix BDefinitions of Terms for precise definitions of technical terms.
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IAO Usage of the Term “RBC Arbitrage”
A letter from IAO to VOSTF dated May 25, 2022, introduces the concept of
RBC arbitrage within the context of CLOs: “The aggregate RBC factor for
owning all of the CLO tranches should be the same as that required for
owning all of the underlying loan collateral. If it is less, it means there is
RBC arbitrage.”
SVO’s Structured Equity & Funds Proposal dated November 28, 2022, also
uses the term “RBC arbitrage” with effectively the same meaning but
expanding the scope from CLOs to include certain feeder fund structures.
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Academy Usage of “RBC Arbitrage”
In our presentation to RBCIRE WG dated December 14, 2022, the Academy
disagreed with the concept that the existence of RBC arbitrage, as defined
by IAO, necessarily implied an incorrect C-1 requirement
The Academy believes dialogue among all parties will be improved if we
first collectively agree on a definition of RBC arbitrage before discussing
its implications for C-1 requirements
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Related Regulatory Concerns
IAO has also pointed out the possibility of RBC-transformative ABS being
used to reclassify investments to technically comply with investment limits
set forth in state insurance law, for example converting equity to debt for
statutory purposes
RBC-transformative ABS may also be used to reclassify investment returns
or losses from an accounting perspective
While we acknowledge these related potential issues, this presentation
focuses only on C-1 implications of RBC-transformative ABS
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Appendix B: Definitions of Terms
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ABS Definition
RBC arbitrage discussions typically involve structured securities, for
example CLOs and rated note feeder fund structures.
Within this presentation, we refer to all such structured securities as ABS,
and we intend for the definition of ABS to align with the emerging
definition of ABS in SSAP 26, most recently exposed November 16, 2022.
Under this definition, ABS has a primary purpose of raising debt capital
backed by collateral that provides the cash flows to service the debt.
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ABS Definition, Continued
Exposed principles-based
definition of ABS is
illustrated here
Image taken from “Assets:
Regulatory Updates in Life
Insurance” April 4, 2023,
webinar by the American
Academy of Actuaries
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Vertical Slice Definition
A vertical slice is an investment in all tranches of an ABS in equal proportion
to the total outstanding. A vertical slice is economically equivalent to a direct
investment in the underlying collateral at any one point in time.
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RBC-Transformative ABS Definition
An RBC-transformative ABS is any ABS where a vertical slice draws a lower
aggregate C-1 requirement than its underlying collateral would draw if held
directly by a life insurer.
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Narrowly Defined RBC Arbitrage
Holding a vertical slice of an RBC-transformative ABS constitutes RBC
arbitrage under the narrow definition.
In this case, it is unambiguously true that absent the structure of the ABS, a
life insurer would be required to hold a higher level of C-1 capital.
Even under the narrow definition of RBC arbitrage, C-1 requirements for the
collateral may be inappropriately high rather than the ABS C-1 requirements
being inappropriately low. Also, C-1 for the ABS and its collateral may be
calibrated precisely to the prescribed risk measures despite the ABS being
RBC-transformative. Regardless, in such cases holding a vertical slice of an
RBC-transformative ABS would still constitute RBC arbitrage.
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Broadly Defined RBC Arbitrage
Holding any part of an RBC-transformative ABS constitutes RBC arbitrage
under the broad definition.
For example, any CLO holdings would constitute RBC arbitrage under this
definition, because CLOs are an RBC-transformative ABS (as discussed in the
Academy’s December 2022 presentation to RBCIRE WG).
IAO letters written to VOSTF during 2022 employ the broad definition of RBC
arbitrage.
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QUESTIONS
Contact:
Amanda Barry-Moilanen, Life Policy Analyst
barrymoilanen@actuary.org
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