TO: Statutory Accounting Principles (E) Working Group s1

MEMORANDUM

TO: Statutory Accounting Principles (E) Working Group

FROM: Kevin Fry (IL), Chair, Investment Risk-Based Capital (E) Working Group

DATE: October 31, 2016

RE: Referral Regarding Increased Granularity in the Life RBC Formula

Background Information

The Investment Risk-Based Capital (E) Working Group is charged with developing recommendations for revisions to the current asset risk structure and factors in each of the risk-based capital (RBC) formulas, and the Working Group has been considering numerous issues to address this charge for a number of years. To assist the Working Group, the American Academy of Actuaries (Academy) developed a bond modeling process that considered default probabilities in order to analyze the current RBC bond structure and factors given modern loss default experience. In August 2015, the Academy released its report, which recommends an increase in the number of RBC categories for bonds in the life formula and includes updated factors for the expanded categories.

The life bond structure has been discussed by the Working Group on several occasions, and there is a general consensus that the number of RBC categories for bonds should be expanded from the current six categories (plus the exempt category) to 20categories (plus exempt.) The current RBC factors are based on the NAIC designations. The expansion would provide more robust and accurate results, primarily as it increases the granularity of the formula and reduces the “cliffs” between the different factors for the different NAIC designations. That is, an insurer may have an incentive to invest in lower-quality bonds within the same NAIC designation category and get the same RBC charge as a higher-quality bond within the same NAIC designation category.

Summary of Proposed Changes and Referral

In short, the expansion to the 20 categories (plus exempt) would be accomplished by including a new electronic-only column in Schedule D. The Academy’s report suggests that these categories be based on the bond’s credit rating from a nationally recognized statistical rating organization (NRSRO). The electronic-only column would be used to accumulate bonds into the 20 bond categories for inclusion in the asset valuation reserve (AVR) default worksheet, and AVR would be calculated based on the new expanded categories. The bond amounts in the AVR default worksheet would then be used to populate the information for bonds in the life RBC formula. The current six NAIC designation categories would continue to be used for accounting and reporting purposes, as well as for state investment law purposes. The Working Group is not proposing any changes in the structure for other assets that received the bond treatment (e.g., Schedule BA) but may consider changes to these investments in the future. Regarding securities valued under Statement of Statutory Accounting Principles (SSAP) No.43R—Loan-Backed and Structured Securities, the breakpoints for both modeled and non-modeled securities would need to be updated to use the 20-category framework.

During an Oct. 20 conference call, the Working Group discussed that it should coordinate its work with other NAIC groups, including the Statutory Accounting Principles (E) Working Group. Although we do not anticipate that the proposed changes to bond granularity will have any impact on the Accounting Practices and Procedures Manual, we would like to formally request that your Working Group review our proposal and confirm this. The Working Group has discussed a target implementation date of year-end 2017, so it would appreciate your feedback in the near future.

Thank you for your assistance, and please contact me or Julie Garber (NAIC) if you have any questions.