Treating Debt As Equity — Emerging Standards In Insurance Regulation

Recent efforts by the National Association of Insurance Commissioners (NAIC), the principal standard-setting body for insurance regulation in the U.S., to establish a "group capital" standard (that is, capital-adequacy rules for insurance companies and their affiliates as a whole) could change the circumstances under which debt instruments are treated as equity for regulatory-capital purposes.

After reviewing some of the basics of insurance company capital requirements and the features of certain "hybrid" debt instruments, this article will explore the NAIC's ongoing group capital project and its possible impact on the treatment of such instruments, including highlights of a recent paper from an NAIC working group.

RBC and Entity-Level Capital Requirements

Historically, capital of insurers has been regulated mainly at the statutory entity level. The principal regulatory tool that state insurance regulators have used for approximately the past 25 years is the NAIC's risk-based capital, or RBC, calculation. Under RBC, each insurance company performs an annual series of prescribed calculations, tailored to its distinct risk profile, product mix, investment portfolio, reinsurance program and other variables, designed to produce (i) a minimum amount of capital and surplus necessary for the entity to conduct its specific business and (ii) the actual amount of "total adjusted capital" residing in the entity. Total adjusted capital must exceed two times the minimum in order for the entity to be in full compliance with RBC requirements. If capital falls below two times the minimum, the regulator may take certain measures to restore the insurer to capital adequacy. Below 1.5 times the minimum, certain additional remedies become available to the regulator to address the capital deficiency, and still further measures can be taken when capital falls below 1.0 times the minimum. At 0.7 times the minimum level, the insurance regulator is required to place the insurer in receivership.

The entity-level determination of minimum capital is consistent with financial regulation of insurers generally, including the use by insurance regulators and companies of "statutory" accounting principles as opposed to generally accepted accounting principles (GAAP). "Stat" or "SAP" accounting operates at the entity level as well and does not consolidate multiple entities. (Of course, insurance companies that are part of a larger group can use GAAP on a consolidated basis and, when registering under U.S. securities laws, must do so.)

Surplus Notes

Under statutory accounting guidelines issued by the NAIC — and, in a number of states, specific insurance statutes — "surplus" notes issued by an insurer are recorded as capital rather than liabilities on the insurer's balance sheet. Surplus notes, generally, are deeply subordinated debt instruments, as to which prior approval of the state regulator is required for issuance, payment of any principal or interest, and any redemption or repurchase. Payments on the notes may be approved by the regulator only if he deems surplus to be sufficient to safely do so. Surplus notes may not be accelerated upon a default, rank senior only to equity, and are subordinated to all other liabilities — policy claims, general unsecured claims, all other debt instruments — except for other series of pari passu surplus notes.

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