VALUATION OF SECURITIES (E) TASK FORCE December 7, 2010

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1 REVISED AND REDITRIBUTED 12/7/10 4:45 PM CT Attachment 1c Conference Call VALUATION OF SECURITIES (E) TASK FORCE December 7, 2010 Summary Report The Valuation of Securities (E) Task Force met on Dec. 7, During this meeting, the Task Force took the following action: 1. FDIC Insurance Adopted a proposed filing exemption for Certificates of Deposit that are required to be reported as bonds under SSAP No. 26. The amendment exempts from filing with the SVO any CD that: o o is for an amount equal to or less that the maximum FDIC deposit insurance. Those CDs are to be reported as Filing Exempt Securities with NAIC1 designation, or is for an amount greater than the maximum FDIC deposit insurance. When the issuer is ARO rated, the CD is required to be filed as a Filing Exempt security, with the NAIC designation equal to the issuer s ARO rating. When the issuer is not ARO rated, the same filing and reporting requirements apply as to any unrated bond. 2. Classification Proposal (a) Adopted a motion to receive the SVO response and Interested Parties comment letter to the Classification proposal that was exposed at the NAIC Fall National Meeting. The proposal would: o o o delete the classification methodology from the SVO Purposes and Procedures Manual; require that securities classification is done (including re-classification when annual updates are done) based on the definitions provided in the relevant SSAPs; and require classification to comply with the statutory hierarchy (b) Adopted a motion to request that the Financial Conditions (E) Committee refers the Classification proposal, the SVO response, and the Interested Parties letter to the Statutory Accounting Principles (E) Working Group for an opinion on the accuracy of the references to statutory accounting used in the proposal and the SVO response; in particular the references to the statutory hierarchy. 3. Instructions for Determining NAIC Designations for Loan-Backed and Structured Securities Adopted Instructions, effective for year-end 12/31/10 for Determining NAIC Designation for Loan Backed and Structured Securities. The instructions explain how insurers should determine the applicable NAIC designation for those loan-backed and other structured securities including RMBS and CMBS that are not modeled. 4. Interim Reposting Instructions for Modeled Securities Adopted Instructions for Modeled Securities for year-end 12/31/10, replacing references to the filing exempt rule in the Purposes and Procedures Manual for those securities, and serve as the instructions referred to by SSAP No. 43R Loan-Backed and Structured Securities Revised National Association of Insurance Commissioners 1

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3 To: Cc: Valuation of Securities (E) Task Force Joseph Fritsch, Chair, Statutory Accounting Principles (E) Working Group Chris Evangel, SVO Managing Director Robert Carcano, Senior SVO Counsel From: Matti Peltonen, New York State Insurance Department Date: 10/01/2010 Re: Eliminating Conflict in Classifying Investments Background: The NAIC Securities Valuation Office (SVO) classification scheme for securities is set forth in Part Four - Special Regulatory Procedures Applicable to Investment Activity Of Insurers, Section 1. Guidelines for Determining Status of New Instruments as Debt, Preferred Equity or Common Equity of the Purposes and Procedures Manual of the NAIC Securities Valuation Office (P&P Manual) that provides guidelines for the SVO staff in describing how securities are to be classified between debt, preferred stocks, and common stocks. This classification method is applied for securities filed with the SVO. This classification approach had worked in the past to highlight securities that were perceived as possibly presenting more types of risks, or risks greater than, e.g., senior corporate debt obligations, in terms of subordination or structural features. That classification approach was instituted when the NAIC s investment schedules lacked the transparency that they now possess. The SVO classification does not, however, take into account the NAIC statutory hierarchy, provided in the preamble of the NAIC Accounting Practices and Procedures Manual (AP&P Manual). The Statements of Statutory Accounting Principles (SSAPs) are the highest level of NAIC statutory authority. The definitions of securities provided in the SSAPs determine how securities are reported and, thus, how regulators perceive those investments. The SSAPs are superior to, and supercede, any determination, including classification, pursuant to the SVO s Purposes and Procedures Manual. The purpose of reporting investments is to provide information in a clear, transparent, and consistent fashion, so that regulators can accurately assess investment risks. Reporting cannot be consistent when classification by the SVO conflicts with the classification that would be arrived at by applying the SSAPs. For example, when the SVO classifies a residential mortgagebacked security (RMBS) as a preferred stock, the filer typically reports it as a preferred stock in accordance with the SVO classification. This classification, however, directly contradicts the guidance provided in SSAP43R and, if followed, results in incorrect reporting. The information provided by the various improvements implemented in Schedule D Part 1 of the annual statement (where bonds are reported), such as the collateral type (for loan-backed and structured securities) and bond characteristics (designed to disclose a variety of risks such as optionality), get lost

4 when a bond is filed as a preferred stock, because the preferred stock schedule does not provide the same level of detail does Part D1. The investment schedules and the categories in Part D1 are designed to enable regulators to assess risk concentrations by security type. Those risk concentrations cannot be accurately assessed when, using RMBS as an example, some RMBS are reported in the loan-backed and structured security buckets and some, following SVO classification, are reported as preferred stocks. There is no way for regulators, in a timely and efficient manner, to identify RMBS filed as preferred stocks are, in fact, not preferred stocks. Requiring bonds to be reported as preferred stocks also results in incorrect valuations. To treat bonds as preferred stocks would ignore the very real differences between the NAIC s method for valuing bonds and its method for valuing preferred stocks; amortized cost is different from lower of cost or fair value. Treating these as interchangeable, which filing bonds as preferred stocks does, could present a regulator with a distorted view of an insurer s balance sheet. If bonds are valued as preferred stocks, there would be no way for the regulator to catch either the true value of the balance sheet or the valuation error. These valuation failures would also be reflected in incorrect Asset Valuation Reserves and Interest Maintenance Reserves. This confusion also prevents a consistent filing of bonds. Mostly, bonds classified as preferred stocks by the SVO represent a level of subordination below the most senior tranches in the cashflow waterfall of a trust, where the payments are divided between the tranches, and the junior tranches support the senior tranches. That subordination is different from the subordination of preferred stock issued by a corporation such preferred stock can be defined as Any class or series of shares the holders of which have any preference over the holder of any other class or series of shares. Thousands of rated bonds representing all levels of subordination are filed as bonds under the Filing Exemption rule. RMBS and CMBS are subject to modeling and filed as bonds. A security representing similar risks in every respect, but lacking a rating, may end up as preferred stock when subject to the SVO P&P Manual s classification. Deeply subordinated bonds may turn out to be a poor investment (that credit risk is reflected by the NAIC designation) but subordination does not turn a bond into a preferred stock. Proposal: Because the SVO classification scheme no longer provides a regulatory benefit in improving identification of investment risks, and as the SVO classification can result in a conflict with the statutory accounting and reporting requirements, it is proposed that: The classification of securities (pages of the P&P Manual) is deleted, and; Security classification performed by the SVO is required to be based on the definitions provided in the relevant SSAPs, and; When the SVO performs annual updates, securities are re-classified as necessary, in accordance with the SSAPs.

5 References NAIC Accounting Practices and Procedures Manual NAIC Statutory Hierarchy (abbreviated), Preamble, page 8: Level 1: SSAPs including GAAP reference materials Level 2: Consensus positions of the Emerging Accounting Issues Working Group as adopted by the NAIC Level 3: NAIC Annual Statement Instructions NAIC Purposes and Procedures of the Securities Valuation Office manual Level 4: Statutory Accounting Principles Statement of Concepts SSAP Definitions of Bonds, Preferred Stocks, Common Stocks, and Loan-Backed and Structured Securities SSAP No Bonds, excluding Loan-backed and Structured Securities 2. Bonds shall be defined as any securities representing a creditor relationship, whereby there is a fixed schedule for one or more future payments. This definition includes: a. U.S. Treasury securities, b. U.S. government agency securities, c. Municipal securities, d. Corporate bonds, e. Bank participations, f. Convertible debt, g. Certificates of deposit and commercial paper that have a fixed schedule of payments and a maturity date in excess of one year from the date of acquisition, h. Commercial Paper, i. Exchange Traded Funds, which qualify for bond treatment, as identified in the NAIC Purposes and Procedures of the Securities Valuation Office, and j. Class 1 Bond Mutual Funds, as identified in the NAIC Purposes and Procedures of the Securities Valuation Office. Loan-backed and structured securities meet this definition, but are excluded from the scope of this statement, and are addressed in SSAP No. 43 Loan-backed and Structured Securities. Securities which meet the definition above, but have a maturity date of one year or less from the date of acquisition are addressed in SSAP No. 2 Cash, Drafts, and Short-term Investments. Mortgage loans and other real estate lending activities made in the ordinary course of business meet the definition above, but are not addressed in this statement. These types of transactions are addressed in SSAP No. 37 Mortgage Loans and SSAP No. 39 Reverse Mortgages.

6 SSAP No. 30 -Investments in Common Stock (excluding investments in common stock of subsidiary, controlled, or affiliated entities) Common stocks (excluding investments in affiliates) are securities which represent a residual ownership in a corporation and shall include: a. Publicly traded common stocks; b. Master limited partnerships trading as common stock and American deposit receipts only if the security is traded on the New York, American, or NASDAQ exchanges; c. Publicly traded common stock warrants; d. Shares of mutual funds, except for certain money market funds, Class 1 Bond Funds, and Exchange Traded Funds, which qualify for bond treatment, as designated in the NAIC Purposes and Procedures of the Securities Valuation Office (Purposes and Procedures of the SVO), regardless of the types or mix of securities owned by the fund, e.g., bonds, stocks, money market instruments, or other type of investments; e. Common stocks that are not publicly traded; and f. Common stocks that are restricted as to transfer of ownership. Restricted stock shall be defined as a security for which sale is restricted by governmental or contractual requirement (other than in connection with being pledged as collateral), except where that requirement terminates within one year or if the holder has the power by contract or otherwise to cause the requirement to be met within one year. Any portion of the security that can be reasonably expected to qualify for sale within one year is not considered restricted. SSAP No Investments in Preferred Stock (including investments in preferred stock of subsidiary, controlled, or affiliated entities) 3. Preferred stock (excluding investments in affiliates), which may or may not be publicly traded and may include shares against which exchange traded call options are outstanding, shall include: a. Redeemable preferred stock, including mandatory sinking fund preferred stock and preferred stock redeemable at the option of the holder; and b. Perpetual preferred stock, including nonredeemable preferred stock and preferred stock redeemable at the option of the issuer. 4. Redeemable preferred stock is defined as preferred stock that must be redeemed by the issuing enterprise or is redeemable at the option of the reporting entity. It includes mandatory sinking fund preferred stock and payment-in-kind (PIK) preferred stock. 5. Mandatory sinking fund preferred stock is defined as redeemable preferred stock subject to a 100% mandatory sinking fund, annual installments of which will (a) commence not more than 10 years from the date of issue or December 31, 1978, if outstanding on that date; (b) be not less than 2% of the number of shares issued (or outstanding on December 31, 1978, if issued prior to that date); (c) provide for the redemption of the entire issue over a period not longer than 40 years from the date of issue, or December 31, 1978, if outstanding on that date. Redeemable preferred stock which is subject to a 100% mandatory sinking fund, but which does not, at date of issue or December 31, 1978, if outstanding at that time, meet one or more of the other requirements above, shall be considered as mandatory sinking fund preferred stock at the time the deficiency is cured through the passage of time or otherwise.

7 6. PIK preferred stock is defined as redeemable preferred stock on which, at the option of the issuer, dividends can be paid in additional securities rather than cash. 7. Perpetual preferred stock is defined as preferred stock with no redemption or sinking fund features or preferred stock redeemable at the option of the issuer. 8. Restricted preferred stock is defined as a security for which sale is restricted by governmental or contractual requirement (other than in connection with being pledged as collateral) except where that requirement terminates within one year or if the holder has the power by contract or otherwise to cause the requirement to be met within one year. Any portion of the security that can be reasonably expected to qualify for sale within one year is not considered restricted. SSAP No. 43R Loan-Backed and Structured Securities 2. Loan-backed securities are defined as pass-through certificates, collateralized mortgage obligations (CMOs), and other securitized loans not included in structured securities, as defined below, for which the payment of interest and/or principal is directly proportional to the interest and/or principal received by the issuer from the mortgage pool or other underlying securities. 3. Structured securities are defined as loan-backed securities which have been divided into two or more classes for which the payment of interest and/or principal of any class of securities has been allocated in a manner which is not proportional to interest and/or principal received by the issuer from the mortgage pool or other underlying securities. 4. Loan-backed securities are issued by special-purpose corporations or trusts (issuer) established by a sponsoring parent organization. Mortgage loans or other securities securing the loan-backed obligation are acquired by the issuer and pledged to an independent trustee until the issuer s obligation has been fully satisfied. The investor can look only to the issuer s assets (primarily the trusteed assets or third parties such as insurers or guarantors) for repayment of the obligation. As a result, the sponsor and its other affiliates may have no financial obligation under the instrument, although one of those entities may retain the responsibility for servicing the underlying mortgage loans. Some sponsors do guarantee the performance of the underlying loans. Purposes and Procedures Manual of the NAIC Securities Valuation Office Part Four - Special Regulatory Procedures Applicable to Investment Activity Of Insurers Section 1. Guidelines for Determining Status of New Instruments as Debt, Preferred Equity or Common Equity (a) Categorization as Debt or Equity The NAIC Financial Conditions Network requires different reserve and risk-based capital factors depending on whether an investment is categorized as a debt instrument, preferred equity or common equity.

8 Increasingly, securities contain hybrid features that blur the distinctions suggested by these three classes of securities; for example, a security may be characterized as debt although the legal significance or likely economic result of certain of its provisions are more closely associated with preferred or common equity. The VOS/TF acknowledges a need to provide guidelines to assist the SVO to categorize filed securities appropriately and in as consistent a manner as possible. The SVO shall apply the guidelines contained in this section to new instruments: Routinely, for any security or financial product filed with the office, As part of the analysis of a security or financial product submitted to the SVO under the Emerging Investment Vehicle process discussed in Part Four, Section 4 of this Manual, When requested to do so by any state insurance regulator acting pursuant to Part Two, Section 2(b) of this Manual and When requested by the Task Force, including in support of the IAWG or In support of any other NAIC group engaged in the analysis of investment risks in new securities. (b) Benchmark for the Guidelines The guidelines provided under this section assign instruments to one of three categories; debt, preferred equity or common equity based on the difference in investor expectation and the rights exhibited by the security under review. This three-tiered capitalization model reflects the U.S. legal and business convention and is the result of the unique accounting, regulatory, tax and corporate securities environment found in the U.S. Because these environments may differ dramatically in other countries, both from the U.S. model and from one another, the concept of what constitutes debt, preferred equity and common equity in other countries will likely also differ from the U.S. conception of these securities classes. The guidelines below provide the SVO with three specific profiles for investor expectations and rights based on the U.S. capitalization model. The SVO is required to use these profiles to determine whether the characteristics of a filed security are more consistent with one profile than with another. Each of the three securities profiles focuses on the following fundamental expectations and rights: The de-facto status accorded the holder of the instrument as creditor or as the holder of a residual interest. The existence or nonexistence of the right to influence issuer management that is associated with the security. The deferability and the cumulative/non-cumulative nature of the promise to make periodic payments. The agreed - upon basis for establishing an expectation as to maturity or redemption of the claim. The nature of a claim in an involuntary redemption such as bankruptcy, liquidation or reorganization as either a debt claim or a residual interest. Each of the three profiles provides an end result to each of these fundamental expectations and rights, thus defining the primary characteristic of the security class. The final categorization decision made by the SVO will be influenced by the degree to which the security characteristics of any one profile predominate, subject always to the synergistic effect of different provisions or characteristics within a security, the regulatory objectives of the NAIC and the SVO's exercise of analytical discretion.

9 (c) Relevant Principles The following statements encapsulate important principles applicable to interpretation of the guidelines. (i) Comparison of Debt and Preferred Equity The expectations and rights of preferred equity securities are, generally speaking, more debt like than common equity - like in that both debt and preferred equity contemplate a par-like claim and a series of periodic payments to be realized in the future. Debt instruments provide higher certainty about receipt of those payments and strong legal rights to protect the payment claim. (ii) Deeply Subordinated Debt The SVO may consider that the degree of subordination is relevant to the categorization of an instrument as debt or equity. (iii) Weighting of Guideline Criteria No single guideline is to be considered paramount and no single criteria predominates in the SVO's decision-making process. (iv) Factors or Criteria Not Listed in Guidelines The SVO may incorporate factors or criteria not listed in the published guidelines in its analysis, although such factors are generally considered subsidiary to the published guidelines. (v) Status of Security under Local (Foreign) Law The status of the security under foreign, i.e., non-u.s. law governing the issuer especially as to insolvency, the rights granted the investor and the powers granted to any non-u.s. regulator is usually analytically instructive on the categorization issue.

10 (vi) Mandatorily Convertible Securities Where a security incorporates a device with the economic characteristic of a forward purchase of a security (e.g., a mandatorily convertible security), the SVO will focus its analysis on the terms of the security subject to the forward purchase. (vii) SVO's Exercise of Discretion These guidelines cannot anticipate or predict all variations or future innovations in the structuring of securities. SVO is charged with analytical responsibility for categorizing securities and may exercise its discretion to attain the purpose of these guidelines, subject to Part One, Sections 2(f). Insurers may utilize the EIV- Regulatory Treatment Analysis Service process described in Part Four, Section 4 to obtain guidance on the issues discussed in these guidelines. (d) Guidelines Tables and Comments (i) About the Guideline Tables The following guidelines are intended solely to facilitate credit assessment and valuation for purposes of categorizing securities within the NAIC Financial Conditions Framework. In particular, the guidelines are not intended as guidance for structuring or creating securities. There can be no assurance that a security structured in reliance on the profiles suggested below will be accorded the treatment intended by a filer. SVO analysts are prohibited from assisting in the structuring of securities. There is no particular relevance to the order in which the characteristics appear and no such relevance should be inferred. (ii) About the Comments The comments to the categorization characteristics are presented as illustrations of important analytical issues or benchmarks that are associated with the profile characteristic under discussion. The comments are also intended to provide greater transparency to the filer by disclosing SVO positions on issues that reoccur in the categorization process.

11 I. Contractual Promise Debt Preferred Equity Comments: Creditor status Preferential status Residual status -An important component of -An instrument described as subordinate creditor status is the right of to all dated debt would warrant scrutiny acceleration upon missed for preferred treatment. -To be payments. -To be categorized as a categorized as a preferred instrument in debt instrument in the NAIC the NAIC Financial Conditions Financial Conditions Framework, Framework, the instrument must always the instruments must always have have priority in all distributions over priority in all distributions over common equity. preferred and common equity. II. Rights Debt Preferred Equity No voting Contingent voting rights Voting rights No profit participation No profit participation Profit participation Cumulative payments Cumulative or non-cumulative Non-cumulative III. Periodic Payment Debt Preferred Equity Payments Deferral Scheduled A deferral is typically viewed as a default. Scheduled with potential for deferral, or as declared - with the expectation that they are viewed as a fixed payment obligation by management. Deferral is not an event of default. Allowed if no common dividend paid. As declared N/A Obligation Comments: Missed payment is an event of default and permits acceleration. -Deferral does not preclude debt treatment. -Issuer's discretion of deferral is limited either to a specific period of time or by specific triggers. Such triggers are generally limited to events that could give debt holders decisionmaking ability under covenants in a debt contract. Obligation may or may not be cumulative. -Deferral or non-payment allowed as long as dividends have not been paid on common equity. -Issuer's discretion is limited only by the requirement to pay dividends if dividend is paid on junior capital. Missed payments are not cumulative. Complete discretion IV. Maturity/Redemption Debt Preferred Equity Contractually established date May or may not have stated maturity, but anticipation of a future redemption with a potentially high degree of uncertainty. No maturity and no redemption anticipated.

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13 To: Members of the Valuation of Securities (E) Task Force From: Chris Evangel, Managing Director, SVO Robert Carcano, Senior Council, SVO Kevin Driscoll, Analyst III, Credit and Regulatory Team II Sharad Gupta, Manager, Credit and Regulatory Analysis Team I Harry Olsen, Manager, Credit and Regulatory Analysis Team II Hilary Renz, Manager, Credit and Regulatory Analysis Team III Re: Comments on the NY Proposal Entitled: Eliminating Conflicts in Classifying Investments Date: December 1, Introduction - The NY Proposal - The SVO staff has an opportunity to review the captioned NY proposal and we believe its basic premise involves assumptions that are not generally accepted. The NY position espouses a viewpoint that we believe is contrary to stated directives adopted by the NAIC and the regulatory intent. The NY proposal states (a) Classification methodology does not take the statutory accounting hierarchy into account; (b) That SSAPs are the highest level of statutory authority and the SVO analytical process must be subordinate to them; (c) That the definitions for securities contained in the SSAPs are the source for determining how securities are to be reported; (d) and That the definitions in the SSAPs are designed to ensure securities are reported by type; (e) That classification methodology conflicts with this objective because it assigns securities to one of three reporting buckets based on risk characteristics instead of permitting securities of the same type to be reported in the same section of the annual statement blank. 2. Discussion - The Statutory Framework and the Role of the SVO - We believe the NY proposal is based on opinion that is inconsistent with the written guidelines specified in the Preamble of the Accounting Practices and Procedures Manual and have been accepted by regulators and interested parties for a substantial number of years. The NY proposal does not accurately interpret how the statutory accounting process is intended to work. As such the proposal makes factual representations that are not validated by the proposal s premise. The position taken relative to classification methodology and credit assessment and, particularly, with respect to the facts of the RMBS transaction it uses as an illustration, highlights the lack of corresponding evidence. (a) By definition, an SSAP is a statement of an accounting principle. The Accounting Practices and Procedures Manual is seems clear that only the Accounting Practices and Procedures (E) Task Force can determine accounting principles (Preamble Paragraph 51). But the Accounting Practices and Procedures Manual also very explicitly says that accounting principles that relate to investments are to be maintained by the Valuation of Securities (E) Task 2010 National Association of Insurance Commissioners 1

14 Force through the instrumentality of the Purposes and Procedures Manual (Preamble Paragraph 52). (b) The hierarchy to which the NY proposal refers is not a statement of exclusive authority as claimed but a user s guide. (Preamble paragraph 39) and it specifically provides that the Purposes and Procedures Manual is a source of statutory accounting principles (Preamble Paragraph 39). (c) Far from being in conflict, the results of the various analytical procedures conducted by the SVO per the Purposes and Procedures Manual are intended to drive reporting and to do so not by reference to what someone decides to call an instrument but by reference to the risk characteristics in the security as determined by the SVO. (Preamble paragraph 52 and invested asset SSAPs). 3. Staff Findings Based on our reading of statutory accounting guidance we would make the following observations and recommendations: Codification sought to ensure that NAIC statutory accounting guidance took into account and was based on an assessment of risk in insurer held securities. At least since the 1990s, insurer eligible investments contain characteristics and features that are inconsistent with the label often assigned to the instrument. Classification seeks to relate these instruments back to the NAIC regulatory reporting framework. The integrity and transparency of credit risk assessment and risk assessment generally would be subverted by requiring SVO determinations on a security s risk to be subordinated to a static statutory accounting framework. Endorsement of this proposal would make state insurance regulators increasing blind to the financial engineering in securities marketed to and held by insurance companies. We believe this was the rationale to place this duty with the SVO to serve as the insurance regulators front-line financial market experts. The analytical function of identifying risk in securities is assigned by the NAIC Executive Committee as a matter of regulatory policy and as a question of corporate organization to the SVO under the general auspices of the Task Force and the direct administrative reporting and accountability procedures provided by the senior staff apparatus. SVO decisions, taken in accordance with established process and methodology, should be entitled to presumptive weight in the statutory accounting and reporting hierarchy as contemplated by the Purposes and Procedures Manual and paragraphs 39 and of the Preamble to the Accounting Practices and Procedures Manual. Classification analysis methodology is one process used to make distinctions about risks. As such, those who engage in this activity on a daily basis (e.g. SVO analytical staff) through years of credit and regulatory experience understand and have utilized the SVO Credit Committee process to classify thousands of insurer reported securities. SVO credit and investment risk analysis is required to be tied at all times to market realities that the SVO is charged with understanding and reflecting, and cannot be constrained or subordinated to the statutory accounting or reporting process. Instead, 2010 National Association of Insurance Commissioners 2

15 SVO expertise must be permitted to guide further developments in the existing framework to ensure that statutory accounting and reporting processes actually reflects investment risk. The SVO supports the various recommendations made by the Hybrid RBC (E) Working Group in their final report, summarized below for you convenience. 4. Classification and Credit Assessment Procedures The interplay between Classification and Credit Assessment Procedures requires the SVO to look beyond the simple acceptance of what an instrument is called by the security s creators. There is a misunderstanding in the memorandum s assertions as to how the SVO conducts classification. The memorandum is incorrect in its assertions as to how classification is conducted. True securitizations do not require classification because they are tranched and the cash-flow waterfall specified in the legal documents already identifies the priority and degree of subordination of each tranche. Classification is utilized to determine the nature of the promise to pay that an instrument contains because only those instruments that contain a promise to pay can be designated. We believe it is inappropriate to use notching instead of classification analysis to make equity like instruments appear to be debt like. Notching refers to the practice of lowering or raising the designation grade assigned to an instrument. Notching is used only to reflect differences in credit quality including the relative position of different instruments in an issuer s capital structure. Again, we believe it would be inappropriate to lower the designation assigned to an instrument to reflect risks other than credit. We also note that the NY proposal does not address and remains completely silent on the concerns expressed by the Hybrid Risk Based Capital (E) Working Group, which cited the need to address definitional and other deficiencies in the SSAPs so that SVO risk assessment can more efficiently assist the regulatory process. 5. Exclusions The NY proposal focuses on the SVO analytical processes in relation to the SAAPs. However, the SVO classification and credit determinations represent only a quarter of the insurance industry s $2 trillion investment holdings. The balance of the investment holdings contain ARO credit rating and follow the Filing Exempt rule. Any proposal should also speak to the rated portion of the insurers investment holding and not simply accept the ARO determination 2010 National Association of Insurance Commissioners 3

16 Attachment One Paragraphs from the Preamble of the Accounting Practices and Procedures Manual IV Statutory Hierarchy Level 1 SSAPs Level 2 Consensus positions of the Emerging Accounting Issues Task Force Level 3- NAIC Annual Statement Instructions Purposes and Procedures Manual of the NAIC Securities Valuation Office 39. If the accounting treatment of a transaction or event is not specified by the SSAPs, preparers, regulators and auditors of statutory accounting statements should consider whether the accounting treatment is specified by another source of established statutory accounting principles. If an established statutory accounting principle from one or more sources in Level 2 or 3 is relevant to the circumstances, the preparer, regulator or auditor should apply such principle. If there is a conflict between statutory accounting principles from one or more sources in Level 2 or 3, the preparer, regulator or auditor should follow the treatment specified by the source in the higher level that is follow Level 2 treatment over Level 3. Revisions to guidance in accordance with additions or revisions to the NAIC statutory hierarchy should be accounted for as a change in accounting principle in accordance with SSAP. No 3 Accounting Changes and Corrections of Errors. (Emphasis added) 51. Various NAIC Committees and their working groups will be involved in issues, at any point in time, that could impact accounting guidance. Recommendations that affect accounting guidance must be referred to the Accounting Practices and Procedures Task Force which has the responsibility for the maintenance of this Manual for determination of appropriate inclusion in SAP. 52. There are instances where the Codification of Statutory Accounting Principles Working Group has established an accounting principle in a SSAP but deferred maintenance and update of the detailed guidance to other NAIC task forces and their working groups. Those instances are specifically set forth in the individual SSAPs and include periodic update to the Purposes and Procedures Manual of the NAIC Securities Valuation Office.* (emphasis added) 53. Changes to statutory accounting principles are not authoritative until approved by the general membership of the NAIC. *Note: Consistent with the paragraph 52 above, references to the Purposes and Procedures Manual of the NAIC Securities Valuation Office are contained in SSAP No 26, at paragraph 7; SSAP No 30, at paragraphs 3 (d) and under Authoritative Literature; SSAP No 32 at paragraphs 15, 16, 18, 19, 20, 21 and as Authoritative Literature. The Definitional Structure of SSAP 43R. The definitional structure in SSAP No. 43 R is out of date with market realities, having been developed at a time when simple trust structures were almost exclusively used in structured securities. The definitional format for SSAP 43R was intended to be a beginning and evolve over time. Requiring reporting based on whether a security structure incorporates a trust elevates the 2010 National Association of Insurance Commissioners 4

17 existence of a trust to an analytical factor when it is in fact only a mechanical aspect of a transaction intended to effectuate legal and or business objectives that bears no relationship to investment risks or its analysis. The focus of statutory risk analysis and reporting should be on the manner in which cash flow is to be generated to pay the insurer and on the risks associated with realizing or not realizing that cash flow. In this respect the staff is in complete agreement with the response made by GNAIE to the proposed changes in SSAP No 43R, which we understand were adopted at the 2010 Fall National Meeting. Summary of the Hybrid RBC (E) Working Group Report The Hybrid WG reached two basic conclusions: a. As to Hybrids: It could not recommend a risk-based capital (RBC) charge for hybrids because RBC only measures credit risk, already addressed by credit ratings under the filing exempt rule. Whatever other risks hybrids contain are not captured by RBC for any security. The NAIC should develop a comprehensive risk framework and apply it to all securities. b. As to the Existing NAIC Framework: The NAIC should focus on improving regulatory tools, and better coordination of those tools. The NAIC should evaluate the procedures used to identify and develop regulatory guidance for new securities. Investment risk should drive RBC, and all other regulatory guidance should align in a way that optimizes capital adequacy. Accordingly, the manner in which SVO risk assessment, statutory accounting, RBC and reporting align should be reviewed. The NAIC should develop a risk matrix for invested assets that could be used to make changes to other components of regulation. The NAIC should evaluate different ways to group instruments for reporting and accounting purposes, emphasizing the identification of risk concentrations to assist the RBC process. Statutory accounting definitions for asset types should be updated, as they are inadequate and conflict with SVO risk assessment instructions; the three bucket paradigm might no longer be useful. Consider how to improve RBC and whether greater granularity and an expansion of NAIC designations would provide greater accuracy in correlating risks to capital. Application of Classification to Structured Securities RMBS, CMBS and ABS are typically not reviewed by the SVO. These asset classes are reported to regulators using the filing exempt process. Therefore the SVO is not called upon to assess structured securities. The SVO is called upon to assess transactions that use various degrees of structural devices to attain various accounting, regulatory, tax and other objectives and which we call structured transactions. These are usually unrated complex securities for which we are the only regulatory analyst. Statements in the NY proposal related to the application of classification methodology would suggest that all structured securities are classified by the SVO. The facts are that if a security is tranched, we would consider it a structured security and consider its risks in accordance with the cash flow (i.e., waterfall) specified in the documents. Those members familiar with the RMBS 2010 National Association of Insurance Commissioners 5

18 and CMBS modeling process will immediately recognize this key principle. There is no need to consider classification or subordination because the securities itself, i.e., the tranches already specify the degree of subordination and right of payment. In a corporate context, there are any number of subordinations at the bond level (i.e., senior versus junior bonds) which are understood and typically require no classification analysis because all of the bonds, by definition, have a priority of claim to the issuer s preferred and common stock. Classification would only be employed when the instrument called a bond is clearly granting a non bond-like contractual promise or when the name of the instrument does not in fact correspond with the issue s actual investor s rights or economic substance. Classification analysis is a key component of securities analysis and it is not the cause of the issues the NY proposal is concerned with. The NY proposal engages in a circuitous and dangerous argument to the effect that a bond should be reported as a bond and not characterized as something else even if the security has risks associated with it that are not bond-like. But the point is that an obligation or instrument can be called anything by the people who created it. Classification analysis addresses this investor rights-based reality by looking to fundamental aspects of the security and relating that back to a common framework. The first step deciding whether a security should receive bond treatment is to see that it is, in economic substance and not only in form, a bond which in SVO parlance means we need to verify that there is a promise to pay. So eliminating classification would have a significant and detrimental impact on the regulation of investments since it implies we have to accept what the security, or in some rare cases, a questionable admitted asset, is called. The proposal also seeks to bind the SVO to the use of asset definitions in the SSAPs. One of the concerns expressed by the Final Report of the Hybrid Risk Based Capital (E) Working Group is that the SSAPs for bonds lacks an adequate definition of what a bond is, that there is no definition of what a preferred stock is and that the definition for common stock is serviceable but primitive. The Final Report also expresses concern that a major deficiency in regulation of invested assets is that the lack of appropriate mechanisms to ensure that SVO analytical insight drive the evolution of statutory accounting and reporting. We would note that the Purposes and Procedures Manual currently specifies the classification methodology as the exclusive way to assess the reporting geography of a new investment. This is no longer factually accurate. That role, determining regulatory guidance for new instruments, is now vested in the Invested Asset (E) Working Group (IAWG) assisted by the SVO and is reflected in the procedures and infrastructure developed by the IAWG. We have, accordingly, recommended that classification methodology be moved to the general methodology section of the Purposes and Procedures Manual National Association of Insurance Commissioners 6

19 D. Keith Bell, CPA Senior Vice President Accounting Policy Corporate Finance The Travelers Companies, Inc ; FAX Rose Albrizio, CPA Vice President Accounting Practices AXA Financial, Inc ; FAX December 3, 2010 Mr. Robert Carcano Mr. Richard Newman Securities Valuation Office 48 Wall Street 6th Floor New York, NY RE: Comments to the NAIC Valuation of Securities Task Force on the New York State Insurance Department memo dated October 1, 2010 concerning Eliminating Conflict in Classifying Investments Dear Mr. Carcano and Mr. Newman, Interested parties appreciate the opportunity to provide comments on this proposal which was exposed for comment during the NAIC Fall National meeting in Orlando, Florida with a deadline of December 3, We understand that this proposal is intended to create consistency between the work of the NAIC Securities Valuation Office (SVO) and the application of the Statements of Statutory Accounting Principles (SSAPs). The proposal states the following: Because the SVO classification scheme no longer provides a regulatory benefit in improving identification of investment risks, and as the SVO classification can result in a conflict with the statutory accounting and reporting requirements, it is proposed that: The classification of securities (pages of the P&P Manual) is deleted, and; Security classification performed by the SVO is required to be based on the definitions provided in the relevant SSAPs, and; When the SVO performs annual updates, securities are re-classified as necessary, in accordance with the SSAPs. The intent and concepts embodied in this proposal have our wholehearted support. To make the implementation successful, careful attention should be paid to the process by which the proposal would be made operational. We firmly believe that the quality of the classification decisions made by regulators or the SVO are improved when those making a particular classification decision are open to, and have the benefit of hearing, diverse views before finalizing any recommendation or decision. To that end we suggest that the process to make classification recommendations or decisions include a step requiring advisory input from interested regulators, industry, NAIC staff and other interested NAIC groups. The proposal involves the interpretation and application of SSAPs. We believe this would be of interest to the NAIC Emerging Accounting Issues Working Group which interprets statutory

20 SAPWG November 22, 2010 Page 2 accounting standards. It would also be of interest to the NAIC Invested Asset Working Group which reviews and evaluates new asset types. Interested parties do not intend for the collection of these views to be cumbersome or timeconsuming. A notice identifying the security in question for which the reviewer may be considering a change coupled with a request for comments posted to the SVO website would be a place to start. Once most of the industry s securities have been classified using the SSAP guidelines, the focus could then be narrowed to new or unusual security types. Industry would welcome an opportunity to work with regulators and the SVO to develop the details of an implementation plan. Sincerely, D. Keith Bell Rose Albrizio cc: Matti Peltonen (NY), NAIC Valuation of Securities Task Force Chair Wally Givler, Northwestern Mutual Interested parties