We understand why the NAIC is open to a new framework

Thomas Majewski

Founder & managing partner

Eagle Point Credit Management

The NAIC is right to tread carefully as it looks to protect its members from ratings arbitrage

For the past 30 years, the National Association of Insurance Commissioners (NAIC) has periodically reviewed internal risk-based capital charges (RBC) across structured product markets. Over time, its approach has shifted from a reliance on external raters to internal NAIC-led financial modelling. Now, through a prudent and deliberate process, the NAIC seems to be on the precipice of another shift. The new framework under consideration proposes that the NAIC should be given the ability to challenge ratings — and even make its own.

We understand the intricacies of undertaking a financial modelling approach and why the NAIC is open to a new framework as it attempts to create a guardrail against ratings shopping and potential ratings arbitrage. While investors in CLOs and CFOs, along with rating agencies, review the possible outcomes, we are encouraged by the recent momentum created by working groups designed to address the NAIC’s concerns.

Charges for residual interests

As some may recall, previous NAIC meetings highlighted the possibility of creating comprehensive modelling paradigms for CLO debt securities, resulting in a 45% charge for residual interests (for example, CLO equity). Market participants and regulators alike supported this approach. After the change was introduced, there were some concerns about the NAIC’s ability to manage such an extensive modelling process and its RBCs — especially for residual interests. Industry participants provided letters to illustrate the complex modelling inputs and the ways that CLOs have performed well under stress, supporting the view that RBCs should not increase down the line.

Most recently, the NAIC held a meeting in Phoenix, and as we study the tea leaves from this meeting, we feel encouraged that the CLO debt securities financial modelling process is still under review. We believe this shows that the NAIC is acknowledging and listening to the concerns raised by its constituents. Our understanding of the current situation is that the Structured Securities Group (SSG), which is currently in charge of such work, stated that implementation was more likely by the end of 2025, rather than 2024, as it begins to work directly with the Risk-Based Capital Investment Risk and Evaluation Group (RBCIRE). The RBCIRE, in turn, is exploring how a new RBC framework could apply to CLO securities, including looking at less model-heavy approaches. Overall, we appreciate and recognise that this process is proceeding at a measured pace.

Concurrently with the SSG, the RBCIRE proposed a workstream to simplify modelling based on a few key factors. This opens the possibility that CLO debt securities might not need to be modelled en masse by the NAIC. Instead, the practice of relying on third-party rating agencies might continue. RBCIRE also demonstrated a willingness to review the 45% residual interest charge that has been adopted, citing recent research on how much better these “residuals” perform against actual stocks. Though we expected a review of the RBC at some point, we are pleased to see that these concerns are being addressed constructively.

At the same meeting, the Securities Valuation Office (SVO) also shared a revised proposal to override RBC ratings from third-party agencies. This would allow the SVO to transparently review specific security designations during the filing exemption process. The NAIC has been clear that this process is meant to be concurrent and additive to other working groups. However, we have yet to learn whether this provides the NAIC with a pathway to review and reject private ratings they deem inadequate without the need to engage in large-scale security reviews. We certainly understand why the NAIC is reviewing this process thoroughly, and believe it recognises it may be more effective with a targeted approach instead of parsing detailed financial data and analysis.

While this may leave market participants in limbo for now, in our view, the NAIC will continue to rely upon large rating agencies, challenging them only occasionally. Potential changes may include deciphering what ratings might be subject to challenge and whether the use of multiple ratings can override the presumption that one rating is faulty. We could also see a scenario where small rating agencies face scrutiny, which may result in bespoke investments facing challenges.

However, we are hopeful that the NAIC recognises that the new review framework should not stifle innovation, as many mainstream products are not originally rated by the largest rating institutions. Overall, we feel the NAIC is taking time to understand the impact that any approach could have on the industry, and we are pleased to see collaboration amongst working groups and regulators. There is certainly more to come on this important topic.

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