In a previous issue of FundsTalk, we discussed collateralized fund obligations (CFOs), investments backed by portfolios of private investment fund interests. In recent months, the National Association of Insurance Commissioners (NAIC), the nation’s leading insurance standard-setting body, has challenged the use of CFOs by insurance companies.

Insurers contemplating new CFO offerings should do the following:

  • Closely monitor regulatory developments in this space, including the public commentary received on the NAIC’s proposal described below.
  • Where feasible, offer more of the debt tranches of the CFO to third parties (rather than retaining these) in order to avoid a possible adverse characterization by the insurance regulator.
  • Consider the impact, if any, of these developments on true-sale and nonconsolidation analysis that is the underpinning of these securitization structures.

On Aug. 3, at the NAIC’s Summer National Meeting in New York, the NAIC’s Statutory Account Principles Working Group (SAPWG) voted to expose for public comment a recommendation that would treat a CFO as an equity, rather than a debt, instrument, even those tranches of a CFO with investment-grade debt ratings. (This treatment would apply under statutory accounting, the regime that governs insurers in their reporting to state insurance regulators, and has nothing to do with GAAP.) The recommendation would modify Statutory Statement on Accounting Principles 43R on Loan-Backed and Structured Securities. The proposal would significantly increase the capital charge that the insurer would incur from holding the CFO and make CFOs less attractive for insurance company investors, or for insurance company CFO sponsors who intend to retain some of the senior tranches of the CFO.

SAPWG seems to be motivated by situations in which an insurer purchases a portion of a CFO sponsored by the insurer itself. This creates what SAPWG perceives as a “repackaging” of equity investments into debt. SAPWG writes disapprovingly that, based on media reports, CFOs allow insurers to “exchange their equity interests into CFOs, maintain the same level of exposure, without having to hold as much capital against the investments because regulators treat CFOs as bonds, not the private equity-linked investments that they are.” The analogy in some media reports to “equity-linked investments” is questionable, given the diverse exposures in most CFO collateral pools to underlying private investments of different types, including real estate and mezzanine debt (for example) and the wholly different characters of a private equity investment and a publicly traded equity security.

SAPWG acknowledges that an insurance company sponsoring a CFO will not necessarily retain all of the economic exposure associated with the underlying funds. Indeed, insurance companies often sell off all or many of the debt pieces of the CFO, retaining only the most subordinated equity tranches. Nevertheless, the working group proposal would, by its literal terms, assign equity treatment to any portion of a CFO, no matter its risk profile or underlying assets or liabilities.

SAPWG has indicated that it expects to take up public comments to the proposal on a January 2020 conference call, if not sooner at December’s Fall National Meeting in Austin. The insurance industry, whose members have sponsored a number of CFO offerings in recent years, is closely following these developments. If the proposal is advanced by SAPWG (in its current form or as it may be modified), it would be subject to review by the NAIC’s Financial Condition Committee.