The Statutory Accounting Principles Working Group of the National Association of Insurance Commissioners (“NAIC”) recently issued a proposal (the "Proposal") to enhance the disclosure of positions held in credit derivatives, hybrid instruments that have embedded credit derivatives, and certain guarantees in the financial statements filed by insurers. The NAIC suggests that due to the significant growth in the sale of credit default swaps products over the past few years and their significant impact on sellers during economic downturns, a thorough disclosure of credit derivatives and guarantees are necessary to provide state regulators the ability to fully understand the solvency condition of insurers that guarantee, or otherwise provide the credit-protection, for credit derivatives and credit-related guarantees.

Under the Proposal, a credit derivative is defined as a derivative instrument (i) in which one or more of its underlyings are related to the credit risk of a specified entity or an index based on the credit-risk-related events and (ii) that exposes the seller to potential loss from credit-risk-related events specified in the contract. Examples include, but are not limited to, credit default swaps, credit spread options, and credit index products. A hybrid instrument is defined as a contract that includes the host contract (the traditional non-derivative portion) and an embedded derivative (e.g., a credit-linked note).

For annual and quarterly financial statements, the seller of a credit derivative must disclose the following information for each credit derivative, or each group of credit derivatives, even if the likelihood of the seller’s having to make any payments under the credit derivative is remote: (i) the nature of the credit derivative, including its term, reasons for entering into the credit derivative, the events or circumstances that would require the seller to perform under the credit derivative, and the current status of the payment/performance risk of the credit derivative; (ii) the maximum potential amount of future payments (undiscounted) the seller could be required to make under the credit derivative; (iii) the fair value of the credit derivative as of the date of the statement of financial position; and (iv) the nature of any recourse provisions or any collateral the seller can obtain or liquidate to recover all or a portion of the amounts paid under the credit derivative.

For hybrid instruments that have embedded credit derivatives, the seller of the embedded credit derivative must disclose the above required information for the entire hybrid instrument, not just the embedded credit derivative.

In regards to the guarantees on indebtedness of others, disclosure must include the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, the events or circumstances that would require the guarantor to perform under the guarantee, and the current status as of the reporting date of the payment/performance risk of the guarantee.

The Proposal would apply to annual statements filed after December 31, 2008. The NAIC will hold a public hearing regarding the Proposal at its winter meeting in December. Public comments on the Proposal are due by November 10, 2008.

To see a copy of the Proposal, click here.