Statutory Accounting Principles Working Group s11

Ref #2017-21

Statutory Accounting Principles (E) Working Group Maintenance Agenda Submission Form Form A

Issue: Double-Counting of Surplus Notes

Check (applicable entity): P/C Life Health Modification of existing SSAP New Issue or SSAP Interpretation

Description of Issue: Surplus notes have the characteristics of both debt and equity. They are used for a variety of reasons, including but not limited to the following: 1) providing regulators with flexibility in dealing with problem situations to attract capital to reporting entities whose surplus levels are deemed inadequate to support their operations; 2) providing a source of capital to mutual and other types of non-stock reporting entities who do not have access to traditional equity markets for capital needs; and 3) providing an alternative source of capital to stock reporting entities, although not for the purpose of initially capitalizing the reporting entity. Surplus notes issued by a reporting entity that are subject to strict control by the commissioner of the reporting entity’s state of domicile and have been approved as to form and content shall be reported as surplus, not debt, if the note contains the following provisions: 1) subordination to policyholders; 2) subordination to claimant and beneficiary claims; 3) subordination to all other classes of creditors other than surplus note holders; and 4) interest payments and principal repayments require prior approval of the commissioner of the state of domicile.

While SSAP No. 97—Investments in Subsidiary, Controlled and Affiliated Entities (SSAP No. 97) explicitly states that “[i]nvestments in common stock, preferred stock and surplus notes are reported separately. Care should be taken to avoid double counting of the separate investments,” clarification of what is considered double counting is not provided. The current guidance is specific to a situation in which the SCA issues the surplus note, which is held by the parent, but an SCA holding a surplus note issued by the parent also creates a double-counting situation when the parent reports the “investment in the SCA” if the investment includes the parent-issued surplus note. The recognition of a surplus note as equity on an issuing entity’s financial statements and simultaneous inclusion of the surplus note in the value of the SCA on the issuing entity’s financial statements is prohibited.

Existing Authoritative Literature:

SSAP No. 41R—Surplus Notes

Holders of Capital or Surplus Notes 9. Investments in capital or surplus notes meet the definition of assets as defined in SSAP No. 4—Assets and Nonadmitted Assets and are admitted assets to the extent they conform to the requirements of this statement. Additionally, the amount admitted is specifically limited to the following two provisions:

a. The admitted asset value of a capital or surplus note shall not exceed the amount that would be admitted if the instrument was considered an equity instrument and added to any other equity instruments in the issuer held directly or indirectly by the holder of the capital or surplus note.

b. The surplus note shall be nonadmitted if issued by an entity that is subject to any order of liquidation, conservation, rehabilitation or any company action level event based on its risk-based capital. Subsequent to this nonadmittance, if any of the conditions described ceased to exist, the holder may admit the surplus note at the value determined under paragraph 11. If a surplus note was nonadmitted pursuant to this paragraph, and the surplus note was ultimately determined to be other-than-temporarily impaired, the reporting entity shall recognize a realized loss for the portion of the surplus note determined to be other-than-temporarily impaired, with elimination of a corresponding amount of the previously nonadmitted assets.

SSAP No. 97—Investments in Subsidiary, Controlled and Affiliated Entities © 2017 National Association of Insurance Commissioners 1 Ref #2017-21 18. A reporting entity that owns an interest in itself via direct ownership of shares of an upstream intermediate or ultimate parent shall reduce the value of such shares for the reciprocal ownership. If the shares of the parent are owned indirectly by a reporting entity, via a downstream SCA entity, the directly held entity, which owns the parent’s shares, shall have its value reduced for the reciprocal ownership.

19. Any parent reporting entity that owns an interest in itself via either direct or indirect ownership of a downstream affiliate, which in turn owns shares of the parent reporting entity, shall eliminate its interest in these shares from the valuation of such affiliate.

Investment in Preferred Stock or Surplus Notes of a Subsidiary, Controlled and Affiliated Entity 27. Investments in common stock, preferred stock and surplus notes are reported separately. Care should be taken to avoid double counting of the separate investments. When the SCA investee has issued multiple equity components such as common stock, preferred stock and/or surplus note(s) the total reported equity of the SCA investee must be separated into the respective components in order to determine the equity attributable to each class.

28. In order to establish the equity value of the common stock investment in an SCA, the reporting entity reduces the total equity of the SCA by the SCA's (issuer’s) value of the preferred stock and/or surplus notes on the issuer’s balance sheet (not the reporting entity's book/adjusted carrying value for the SCA’s preferred stock and/or surplus notes held).

29. Investments in the preferred stock of an SCA shall be accounted for and reported in accordance with the provisions of SSAP No. 32–Preferred Stock (SSAP No. 32).

30. Investments in the surplus notes of an SCA shall be accounted for and reported in accordance with the provisions of SSAP No. 41R–Surplus Notes (SSAP No. 41R).

31. The following example is provided to illustrate the accounting and reporting. The reporting entity holds 100% of the preferred stock. The SCA issued the preferred stock for $50,000. The investment in the SCA, measured in accordance with this SSAP is $250,000 including the preferred stock of the SCA. The investment in the SCA is $200,000 ($250,000-50,000) and the preferred stock is measured and reported in accordance with SSAP No. 32.

Activity to Date (issues previously addressed by the Working Group, Emerging Accounting Issues (E) Working Group, SEC, FASB, other State Departments of Insurance or other NAIC groups): None

Information or issues (included in Description of Issue) not previously contemplated by the Working Group: None

Convergence with International Financial Reporting Standards (IFRS): None

Staff Recommendation: Staff recommends that the Working Group move this item to the active listing, categorized as nonsubstantive and expose revisions to SSAP Nos. 41R and 97 as detailed below. These revisions clarify that the “double-counting” concept applies to surplus notes that are issued by the parent and held by an SCA, which is reported as an “investment in SCA” on the parent’s financial statements. (Previously, the double-counting concept was only captured for surplus notes “issued” by an SCA, but the concept should apply to both scenarios.) The guidance would require elimination of parent-issued surplus notes in a manner similar to equity investments. (It is noted that this guidance is specific to surplus notes (as they are reported as equity) and would not apply to debt instruments issued by the parent and held by the SCA.)

Holders of Capital or Surplus Notes 9. Investments in capital or surplus notes meet the definition of assets as defined in SSAP No. 4—Assets and Nonadmitted Assets and are admitted assets to the extent they conform to the requirements of this statement. Additionally, the amount admitted is specifically limited to the following two provisions: © 2017 National Association of Insurance Commissioners 2 Ref #2017-21 a. The admitted asset value of a capital or surplus note shall not exceed the amount that would be admitted if the instrument was considered an equity instrument and added to any other equity instruments in the issuer held directly or indirectly by the holder of the capital or surplus note.

b. The surplus note shall be nonadmitted if issued by an entity that is subject to any order of liquidation, conservation, rehabilitation or any company action level event based on its risk-based capital. Subsequent to this nonadmittance, if any of the conditions described ceased to exist, the holder may admit the surplus note at the value determined under paragraph 11. If a surplus note was nonadmitted pursuant to this paragraph, and the surplus note was ultimately determined to be other-than-temporarily impaired, the reporting entity shall recognize a realized loss for the portion of the surplus note determined to be other-than-temporarily impaired, with elimination of a corresponding amount of the previously nonadmitted assets.

Impairment

17. For surplus notes issued and held between insurance reporting entities and subsidiary, controlled and affiliated entities, the guidance in SSAP No. 97 requires adjustment to prevent double-counting of surplus notes. For example, an insurance reporting entity is not permitted to issue a surplus note, acquired by an SCA, and report both the issuance as an increase in surplus, and an asset representing the investment in the SCA. Pursuant to SSAP No. 97, the “investment in the SCA” shall be adjusted to eliminate the surplus note issued by the insurance reporting entity.

SSAP No. 97—Investments in Subsidiary, Controlled and Affiliated Entities

Investment in Preferred Stock or Surplus Notes of a Subsidiary, Controlled and Affiliated Entity

20. Any parent reporting entity that has issued a surplus note, which has been acquired by SCA, shall adjust the investment in the SCA to eliminate the issued surplus note to prevent double counting of the surplus note at the parent reporting entity. Without adjustment, the issued surplus note would be reported both as an increase in surplus by the parent reporting entity, as well as an admitted asset of the parent through the “investment in an SCA.”

Investments in Preferred Stock or Surplus Notes of a Subsidiary Controlled and Affiliated Entity

27. Investments in common stock, preferred stock and surplus notes are reported separately. Care should be taken to avoid double counting of the separate investments. When the SCA investee has issued multiple equity components such as common stock, preferred stock and/or surplus note(s) the total reported equity of the SCA investee must be separated into the respective components in order to determine the equity attributable to each class.

28. In order to establish the equity value of the common stock investment in an SCA, the reporting entity reduces the total equity of the SCA by the SCA's (issuer’s) value of the preferred stock and/or surplus notes on the issuer’s balance sheet (not the reporting entity's book/adjusted carrying value for the SCA’s preferred stock and/or surplus notes held).

Holders of Capital or Surplus Notes 13. For surplus notes issued and held (directly or indirectly), between insurance reporting entities and subsidiary, controlled and affiliated entities, the guidance in SSAP No. 97 requires adjustment to prevent double- counting of surplus notes. For example, an insurance reporting entity is not permitted to issue a surplus note, acquired by an SCA, and report both the issuance of a surplus note as an increase in surplus, and have an asset representing thean investment in the SCA that includes the issued surplus note (held by an SCA). Pursuant to SSAP No. 97, the “investment in the SCA” shall be adjusted to eliminate the surplus note issued by the direct or indirect parent insurance reporting entity. This treatment shall also apply for instances in which the SCA acquires any portion of outstanding surplus notes issued by the direct or indirect parent through any means (e.g., directly acquired from the parent, acquired through a third-party broker, or via the market.).

SSAP No. 97—Investments in Subsidiary, Controlled and Affiliated Entities

Investment in Preferred Stock or Surplus Notes of a Subsidiary, Controlled and Affiliated Entity 20. Any parent reporting entity that has issued a surplus note, which has been acquired by an SCA (held directly or indirectly), shall adjust the investment in the SCA to eliminate the issued surplus note to prevent double counting of the surplus note at the parent reporting entity. Without adjustment, the issued surplus note would be reported both as an increase in surplus by the parent reporting entity, as well as an admitted asset of the parent through the “investment in an SCA.” The surplus note shall also be eliminated for instances in which the SCA acquires any portion of outstanding surplus notes issued by the parent through any means (e.g., directly acquired from the parent, acquired through a third-party broker, or via the market.).

Staff Review Completed by: Fatima Sediqzad - NAIC Staff, June 2017

Status: On August 6, 2017, the Statutory Accounting Principles (E) Working Group moved this agenda item to the active listing, categorized as nonsubstantive, and exposed revisions to SSAP No. 41R—Surplus Notes and SSAP No. 97 —Investments in Subsidiary, Controlled and Affiliated Entities, as illustrated above, to clarify that the existing concept that restricts the “double-counting” of surplus notes issued by subsidiary, controlled and affiliated (SCA) entities shall also apply to surplus notes that are issued by the parent and held by an SCA entity. The revisions will require reporting entities to eliminate parent-issued surplus notes held by an SCA entity similar to other equity investments.

On November 6, 2017, the Statutory Accounting Principles (E) Working Group exposed revisions, as detailed above under “November 2017 Revisions.” The revisions to SSAP No. 41R and SSAP No. 97 are shown as tracked, with shading to identify the additional revisions. The original proposed revisions have been expanded to clarify that an SCA’s acquisition of a surplus note issued by the parent shall always be eliminated in the SCA’s value reported by the parent insurance company.

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