NOTE: The SAPWG requests comments on Blackrock’s “valuation proposal” which suggests a calculation of
amortized cost for exchange traded funds (ETFs) that qualify for bond treatment.
Questions on the proposal may be sent to Katie Garvey, Blackrock at katie.garvey@blackrock.com. All comments on
the proposal shall be addressed to Dale Bruggeman, Chair of the Statutory Accounting Principles (E) Working Group
and sent electronically to NAIC staff – Julie Gann (jgann@naic.org) or Robin Marcotte (rmarcotte@naic.org).
May 26, 2014
Dale Bruggeman, Chair
Statutory Accounting Principles Working Group
National Association of Insurance Commissioners
2301 McGee Street, Suite 800
Kansas City, MO 64108-2604
Attn:
Robin Marcotte (NAIC) and
Julie Gann (NAIC)
Re:
Investment Classification Project – Discussion Papers 1-5
(Reference Number 2013-36)
Dear Chairman Bruggeman:
We would again like to thank the Working Group for this opportunity to offer our comments and
observations regarding the Investment Classification Project – Discussions Topics:
1. Inclusion of Security Definition in SSAP No. 26 (hereafter “Discussion Paper 1”)
2. Requirement for ‘Contractual Amount of Principal Due’ (hereafter “Discussion Paper 2”)
3. ETF – Financial Data Summary as of Year-End 2013 (hereafter “Discussion Paper 3”)
4. Definitions of Non-Bond Items (hereafter “Discussion Paper 4”)
5. ETF – Financial Data Summary as of Year-End 2014 (hereafter “Discussion Paper 5”)
Our comments on the various Discussion Papers are set forth below (Discussion Paper wording
is highlighted in gray).
As the world’s largest asset manager and provider of exchange traded funds (ETFs) we are
happy to share our perspective and offer assistance to the regulatory community regarding the
treatment of bond ETFs for statutory accounting purposes. This is an issue of great importance
for the insurance industry, particularly those small to mid-size insurers who have continued to
struggle to gain access to bonds and who benefit greatly from the liquidity and diversification
attributes of bond ETFs, which are essentially transparent portfolios of bonds that trade on an
exchange.1
We stand ready to work with the regulators and provide any follow-up data or analysis that
would be helpful in reviewing our proposal.
1
ETFs as referenced in this comment letter are managed funds which trade on an exchange and most often track a passive
benchmark with clearly defined index methodology. There are fund expenses and fees which come out of the performance of
the net asset value of the underlying bond portfolio.
BlackRock Comments:
We agree that industry and regulators alike would benefit from greater clarity in reporting NAIC
designated bond ETFs, and clearly there are demonstrable reporting inconsistencies (as
highlighted in Discussion Papers 3 & 5). However, we propose adhering to the current rationale
of including NAIC designated bond ETFs within SSAP 26 along with the other investments
mentioned in Discussion Paper 4 that do not meet the new “Security” definition for SSAP 26
based upon the assessed risk of the underlying securities (e.g. consideration for a “SSAP 26 –
A” for bonds and “SSAP 26 – B” for bond-like investments). There are a number of reasons for
this, which are broken out and described in greater detail below under “Rationale.”
We put forth an alternative proposal to resolve the current transparency issues & reporting
inconsistencies: similar to other fixed income investments on Schedule D Part 1, NAIC
designated bond ETFs should continue to be reported on Schedule D Part 1 but broken out into
their own separate sub-section. This would alleviate regulators’ concerns about not being able
to locate each ETF within the other reported bond holdings, help clarify important reporting
differences for insurance companies who hold ETFs, and hopefully reduce the number of
reporting inconsistencies going forward. Importantly, it would continue to group NAIC
designated bond ETFs, which are generally simple, transparent pass-through portfolios of
bonds, along with other fixed income investments and would eliminate the potential for several
other unintended consequences caused by inclusion within a new “Funds” SSAP and a move to
a new reporting schedule.
Recognizing that SSAP No. 26 uses an amortized cost measurement for bonds, however, and
that an “original cost” valuation method is no longer supported by ICP 14, we propose that NAIC
consider an amortized cost valuation methodology akin to that of other fixed income
investments with multiple individual positions and fluctuating cashflows. The method used to
value NAIC designated bond ETFs must be able to account for the changing composition of the
ETF’s underlying bond portfolio over time without introducing noise into the valuation process, in
the form of interest rate fluctuations and market influences, which should not be present from a
statutory accounting perspective for fixed income investments. Accordingly, BlackRock puts
forth a preliminary proposal of an amortized cost valuation methodology below. We are happy
to work with regulators to assess the feasibility of this proposal.
2
Valuation Proposal2
Each NAIC designated fixed income ETF holding shall be revalued each quarter using the
current underlying bond portfolio’s projected cash flows and using the prospective adjustment
methodology:
1. The prospective approach recognizes, through the recalculation of the effective yield to be
applied to future periods, the effects of all cash flows whose amounts differ from those
estimated earlier and the effects and changes in projected cash flows.
2. Under the prospective method, the recalculated effective yield will equate the carrying
amount of the investment to the present value of the anticipated future cash flows.
a. “Carrying amount” at T0 = purchase price
b. “Carrying amount” for all subsequent periods = Book Value, where:
c. Book Value = Original Cost –/+ Amortization/Accretion
d. Amortization/Accretion Amount = Earned Income – Sum of monthly distributions
e. Earned Income = (Recalculated effective yield x current book value) / 4
(NB: using “4” in this case for quarterly earned income)
f. Recalculated effective (book) yield = Implied yield on the difference between book
value and the current PV of future cashflows
g. The amortization period shall reflect the dollar weighted average maturity of the
underlying bonds in the portfolio.
ETFs are effectively already handling the accounting of the underlying bonds in the portfolio
within the ETF. Investors are essentially receiving the book yield of the fund via the periodic
distributions, since the fund distributes the Earned Income less the net amortizations/accretions
of each bond within the portfolio (calculated daily by the fund custodian).
This amortized cost valuation method provides a solution that is both relatively simple to
calculate and auditable. This valuation method would also solve the previous issues with ETFs
being a “square peg in a round hole” on Schedule D Part 1. The other columns which are
currently left blank or “N/A” could now be filled with available information, for example:
1. Maturity: Dollar weighted average maturity of the bond portfolio
2. Book Yield: Recalculated effective yield
3. Par Value: Dollar weighted average face value
4. IMR: gain or loss at the point of sale could be amortized over the dollar weighted average
maturity of the ETF’s bond portfolio at that point in time.
5. OTTI: credit gain/loss would occur if there was a downgrade of the ETF’s NAIC designation.
Impairments of individual bonds within the ETF portfolio are typically removed from the fund
when the bond falls out of the index that the ETF is tracking.
2
The method proposed may be subject to further revisions.
3
Rationale
As stated in our previous comment letters, SAP and GAAP accounting standards have always
had distinct differences, given SAP’s focus on solvency regulation. The process of codification
to include bond ETFs within SSAP No. 26 in the Accounting Practices & Procedures manual
was based upon this premise and the decision was made that NAIC designated bond ETFs
should be treated like other fixed income investments. These fundamentals have not changed,
and bond ETFs, as a transparent portfolio of bonds, continue to have the economic profile of
bonds and should continue to be treated as such. By working with the regulators to address the
needs around clarifying the reporting of bond ETFs we believe the promulgation of a new SSAP
is unwarranted.
Potential unintended consequences should be carefully considered before bond ETFs are
removed from SSAP 26 to a new “Funds” SSAP and changing the valuation methodology to
“fair value.” Since bond ETFs simply hold a portfolio of bonds, if interest rates go up, under
normal circumstances the value of these bond portfolios will go down (just as an insurer’s own
portfolio of bonds would if they were forced to mark to market).
Thus, a valuation change to a fair value-based standard would significantly impair an insurer’s
ability to invest in NAIC designated bond ETFs, and potentially disadvantage bond ETF holders
relative to other insurers.
It is important to note that the investors with the greatest potential to be adversely impacted by
any change to reporting, accounting, and capital treatment of bond ETFs are the small to midsize insurers who currently struggle to gain access to bonds and who currently enjoy the low
cost, liquidity and diversification benefits of NAIC designated bond ETFs. As the Working
Group noted in Discussion Paper 5: “Concerns regarding the potential impact to small
companies may be overstated due to the limited number of Bond ETFs held by most
companies. (75% of companies with Bond ETFs own 3 or less, 83% own 4 or fewer, and 89%
own 5 or less).” While it is true that insurers may hold a limited number of bond ETFs, this is not
surprising given the fact that each of these investments holds a diversified portfolio of several
hundred (and sometimes several thousand) bonds. Therefore there is much less of a need to
hold a large number of bond ETFs. Since insurers tend to gravitate towards buying the ETF with
the
lowest
total
cost
of
ownership
which
best
maps
over
to
the
credit/duration/yield/sector/geography of their fixed income benchmark(s), there is little need for
insurers to buy more than one bond ETF to obtain a given exposure. For example, if an insurer
primarily holds IG corporate bonds, they may only hold one IG Corporate Bond ETF which
correlates to their benchmark.
4
84
6
83
5
82
4
81
3
80
2
79
1
78
77
12/31/2003
12/31/2004
SHY NAV
12/31/2005
Fed Funds Rate
12/31/2006
Itnerest Trate (%)
SHV NAV ($)
The comments within Discussion Papers 3 and 5 regarding the assessed “negligible” impact of
a change from original cost to fair value3 overlook several considerations:
1. While it is true that changing the valuation of a fixed income investment from original cost to
fair value in a flat rate environment would have a “negligible” impact, once rates increase
there will be a very real and negative impact to the valuations of bond ETFs if they are held
at fair value.
2. The potential negative impact to NAV of rising rates can be demonstrated by looking at a
historical example: From June 2004 to June 2006, the Fed steadily raised the Fed Funds
target rate from 1% to 5.25%. During that period, the NAV of the iShares 1–3 Year Treasury
Bond ETF (SHY) fell from a high of $83.03 to a low of $79.26, as reflected in the table
below. Over the same period, SHY’s index’s yield rose from 2.62% to 5.18% as the index
continuously reinvested in new bonds offered at higher yields throughout the period. As a
result, the ETF’s total return was positive from the additional income gained by holding
higher yielding bonds.
0
12/31/2007
2-Yr Treasury Rate
3. SAP has allowed insurers to use an amortized cost valuation method for fixed income
investments to stabilize this volatility of valuations through different rate environments.
4. As noted in previous comment letters, bond ETFs share a number of similarities with other
pass-through securities that are comprised of multiple individual positions with changing
cashflows (currently reported on Schedule D Part 1) and that are using a modified amortized
cost valuation method.
3
“By requiring a fair value measurement method (or Net Asset Value - NAV - as a practical expedient) for all ETFs at this time, in
most instances, the individual company impact would be negligible to the reporting company,” Reference: 2013-36 Investment
Classification Project - Discussion Paper 3
5
Additionally it was noted in Discussion Paper 3 that changing ETFs to fair value “would
result [in] companies consistently reporting these assets at a publicly-traded value which
represents the amount available for policyholder claims.” To the extent this reflects a
concern that bond ETFs don’t mature and insurers will be receiving fair value if they decide
to sell their exposure, below is a comparison of two hypothetical insurers’ portfolios which
illustrates how bond ETFs can be viewed as a HTM fixed income investment, and how the
liquidity and diversification benefits of the ETF ultimately provide benefits over and above
that which insurers receive from holding only individual bonds in their portfolio:
1. Insurance Company A: Buys individual bonds that collectively have an average duration
that (ideally) broadly matches the duration of its liabilities. In the case of most liabilities,
this is not a 1-for-1 match (i.e. the insurer is not buying a bond which it knows will mature
at the same time that a certain liability comes due - excepting certain liabilities like fixed
annuities). Over time the bonds in Company A’s portfolio roll down the curve, payout
principal, and get reinvested in another bond which matches the rough benchmark for
their portfolio (i.e. in terms of duration, yield target, credit, etc.). As liabilities come due
there is an ongoing cash buffer, but to the extent that there is an unexpected larger cash
outflow, the company raises cash by selling bonds in its portfolio. Although Company A
may have intended to hold these bonds to maturity when it originally purchased them, it
nevertheless decided to sell them to raise the necessary cash. When deciding which
bonds in the portfolio to sell, the insurer will generally gravitate towards selling the most
liquid securities (e.g. very liquid IG bonds, MBS, etc.), as those will have the least
amount of impact in terms of trading costs & price. Importantly, when Company A sells
these bonds (which were previously HTM and valued at amortized cost), it will be getting
fair value. In this case, Company A would likely be selling higher quality bonds, which
tend to be more liquid. To the extent that it sells a disproportionately larger amount of
higher quality bonds, Company A is left with a more concentrated portfolio in less liquid,
lower quality bonds.
2. Insurance Company B: buys fixed income ETFs which map over to the broader
benchmark of its fixed income portfolio (e.g. in terms of duration, credit, yield, etc.). Like
the individual bond portfolio of Company A, Company B also maps to the duration/yield
needs of its liabilities and is buying these ETFs as a liquid core holding within its broader
fixed income portfolio. The economics that Company B receives from the fixed income
ETF as it buys & holds it are almost identical to the economics from its own individual
bond portfolio: bonds in the ETF portfolio are rolling down the curve and getting
reinvested into similar bonds in the index, with the amortizations/accretions handled
within the ETF wrapper as coupons are partially paid out and the aggregate premium
amortization/ discount accretions are held back and reinvested into similar bonds in the
index. As Company B holds the ETF it receives the effective book yield of the ETF’s
underlying bond portfolio. When Company B has an unexpected cash outflow, the fact
that it decides to sell the more liquid bond ETF to raise cash does not necessarily
indicate that its intention at the time of purchase was not to buy & hold the investment
(any more than it was for the liquid IG bonds or MBS that Company A had to sell to raise
cash). Like Company A, Company B will be receiving fair value for the fixed income ETF
it sells. The only difference is that Company B will be able to sell its ETF holding for a
fraction of the trading costs that would be required to sell the underlying bonds, and it
will be able to do so quickly and easily. Importantly, by selling a diverse portfolio of
bonds through the ETF, Company B is less likely to adversely impact the overall credit
quality of its remaining bond portfolio.
6
ETFs provide insurance companies a liquid, low cost means of accessing the bond market. This
particularly benefits the small to mid-size companies who struggle most to source new bonds.
Additionally, ETFs offer diversified fixed income exposure that matches the needs of insurers’
liabilities and provides all the related risks and benefits of bonds; therefore the accounting
should mirror/reflect that. Continuing to include bond ETFs in SSAP 26 and report them in a
separate sub-section on Schedule D Part 1, in conjunction with implementing the above
amortized cost valuation method, would resolve many of the current issues around reporting
inconsistencies and avoid potential unintended consequences of changing the accounting and
reporting of ETFs. We hope that the working group will take all of the above points into
consideration before making a decision that could potentially hurt insurers’ ability to access fixed
income exposure through NAIC designated bond ETFs in the future.
Thank you for your consideration of these comments. If the Statutory Accounting Principles
Working Group has any questions or desires any additional information, please do not hesitate
to contact us and we will be pleased to assist. We remain ready to work with you and your
colleagues on these issues.
Sincerely,
Katie Garvey
Vice President
BlackRock
7