NAIC accounting tweak expected to give insurer bond trading a boost

A statutory accounting tweak change made by the National Association of Insurance Commissioners (NAIC) last year is anticipated to boost bond trading by US life insurers in 2024.

Life insurers began admitting their negative interest maintenance reserve (IMR) balances as an asset after regulators adopted an optional limited-time interpretation intended to reduce the impact of losses from sales of investments due solely to interest rate movements.

Prior to the IMR accounting change, insurers were disincentivized from "appropriate" risk management and ordinary trading, CreditSights analyst Josh Esterov said in an interview.

"Asset class allocation shifts were very limited in 2023, and one of several drivers of that was likely the lack of the IMR tweak for portions of 2023," Esterov said. "We're expecting higher levels of trading in 2024 relative to 2023."

An accounting fix

The impact of the accounting change on different insurers is expected to vary depending on factors such as individual investment strategies and the size of company balance sheets.

Anthony Lupa, a senior insurance strategist at DWS agreed that bond trading would increase this year but said the accounting change is just one factor driving the situation.

"In the life sector, where the optics of creating a negative IMR were unpalatable to companies, they can now establish a loss budget for their managers large enough to accelerate the rebalancing of their overall asset portfolios," Lupa said. "I see the new interpretive guidance as additive to trading volumes but not leading to an explosion of trading."

The shift to a high interest rate environment was a key reason for regulators to make the accounting change.

After the financial crisis, the accounting rules were really only written for what to do in a low interest rate environment, Esterov said. For example, if an insurer bought a 30-year bond and sold it 10 years later at a gain, it would amortize that gain over the remaining 20-year period, thus smoothing the capital impact.

But now, if an insurer wanted to sell a bond to reduce exposure to a certain company and reinvest it into something with a similar yield and duration, it would be selling the bond at a loss in this high interest rate environment. Before the new temporary accounting guidance, it would immediately have to take a hit on capital rather than being able to amortize that hit over the expected life of the bond, Esterov said.

Esterov said he believes the IMR fix is a "positive development" because it means that insurers can get back to ordinary trading.

Growing negative IMR

Meanwhile, about 37.7% of individual US life entities reported a negative IMR in their general account, which reflects an increase of 11.8 percentage points from 2022, according to an S&P Global Market Intelligence analysis of year-end 2023 statutory financial filings.

As of Dec. 31, at least 151 entities used the temporary changes to admit at least a portion of their negative IMRs in a combined amount of more than $8 billion, up from 113 individual insurance subsidiaries reporting a negative IMR balance as an admitted asset as of Sept. 30, 2023. The industry's aggregate calculated IMR balance of $5.71 billion in the general accounts, before using the temporary guidance and inclusive of negative values, made it the lowest result since the global financial crisis.

As of Dec. 31, The Northwestern Mutual Life Insurance Co. held the largest negative IMR within its general account among US life insurers, a spot it has had since the accounting change was made. Its reserves sat at negative $2.46 billion, up from $2.15 billion at the end of the third quarter.

Prudential Financial Inc.'s The Prudential Insurance Co. of America subsidiary had the second largest balance with $1.19 billion of total negative IMR within its general account, of which the insurer was able to admit only $1.06 billion of the balance. The insurer also reported a negative IMR balance of about $1.2 billion within its separate account.

The NAIC's adopted interpretation for negative IMR treatment will be effective through Dec. 31, 2025, and automatically nullified Jan. 1, 2026, although the effective date could be subject to change.

Esterov said regulators may end up making the guidance permanent because it would make sense to have "symmetrical rules and mechanisms" that apply for how to act during rising and falling interest rate environments.

"I don't think that insurance regulators want to disincentivize insurers from appropriate trading and risk management so making this fix permanent will sort of create a rules framework that makes sense in both directions," Esterov said.

The NAIC has formed an ad-hoc working group to sort out a more permanent solution.