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Hybrid securities spur classification dilemma


Insurers that invested in some hybrid securities are facing uncertainties as U.S. regulators continue to deliberate how those securities should be classified and reported.

The uncertainty began in March when the National Assn. of Insurance Commissioners' New York-based Securities Valuation Office reclassified some hybrid securities into the riskier category of "common equity." Previously, the SVO had considered most hybrid securities-which are designed with characteristics of both debt and equity investments-as "debt" or "preferred equity."

The SVO's reclassification was "of great importance" to insurance companies that invested in them because those companies would face "substantially higher risk-based capital charges" when they report them as assets to regulators at the end of the year, according to an NAIC statement. A higher risk-based capital charge would greatly increase the amount of capital an insurer needs to count such investments as an asset.

The SVO's reclassification roiled financial markets because many insurers sold their hybrid securities investments and stopped purchasing new ones.

NAIC regulators say their most pressing concern is to craft short-term guidance for insurers to use in reporting their financial statements at year-end. The NAIC's risk-based capital formula cannot be changed this year, according to Lou Felice, who chairs the NAIC's Hybrid RBC Working Group. He is an assistant chief examiner in the New York Insurance Department's Health Bureau.

"Assessing the investment risks insurers take when building adequate reserves-monies which are set aside to pay policyholders' claims-goes to the very heart of our mission: to ensure the insurance industry's safety and soundness," according to a statement by New York Insurance Superintendent Howard D. Mills III, who chairs separate NAIC task forces on capital adequacy and the valuation of securities.

Meanwhile, several representatives of insurers and financial markets question the validity of regulators' concerns and complain about their initial lack of transparency and responsiveness.

Among life insurers, "there is some real concern by the industry as to what other potential securities in their investment portfolios are subject to reclassification," said Jim Renz, director of accounting policy for the Washington-based American Council of Life Insurers.

Critics question why New York regulators asked the SVO to review the classification of some hybrids earlier this year, especially since January 2004 it generally had accepted the determinations of so-called "nationally recognized statistical rating organizations" that such rated issues were in the less risky classifications of debt or preferred equity.

"I think that most of us (life insurance investor representatives) feel that risk related to most hybrids is preferred-like" and a safer investment than common stock, said Bob Peterson, senior vp and chief investment officer for Shenandoah Life Insurance Co. in Roanoke, Va.

Confusion defined

The financial markets have felt the confusion.

"NAIC classifications significantly impact prices of individual securities and types of securities because they affect insurer demand for assets," according to a joint letter to NAIC leaders from the ACLI and the New York-based Bond Market Assn., a trade association that represents about 200 securities firms, banks and asset managers. When a hybrid's classification is downgraded, "most insurance companies, unprepared for such a significant change, simply sell the affected hybrid securities. This in turn influences the decisions of noninsurance companies," according to the letter co-signed by Steven Clayburn, the ACLI's senior director and actuary, and Mary Kuan, the BMA's vp and assistant general counsel.

Hybrid investments from highly rated issuers-companies often with an AA or A rating-play "an important role" in many life insurers' portfolios, because insurers can get better returns than they can with similarly rated corporate bonds, Mr. Renz said. To get the same return, an insurer would have to invest with a less-highly rated company, like one with a BBB rating, he said.

Insurance companies represented roughly 10% to 30% of hybrid bond holders "in a roughly $12 billion to $15 billion market" before the SVO's reclassifications, Ms. Kuan said.

Most of those hybrid bond holders are life insurers because of the 10-year-plus duration of many contracts, several sources said.

Most of the American Insurance Assn.'s property/casualty members invest in short-duration securities, although the association is concerned about what is happening and monitoring the situation, said Phillip Carson, assistant general counsel of the Washington-based association.

The reclassification issue surfaced after New York regulators required a domestic insurer to submit for SVO classification a hybrid in which it had invested. Since then, the SVO has reclassified more than a dozen hybrids as common stock.

The effect on an insurer's capital requirements can be significant.

For example, a typical life insurer's investment that is classified as debt or preferred equity receives one of six risk-based capital factors ranging from a charge of 0.4% to 30%, while an investment classified as common equity typically receives a charge of 30%. So, if an insurer's $1,000 investment was classified as the highest-rated preferred debt (0.4% factor), the insurer would have to carry $4 in capital to maintain that investment as an asset; if the investment were classified as common equity (30% factor), the insurer would have to carry $300 in capital to count it as an asset.

"The impact on small extraordinarily high," said Shenandoah's Mr. Peterson. That is because A.M. Best Co. Inc.'s rating practice is to use the NAIC's 30% RBC factor and multiply it as much as threefold, he said. Best has given Shenandoah, which has about $1.6 billion in assets, a size-related factor of 1.9, which means that a reclassification of a hybrid security from debt to common equity could mean a 57% increase in the required capital, he said.


In recent weeks, regulators devoted several meetings and conference calls to crafting short-term guidance for insurers to use for year-end filings, Mr. Felice said. Subsequently, regulators plan to explore a more long-term solution that could include amending the RBC formula, the debt/equity guidelines or both, regulators say.

Actions during NAIC meetings and the SVO's ratings of hybrid securities were "extremely disturbing" to ACLI members, association President and Chief Executive Officer Frank Keating said in a summer letter to the NAIC leadership.

Initially, Mr. Renz and other insurer representatives complained about "a real lack of definition as to what the NAIC is defining as a hybrid security" because the SVO hadn't specifically identified those features that make a security equity-like. In addition, the SVO acknowledges that there may be subjectivity in the classification, he said.

Subsequently, New York regulator Michael Moriarty, who chairs the NAIC's Valuation of Securities Task Force, said it was his opinion that the market has acknowledged that the structure of some hybrid investments is riskier because the market pays more return for them than it does for senior debt, which is a safer asset because it has a prior claim on a corporation's assets in the event of liquidation. In addition, he said, there are other risks not addressed by credit ratings, including the possibility that an issuer might extend the repayment date of a given hybrid contract.

Initially, members of the financial community were concerned about the NAIC's and SVO's slow pace in publicizing its decisions and making them easily available to all interested parties. Such decisions impact market activity and should be readily available to all, they said.

"We want to make sure that all market participants are on the same footing-that they have access to the same information at the same time, to the extent that it is material," Ms. Kuan said. Also, there is continuing interest in the NAIC/SVO activities and a desire that their activities be transparent and understandable, in terms of releasing their rationale for any decision.

Regulators have made some strides in meeting the bond association's request for greater transparency, including the posting of some SVO hybrid classifications on the NAIC's Web site so they are available to the public at the same time. Industry representatives, however, are still concerned about their ability to influence the process, according to comments from several sources.

Initially, "I don't believe the regulators understood the impact on companies," Mr. Peterson said. "They do now." Also, "I think the process has come a long way," he said. "There is constructive action going on."

NAIC regulators are committed to adopting a short-term solution by the end of 2006 and then crafting a long-term solution by next summer, according to regulators' comments. "In the long term, we are looking at all hybrids," Mr. Moriarty said during a conference call.

Many industry representatives, though, are concerned about the speed with which regulators are seeking even a short-term solution.

"I just really feel that it's more important to get it done correctly than to get it done fast," Tom Considine, vp-government relations in the Long Island City, N.Y. office of Metropolitan Life Insurance Co., said during a conference call.