Fitch: Proposed NAIC Approach to Downgraded RMBS Unlikely to Impact U.S. Life Insurance Ratings

Fitch Ratings does not expect that the National Association of Insurance Commissioners’ (NAIC) efforts to address issues in its Risk Based Capital (RBC) formula related to downgraded residential mortgage-backed securities (RMBS) will ultimately have a material impact on Fitch’s analysis or the ratings of U.S. life insurance companies. While Fitch reviews the NAIC RBC ratio as part of its ratings analysis, Fitch believes its review of insurer capital strength will not be materially impacted by the adjustments expected by the NAIC because Fitch takes a multi-faceted approach to capital analysis as compared to that used by regulators.

As part of this multi-faceted approach, Fitch reviews multiple capital measures, including various leverage ratios and its own capital model. Fitch also projects potential changes in an insurer’s capital adequacy measures, including the NAIC RBC, based on the agency’s view of various stress test scenarios. Ultimately, while Fitch recognizes that a severely weakened RBC result can negatively impact the ability of an insurance company to maintain its business as a going concern, Fitch’s ratings place greater emphasis on its internal analysis.

This commentary is provided in response to questions Fitch has received from investors and insurance companies asking how possible changes in RMBS treatment by NAIC may be viewed by Fitch in its ratings applications.

As background, in 1993 NAIC introduced its RBC ratio as a way to help identify insurance companies with potentially weak capital positions requiring some form of closer regulatory scrutiny or corrective action. For risks related to the insurers’ fixed income investment portfolios, capital charges are based on the application of a risk factor against the book value of each fixed income security held by the insurer, with the risk charge increasing at each successive NAIC rating category 1-6. These six NAIC rating categories are derived from the ratings of certain Nationally Recognized Statistical Rating Organizations (NRSROs).

The approach used by the NAIC for risk evaluations of fixed income invested assets in its RBC formula has remained essentially static since the ratio was first introduced 16 years ago. There has never been differentiation in the RBC formula in the application of the risk factor charges for corporate versus structured finance securities.

Fitch notes that since the initial introduction of the NAIC RBC ratio, structured finance has grown rapidly to comprise a significantly larger proportion of life insurers invested assets. Further, over the past five plus years, there has been growing discussion across the capital markets as to what the best risk metrics are to measure credit risk of structured finance securities. These discussions have mainly focused on the relative value of probability of default (PD) measures versus expected loss (EL) measures that capture both PD and expected recoveries in the event of default.

Fitch believes the capital market’s interest in expected loss measures is appropriate in structured finance since senior securities at the highest levels of the capital structure of a securitization may benefit from very strong recoveries in a default, whereas subordinated or mezzanine tranche securities could suffer large if not complete losses. As a result, structured finance recoveries vary greatly from corporate recoveries, and from tranche to tranche within a given securitization. In its own analysis, Fitch may consider information provided by Fitch’s RMBS group which published recovery ratings on the impaired RMBS securities it rates.

Given the collapse of the real estate markets, and subsequent financial crisis and global economic recession, the various NRSROs have downgraded their primarily PD-based ratings of a number of RMBS securities, including some downgrades of once ‘AAA’-rated securities to low non-investment grade levels. Under the NAIC’s RBC formula, which is currently designed to only capture primarily PD-based ratings (and not recovery or loss given default ratings, or recovery statistics), the implied capital charges for downgraded RMBS held by many life insurers would increase for year end 2009 financial reporting of the RBC ratio.

To put this in perspective, the life industry estimates that it held $145 billion of non-agency RMBS securities at year end 2008. The RBC requirement for these securities was estimated to be $2 billion at that time. Given the recent downgrades, the industry estimated that the capital requirements would increase to $11 billion, with approximately 53% of that increase borne by the 20 largest life insurers.

Due to this expectation of increased capital requirements linked to the noted ratings migration, the American Council of Life Insurers (ACLI) has several times this year discussed the potential for capital relief with the NAIC, citing that primarily PD-based ratings used by regulators in their RBC formula do not adequately capture the expected loss of these securities. The ACLI’s concern is mainly related to senior securities with high expected recoveries.

In response to the ACLI’s request and following study of the matter, the NAIC’s Valuation of Securities Task Force and the Financial Condition (E) Committee yesterday approved the core aspects of ACLI’s proposal to make an interim update to the 1993 RBC formula. A key part of the proposal would involve the employ of a risk advisory firm(s) that will develop EL estimates for downgraded RMBS securities. These EL estimates would form the basis for the capital charges used in the RBC ratio for year end 2009 financial reporting, and would replace use of the historic PD approach. Fitch understands final ratification of the ACLI proposal is subject to NAIC Executive Committee approval and that approval is expected.

In considering the ultimate usefulness for ratings analysis purposes of any regulatory changes in statutory capital measurements or formulas, Fitch considers how the change aligns with its rating philosophies.

For example, during its ratings reviews this year, Fitch has eliminated the impact of so-called ‘permitted practices’ approved by a number of state regulators to provide capital relief to insurers’ year end 2008 capital balances and RBC ratios. This reversal was due primarily to the changes in the definition of capital implied by the permitted practices being inconsistent with Fitch’s ratings-based definition of economic or stressed capital. The reversal also reflected the fact that approval of permitted practices was not uniform from state to state, or company to company.

In making these reversals of permitted practices for analytical purposes, Fitch expresses no opinion of the validity of the permitted practice for regulatory purposes. Similarly, Fitch has not expressed an opinion on the validity of the NAIC’s likely path in its approach to RMBS securities from a regulatory perspective. However, from the perspective of the usefulness of the expected NAIC’s RMBS-related changes for insurance company ratings analysis purposes, Fitch makes the following observations:

—A movement to a more refined approach to EL for RMBS securities is useful for insurance company ratings analysis purposes, since it helps bring the 1993 NAIC formula more up-to-date with current capital markets thinking on structured finance credit risk, and closer to Fitch’s approach to investment risk analysis. In its own capital model, Fitch’s investment risk charges consider not only PD and EL risks of invested assets, but also market risks and price volatility.

—It will be important that the approach consider not only the high expected recoveries for senior RMBS securities, but also the very poor or full losses expected on mezzanine and subordinated securities. Otherwise the approach will lack balance and be less useful for insurance company ratings analysis purposes.

—Fitch notes that in the current environment other securities may experience lower recoveries than average (and thus lower than those implied in the current RBC formula), as Fitch notes recoveries tend to fluctuate over time, and are typically at their lowest average levels during economic recessions. Fitch’s stress test analyses of insurer’s investment portfolios encompass a broad range of asset classes, not just RMBS, and consider both default and recovery variability.

—Fitch notes the expected change is only being enacted for life RBC, and not property/casualty RBC, though Fitch also notes the property/casualty industries’ exposure to RMBS is significantly lower than that of the life industry. Historically, other risk charges have also differed between the two RBC formulas, such as the charge used for common stock investments.

—To make the process transparent for analytical purposes, it would be helpful if the NAIC required disclosure of the ELs in insurers’ investment schedules included as part of publicly available statutory annual reports.

—Finally, for consistency and to support analytical rigor, it would be important that the EL factors developed by the risk advisory firm(s) be set at the same confidence level as other risk charges in the RBC formula since most NAIC risk factors are set at a confidence level higher than the pure expected loss.

Fitch understands a number of issues need to be resolved in implementing the NAIC’s expected changes in capital methodology. These include final selection of a risk advisory firm(s) that will develop the EL estimates and agreement on modeling assumptions used by the risk advisor(s), including the time horizon used in developing the EL.

Assuming final ratification, Fitch expects a more complete picture will become apparent as year end reporting approaches. As appropriate, Fitch will monitor new developments and provide additional comments as new facts emerge.

Additional information is available at www.fitchratings.com.

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