The age-old practice of rating distributions is on the cusp of a new era. Effective Jan. 1, 2004, the ratings process for private market issuers will undergo a streamlining between the National Association of Insurance Commissioners (NAIC) and rating agencies - the latter of which has a fresh face on the scene.

According to the NAIC, an issuer already graced with an investment-grade rating by an NRSRO (Nationally Recognized Statistical Rating Organization) will immediately generate an equivalent NAIC rating. The move dramatically expands the way issuers can access the private lending market by affecting costs associated with generating a rating and time to market.

Word of the streamlining came, coincidently, in the same week Dominion Bond Rating Service Ltd. (DBRS) announced it had been granted NRSRO status by the Securities and Exchange Commission (SEC).

Rules of the game explained

Donning the name the Filing Exempt (FE) Process, the new NAIC program means that an issuer with an investment-grade rating garnered from an NRSRO will immediately be assigned an NAIC rating of a 1 or a 2.

The NAIC has been working on the new process all year, confirmed Tony Urich, credit manager at the Securities Valuation Office (SVO) of the NAIC. "It will make it more efficient and add value," said Urich. "The FE process will allow the NAIC to focus on where we can put our analytical skills to work."

Though the nitty-gritty details have yet to be ironed out, the overarching theme of these rating changes, according the market sources, is an effort to increase efficiency in the market.

Currently, a firm that wishes to issue a private placement can spend a considerable sum of money and get rated by an NRSRO, though it doesn't have to. (NRSROs include Moody's Investors Service, Standard & Poor's, Fitch Ratings and DBRS, which was notified on Oct. 21 that it received NRSRO status.)

The alternative to an NRSRO rating has been the NAIC. Aside from the expense, an issuer may skip getting an NRSRO rating because chances are it will need a NAIC rating regardless to complete the deal. While ratings are not a requirement in the private market per se, most private placement buysiders are insurance companies. By ordinance, insurance companies must file with the NAIC's SVO in order to obtain a credit quality valuation for every security they purchase. This process, while less expensive than going to an NRSRO, is considerably more time-consuming.

Eradicating the difficulties

"The NAIC doesn't ask questions or conduct any interviews with the companies," said one market source. "They just slap on a rating, and it's often haphazard and unpredictable."

Issuers have been hampered, to a large extent, by the length of the NAIC process - which was described as "extremely erratic" by one sellside source.

Some of this so-called erratic nature can be attributed to staffing levels. A June 23 meeting of the Securities Valuation Office Oversight Working Group revealed that the average analyst at Fitch is responsible for 13 issues whereas a typical analyst at the SVO is responsible for more than 200.

According to Michael Ho, ratings origination manager at DBRS, three months to a year is the average time it takes the NAIC to assign a rating. The new process is pretty simple and "a lot easier to use," said Ho.

By removing the most harrowing inefficiencies in the ratings game, the FE process increases an issuer's options. Deal execution speed is expected to increase come January for investment-grade issuers.

According to Ho, the average time it takes DBRS to assign a rating is two to six weeks.

In theory, when a company goes to an NRSRO for a rating, it can attain one at a much faster speed and, provided the NRSRO rating is investment-grade, the issuer will automatically receive an NAIC rating, satisfying the SVO requirements for insurance buysiders.

To rate or not to rate

At the same time, a firm that isn't rated can still skip the formal ratings process and go directly to the NAIC - but with fewer companies to rate, the turnaround time will get faster and accuracy at the NAIC will increase, noted Urich. "It will make [ratings] more efficient and add value," he said. Furthermore, the FE process is expected to eschew the backlog of companies the NAIC has to rate, as well as reduce the redundancy of assigning investment-grade ratings, he noted.

Despite the notable enhancements, some non-investment grade small to medium-sized firms seeking private placement will still be turned off by the expense of going through the formal process of getting a rating. These are likely to be the companies the NAIC will focus more heavily on in the future, sources indicated.

At the same time, DBRS' Ho explained that as far as costs go, life insurance companies pay the NAIC for every single security the company owns. The cost is $2,100 for non-rated firms and $700 for new issues, he said. But under the new process, the NAIC will no longer be collecting fees for its investment-grade ratings.

"The NAIC proposed replacing revenue lost from the removal of NAIC-1 and 2 equivalents with proceeds of a new fee for service structure," according to the minutes from the June 23 meeting of the SVO Oversight Working Group. Because they are no longer required to pay the filing fee for their investment-grade securities if the firm already has an investment-grade rating by an NRSRO, insurance companies may encourage private placement issuers to get an NRSRO rating. At least that's one aspect about this FE Process that is particularly encouraging for NRSROs.

At present, smaller to medium-sized firms get "bucketed" by the larger rating agencies - which means they automatically get a lower rating if their market capitalization is below a certain level. The co-joining of NRSRO and NAIC ratings could encourage some NRSRO agencies to stay away from bucketing smaller companies looking to issue private placements.

According to Ho, DBRS wants to provide a more comprehensive ratings service for smaller to medium-sized firms. There are a number of other factors it will consider so it can avoid bucketing the smaller firms, including the amount of debt a company holds, the type of debt on its books and the hedging strategies it employs, among others, he said.

The FE process presents a significant change, and while there is often a certain degree of hesitation surrounding change, the initial reaction is upbeat. "It's very big positive, cost-effective, and comfortable for investors," said a market source.

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