Market dynamics for triple-B rated paper could be impacted by the new streamlined risk-based capital regime for insurance companies released by the U.K. Financial Service Authority (FSA).

According to press statement released by the FSA earlier this month, the new Policy Statement, PS04/16, reports on the main issues arising from Consultation Paper 190 (enhanced capital requirements and individual capital assessments for non-life insurers), Consultation Paper 195 (enhanced capital requirements and individual capital assessments for life insurers) and the audit and reviewing actuary proposals in Consultation Paper 202 (insurance regulatory reporting - changes to the publicly available annual return for insurers). The FSA published the associated rules and guidance, incorporated under a lengthy 300-plus-word document that industry sources said has just begun to be broached by the industry.

As far as securitization is concerned, the new policy will have implications on capital requirements for credit investments based on an investment's ratings, spread and modified duration.

"The market called the credit risk test included under CP195 strenuous but, at first glance, the new policy looks just as harsh for certain aspects of an insurers holdings," said one market source. "On a stand-alone basis, the holding of triple-B paper looks really unattractive under the new risk weightings proposed by the policy."

Just like triple-B

The enhanced capital requirements under consideration bear some resemblance to rating agency triple-B solvency requirements, which could create a linkage to how an insurance company views the quality of its investment portfolio, explained one insurance company source. "The amount of investments in triple-B rated securities could face tighter limits by investment committees or investment guidelines," the source said. "The risk would be that such investments could get downgraded below triple-B (or worse) and then adversely impact a company's solvency."

The new rules outlined in the policy statement are expected to take effect on Dec. 31, 2004. Firms with fiscal years ending on that date or later will be required to complete their annual returns on the basis of the rules in the policy statement.

In the intermediate term, though, the switch could create some relative buying opportunities for investors who have been waiting for spread widening down the credit curve.

The harsher treatment for triple-B holdings at the intermediate and long end of the curve has already widened trading for this paper by 15 to 20 basis points, noted a Morgan Stanley research report published last week,.

"It means that in the long run insurance companies will be less likely to take on paper at that level," said one source. "But since spreads have widened, it certainly creates some buying opportunity for others in the market who have up to now regarded pricing as too expensive for some of this paper,"

The new policy, which will be included under the FSA's Prudential sourcebook for insurers, is not meant to put U.K. insurers at a disadvantage.

Some industry sources said that the changes come ahead of anticipated European Union-wide modifications expected to be outlined under the EU Solvency 2 directive currently in process. And while at first glance it may look punitive, it's important to note the individual changes under a larger scale of changes that have been made to several different aspects of insurance capital holdings.

Rule applications

The rules will apply to large firms writing with profit business and is intended to bring provisioning and capital requirements more closely linked to the payments and bonuses policyholders expect.

"I think looking at just the triple-B holdings fails to take into account the overhauling the FSA has done to the entire system," said one market source. " It's like Basel II - the whole point is to bring insurance holdings in line with realistic capital holdings. The rules are actually quite positive for senior tranche holdings and credit bonds [which], on a whole, don't look as unattractive as equity holdings under the new policy."

The new holding requirements will apply to both principal and coupon and could create an advantage for the increased use of wraps in the future, which, said sources, would be exempt from the stress test incorporated under the new policy.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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