In the aftermath of wholesale downgrades of RMBS by the ratings agencies, following the housing market downturn, the National Association of Insurance Commissioners (NAIC) decided to try a different approach.
The NAIC hired PIMCO in 2009 to develop modeling techniques to get a better idea about the risk associated with RMBS for life company capital adequacy purposes.
And in 2010 the NAIC hired BlackRock to develop such modeling techniques for CMBS securities too.
Matti Peltonen, capital markets bureau chief, New York State Insurance Department, believes that the NAIC's objectives are being met with this modeling approach.
"It was a mechanical approach (using ratings agency ratings) as opposed to a process where we are more in control of the timing and the credit evaluation and where we control the assumptions," Peltonen noted.
With the use of rating agency ratings, timing was an issue for the NAIC, according to Peltonen. At the point the agency implemented a rating agency's rating, it might be weeks, or even years, old.
There are also five or six major credit rating agencies, each with its own methodology that is not exactly comparable.
Another advantage of the modeling approach is that every company's cost is taken into account. This means that the risk-based capital charge for a company that bought a security at a lower cost will be lower than for a company that bought it at a higher cost.
Andrew Edelsberg, an analyst/vice president with A.M.Best, a credit rating agency that rates insurance companies, also believes that the modeling approach is "a more accurate reflection of the risk of the securities and the capital necessary to hold against the securities."
One potential drawback, according to Peltonen, is that there is only one vendor each that does the modeling for RMBS and for CMBS, which leads to dependency.
There is also the question of transparency. "We have to be careful that there is adequate transparency," Peltonen noted. "While we can't disclose the exact nuts and bolts of how each firm's model works, we can at least disclose an adequate amount of information about how we do that so that the insurance companies are clear how we arrived at the results."
George Hansen, senior financial analyst with A.M. Best, also noted that one of the primary drawbacks to this modeling initiative is a lack of transparency.
"With the rating agencies at least, once the rating changes were announced, you knew what you were going to deal with in terms of required capital. This (modeling) might be more of a black box approach in that companies don't really know what the final result is until very late in the year," Hansen said.
This means that an insurance company buying a security won't know what capital to hold against the security until the pricing matrices come out from PIMCO and BlackRock.
The modelers refresh the matrices every year, taking into account changes in the macroeconomic environment.
Fitch Ratings has also commented on the lack of transparency of the modeling approach by noting that additional disclosure about mortgage pool loss amounts, timing and prepayments would be helpful, considering that RMBS valuations are very sensitive to the assumptions made.
Modeling for CMBS securities is even more complex, considering that the loans are bigger and more dissimilar. This means that CMBS doesn't lend itself as well to modeling as RMBS.
Peltonen noted that the CMBS modeling approach will involve a combination of modeling and a more traditional credit analysis of each deal.
The life companies now use the modeling input to reckon capital adequacy needs for about 10% of their RMBS and CMBS holdings.
As for the prospect of extending this approach to other ABS, Peltonen doesn't believe that it will be practical or economical to do that, considering that these are much smaller sectors.
"We are looking at different ways to improve that process too, but it is unlikely that we will use modeling," he said. "Also, the ratings and credit quality for these other ABS have been more stable. There haven't been that many downgrades in the areas of autos or credit card loans or student loans."