Insurance regulators remain steadfast in their position that certain kinds of bonds should be treated as structured securities, even amid criticism that the move will make them less attractive to their most important investors.

The National Association of Insurance Commissioners (NAIC) last week voted to uphold its new definition of loan-backed and other securities, over the objection of the insurance industry, which believes the classification could shrink certain asset classes and unfairly penalize specific deals.

In a 9-7 vote last Tuesday, the NAIC instituted its proposal to designate certain bonds — like credit tenant leases and equipment trust certificates — as structured securities. The new regulation, which was initially proposed in 2010, will go into effect this year, despite an opposition campaign headed up by the American Council of Life Insurers (ACLI).

“We’re happy treating these as bonds,” said Mike Monahan, director of accounting policy for the ACLI. “They look like bonds; they walk like bonds. And, that’s our view.”

Investors fear that grouping CTLs with other structured products, such as ABS or MBS, could dry up liquidity in the secondary market, particularly if a transaction is sold at a premium.

Credit tenant leases are currently treated as corporate bonds, and the ratings for CTLs — which are built around one tenant, usually a large, publicly traded retail company — depend largely on the credit-worthiness of the tenant, and its likelihood of paying future rents. Those rents are assigned to the lender as security for the principle and interest on the note. CTLs should remain separate from CMBS and other ABS, according to the insurers, because those securities are composed of pools of loans, which makes for a more sophisticated and complex rating process.

The NAIC designates a rating on a structured security partly based on the price paid for that security. Under the new rule, if an insurer purchases a CTL at par and sells it at a premium, the NAIC designation changes. A coupon purchased at a premium receives a lower NAIC designation, which would in turn force a secondary investor to maintain higher reserves for that deal, according to market participants. Conversely, if a trade is issued at a lower price, or discount, the NAIC designation improves on the secondary market, allowing for an insurer to free up reserve levels.

A July memo to the NAIC from Matti Peltonen, of the New York State Insurance Department, explained why a security issued at a premium should be downgraded.

“[T]he investor, having bought a security at a premium has more at risk than the investor that bought a lower coupon security by the same issuer at a discount,” the memo stated.

Officials from the NAIC did not respond to requests for comment.

Lewis A. Burleigh, a partner with Dechert law firm, represents insurance companies in CTL transactions and other single-credit securities. He believes, that under the new rules, his clients could have a more difficult time selling their CTLs to other insurance companies at a premium, “because there will be a big hit to their regulatory capital.”

“It will diminish the secondary market, and that will make the asset class less attractive to some investors, who are likely to trade out of privates,” he said “But, I don’t think it will be a disaster.”
The impact on the market will not be known until insurance companies file their financial statements early next year for 2011 reporting. Many investors agree with Burleigh that the secondary market is vulnerable under the new rule, but few could quantify that potential drop in activity.

Instead, they question the NAIC’s reasoning.

“It doesn’t make any sense to me that they’re taking CTLs and classifying them with other types of loans that really don’t have similar characteristics,” said Alex Fisher, president of International Amalgamated Group, which provides lease insurance on CTL deals. “This could result in a significant disruption of liquity in the marketplace.”

Others hope that the NAIC reverses course before the end of the year. Part of the vote on Tuesday allowed for the creation of a sub-committee of industry leaders and regulators, which would examine the regulation as it relates to single-credit securities.

Monahan, of the ACLI, is hopeful that group will help reclassify CTLs.

“We respect the vote,” he said. “What we want to do is to fix certain classes of securities which we believe were unintentionally scoped into the (classification). We want to put those back where they belong, in the bond classification.”

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