The insurance industry, market analysts said, is increasingly relying on the National Association of Insurance Commissioners (NAIC) ratings to evaluate non-agency RMBS.
This puts the sector ahead of the game when it comes to getting away from the purview of credit ratings in evaluating capital.
U.S. life insurers are subject to minimum statutory capital requirements that are determined using a risk-based capital (RBC) formula that was developed and maintained by the NAIC.
Effective Dec. 31, 2009, the NAIC modified its methodology for determining the NAIC designation for RMBS securities. The nationally recognized statistical rating organization (NRSRO)-based methodology was replaced by one that relies on the results of a financial model that projects expected bond loss.
To determine the expected bond loss, PIMCO Advisory performed a security-level analysis on more than 20,000 RMBS securities held by the U.S. insurance industry by using a proprietary valuation model.
The new methodology, referred to by the NAIC as the RMBS Initiative, utilizes an expected bond loss approach and factors in the statutory carrying value of the bond (relative to remaining par value).
The NAIC's move was motivated by the headache that ratings were causing for insurance companies.
As a result of the large number of RMBS rating downgrades experienced in 2009, the percentage of life insurer RMBS holdings designated as NAIC-1 would have dropped from 84% to approximately 44% using a ratings-based methodology, according to NAIC estimates.
"Given that non-agency RMBS is a material asset class for the life insurance industry, the RBC impact due to RMBS downgrades would have been significant," Fitch Ratings analysts said. "The RBC charge on non-agency RMBS investments for life insurers would have increased from $2.1 billion to an estimated $14.3 billion."
The NAIC uses an expected loss model that avoided penalizing companies for holding previously 'AAA'-rated bonds while still recognizing the impairments that threatened them.
It also noted that long-term credit ratings for structured finance securities are intended to reflect the risk of default, but are not intended to provide guidance on the amount of the bond loss in the event of default.
The amount of the bond loss in the event of default became an increasingly important issue in 2009 as large senior classes were downgraded to distressed long-term credit ratings.
Previously, RMBS bond defaults were largely limited to very thin subordinate tranches with limited recovery prospects.
While Fitch provides the marketplace supplemental ratings, such as Loss Severity and Recovery Ratings, to offer guidance on estimated bond loss in the event of a default, these supplemental ratings had never been incorporated into the NAIC's methodology.
Fitch estimated that the prime RMBS senior classes expected to default will recover more than 90% of the par amount on average. As a result, under the prior methodology, a senior class with a long-term credit rating of 'CCC' could have a projected loss as small as 1% but a risk-based capital charge of 23%.
The NAIC ratings are now based on an alternative methodology comparing the present value of the expected loss to the security relative to the carrying cost of the security. These are used to determine capital charges on an insurance company's investment assets, which Amherst Securities Group (ASG) analysts said is a "far more rational way to look at a portfolio."
The new method for RMBS and CMBS uses a third-party credit model, with PIMCO and BlackRock Solutions, respectively, as vendors. This is used to come up with an intrinsic value for each security, which is for calculating a price breakpoint for each NAIC designation level.
For each bond, PIMCO Advisory provides price ranges for each of the six NAIC categories based on the discounted value of the bond's projected principal loss.
The NAIC designation for each RMBS security is based on where the statutory book value (relative to par value) matches the price ranges for a rating category. For life insurance companies, if the initial NAIC category is NAIC-6 based on statutory book value, the final RBC category is assigned with a second iteration using the bond's fair value.
Capital and mark-to-market requirements are then calculated based on the amortized cost basis of the security in relation to the price breakpoint for each of the NAIC designations.
"A distressed bond with a projected principal loss amount can still achieve the lowest-risk NAIC 1 designation if the bond's carrying price appropriately reflects the amount of the projected principal write-down," Fitch analysts said. "A bond will be assigned a higher-risk NAIC designation to the extent that a bond's carrying price is higher than the estimated intrinsic price, which is the difference between the bond's par amount and the present value of the projected writedown."
Close to 96% of the non-agency RMBS that were either traded or offered over the past month had a NAIC 1 rating, ASG analysts said.
Of the 629 CUSIPs that ASG looked at, 578 were NAIC 1' Of those NAIC 1-rated securities, only 113 are rated investment grade by all rating agencies that rated them, which includes the big three - Moody's Investors Service, Standard & Poor's and Fitch.
"If the old rating structure were in effect, then these securities would be rated NAIC 1 or NAIC 2," ASG analysts said. "The other 449 securities would be rated NAIC 3, NAIC 4, NAIC 5, or NAIC 6, with much higher capital charges. The NAIC charges on non-agency securities should spur insurance company demand for this sector."
These non-agency RMBS that are currently rated below investment grade by the approved rating organizations and that are expected to be rated NAIC 1 will likely play a more important part of the insurance company landscape in 2011, they said.
Calculations Different for Non-Mortgage ABS
But for non-mortgage-related assets, using NAIC designations might not be working as well as it has for the non-agency space.
This is because, unlike the calculation for RMBS, the NAIC does not require a third-party credit model for non-mortgage-related structures and instead determines the discounted value of the expected loss on a security calculated by PIMCO, as well as the security's carrying price.
In a two-step process, the NAIC first determines its initial designation of the bond using the second-lowest assigned rating that must either have been assigned or affirmed within the past 12 months. After determining the initial NAIC designation, the amortized cost - or the bonds carrying value - is compared with the range of predetermined values.
Each security has a minimum and maximum carrying price breakpoint for each NAIC designation, based upon the discounted value of the expected loss for the security. If the carrying value of the bond lies between these breakpoints, then that determines the initial NAIC designation for the bond. The NAIC designation will change when the carrying value exceeds the breakpoint. This process replaced the totally ratings-based system that was in place.
The only exception is for securities with an initial designation of NAIC 1 that are assumed to have zero expected loss. At the other end of the waterfall are securities with a designation of NAIC 6, which will remain NAIC 6 despite the carrying value.
"NAIC designations have been almost an afterthought for insurance companies investing in non-mortgage asset-backed securities," Barclays Capital analysts said. "This was because NAIC designations had traditionally been ratings based, and the vast majority of securitizations purchased by insurance companies were rated investment grade, resulting in an NAIC 1 or NAIC 2 designation."
However, they added that the calculations "arbitrarily penalize premium-priced non-mortgage ABS" because the carrying value matrix makes a significant distinction in risk-based capital charges between these bonds. This, analysts explained, can make it less attractive for insurance companies to buy subordinate or non-mortgage ABS at premium dollar prices in the secondary market because of the risk-based capital's negative impact.
"However, this phenomenon really applies only to non-mortgage ABS rated 'Baa1'/'BBB+'/'BBB+' or below; carrying value has no effect on bonds rated above
'A3'/'A-'/'A-' with an NAIC 1 designation, which generally encompass most non-mortgage ABS senior and mezzanine classes," Barclays analysts said. "In addition, much of the non-mortgage ABS purchase activity of insurance companies historically has occurred in primary markets with a carrying value generally at or slightly below par; even if a subordinate non-mortgage ABS is subject to NAIC designation modification, with a new-issue carrying value, we believe the bond is likely to maintain its initial NAIC2 designation."
NAIC on the U.S. Downgrade
The early August S&P's downgrade of the U.S. sovereign debt rating will have no impact on insurer investment, the NAIC said.
"There is no impact on insurer investments in U.S. government and government-related securities from the actions recently taken by the rating agencies," Susan Voss, commissioner of the Iowa Insurance Division, said in a statement. "Risk-based capital and asset valuation reserves are unaffected. State insurance regulators and the NAIC will consider changes to our regulatory treatment if it becomes necessary in the future."
"Our risk-based capital system does not assign a credit risk charge for instruments that are backed by the full faith and credit of the U.S. government," said Therese Vaughan, NAIC CEO. "The fact that this was downgraded by one rating agency really has no effect."
