Structured settlement ABS have certain inherent risks setting them apart from other structured finance assets, according to a report from Standard & Poor's updating its criteria for the sector.
The collateral pools for these deals comprise streams of periodic payments from insurers to claimants for settlements of legal claims, and thus usually have considerable concentrations among obligors in the same industry.
Because of this, these deals are particularly sensitive to the risk that unforeseen events might affect the whole insurance sector or the top insurance carriers, S&P said.
To better assess if deals address these risks, S&P updated its methodology for rating structured settlement securitizations in December 2009.
As part of the update, S&P added two supplemental tests that factor in the event risk and model risk that affect these deals, which resulted in the downgrades of four tranches from three transactions: two to 'AA+' from 'AAA', one to 'A+' from 'AA', and one to 'BBB+' from 'A'.
Additionally, S&P also affirmed its ratings on 35 tranches from 20 transactions and removed all of the lowered and affirmed ratings from CreditWatch negative.
Responding to questions S&P received from market players, the rating agency is now offering added information about its approach to rating structured settlement securitizations and the revisions that it has made to its criteria late last year.
While such concentration-related "event risks" are not unique to this asset class, S&P analysts believe two factors heighten the risks in these transactions: their longer terms to maturity that prolong the period during which event risks are present as well as the lack of excess spread as a form of liquidity to lessen these risks.
Not like many other structured finance asset types, the underlying payment streams for these deals are not broken down into separate principal and interest components, therefore excess spread no longer becomes a form of credit enhancement.
In these offerings, arrangers generally determine the credit enhancement by discounting the projected future cash flow by the cost of debt as a percentage, plus a small margin, to determine the sufficient amount of overcollateralization to support the notes.
Credit enhancement usually builds only moderately throughout the deal's life to absorb possible collateral losses. Furthermore, the term to maturity for a structured settlement ABS usually goes over 30 years. This compares, for instance, to an insurance premium finance deal with a maturity of 10 to 15 years and a revolving collateral pool. Carrier event risk tends to increase over time as the collateral matures and carrier concentrations increase.
S&P uses its CDO Evaluator as its main tool for assessing insurance company default risk in structured settlement deals.
In December 2009, it refined its methodology and assumptions for rating structured settlement payment securitizations. The rating agency recalibrated CDO Evaluator and added a new corporate default table with targeted portfolio defaults as part of the update.
Additionally, it now applies two supplemental stress tests — the largest-obligor default test and the largest-industry default test — to assess the insurance carriers' risk of default in a given pool. CDO Evaluator calculates the results of these tests in addition to estimating the SDRs.
The supplemental tests assess whether a rated tranche has enough credit enhancement to withstand specific combinations of defaults among insurance companies after applying specific levels of recoveries.
They aim to address both potential event risk — the risk that unforeseen events can impact the issuer's ability to pay timely interest and/or ultimate principal — and model risk, which is the risk that a model oversimpliflies or fails to take into account certain factors.