Hubrid insecurities: the actions of an agency under the National Association of Insurance Commissioners caused financial repercussions in a corner of the investment market. While regulators have offered a short-term solution, industry leaders are calling for additional changes.

Key Points

* Insurers own about 25% of hybrid securities issued.

* Life insurers hold about $4.2 trillion in securities, or about 12% of total investments in the U.S. capital market.

* To buy a common stock, insurers have to put up 100 times more risk-based capital to back the investment than if they had purchased a securely rated debt instrument.

Last spring, the National Association of Insurance Commissioners' Securities Valuation Office--which is charged with evaluating the quality of insurance company investments--made a ruling that dampened the investment market for hybrid securities for six months, causing the value of investments held by life insurers to fall $1 billion in value.

After an industry outcry, the NAIC set about to find a remedy to the situation. In September 2006, it reached an interim agreement that has returned stability to the market, and the value of hybrid securities has rebounded.

"All eyes are now on the long-term solution," said Jim Renz, director of accounting policy for the American Council of Life Insurers. "We really should be considering whether or not the SVO should be in the rating business at all. We think [it] could be reinvented to provide better value to state insurance agencies."

North Dakota Insurance Commissioner Jim Poolman said the NAIC is open to improving its process, but said one of his concerns is "putting regulators in the middle of a potential deal. That is not the function of a regulator. Our constituency is the consumers who want a financially sound company. Our constituency is not getting in the middle of financial deals to help structure them. It's a potential conflict of interest of what our role is as a regulator."

Hybrid securities have been around for decades and play an important role in Insurers' investments. How state regulators view hybrid securities could have wide-ranging implications not just for insurers, but for other issuers and buyers of hybrid securities.

Equity or Debt

Regulators--and rating agencies--want to make sure insurance companies have enough money to pay their obligations. To do this, they keep tabs on a company's financial health by analyzing, among other things, the risks it takes, the reserves it holds and the investments it keeps. Through applying the standards of risk-based capital, regulators and rating agencies aim to establish a minimum level of capital necessary for a company to support its operations. They do this, in part, by requiring higher amounts of capital for bearing higher amounts of risk.

Insurers' investment portfolios include common stock, or equity; bond issues, or debt; and hybrid instruments, which have characteristics of both equity and debt (See Types of Hybrids).

At issue is how the SVO and regulators view hybrid securities.

Rating agencies, including A.M. Best Co., can treat the securities as either debt or equity, or a combination of both--for example, 25% debt and 75% equity--dependIng on how the securities are structured. A.M. Best uses a security's "equity credit" in calculating an organization's financial leverage, which is a factor in evaluating a company's financial health. The more equity-like the security is, the more equity credit it would receive. Characteristics of equity include no maturity date, no ongoing payments, and deep subordination, which means it's low on the hierarchy of debtors who'd receive cash if the issuing company went under.

All hybrid securities have a regular payment stream like a debt instrument, but the payments may be deferred and may or may not be cumulative. Historically, when an insurance company has invested in these hybrid securities, the securities have generally been classified as bonds.

The SVO's role is to recommend to insurance commissioners how much regulatory capital insurance companies should hold against particular investments. This helps to keep insurers from investing too much in risky assets, because insurance companies have to consider the cost of capital charges against any potential income from an investment.

Both an insurance company that issues a hybrid security and an insurance company that buys one are impacted by how the SVO classifies a hybrid security.

"When an insurance company issues a security, its treatment by rating agencies and regulatory bodies can impact the composition of the insurer's balance sheet and the level of capital and surplus it reports," said Edward Easop, vice president of rating criteria for A.M. Best Co. "When an insurance company buys a security, its treatment can also impact its financial position, particularly as it relates to the development of risk-based capital requirements."

Basically, the amount of capital an insurer is required to hold on any asset in most capital markets is based on the default characteristics of the asset or the relative likelihood that the asset will lose value, Easop said. A number of factors influence an asset's default characteristics, including the credit quality of the issuer and the type of security--which is where the SVO determination comes in.

While the SVO had historically considered hybrid securities to be bond-like, the SVO in March reclassified a hybrid security--a $300 million Enhanced Capital Advantaged Preferred security issued by an affiliate of Lehman Brothers Holdings Inc.--as common stock. This change in classification made the securities 100 times more expensive for insurers, in terms of risk-based capital.

For example, while a highly-rated "Class 1" debt instrument or preferred stock requires a 0.3% capital charge, a highly rated "Class 1" common stock requires a capital charge of 30%, or 100 times higher than that of debt or preferred stock under NAIC risk-based capital guidelines. So a highly-rated debt instrument with a market value of $1 million would have required an insurance company to allocate $3,000 for risk-based capital, while a common stock of equal value would require $300,000, according to the ACLI.

While the SVO ruling applied to a specific security, it impacted similar hybrid securities in the marketplace, according to the Securities Industry and Financial Markets Association (created by the November merger of the Bond Markets Association and the Securities Industry Association).

In the six months following the SVO's hybrids ruling in March, the market value of hybrids held by insurers fell by $1 billion, ACLI said. And companies that could once liquidate positions as great as $50 million in a single day found they were only able to sell $10 million a day after SVO's action.

Spreads, or the difference between the interest rate on a particular security and a benchmark such as a Treasury bond, widened on hybrids after the SVO riding. For instance, a hybrid issued by Zurich Financial Services widened by as much as 45 basis points within two weeks of the Lehman ruling, Kevin Conery, senior director of Merrill Lynch, testified before Congress in September. Widening spreads mean higher interest rates, or an increase in borrowing costs for issuers. It also means the value of hybrid securities held by insurance companies and other investors fell--by $159 million in the case of the Zurich issue, Conery said.

Resolution Reached

In September, the NAIC reached an agreement not to overrule the SVO's decision in viewing hybrid securities as equity, but to change the risk-based capital requirements on hybrid securities, said Poolman, North Dakota insurance commissioner and chairman of the NAIC's Life Insurance and Annuities Committee. The majority of insurers investing in hybrid securities are life insurers.

The NAIC agreed to a risk-based capital charge of between 0.3% and 2% for hybrid securities, even those that are considered equity by the SVO.

The NAIC's hybrid security working group is considering other changes to its evaluation process. "Everyone was worried about how they were going to report these things for the 2006 financial year. We have resolved that, and it's given us time to do a more comprehensive study of the risk associated with hybrids," Poolman said.

Insurance and bond market leaders have said they're pleased with the NAIC's risk-based capital action, but continue to push for the SVO to release its information to the public, not just the insurers or regulators who request the SVO's opinion on a security. Even insurers who issue hybrids cannot directly approach the SVO for an opinion, but must find a potential insurance company buyer to do so.

"The NAIC did not publicly disclose its reasoning for this decision broadly, though a small number of insurance companies that appealed the ruling did gain access to this information. The information, however, was confidential. As a consequence of the classification, the prices of hybrid securities with features similar [to the Lehman issue] and other hybrid securities with similar features dropped and their yields rose relative to other fixed-income securities. Investors--reasoning by analogy--viewed the securities as likely to suffer from a similar drop in demand due to a similar SVO classification," Conery said.

Poolman cautioned that while the NAIC is open to improving communication, the SVO, as a regulatory body, is not designed to serve investors or the general market. Its constituency is consumers, and its goal is to ensure those consumers have a financially solvent company with which to do business, he said.

However, the SVO can do some things so that the industry "has a better understanding of our decisionmaking process," said Poolman. "But my concern is if we lay out our decision-making process, and they don't get the decision they want, there will still be conflict."

Market Thaws

After the SVO's March decision, the market for hybrids "basically shut down for a month and a half," said Juerg Hess, treasurer of Swiss Re.

This put Swiss Re in "an interesting situation," Hess said. The company had planned to issue $500 million in hybrid securities in the United States to help fund its acquisition of GE Insurance Solutions.

But after doing its own due diligence with potential buyers, Swiss Re found the market still had an appetite for hybrid securities, said Andreas Weber, head of corporate finance for the Zurich-based company.

"It was clear that insurers, who had historically been a very large buyer of these securities, were understandably cautious. We didn't know what the impact would be. The hybrid was switched from senior debt to equity, so insurers took a cautious approach," Weber said. "But on the other hand, some of the other institutional investors were quite eager to see the market reopen, and they were very interested in putting money to work."

Ultimately, Swiss Re in May went ahead and issued its hybrid securities in the U.S. market, and it found such a strong demand for the securities that it increased the issue to $750 million.

Swiss Re was still concerned about how insurance companies would view the issue, in light of the SVO's earlier ruling.

"We made sure that the insurance investors knew that it wasn't our place to speak for the NAIC. We even had them sign a release form to confirm that we couldn't give any insight into what the NAIC would do," Hess said.

The SVO ruled the securities would be considered as equity.

"When we were advised by the SVO that we were going to receive equity treatment for our hybrid, we decided to issue a press release so our investors knew what was happening," Hess said.

Swiss Re is pleased with the recent action taken by the SVO and the NAIC, Hess said. "The proposal has restored stability to the capital markets and is a fair balance between the responsibility of the regulators and the insurers' desire to invest in these valuable financial instruments."

One Rating Too Many?

Some in the insurance industry have questioned whether the SVO plays a necessary role in rating securities at all.

"They have two dozen analysts there. The [NRSROs] have thousands of analysts. One could certainly make the assumption that the SVO isn't nearly in the position to do the job as adequately as the rating agencies," Renz said.

William Boyd, financial regulation manager for the National Association of Mutual Insurance Companies, agreed. "Why should they rate securities if other rating agencies are rating securities? It's a waste of time. The SVO is acting merely as a toll booth collecting fees," Boyd said.

Poolman disagreed.

"Much of the work we are doing right now is on private placements. We have exempted the filings of many securities that are already rated by the NRSROs. But the bulk of the work is on private placements, which aren't rated. And they can be significantly more risky to portfolios," Poolman said.

A.M. Best Co. would only rate a hybrid security that was issued by an insurance company.

"The SVO treatment is typically used by insurance analysts, including A.M. Best Co., as a primary source for the determination of a security's asset class assignment," Easop of A.M. Best, said. "Assets that are in relatively more volatile or risky classes are assigned higher risk factors in developing required capital charges. As a result, the SVO accounting can have an impact on risk-based capitalization." However, he noted that A.M. Best's approach to rating entities is not entirely mechanical, and analysts have the ability to make adjustments as needed "to appropriately capture the underlying risk of any asset or liability captured in the financial statements."

The American Insurance Association has pointed to the turmoil caused by the SVO's March ruling as an example of why there should be an optional federal charter for insurers. "Modernizing insurance regulation, including reforming oversight of insurer investments, will result in healthy, robust insurance markets that benefit insurance consumers," said Drew Cantor, AIA vice president and director, federal affairs, in a statement.

The AIA issued the statement on Sept. 20, 2006, the day a House Financial Services Subcommittee held a hearing aimed at examining how insurer investments are regulated by the states.

NAMIC's Boyd said while NAMIC has had "historical differences with the NAIC's SVO, this issue does not justify any thrust toward optional federal chartering."

Poolman said the optional federal charter "is one of the biggest red herrings ever.

"Any time companies or organizations get an answer they don't like, they will point to the need for an alternative regulator because they think they can get the answer they want somewhere else," he said. "I don't buy it, and the consumers won't buy it either."

Types of Hybrids

Hybrid securities are instruments with characteristics of both debt and equity. They include:

Traditional Preferred Stock

Generally viewed as the original form of hybrid security, preferred stock pays a stated dividend field, much like the interest rate paid on bonds. But unlike common stock, it does not confer voting rights. Preferred stock holders also have certain priorities over common stock holders with dividends or distribution of assets in the event of bankruptcy or liquidation. Preferred stock is issued by a holding company or operating company and can include equity-like features such as perpetual maturity issues, with no put options that present refinancing or repayment risk; ongoing payments can be deferred; and deep subordination, senior only to common stock.

Convertible Securities

These are securities that can be converted into shams of a company's common stock. In general, they can be grouped into two broad categories--mandatory conversion and optional conversion. In a traditional mandatory conversion, the security converts into common stock at a fixed price when it matures. Like equities, mandatory conversion instruments carry no obligation to return cash to investors. The dividends or ongoing cash payments from optional convertible securities can be deferred.

Trust Preferred Securities

These can include issues such as Monthly Income Preferred Stock, Quarterly Income Preferred Stock, and Trust Originated Preferred Redeemable Stock. They allow the issuer to make tax-deductible interest payments, which reduce the issuer's cost of capital, while also providing equity-like benefits similar to traditional preferred stock.

Surplus Notes

Surplus notes act like debt in that buyers receive stated payments and do not get to vote on company matters. However, like equity, surplus notes are subordinated to policyholder obligations, and the interest and principal can be deferred. Generally, they are issued by mutual and reciprocal insurers and stand-alone stock insurers, who cannot issue debt directly because they lack a holding company.

Source: A.M. Best Co.

Note: For more information on A.M. Best's methodologies, please see www.ambest.com/ratings/methodology.

SVO in Nutshell

* The SVO's database contains about 220,000 securities with close to 28,000 issuers.

* Each security is assessed and/or valued when it is initially filed with the SVO, and is subject to an annual review.

* If a security is not rated by an NRSRO, the SVO will value and classify the security as debt, preferred equity or common equity. Each designation brings different capital requirements to insurers that hold the security in their investment portfolios.

Learn More

Swiss Re Group

A.M. Best Company # 85010 Distribution: Reinsurance brokers

For ratings and other financial strength information about this company, visit www.ambest.com.