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Building new boundaries for life companies.

Life insurance regulators are mandating new reserves and are attempting to set risk-based capital standards for real estate investments as key components of their solvency agenda.

The well-publicized failures last year of Executive Life Insurance Company and Mutual Benefit Life Insurance Company prompted an in-depth examination of life insurance companies' overall solvency and focused attention on the risk that stems from the industry's asset exposure in commercial real estate.

When Mutual Benefit was placed into rehabilitation status to prevent a wave of premium redemptions on July 15, 1991, the company's investment in poor quality commercial real estate surfaced. This action, in turn, fueled regulators' mission to further scrutinize life companies' investment in this asset class.

This article explores recent initiatives by insurance industry regulators to mandate asset reserves, to establish risk-based capital (RBC) standards and to limit life insurance company investment in commercial real estate.

Background: state insurance


In 1868, the U.S. Supreme Court in Paul v. Virginia, (75 U.S. 168 [1868]) held that insurance business did not constitute commerce subject to federal regulation under the commerce clause of the U.S. Constitution. However, the high court deserted this notion in 1944, upholding the application of federal antitrust laws to the insurance industry.

In the subsequent year, the U.S. Congress enacted the McCarran-Ferguson Act, delegating daily responsibility for insurance regulation to the states. This act strictly limited the extent to which federal law pre-empted state insurance law, provided the states themselves regulated the insurance business.

While individual states exercise direct regulatory powers, the National Association of Insurance Commissioners (NAIC) assists state regulators in supervising the financial condition of interstate companies. NAIC, created in 1871, is a voluntary association comprised of the insurance department heads of the fifty states, the District of Columbia and the four U.S. territories.

Through the NAIC, state regulators have facilitated regulation of multistate life insurance companies through three primary means: uniform reporting and accounting requirements; standardized procedures for financial examinations; and parallel regulatory measures embodied in model acts and regulations.

In December 1990, the NAIC officially adopted the Solvency Agency for 1991, which investigated the imposition of capital reserves for commercial real estate mortgages and equities, recommended risk-based capital requirements for all asset classes and exposed for consideration a draft model law on authorized insurer investments to restrict a life insurance company's asset exposure in commercial real estate.


To enforce adequate and balanced industry capitalization, the NAIC required reserves for real estate assets for the first time in 1992. The NAIC's establishment of the Asset Valuation Reserve (AVR) represents one of the most significant proposals to address credit-related losses on real estate mortgages and equity investments experienced by life companies. While the AVR's predecessor, the Mandatory Securities Valuation Reserve (MSVR), set reserves only for a portion of investments, the new AVR would cover all assets held by insurers and would first appear on the December 1992 statutory statement submitted by life insurance companies to the appropriate state insurance regulatory body.

The AVR contains two major components: The default component - to provide for future credit-related losses on fixed-income investments, such as real estate mortgages and the equity component - to address all types of equities, including real estate owned by life insurance companies.


The NAIC designated annual reserve maximums for both real estate mortgages and equities. The AVR for mortgages consists of the following components: * A basic factor; * The statement value of mortgages, (i.e., the book value); * An experience adjustment factor; and * A "phase-in" component.

The resulting annual AVR contribution is a product of these four factors. Life companies must report separate statement value balances for the following mortgage types: farm, residential insured or guaranteed, residential - all other, commercial insured or guaranteed and commercial - all other.

The basic factor attempts to provide adequate capital reserves for mortgages based on the creditworthiness of a life insurance company mortgage portfolio, on average. The NAIC arrived at a 3.5 percent basic factor through analysis of empirical industry data gathered on the default rates of various categories of mortgage loans. Due to limited, unbiased information on historical performance of mortgage portfolios, the Industry Advisory Committee (IAC) to the NAIC Life Risk-Based Capital Working Group also compared typical mortgage portfolio credit quality to those of bonds.

In arriving at this 3.5 percent factor, the IAC explored credit ratings assigned to different quality levels of bonds, their corresponding impairment/default experience and then estimated a parallel factor to account for losses on a typical mortgage portfolio. Based on this assessment, the IAC concluded that the creditworthiness of life insurance companies' mortgage portfolios, on average, mimics that of the NAIC's Securities Valuation Office (SVO) category 2 or category 3 bond designation. The SVO establishes six bond categories ranging in credit quality, with category 1 bonds viewed as superior to the other five classes.

The experience adjustment factor equates to a moving average (over two years) of the company's delinquency and foreclosure rate divided by the corresponding two-year moving industry average. NAIC's Securities Valuation Office will provide the industry experience information based on their annual survey. The years 1990 and 1991 would comprise the initial survey period for use in the December 1992 statement. The company's "delinquency and foreclosure rate" measures the ratio of mortgages overdue, in the process of foreclosure and foreclosed within the appropriate two-year time period relative to the book value of outstanding loans and those foreclosed within the same time period.

The product of the basic factor and the experience adjustment factor results in the "maximum factor." The experience adjustment permits individual life companies who outperform the industry to reserve less capital. The resulting maximum factor, after the experience adjustment, cannot exceed 10.5 percent nor be less than 1.75 percent (3.5 percent for companies with less than five years mortgage experience) of the reported statement value.

The "phase-in" component furnishes a gradual implementation of the new reserves for real estate. The NAIC has recommended a 10 percent contribution for 1992, increasing to 15 percent in 1993 and 20 percent thereafter.


For equities, the annual maximum reserve factor would equal 7.5 percent of statement value in 1992, allowing for the same phase-in component as that applied to mortgages. The NAIC has proposed a 10 percent maximum reduced by a credit for appraised market values in excess of statement values for years 1993 and beyond. However, the maximum reserve factor, after applying the appraisal credit, could not equate to less than 2 percent of the real estate equity statement value.

Figure 1 provides an example of AVR calculations for real estate mortgage and equity investments. Assuming a constant mortgage and equity portfolio value through the years, the AVR approaches, but never reaches the targeted reserve volume. This "asymptotic" approach, applicable to both mortgage and equity reserves, is demonstrated in Figure 2.


Risk-based capital

While the AVR establishes actual reserves to protect against adverse risk, a company's risk-based capital (RBC) ratio serves as a trigger mechanism to alert regulators when companies dip below an acceptable ratio of a company's surplus and capital relative to its risk exposure. Risk-based capital formulas have been used by companies to manage portfolios internally and by regulators to gauge adequate capital levels for companies of different sizes and with disparate risk profiles.

Risk-based capital formulas, depending on the purpose, may be designed with capital tiers. Capital levels may address minimum acceptable operating amounts, the capital needs of a well-managed going concern and amounts accommodating a company's plans for future growth or diversification. Regulators typically employ minimum acceptable levels, where RBC formulas serve as diagnostic tools to distinguish between well-capitalized versus weakly capitalized companies.

The Federal Deposit Insurance Corporation (FDIC) and the other federal banking agencies have set a precedent for risk-based capital, to guard against unsound banking investment practices. In March 1989, the FDIC approved a framework for state-chartered bank capital standards reflecting the relative investment risks of various assets. This capital policy arose from an ongoing effort on the part of banking regulators in the United States and other industrialized nations to achieve common international capital standards for banking institutions. Commercial real estate mortgages carried a 100 percent risk weighting in these international capital standards for banks, while loans secured by owner-occupied, one-to-four family, residential properties were granted a more preferential 50 percent risk-weight classification.

In providing guidance to life insurance company regulators, the NAIC has simulated the risk-based capital approach relied upon by the commercial banking industry. However, the RBC factors themselves differ dramatically, given the life companies' relatively conservative approach to real estate investment and their beneficial financial condition, compared to commercial banks.

In December 1990, the NAIC commissioned two working groups (one life and one property/casualty) to develop risk-based capital formulas as part of the insurance regulatory structure. On November 27, 1991, the Industry Advisory Committee to the NAIC Life Risk-Based Capital Working Group released a report outlining recommendations for life insurance companies' risk-based capital thresholds. The IAC developed a formula, utilizing the Minnesota and the New York state test formulas as models.

In establishing the RBC standards, the IAC directed its efforts at ultimately reducing the number of life company failures and the resulting cost of any such failures. The IAC strongly cautioned against employing the recommended risk-based capital formula to rank or rate companies. According to the IAC, the committee's proposal should not serve as a substitute for a well-designed, individual company formula. While the latter is aimed at satisfying specific corporate goals, such as the maintenance of certain commercial ratings or product line expansion plans, the IAC intended their RBC formula to be used as:

* An early warning tool to identify possible weakly capitalized companies, thereby assisting in early identification of companies with inadequate capital levels, and allowing prompt and corrective regulatory actions; and

* A new minimum capital standard to supplement the prevailing system of low, fixed capital and surplus requirements.

The general formula

The formula separates risk into four distinct categories:

* C-1 asset default risk, pertaining to asset impairment or default (this does not include risk attributable to fluctuating interest rates);

* C-2 adverse insurance experience, associated with the actuarial and pricing risk of insurance policies;

* C-3 disintermediation risk, arising from unforeseen interest rate fluctuations; and

* C-4 miscellaneous and external-event risk, resulting from all other types of business risks.

Risk accompanying commercial real estate investments, both mortgages and acquisitions, is classified under C-1 asset risk. The formula intends to furnish a surplus level adequate to cover at least 90 percent of default losses in each C-1 risk category. In all C-1 asset classes, the Industry Advisory Committee recommends the risk-based capital factors be no less than those used for the AVR maximum reserves. The AVR is included in the surplus component of the RBC ratio of surplus and capital to the proposed risk-based capital.

Real estate mortgages and equities

The risk-based capital factors segregate mortgage default risk into four broad categories: * Residential; * Farm; * Guaranteed and insured city mortgages; and * Other mortgages.

Conventional mortgages secured by commercial real estate come under this latter heading, "other mortgages." Under this broad category, the IAC further divides the RBC factors for commercial mortgages based on payment status in the following fashion: * Mortgages in good standing; * Mortgages that are more than 90 days overdue; * Mortgages with due and unpaid interest; * Mortgages with unpaid taxes; and * Mortgages in process of foreclosure (See Figure 3).
Proposed NAIC Risk-Based Capital
Formula Commercial Real Estate
Mortgages and Equities
 Factor to
 Item Description Calculation

I. Commercial Real Estate (CRE) Mortgages
 In good standing 0.030(*)
 90 days overdue 0.060(*)
 Due and unpaid interest 1.000
 Unpaid Taxes 1.000
CRE Mortgages in Foreclosure 0.200

II. Real Estate Equities
 Company occupied 0.100
 Investment 0.100
 Foreclosed 0.150

(*) To be adjusted for individual company experience, similar to
future AVR adjustments for mortgages.

In assigning the applicable RBC factors, the committee compared real estate mortgages to bonds. The IAC also predicated factors upon the results of a 1990 survey of twenty-five life insurance companies and upon two models developed by the IAC members who estimated their own company's surplus needs.

Similar to the Asset Valuation Reserve, the risk-based capital formula would apply a moving two-year average ratio of company-to-industry experience in the absence of a standardized credit rating system for commercial real estate mortgages. Again, the formula would effect minimum and maximum limits on the level of risk-based capital proposed after the experience adjustment. This adjustment will be defined and calculated in concert with the AVR experience factor.

Due to the lack of available industry data on equity investment performance, the Industry Advisory Committee considered real estate equity investment volatility relative to common stock (another equity asset), the tax benefits inuring to ownership, the added risk attending to assets acquired via foreclosure and intercompany performance survey results. The May-June 1991 edition of the Financial Analysts Journal, according to the IAC, suggests real estate equity variability equivalent to 60 percent of common stock volatility. Based on the RBC factor for common stock, this implies an 18 percent risk-based capital calculation. Incorporating losses for tax purposes, the subcommittee reports a 10 percent outcome. Consequently, they have recommended a 10 percent RBC factor for all real estate equity subcategories, except assets acquired by foreclosure, which would incur a 15 percent weight.

Other formula factors affecting real


To reflect the impact of high concentrations in single-asset exposures, the subcommittee developed "the concentration adjustment factor." This formula element would effectively double the risk-based capital factor of the 10 largest assets, with a maximum ceiling of 30 percent. An example of the manner in which a life company would calculate the adjustment follows:

* Aggregate all C-1 assets by name exposure, using taxpayer identification number or other identification;

* Select the 10 largest of these exposures;

* Apply twice the C-1 risk basis factor (before the application of the experience adjustment factor for mortgages) to each of these assets, with a total ceiling set at 30 percent. For example, if one of the 10 largest exposures carries a C-1 factor of no greater than 3 percent, (e.g., commercial real estate mortgages in good standing), the concentration factor would require an additional 3 percent be added for this exposure. Loans guaranteed by the federal government or a federal agency and equity real estate occupied by the life company would not be subject to the concentration adjustment.

Covariance adjustment

The formula also acknowledges the improbability that losses across risk categories will occur simultaneously. To account for this improbability, the formula design recognizes C-2 risk random occurrences, relative to C-1 and C-3 risks. C-2 risk relates to insurance pricing and actuarial determinations. However, other risks bear a direct relationship with one another. For example, disintermediation risk (C-3) is linked to C-1 asset risk. The simple mathematical addition of all four risk factors would overstate the risk exposure of a company at any point in time. Therefore, when calculating the total risk-based capital, the formula compensates for these risk relationship through a "covariance adjustment" (see Figure 4).
Figure 4
Life Insurance Companies' Proposed
Risk-Based Capital Formula: Risk
Covariance Adjustment

Total Risk-Based Capital =
[square root of][(C1 + C3).sup.2] + [C2.sup.2] + C4, where

C1 = Asset Risk
C2 = Adverse Insurance Experience Risk
C3 = Disintermediation Risk and
C4 = Miscellaneous and External Event Risk

In arriving at the final step, calculation of the RBC ratio, the life insurance company must determine its actual surplus and capital relative to the total RBC threshold. To arrive at the company's actual surplus, the formula would adjust statutory statement surplus by adding in any voluntary reserves for default losses on real estate and mortgages, the Asset Valuation Reserve and 50 percent of the annual statement dividend liability.

Regulatory response actions

A company's failure to meet the stated risk-based capital ratios would effect a range of remedial regulatory actions, contingent upon the severity of the circumstances. Although the IAC has not yet identified specific RBC ratios that would trigger regulatory interference, it has outlined three tiers of governmental intervention. Each level represents more stringent regulatory measures, as RBC ratios diminish.

Level A: In this initial phase, the regulator would require the individual company to file a plan of action. Therefore, the burden rests on the company, not the regulator, to correct the adverse capital condition. The regulator can then take appropriate actions considering the company's capital situation and action plan.

Level B: This second tier shifts the burden of action to the regulator who would perform a detailed investigation of the company and would require corrective measures.

Level C: Companies with risk-based capital ratios below this third level would be insufficiently capitalized to continue doing business. Thus, the regulator would be required to take action necessary to cause the insurer to be placed into conservatorship, pursuant to the state's rehabilitation and liquidation statute.

Test findings

At their March meeting, the NAIC Examination Oversight Task Force approved testing of the risk-based capital formula. In addition, the IAC recommended that sensitivity tests remain a permanent component of the risk-based capital formula. The sensitivity test permits the NAIC to consider the impact of factors to which the formula is particularly sensitive and whether or not a "right factor" exists for the entire industry.

To ascertain accuracy, the committee performed a preliminary test, utilizing an electronic database containing publicly available data for 674 companies with assets equal to or exceeding $50 million. Test findings generally suggested: an adequately capitalized industry; small companies' tendency to possess higher RBC ratios; a concentration of the largest companies in the bottom 50 percent of the RBC ratio range; and a preponderance of C-1 asset risk when compared to all other risk categories.

On average, the larger the company, the more important role asset risk played in determining the overall level of risk-based capital, primarily because larger companies demonstrate a greater likelihood of asset-intensive business investments, such as annuities and pensions and because they hold a larger proportion of higher risk assets. Of the C-1 asset risk, bonds constituted the largest component in the sample tested, followed closely by mortgages.


In addition to reserves and risk-based capital, the NAIC has exposed for consideration a model law which would set limits on a life company's commercial real estate exposure. These regulations attempt to complement reserve requirements and risk-based capital standards, by imposing legally adopted constraints on commercial real estate exposure.

The latest draft of the model law, the "Investments of Insurers Model Act," would set loan-to-value (LTV) ratio ceilings on mortgages secured by real estate; limit investments in mortgages covering any one secured location; cap the percentage of mortgages issued to any one borrower; restrict aggregate investments in mortgages based upon a percentage of admitted assets; and prohibit an insurer from investing in income-producing equity real estate beyond a specified percentage of admitted assets.

Specifically, the Investments of Insurers Model Act draft would:

* Establish an 80 percent LTV limit on mortgage loans secured by real estate, unless the obligation is secured by a purchase money mortgage or a similar security received by the insurer in disposing of real estate, with few exceptions;

* Limit an insurer's investment in home office properties to 10 percent of its admitted assets;

* Cap mortgages covering any one secured location at 2 percent of an insurer's admitted assets;

* Constrain mortgage investments issued to any one borrower to 3 percent of its admitted assets;

* Set an overall ceiling on commercial real estate mortgage investments, equivalent to 50 percent of aggregate admitted assets for life insurance companies;

* Prescribe a 2 percent limitation on an insurer's equity real estate investment in any one property or grouping of contiguous properties; and

* Restrict aggregate investment in income-producing equity real estate to 10 percent of an insurer's admitted assets.

The NAIC Industry Advisory Committee disseminated the latest model act for industry consideration and exposure. The NAIC does not anticipate approval by their executive committee of a final model law until late 1993, at the earliest. Once the NAIC executive committee has approved a model act, states must enact the legislation to receive or retain NAIC accreditation.


The Industry Advisory Committee does not intend risk-based capital ratios to serve as the gauge by which life companies assess their portfolio management decisions. Similarly, the committee does not advise individual companies to alter their investment plans, simply to meet or exceed the "magic" RBC ratio. However, given the industry's current sentiment toward commercial real estate, implementation of the Asset Valuation Reserve and risk-based capital standards, coupled with prospective adoption of model laws to limit investment concentration in commercial real estate, could profoundly affect life insurance companies' strategic investment plans.

To design a sound and profitable commercial real estate investment blueprint, insurance carriers must first assess their existing mortgage and equity asset quality. This evaluation would entail reunderwriting and would encourage development of internal rating systems to compare loans across competing financial instruments, such as bonds. Aggressive asset management of mortgage and equity portfolios, aimed at increasing commercial real estate values and stemming defaults, could yield a competitive industry advantage, improve experience adjustment factors and diminish the amount of reserves and risk-based capital.

As companies position themselves for profitability, they will consider risk-based capital ratios, reserves and legal asset exposure constraints. Carriers with marginal RBC ratios due to disadvantageous commercial real estate mortgage exposure could securitize and dispose of loans, in exchange for higher quality assets, such as category 1 bonds. Conversely, smaller companies with less commercial real estate concentration could purchase whole loans to diversify their asset base.

Perfection of a securitized instrument and expansion of a secondary market for commercial real estate mortgages will bring about greater asset liquidity. This enhanced liquidity, in turn, will reduce the perceived risk associated with commercial real estate and will reduce interest rate spreads. As carriers familiarize themselves with competing forces, companies may merge with those better capitalized or those with divergent and complementary risk profiles. Finally, the life insurance carriers will refine their asset pricing and portfolio management strategies to avoid the adverse effects of asset and liability mismatching.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Davis, Gail
Publication:Mortgage Banking
Date:Jul 1, 1992
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