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Retirement Planning > Social Security

Ruling On Hybrids Has Insurers Concerned Over Capital Costs

By Jim Connolly

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Insurers are concerned over the classification of hybrid securities as common stock in their portfolios and it has them asking state insurance regulators what it will mean for the amount of capital they need to hold.

That concern prompted regulators to hold an informational call on April 19.

Hybrid securities have both equity and debt features but can vary greatly depending on the individual security.

Insurers are concerned that the classification as common stock rather than as debt will increase the risk-based capital they are required to hold to ensure that they are financially strong.

“RBC charges will flow from the classification of the SVO,” explained Scott Holeman, a spokesman for the National Association of Insurance Commissioners, Kansas City, Mo. The Securities Valuation Office, a unit of the NAIC based in New York, held the call along with the New York insurance department. “Thus, if common stock, it flows through to RBC as common stock and gets a common stock RBC charge.

“The investment limitation statutes in the states would be based upon the SVO decision. If the SVO classified it as common stock, then that would become part of the total common stock portfolio of the insurer, which would be subject to the investment statute limitation for common stock in the domiciliary state,” Holeman continued.

Capital and trust preferred securities held by life insurers in 2005 totaled $35 billion in 2005 compared with $29 billion in 2004, said Robert Carcano, SVO senior counsel and senior vice president.

Among the companies on the call were Aegon, Credit Suisse, Genworth Financial, HSBC, John Hancock, Merrill Lynch, Prudential Financial and TIAA-CREF.

“We are looking at the issue and trying to get some clarity about what this means for companies,” said Whit Cornman, a spokesman for the American Council of Life Insurers, Washington.

The issue was first raised when a Lehman E-Capital Trust I security purchased by a New York domiciled insurer in August 2005 was required by the New York department to be filed with the SVO for analysis.

The required review was made in the fall of 2005, and in early March 2006 the SVO notified the department that the security should be classified as common equity. An appeal was filed on March 24.

The security also is owned by nine other insurers, according to the SVO. In mid-March, following the determination, the New York department requested other insurers to file various hybrid securities with the SVO for analysis.

Howard Mills, New York Superintendent, opened the discussion by noting that concern about the decision and the impact on pricing of these securities in the marketplace and new securities currently in the pipeline led to a decision to hold an informational call.

During the call, Mike Moriarty, director of the New York department’s capital markets bureau, noted that the significance of hybrid securities among insurers has increased.

A change in classification of these securities should not impact a company’s risk-based capital ratio, he continued. “If it did impact a company’s RBC ratio, the company is probably already stressed or the portfolio of hybrids is already significant.”

The NAIC’s RBC requirements are not an indicator of financial strength, he says, but rather are formula-driven standards.

The fact that RBC is used as a financial strength indicator or to measure financial performance is a factor outside of regulators’ control, as was noted during the discussion. “If it is used for financial strength, it is not what it was intended for or what it was validated to do,” remarks indicated.

“There is a need to recognize that there is a different model that the market is using. We have been trying to demonstrate since 1994 that we wanted a model in addition to the credit rating. It is very important to keep that in perspective,” Carcano noted in trying to explain the difference between regulators’ and rating agencies’ responsibilities.

During the dialogue, Carcano said there has been no change in the method for evaluating any security.

Other points the SVO made in response to questions from institutions include:

–All rating agencies are given similar weight when evaluating a security;

–It is not publicly disclosed if a security is under review because “unlike an NRSRO [nationally recognized statistical rating organization] or an investment bank, legally and practically the role is restricted to a regulatory context”;

–An institution interested in purchasing a security can subscribe to an SVO service that will monitor that security;

–The SVO does not discuss the rationale behind the classifications of securities and whether a precedent is being established;

–An institution has the right to appeal an SVO decision.

The issue also has prompted Moody’s Investors Service, New York, to note in a report that “the classification of E-CAPs [a hybrid security] as an equity security, rather than a bond or preferred stock will have capital requirement implications for insurers holding the security.”

“In addition, some market participants claim that the ruling may have a dampening impact on the market for hybrids in the U.S.,” says Barbara Havlicek, author of the report.

The Moody’s report illustrates how complex these securities can be and notes that some hybrids “may have equity characteristics when analyzing the issuer’s leverage but can behave more like preferred stock or bonds in the capital markets in terms of price volatility.”

Havlicek says that “different hybrid instruments may have the same credit rating and same equity basket treatment on Moody’s Debt-Equity Continuum but may exhibit very different price volatility.”

The Moody’s report presents data that shows the price volatility of some hybrids– mandatory convertible hybrids–is much closer to the company’s equity price volatility than its bond price volatility, whereas the opposite is true for other types of hybrids–mandatory deferral hybrids.

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