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Regulators, Rating Agencies Mull Hybrid Issue

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Most insurers want regulators to treat the hybrid securities they buy as debt, but many of the issuers would prefer to treat the capital they raise through the sale of hybrid securities as equity.

Rating agency insurance analysts talked about that conflict this week as they and regulators prepared for a July 13 public hearing in New York on risk classification of hybrid securities.

The Valuation of Securities Task Force and the Capital Adequacy Task Force of the National Association of Insurance Commissioners, Kansas City, Mo., plan to hold the hearing to give state insurance regulators a chance to hear more about the issue.

Regulators hope to get a better understanding of what hybrid securities are as well as the risks associated with hybrids, Michael Moriarty, a New York regulator, said during a recent NAIC conference call.

One topic to be discussed will be the economic impact changes in securities risk classification could have on “companies and players in the capital markets,” Moriarty said.

Lou Felice, a New York regulator and chair of the Capital Adequacy task force, says regulators need to come up with a long-term solution.

Options could include assigning a hybrid securities issue a lower class than a comparable debt issue might earn; simply treating some or all hybrids as equity; or finding some other solution, Felice says.

The NAIC’s New York-based Securities Valuation Office, an organization that values and assesses the credit quality of securities owned by state-regulated insurance companies, tends to assume that stock will be riskier than high-grade bonds and other high-grade debt securities. Because of that assumption, insurers must apply a discount, or “charge,” of 15% to 30% to the current market value of stock holdings when including stock holdings in risk-based capital calculations.

Traditionally, the SVO has treated hybrid securities, or securities that combine features of stock with features of debt securities, as if they were preferred stock.

But in March, the SVO reclassified $300 million in “Enhanced Capital Advantage Preferred Securities” or ECAPS, issued by Lehman Brothers Holding Inc., New York, as common stock.

The March reclassification caused spreads between ECAPS rates and Treasury rates to widen more than twice as much over the following 2 months as spreads between corporate debt securities rates and Treasury rates, according to financial services industry groups.

Insurers and industry groups are saying classifying hybrid securities as equity could hurt both insurers and the hybrid securities market.

Insurers and industry groups also are complaining about what they say is lack of information about how the SVO rates securities.

NAIC officials have left the SVO ruling in place while taking time to review the issue.

Regulators have emphasized that the SVO’s decision reflects their responsibility to protect insurers’ solvency and look after policyholders’ interests.

Private rating agency analysts say their firms assess the riskiness of hybrid securities on an issue-by-issue basis.

For the most part, Fitch Ratings views hybrid securities as preferred stock rather than as equity or as debt, says Julie Burke, an analyst in the firm’s Chicago office.

Fitch analysts have tested a sample of hybrid securities to see how they performed from 2001 to 2003.

In extremely depressed circumstances, hybrid securities may perform like equity securities, but the Fitch analysts concluded after reviewing the test results that preferred stock treatment usually is appropriate, Burke says.

At Moody’s Investors Service, New York, the firm starts by looking at the ability of a hybrid to cushion holders against the effects of an issuer’s bankruptcy, according to Barbara Havlicek, a Moody’s analyst.

Moody’s could end up ranking a hybrid as if it were 100% debt, a mixture of debt and equity, or 100% equity, Havlicek says.

She notes that Swiss Reinsurance Company, Zurich, recently issued hybrids that were classified as being made completely of equity.

Moody’s is treating the Lehman ECAPS that the SVO reclassified in March as if they consisted 25% of debt and 75% of equity.

Robert Riegel, a Moody’s analyst, points out that the issuing companies usually want Moody’s to treat the hybrids as equity.

One reason is that hybrids are usually more expensive to issue than debt, Riegel says.

If a hybrid would be rated as if it were pure debt, a typical issuer probably would prefer to cut costs by issuing pure debt, Riegel says.

Although the RBC charge applied to insurers’ equity investments can be 100 times as great as the charge applied to debt securities, most insurers now are extremely well-capitalized, and their average RBC level is over 400% of the company action level, Riegel says.

Even if many hybrids were reclassified as pure equity, the change “would not move the dial much” in terms of financial strength ratings, according to Riegel.