Regulators say that they will take comments aired by insurers during a public hearing on hybrid securities July 13 and review their risk-based capital treatment as well as examine the issue of rating transparency.

During a joint hearing held by the National Association of Insurance Commissioners, Kansas City, Mo., Alessandro Iuppa, NAIC president, said a new group of regulators would look for risk-based capital solutions that could range from creating a fourth investment category for rating purposes or a notching system that ratings agencies use.

But, he said, the details would depend very much on technical input. And, he noted that although insurers would not be part of the group, they would be able to offer input as a solution was developed.

New York Superintendent Howard Mills, who chaired the meeting, said the first step would be to address expeditiously the risk-based capital treatment for hybrids and have an absolute resolution to the transparency issue by year-end.

The joint hearing of the NAIC’s Valuation of Securities Task Force and the Capital Adequacy Task Force was held in response to insurers’ reaction to the classification of hybrid securities by the Securities Valuation Office, the New York securities rating arm of the NAIC.

The SVO, at the request of the New York insurance department, was asked to review hybrid securities issues. In March, it determined the issues should receive equity rather than debt treatment.

Treating the hybrids as equity rather than as debt significantly can increase the risk-based capital charge for companies. For instance, for an NAIC class 1 security for life insurers, the highest rated security, debt would receive a .3% charge, while common stock would receive a 30% RBC charge. For class 6 securities, the lowest ranked NAIC category, debt would receive a 20% charge and common stock, a 30% charge.

Insurers are saying that it also is threatening the stability of the market. A panel of insurance industry investment officers explained to commissioners the existing impact and the potential result of not changing the current SVO assessment of hybrid securities.

Lou Felice, a New York regulator, said the RBC formulas are in place for 2006 but that regulators could consider where in the annual statement schedules that hybrid holdings are filed, which could impact RBC. The formulas for 2007 will need to be discussed, he added.

Stephen Kandarian, executive vice president and chief investment officer of MetLife, New York, explained that the purchase of hybrid securities from a high grade issuer offers “very low” likelihood of insolvency as well as “attractive spreads” that make it possible for the company’s salespeople to sell products.

Kandarian said hybrids trade like a high-quality bond with a spread over Treasuries and that they should not be classified as common equity.

Such a classification will weigh heavily on insurers, he noted. For instance, the Yankee Tier I hybrids are a $75 billion market of which insurers hold $45 billion or 60% of that market, he said. A lot of these securities were purchased based on a perception of treatment of securities that already had been purchased and rated, he continued.

With the uncertainty surrounding these securities, Kandarian said, the brokerage community has “seized up,” and a market that used to be able to move $50 million in these securities now has trouble moving $10 million transactions. Spreads have widened by 30 basis points, which means that on $45 billion in securities held by the industry, the value is down by $1 billion.

If the matter is not addressed, he says, insurers will have to sell these securities, and in an illiquid market, hedge funds will purchase them at greatly reduced prices. Consequently, according to Kandarian, “there will be a wealth transfer from insurers to others.”

Eric Goodman, president and CIO of AEGON USA Investment Management L.L.C., Cedar Rapids, Iowa, said hybrids are fixed income securities and are issued by high-quality financial institutions, even though he did acknowledge that they can be highly subordinated and have features specific to an issue that can increase risk. Capital treatment as equity is punitive, he said. One potential solution would be for the SVO to use a notching system that would reflect the actual risk in an issue, he said.

Speaking about the impact on small companies, Robert Peterson, representing Shenandoah Life Insurance Company, Roanoke, Va., said the RBC impact can be even more severe. For instance, he said if a higher RBC charge is assessed, that percentage is multiplied by a factor in rating processes such as with A.M. Best & Co., Oldwick, N.J. So, in Shenandoah’s case, a 30% RBC charge would be multiplied by 1.95 for a capital charge of 58.5%. Such a charge could result in a downgrade, which, he said, makes it more difficult to operate given the competitive life insurance selling environment.

Trade groups also weighed in. Transparency of both a classification decision and the specific reason for the decision was argued by Mary Kuan, vice president and assistant general counsel with the Bond Market Association, New York.

Jim Renz, director of accounting policy with the American Council of Life Insurers, Washington, said the option to get an advance rating review from the SVO will result in hundreds of such requests. A recent request took 34 calendar days after filing for a determination to be made, he continued.

Procedure as outlined in the SVO’s purposes and procedures manual either has not been understood or has been ignored, according to Ed Stephenson for Barnert Associates, New York. Stephenson was representing the National Alliance of Life Companies, Rosemont, Ill., and the National Association of Mutual Insurance Companies, Indianapolis.

The proper procedure when there is a major policy question, according to Stephenson, is to bring the issue to the SVO task force for consideration, he said.

His remarks were greeted by spontaneous applause from hearing attendees.

Regulators, for their part, tried to put the issue in perspective. During the hearing, Roger Sevigny, New Hampshire insurance commissioner and NAIC Secretary Treasurer, noted that hybrids had different terms and call features and could not just be classified in one way.

North Dakota Insurance Commissioner Jim Poolman asked whether the advance rating option was used often and was told by Chris Evangel, SVO managing director, that there might be about six to eight requests annually. However, since the issue over hybrids began, there have been 10 requests, he said.

After the hearing, the NAIC’s Iuppa disputed the assertion that SVO policy had disrupted the market. “Market disruption is something that happened after Enron” and not as a result of an SVO classification decision, he said. He noted that regulators’ primary responsibility was to ensure the solvency of companies and consumer protection. And, Iuppa disputed the assertion that the SVO had disregarded procedure, noting it had followed procedure and had acted at the request of a state insurance department.