Insurance regulators are considering 3 possible short-term strategies for resolving the hybrid securities risk classification crisis, which has alarmed Wall Street and raised questions about tens of billions of dollars in life company investment holdings.

The National Association of Insurance Commissioners, Kansas City, Mo., has formed a new working group to study the relationship between risk-based capital calculations and regulatory treatment of hybrid securities, or securities that combine characteristics both of stock and of debt.

In March, the NAIC’s Securities Valuation Office proposed treating a hybrid securities issue as if it were stock. That risk classification has alarmed insurers and hybrid issuers, because the NAIC assumes stocks are more volatile than bonds. Insurers are supposed to compensate for the extra volatility by applying a big charge, or RBC risk factor, to the value of stock holdings when calculating RBC levels. The RBC risk factor for bonds is much smaller.

Lou Felice, a New York regulator and chair of the new working group, said Wednesday during a group session that the goal is to come up with a short-term solution for 2006 and a long-term solution for 2007 and beyond.

Regulators exposed 3 potential short term scenarios for comment:

Scenario 1. The SVO would not classify hybrids. Insurers would have to use the debt-equity guidelines set forth in the SVO Policies and Procedures Manual to report hybrid securities as bonds or preferred stock.

Life insurers would have to apply RBC factors of 0.4% to 20% to hybrids they hold, and health insurers would apply RBC factors of 0.3% to 30%.

Whether an insurer reported a hybrid as a bond or a preferred security would affect how the security would be valued.

Scenario 2. The SVO would define hybrids as preferred stock but give them an NAIC designation that was 1 notch lower. If the SVO said a preferred stock hybrid had common stock characteristics, the designation would be 2 notches lower.

No hybrid securities would be treated as bonds, and hybrids defined as preferred securities would receive the same treatment as in the first scenario for valuation and selection of RBC factors.

Scenario 3. The SVO would classify hybrids as bonds, preferred stock or common stock. Insurers would report and value the hybrids according to the SVO classification assignment.

Valuation and RBC factor rules would be similar to the rules for the first scenario, but the rules governing common stock would be different.

A life company, for example, would use a default RBC factor of 30% for unaffiliated common stock. But the company could use its beta value – a measure of volatility – to cut the RBC factor to as low as 15%.

Members of the public will have 15 days to comment on the scenarios before the issue is taken up at the NAIC’s fall national meeting in St. Louis.

Felice says coming up with a long-term solution to the hybrid securities problem is even more important than coming up with a short-term solution.

Doug Stolte, a Virginia regulator, said one possible solution would be to adopt the kind of blended RBC calculation that rating agencies use for hybrid securities credit ratings.

A hybrid security could be treated as if it were 100% debt, 100% common stock or some mixture of debt and common stock, based on its specific characteristics, Stolte said.

Insurers and representatives of those issuing and selling hybrids peppered regulators with questions.

Several questioners asked regulators to provide an exact definition of the term “hybrid” as the regulators are using that term.

Questioners also asked regulators to describe what, if any, extra risk they see in hybrid securities.

Regulators noted that one peril associated with hybrid securities is the possibility that a security might not mature at the time that it is expected to mature.

Another peril is the possibility that a hybrid security might prove to be more volatile than any available ratings had suggested, regulators said.