Treatment of hybrid securities by state insurance regulators continues to draw fire from the industry and Wall Street even as regulators expose potential short-term risk-based capital solutions.

During a recent session of the new hybrid RBC working group of the National Association of Insurance Commissioners, regulators exposed three potential short-term scenarios for comment.

The goal, says Lou Felice, a New York regulator and chair of the working group, is to reach a short-term solution for 2006 and a long-term solution for 2007 and beyond.

As part of the short-term solution, the scenarios would have different RBC treatments.

Under Scenario 1, life bonds and preferred securities would receive RBC factors of between 0.4% and 20% based on NAIC category designations, while property-casualty and health bonds and preferred securities would receive RBC factors of 0.3% to 30% based on NAIC category designations.

Under Scenario 2, no hybrid securities would be reported as bonds, and preferred securities would receive the same treatment as Scenario 1. More preferred securities would use higher RBC factors due to the notching requirement. Securities could be lowered by up to two notches based on NAIC designation classes.

Scenario 3 is the same as Scenario 1 except that for life unaffiliated capital securities there would be 30% default adjusted by an insurer’s beta to a minimum of 15% and property-casualty and health unaffiliated common stock would be 15% default factor. All affiliated capital stock would be a percent of RBC or other calculation by type or affiliate.

The scenarios will receive a 15-day comment period before the issue is taken up at the NAIC fall meeting in St. Louis in September.

While regulators seek a short-term resolution to the dispute with industry, Felice says a long-term effort to analyze risks and associated charges for hybrids is even more important.

Among the risks that regulators cited during the discussion are: extension risk in which the security might not mature at the time it was expected to mature, and that the security would be more volatile than was incorporated in any of its available ratings.

Doug Stolte, a Virginia regulator, suggested one possible solution would be to use a blended RBC calculation like rating agencies use for credit ratings with a range from 100% debt to 100% common stock.

Insurers and representatives of those issuing and selling hybrids peppered regulators with questions. One query raised repeatedly was what extra risk regulators saw in these securities that was prompting them to change RBC requirements.

Other points they asked about were what is the exact definition of a hybrid regulators are using and what risk is being addressed.