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Portfolio > Mutual Funds > Bond Funds

Bond Insurers' Woes Prompt NAIC Guidance

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The current credit crunch precipitated by subprime mortgage problems is hurting bond insurers and, in turn, creating problems for carriers who hold bonds in their portfolios that are guaranteed by these bond carriers.

Evidence of the dilemma that both life and property-casualty insurers face surfaced during a recent discussion of the VOS “E” Task Force of the National Association of Insurance Commissioners, Kansas City, Mo.

Rating agencies are downgrading the financial strength ratings of some bond insurers. For instance, on Jan. 18, 2008, Fitch Ratings downgraded the insurer financial strength ratings on Ambac Financial Group Inc.’s affiliated insurance entities (Ambac) to ‘AA’ from ‘AAA’. They remain on Rating Watch Negative (RWN), according to Fitch. The IFS rating downgrades resulted in corresponding downgrades on approximately 137,000 Ambac-insured municipal bonds.

On Dec. 19, 2007, Standard and Poor’s Corp. downgraded the financial strength rating of ACA Financial Guaranty Corp. (ACA) from A/Credit Watch Negative to CCC/Credit Watch Developing.

Following that downgrade, on Jan. 11, S&P reported that after concluding that the current ACA enhanced issue ratings may not adequately reflect the underlying credit characteristics of the bonds, it had suspended the rating of those ACA insured bonds for which the issuer has not sought an S&P public underlying rating (SPUR). The underlying rating is a rating associated with the issuer itself.

Consequently, insurers turned to state insurance regulators for guidance on how they should rate bonds they hold in their portfolios. During a Jan. 22 discussion, regulators unanimously adopted guidance in a Jan. 14 memo issued by Mike Moriarty, VOS chair and a New York regulator.

The memo provides guidance for both 2007 filing requirements and guidelines for 2008. Guidance for how to classify these bonds in 2007 is considered important because filing must be completed by March.

In fact, Chris Anderson, a representative with Merrill Lynch, New York, thanked regulators on behalf of insurers for their quick action on the matter.

For 2007 year-end reporting, the memo addresses all ACA bonds rated ‘CCC’ by S&P, the equivalent of an NAIC 5 rating from the Securities Valuation Office, the New York securities rating operation of the NAIC. The memo offers the following reporting instructions:

–Bonds insured by ACA and rated only by S&P should report an NAIC 5 designation for those bonds while those rated by more than one NAIC-approved rating organization should report the second lowest of the 2 or more ratings.

–However, if, the credit quality of specific bonds is higher than NAIC 5, as measured by a SPUR, the insurer may translate the S&P SPUR rating into its equivalent NAIC designation and report that designation.

–Insurers can also opt to file the ACA guaranteed bonds with the SVO for a rating and apply the rating that is received for the 2007 annual statement filing.

For 2008, the memo offers the following guidance:

–Noting that S&P has withdrawn ratings on ACA guaranteed bonds, the memo says that to the extent another rating is not available, ACA insured bonds will no longer be eligible for a SVO filing exemption. These bonds will have to be filed with the SVO for credit quality assessment.

–Bonds with SPUR ratings will report an NAIC-3 designation until assigned a designation by the SVO.

–But if the issuer of a bond with a SPUR converts the SPUR into an S&P rating, the security is again eligible for a filing exemption.

During the call it was noted that reference of the S&P underlying rating was being used as a reference to underlying ratings available through all rating agencies.

Alan Close, who represented the American Council of Life Insurers during the discussion, says how large an impact there is on insurers is difficult to determine because there is really no analysis of the extent of the holdings of these guaranteed bonds in insurers’ portfolios.

However, he says that in many cases, these bonds are not publicly traded. Still, Close says the issue remains one of credit risk more than liquidity.

The impact is potentially different for life insurers and property-casualty insurers, according to Close. P-c insurers could be required to measure a bond at fair value but for life insurers, it would not necessarily result in marking the security to fair value, he explains. However, for life insurers, Close continues, it could result in a change in risk-based capital requirements.

But for both life and p-c insurers, the possibility of a bond’s SVO rating being dropped to an NAIC-5 rating is a big consideration. An NAIC-1 rating is considered the highest rating by the SVO.

He compares the inability of a guarantee from a bond insurer to maintain the rating of a bond to a reinsurer going into default and creating a loss of reinsurance coverage to the ceding company. However, Close notes that the debt issuer is still liable for payments on the security.

Close says the decision by regulators “gives companies some clarity regarding reporting for 2007″ as well as guidance for 2008.


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