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NEW YORK --Regulators evaluating how to govern insurers' risk-based portfolios will consider options including a new investment category or rating system, a key regulator said.

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

His comments came after regulators heard insurance industry representatives' reactions during a public hearing on hybrid securities on July 13.

Regulators said they will take comments aired by insurers and review their risk-based capital treatment as well as examine the issue of rating transparency.

Mr. Iuppa said the details would depend very much on technical input. 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 Insurance Superintendent Howard Mills, who chaired the hearing, said the first step would be to expeditiously address 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' concerns over 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 that the issues should receive equity rather than debt treatment.

Treating the hybrids as equity rather than as debt can significantly increase the risk-based capital charge for companies and their capital reserve requirement.

For instance, for an NAIC class 1 security for life insurers, the highest rated security, debt would receive a .3 percent charge while common stock would receive a 30 percent RBC charge. For class 6 securities, the lowest ranked NAIC category, debt would receive a 20 percent charge while common stock received a 30 percent charge.

Insurers have said that this threatens 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.

After the hearing, Mr. Iuppa disputed a life insurance representative's 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. Mr. Iuppa disputed the assertion that the SVO had disregarded procedure, noting that it had followed procedure and had acted at the request of a state insurance department.

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 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 Met Life, 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 help the insurer's sales people sell products.

Mr. Kandarian said that 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 notes. For instance, the Yankee Tier I hybrids are a $75 billion market of which insurers hold $45 billion, or 60 percent of that market, he said. A lot of these securities were purchased based on a perception of treatment of securities that had already been purchased and rated, he continued.

With the uncertainty surrounding these securities, Mr. 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 said, insurers will have to sell these securities, and in an illiquid market hedge funds will purchase them at greatly reduced prices. Consequently, according to Mr. Kandarian, "there will be a wealth transfer from insurers to others."

Eric Goodman, president and chief investment officer of AEGON USA Investment Management LLC, Cedar Rapids, Iowa, said that hybrids are fixed income securities and are issued by high quality financial institutions.

He acknowledged 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.

Robert Peterson, representing Shenandoah Life Insurance Company, Roanoke, Va., said the RBC impact on small companies can be 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

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