Battle Shapes Up Over Hybrid Securities Valuation

Insurers and some brokerage houses are strongly voicing their opposition to the way insurance regulators view the financial strength of insurers' hybrid securities investments.

Their concerns come in advance of a meeting on the issue set for July 13 by the National Association of Insurance Commissioners.

Meanwhile, rating agencies are saying their positions on the hybrid securities are based on a perspective that is broader than regulators' focus on solvency.

The NAIC's Securities Valuation Office, in New York, which rates securities, has classified some hybrid securities issues as equity, drawing a variety of objections from insurers and securities issuers.

Among the complaints are: possible damage to investment in the insurance sector; potential damage to the hybrid securities market; the impact of decisions on risk-based capital charges; lack of transparency over how the SVO rates securities; and lack of even treatment between different issues of hybrid securities.

Regulators, including several commissioners, for their part assert that they are responsible for solvency and for policyholders' interests and that the SVO's decisions reflects their focus.

The issue comes up July 13 when the NAIC's SVO Task Force and the Capital Adequacy Task Force are scheduled to hold a hearing New York.

During an NAIC Capital Adequacy “E” task force conference call yesterday, Michael Moriarity, a New York regulator, said regulators hope to get a better understanding of what hybrid securities are as well as the risks associated with them. He noted that rating agencies will be represented during the hearing.

Lou Felice, a New York regulator and chair of the Capital Adequacy Task Force, said that in addition to a short-term resolution on the issue, there needs to be a long-term solution to how risk-based capital should be treated.

Potential long-term solutions, said Mr. Felice, could range from lowering the issue a class from what it would be considered if it were debt, “letting the chips fall” if it were rated equity and just saying it is equity, to finding another solution.

Under the strictest treatment of hybrid securities, there can be a 30 percent after-tax risk-based capital (RBC) charge for both property-casualty and life insurance companies, Mr. Felice said. Charges for life insurers are tiered with after-tax charges ranging from 30 percent to 15 percent, he noted.

Mr. Moriarity noted that one point that will be explored during the hearing is the potential “economic impact RBC has on companies and players in the capital market.”

At Fitch Ratings, which is holding a conference call today to discuss the issue, analyst Julie Burke in Fitch's Chicago office said that, in general, the rating agency views hybrid securities as preferred stock rather than as equity or as debt.

Fitch performed a sample testing of hybrid securities, according to Ms. Burke, looking at performance during 2001-2003 and reached a conclusion that usually preferred stock treatment is appropriate. She noted that in extremely distressed circumstances, hybrid securities can perform like equity securities.

Hybrids are rated by looking at individual issues and, if an insurer issues them, they are usually one notch below the insurer's senior debt rating, she added. For hybrids that are being purchased by insurers, the notching depends on factors such as the industry the issuing company is in, she said.

Ms. Burke noted that rating agencies and regulators sometimes have different assessments on investments or insurance products. For instance, she said Fitch assigns a higher capital charge for variable annuities than the NAIC does.

Analysts from Moody's Investors Service, New York, discussed hybrid securities' impact on both issuers and purchasers.

Hybrids are compared to common equity and the ability of those instruments to cushion or absorb losses in the event of a bankruptcy, according to Barbara Havlicek, a Moody's analyst. Rankings run from complete debt to complete equity, she said, noting that Swiss Re recently issued hybrids that were classified complete equity.

Robert Riegel, a Moody's insurance analyst, said that issuing companies usually want equity credit. One reason, he explained, is that hybrids are usually more expensive to issue than debt, and if a hybrid issue is assigned a straight debt rating, then the issuer would want to just issue debt.

Insurers who are buying hybrids would want to look at a number of factors including yield, credit rating and capital charges, he said.