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In this edition of Insurance Perspectives, we discuss the future of financial guaranty insurance, important FASB tentative decisions on accounting for credit impairment, recent guidance that will change the way insurers manage their securities lending programs and changes that could impact capital requirements for commercial mortgage loans.

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Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. Financial Guaranty Insurance: What’s in the Future?
2. Accounting for Credit Impairment Emerges as Potential Obstacle to Convergence of U.S. GAAP and IFRS
3. New Regulatory Guidance Will Change the Risk Profile of Securities Lending Programs
4. Capital Requirements for Commercial Mortgage Loans – Change is in the Wind

Financial Guaranty Insurance: What’s in the Future?
by Elise Brenneman

It was just over two years ago when a little known financial guarantor, ACA Financial, announced a substantial quarterly loss in the third quarter of 2007. Rising delinquencies on structured securities containing subprime residential mortgage exposures backed by ACA stirred up nervousness in the markets. That uncertainty was brought on by heightened concerns that credit default models in use were inadequate as to their assumptions of the risk underlying many portfolios.

Market leaders MBIA, Ambac and FGIC then began precipitous falls from their once “AAA”-rated perches. Stunned by strong, negative market sentiment, the leading guarantors recalibrated their own credit models, suffering massive underwriting losses and severely weakened capital positions by the end of 2007, which have persisted through 2009.

As a result, the financial guaranty segment of the insurance industry has been deeply damaged and has undergone a secular shift. For example, Bermuda-based guarantor Assured Guaranty, a small player just two years ago, reportedly now dominates new municipal issuance guarantees. Syncora (formerly part of XL Capital) has been restructured to eliminate a surplus deficit, and now FGIC, once a leader in structured securities credit enhancement, has been ordered by the New York Insurance Department to suspend paying claims because of its reported surplus deficit. FGIC recently submitted a surplus restoration plan that is under review by the New York Insurance Department.

The big question today is whether the financial guarantors that remain will survive the crisis, and, if so, how different will they be from their former selves? While some market indicators are looking more positive than they were a year ago at the depths of the crisis, these mono-line companies are not out of the woods yet. For example, their reputations have taken a beating, and valuations of their credit-enhanced portfolios may be challenged if the recession persists or if inflation surges. Continued vigilance with in-depth evaluations of their underlying portfolios and robust testing of the sensitivity of the portfolios to stressful outcomes will be a high priority going forward.

The general market consensus seems to indicate that mortgage delinquencies are at or near their peak. This is good news for the financial guarantors. Some other good news is that MBIA and Ambac seem to have made progress in clawing their way back. Despite these efforts, the equity markets appear unmoved as MBIA and Ambac reported near record low stock prices at the end of January.

So at present, it’s a mixed bag. While it is difficult to know exactly what the future holds for this troubled industry segment, the winners will likely be those who make the most of lessons learned though the crisis and who have the financial wherewithal to capitalize on that going forward. There may be a limited future for some of the beleaguered mono-lines. The emergence of new entrants - Berkshire Hathaway Assurance Corp, Municipal and Infrastructure Assurance Corp., and other applicants in the wings – may be betting on this. Or, perhaps some of the original players will recover. One thing is for certain, and that is the new competitive environment will continue to influence and reshape this embattled industry segment.

For more information, contact Elise Brenneman.

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Accounting for Credit Impairment Emerges as Potential Obstacle to Convergence of U.S. GAAP and IFRS
by Jim Stangroom

As part of its ongoing project on accounting for financial instruments, the Financial Accounting Standards Board (FASB) reached several important tentative decisions on the recognition and measurement of credit impairments. At its meeting on January 13, 2010, the FASB affirmed a core principle that credit impairments should be based on all available information relating to past events and existing conditions. Therefore, under the FASB’s proposal, possible future scenarios, probabilities of future events occurring, or even near term expected conditions would not be considered in assessing impairment.

The FASB’s support for such an “incurred loss approach” differs markedly from the International Accounting Standards Board’s (IASB) “expected loss approach.” The IASB’s November 2009 exposure draft would estimate impairments based on expected cash flows adjusted for the probability weighting of possible future credit losses over the life of the subject financial assets. While the FASB and the IASB are committed to their joint project of developing one universal standard on accounting for financial instruments, this fundamental difference in estimating credit impairment losses, among other differences, illustrates how elusive that goal may be.

The FASB’s tentative decisions would not constitute a radical change to existing impairment accounting standards in the U.S. However, the FASB is proposing that a single standard apply to all financial assets that are carried at fair value through other comprehensive income under the FASB’s proposed model for accounting for financial instruments. Current U.S. GAAP standards applicable to loans, debt securities and beneficial interests in structured securities differ to some degree from one another, but they do embrace some general concepts, i.e., that losses should not be recognized before they have been incurred and that impairment should be measured based on the present value of expected future cash flows (only to the extent such future cash flows are affected by past events and existing conditions). Those general concepts survived in the FASB’s recent tentative decisions. There would be no need to evaluate impairment for financial assets carried at fair value through net income.

One change that would result from the adoption of the FASB’s tentative decision supporting the incurred loss impairment model is the elimination of any probability threshold for the occurrence of events or the impact of existing conditions in determining impairment. For example, the current model as described in FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (FASB Codification Subtopic 310-40), requires an entity to recognize an impairment loss if it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of a loan agreement. The elimination of a “probability” threshold could result in the earlier recognition of impairment losses on commercial mortgage loans if the threshold that develops in practice evolves into one of “more likely than not” or “reasonably possible.” Another proposed change is that interest income would be based on the effective interest rate adjusted for any credit losses expected at the acquisition of the financial instruments.

The FASB plans to issue a comprehensive exposure draft in March 2010 on all aspects of accounting for financial instruments, including impairments, with the goal of issuing a final standard before the end of the year.

Despite the extraordinary level of impairment losses recognized by the insurance industry in 2008 and 2009, some analysts believe that the fragile state of the economic recovery and the uncertain conditions in the real estate markets and other sectors could result in further significant impairment losses. As a result, accounting by insurers for credit impairment losses will remain a critical issue. Insurers, regulators and financial analysts alike will be wise to keep a sharp eye on further deliberations of the FASB and the IASB on their financial instruments projects.

For more information, contact Jim Stangroom.

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New Regulatory Guidance Will Change the Risk Profile of Securities Lending Programs
by Tim Foley

Traditionally, securities lending has been viewed as an essentially risk-free way to enhance investment portfolio yields. Collateralization requirements virtually eliminated the financial risk of counter-party default. Minimal credit risk, coupled with manageable operations risk (due to relatively simple administrative and accounting requirements) made securities lending a natural fit within the investment strategies of many insurers. The recent credit crisis, however, highlighted the more significant and often overlooked risks associated with securities lending programs: collateral reinvestment and liquidity risk. And new guidelines put forth by the State of New York Insurance Department (the Department) seek to change how insurers manage these risks and place limits on the size of securities lending programs.

Last month the Department issued a draft circular letter “to advise insurers as to the Department’s expectations” for insurers engaging in securities lending. The Department expressed concern over recently reported “significant losses” within such programs and went on to set forth its view on prudent practices it expects of its insurers. The three major areas of concern cited in the draft circular letter were the maintenance of adequate collateral levels, the investing of cash collateral and the reporting of securities lending activities.

Some of the recommendations put forth last month simply reiterate existing requirements. For example, the Department noted instances of non-compliance with SSAP 91R (Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities), and in particular ¶57 which requires initial cash collateralization at 102% (105% for foreign securities) and periodic re-collateralization if the collateral value drops to 100%. Similarly, the Department emphasized the need for compliance with Article 14 of the New York Insurance Law, indicating that the investment guidelines applicable to the securities lending collateral reinvestment portfolio are no different from any other general account investment of the insurer.

Other recommendations are more compliance-focused. Insurers should have written agreements that govern the terms of the lending transaction and the roles and responsibilities of each party in situations where lending agents are involved. Further, insurers must be mindful of existing regulations on record-keeping (Regulation 152), including detailed records of securities on loan, collateral maintained on each loan and details on the cash collateral reinvestment portfolio that includes book and market values for each security. Finally, the Department is clearly interested in seeing more formal board oversight of management committees involved in the counter-party approval process to better manage credit risk and in setting the cash collateral reinvestment policy to better manage market and liquidity risk.

There are two key recommendations within the draft circular letter that may have the greatest impact on how insurers manage their programs:

1. Proposal to limit size of lending program to 5% of admitted assets.
   
   The proposal to limit the program size is seen by the Department as a way to limit overall exposure to all risks associated with securities lending. Given the liquidity crisis suffered by many of the largest lenders in late 2008, some insurers have already reduced their program size and might go along willingly with this limit. But given the relatively small spreads earned in most securities lending programs, and thus the need for volume to justify program existence, such a size limitation might drive many lenders from the market altogether.
   
   
2. Reinvestment portfolio maturity date limitations to minimize asset / liability mismatches.
   
   Part of a typical securities lending transaction involves the payment of a small fee to the borrower for use of the collateral. The lender pays for this fee and earns its spread by reinvesting the collateral in securities yielding a return in excess of the fee paid to the borrower. Collateral reinvestment in an asset with a longer term to maturity, or a higher duration, naturally earns a greater return for the insurer. But this also increases the level of risk. Securities are generally on loan for relatively short periods of time, many with terms of 30 to 90 days. The balance of the portfolio on loan is often with open terms, meaning the security can be returned to the lender at any time (or practically speaking, within one business day).
   
   Consider the state of the market in late 2008. Liquidity was a key concern for most financial institutions. As such, the market for securities lending dried up quickly with counterparties returning securities and seeking immediate return of their cash collateral. With few lending opportunities available to replenish available cash, many lenders were forced to liquidate portions of their cash collateral reinvestment portfolios. Unfortunately, as a result of depressed prices and few buyers, many sustained significant realized losses. Some insurers that had invested securities lending collateral in sub-prime mortgage-backed securities or other similar securities, found that liquidation even at fire-sale prices was often a challenge. Had these insurers invested their collateral in, say, 30- or 90-day treasury bills, their losses would have been greatly reduced. Likewise, their securities lending program profits also would have been reduced during the “good years.”
   

Given the recent experience of many lenders, it is not surprising that the Department is seeking less aggressive investment policies with respect to securities lending collateral. In addition to term to maturity limitations, the Department is also seeking asset diversification, credit quality restrictions and asset type limitations within collateral reinvestment portfolios.

The challenge for insurers that participate in the securities lending market is not merely compliance. Their primary challenge will be to develop a program that has the appropriate risk management controls while, at the same time, is efficient enough to earn an adequate return and justify continued participation in the securities lending market.

For more information, contact Tim Foley.

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Capital Requirements for Commercial Mortgage Loans – Change is in the Wind
by Tom Finnell

As many are predicting that investments in Commercial Mortgage Loans (CMLs) and Commercial Mortgage-Backed Securities (CMBS) will sour from the continuing effects of the economic slowdown, an NAIC working group is considering changes that would impact the amount of capital that life insurers would have to set aside for their investments in those asset classes.

Activity is underway at the NAIC’s Life Risk-Based Capital Working Group, which recently discussed a proposal by the American Council of Life Insurers (ACLI) to replace the current CML experience factors in the NAIC’s Life Risk-Based Capital (RBC) formula. The proposal would use a standardized Debt Service Coverage ratio, applied at the individual CML level and then aggregated to determine the total capital requirement for an insurer’s CML portfolio. A survey by the ACLI of 20 insurers representing 40% of the industry’s CML holdings showed that if the proposal had been applied at year-end 2008 – a much more favorable time for investors in CMLs than in the current economic environment – the corresponding RBC requirement for those insurers would have been reduced on average by 10% as compared to the current NAIC RBC formula.

The working group appears receptive to further consideration of the framework proposed by the ACLI, but much work lies ahead to nail down specifics and to evaluate its potential for use going forward as a replacement for the current CML experience factors.

The life insurance industry has been considering changes to RBC requirements for CMLs for some time, prompted by concerns that the current approach of comparing an insurer’s mortgage loan experience relative to the industry inadequately addresses risk for a specific portfolio. Along the way, consideration was given to the use of loan-to-value ratios; however, they were deemed to be too subjective and volatile. That would be particularly true in the current environment where many fewer current transactions exist to support estimates of market values.

As a result, the ACLI then focused on the use of a “standardized Debt Service Coverage ratio,” or DSC. Such ratios are in standard use throughout the mortgage loan industry and measure the ability of a borrower to repay a loan and, therefore, the likelihood of default. DSC is calculated as the net operating income for the property – the rental income less operating expenses before finance costs, depreciation and capital costs – divided by the debt service, or the cost of mortgage payments. While CMLs vary in terms of their amortization / payback periods, the proposal would “standardize” the DSC for purposes of the RBC calculation by using a constant 25-year amortization of the current balance for each loan.

The ACLI contends that the proposed approach would distinguish a loan portfolio based on the characteristics of the specific loans within that portfolio and that change in risk profiles of CMLs would be updated automatically through the DSC metric. It also would ease capital planning by insurers in that they can more readily measure current and forecasted capital needs based on their own portfolio data rather than having to rely on industry experience factors, which are determined after-the-fact on an annual basis.

While regulators are willing to give the proposal further consideration, their recent comments shed some light on potential areas of concern:

• Any single factor may be inadequate or may encourage “gaming” of the system;
  
• Annual Statement schedules would need to be reconsidered so as to better disclose individual loan characteristics in addition to basic accounting information; and
• Application to more recent data such as year-end 2009 statements would be necessary.

While further evaluation of the ACLI’s proposal will take some time, it stands out as another example where both industry and regulators continue to emphasize a risk-focused approach and develop meaningful measures that are both relevant and current.

For more information, contact Tom Finnell.

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