The NAIC’s Valuation of Securities (VOS) Task Force decided it was good to hope for the best but prepare for the worst when it voted today 11-2, with abstentions to adopt a controversial proposal that will likely result in life insurances having to increase their risk-based capital for their mortgage backed securities.
Life insurers are concerned that with the VOS Task Force, in targeting a higher capital number rather than retaining the fundamentals-based capital system for RMBS and CMBS, will make it very hard for insurance companies to plan for capital or to purchase securities with predictable capital impacts.
The proposal took a more conservative path than some regulators and the life insurance industry had wanted. The proposal, if and when adopted by the NAIC, affects the assignment of particular RMBS/CMBS securities to rating categories.
The NAIC has been looking into the potential for volatility in U.S. insurer holdings of RMBS.
According to the NAIC’s Capital markets Bureau special report, Potential for Volatility in U.S. Insurer Holdings of Residential Mortgage-Backed Securities, total RMBS exposure as of the end of 2011 was $123.2 billion. This is compared with a total par value of $151.5 billion for a weighted average price of $81.30.
The NAIC found that, though it is a relatively small percentage of the industry’s holdings, there are bonds within the group of 18,459 that were modeled by the NAIC that have profiles that are potentially problematic. These bonds demonstrate a substantial amount of downside risk if the market environment turns negative relative to those assumptions used in the year-end modeling, without a significant amount of upside potential.
An issue worth considering, according to the report, is whether the current framework properly addresses the additional volatility that is represented in those securities. The current formula applies the same weighting and approach to all RMBS, regardless of their volatility characteristics.
Perhaps this paved the way for the VOS Task Force decision to introduce a more conservative bias into the modeling, despite protests from the life insurers that the housing market has been recovering, by changing the weighting of the pessimistic housing percentages from 25 percent to 40 percent, creating an increase in risk-based capital required to be held for the RMBS and CMBS securities once the measure is adopted by the NAIC.
The “most conservative” housing price projection is a further 30 percent decline from peak levels, translating to a 43 percent decline in current home prices. When benchmarked to the 103 Wall Street housing economist models, NAIC’s most conservative housing price decline is six times worse than the average of the five most pessimistic housing economists. The “conservative” scenario, even if unchanged from previous years, is still a depression-like scenario where nominal home prices do not change for 10 years and inflation-adjusted prices would likely be substantially lower, a cadre of life insurers told the VOS Task Force.
“As the housing market recovers and delinquency numbers improve, we would expect a lower capital charge for this segment of investments rather than a higher one,” stated the American Council of Life Insurers in a letter to Kevin Fry, chair of the NAIC VOS Task Force Oct. 23.
Yet the NAIC is now projecting a 40 percent chance of either no nominal change in housing prices over the next 10 years or projecting a further drop in nationwide home price appreciation, according to a report.
“The NAIC presentation anticipates an increase from 2.7 percent to 3.2 percent in capital for the universe of bonds. Instead of focusing on the overall number, having more granular information on changes, as well as a better understanding of the potential impacts on individual insurance companies, would help ACLI in assessing the impact and reasonability of the proposal,” stated the ACLI letter signed by Michael Monahan, senior director of accounting policy for the association.
Regulators from Iowa and Oklahoma voted against today's proposal. Some regulators were concerned that there was no formal methodology to support the changes made in the assumptions.
The VOS Task Force formulates policy recommendations and administrative instructions to regulate investments and investment risk. The Task Force also formulates NAIC policy that governs how analytical tools— for example, credit assessment, valuation and classification of insurer-owned securities—is employed and how analytical insight into investment risk is applied for regulation. The Task Force is supported by the NAIC Securities Valuation Office.
As Fitch Ratings once explained, in 1993, NAIC introduced its RBC ratio as a way to help identify insurance companies with potentially weak capital positions requiring some form of closer regulatory scrutiny or corrective action. For risks related to the insurers' fixed income investment portfolios, capital charges are based on the application of a risk factor against the book value of each fixed income security held by the insurer, with the risk charge increasing at each successive NAIC rating category.