Nov 6

NAIC’s New RMBS Rating Model: Be Careful What You Wish For

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“Be careful what you wish for” could be the most appropriate saying for the insurance industry, when reviewing the NAIC’s latest attempt to diminish increasing risk based capital charges (RBC) at mostly large, capital starved insurers.
One only has to visit the NAIC’s website and note how proud they are of the latest change to RBC rules for residential mortgage backed securities (RMBS). The reasoning is simple enough and goes something like this.
1 – The rating agencies did a poor job of rating these non-agency RMBS in the past and their current model is too punitive on the most conservative tranches of these securities. Ergo…
2 – The NAIC can do a better job of assessing RBC charges by partnering with a so-called ‘independent’ firm to re-analyze and provide a ‘revised’ rating for purposes of the Securities Valuation Office (SVO) of the NAIC.
This is all well and good, once you get over the fact that no firm we know of can possibly be completely independent in their modeling.
But, putting that “small” fact aside, we move towards valuation and how this jives with impairment rules. Here is how one might expect the NAIC to compare expected losses to NAIC SVO ratings (remember below investment grade is 3 through 6):

 

NAIC SVO Rating
Expected Loss
1
< 0.5%
2
0.5-1%
3
1-6%
4
6-15%
5
15-27%
6
>27%

 

This chart seems reasonable, prima facie, since the relationship between expected loss and SVO rating are similar to that imbedded in the NAIC risk based capital models.

On the valuation front, please remember that most insurers use some kind of arbitrary dividing line to determine if a bond needs to be reviewed for potential write down.  We typically see that level at about 20% below book value. Most of this decline in book value is unsurprisingly due to expected losses.
Now imagine an insurer dutifully analyzing a non-agency RMBS and determining that due to expected losses, the bond is worth about 85. No write down is needed since it has not pierced 20% below book. Now, let’s say the ‘independent’ firm employed by the NAIC to model bonds agrees with that assessment. So, it’s time to slap an SVO 5 on the bond, even though using the old model of relying upon the rating agencies may not produce a rating as low as SVO 5 (a CCC rated bond).
Or how about a non-agency RMBS modeled at 98, with a 2% expected loss? No write down necessary under impairment rules, but it would be an SVO 3 under the new rubric, subject to immediate write down for P/C insurers.
Insurance regulation is a very difficult task. It is made more difficult by a few companies who did a less than stellar job in their investment process and who are now are asking for regulatory relief. These companies have undoubtedly run all the numbers and believe they have ‘won’ in this latest NAIC ruling. However, the impact on each individual company in the industry has undoubtedly not been completely assessed….certainly not by the NAIC, captured by the largest insurers in this latest regulatory bailout.