Attachment
Financial Condition (E) Committee
12/12/06
Drafted: 12/7/06
Hybrid RBC (E) Working Group
Conference Call
October 26, 2006
The Hybrid RBC Working Group of the Financial Condition (E) Committee met in New York, New York and via conference
call Oct. 26, 2006. A quorum was present, and Lou Felice (NY) chaired the meeting. The following Working Group members
were present: Richard Ford (AL); Tomoko Stock (CA); Philip Barlow (DC); Paul Kropp (NH); Kaushik Patel (PA); Betty
Patterson (TX); Van Tompkins (VA); and Roger Peterson (WI). Also in attendance were: Mike Moriarity and Matti Peltonen
(NY).
1.
American Academy of Actuaries (AAA) Work Plan
Mr. Felice said the Hybrid RBC (E) Working Group would be working with a lot of other groups in the NAIC. The Working
Group would need to work with the Valuation of Securities (E) Task Force, the Blanks (E) Working Group and the Capital
Adequacy (E) Task Force to bring everything together. The Working Group was also dealing with the inherit risks of contract
provisions and the probability of the risk.
Mr. Felice asked the AAA to provide a broad overview as to the status in the deliberations in a developing a work plan and
the elements that would go into the plan. David Berger (Ameriprise Financial) said the work plan was still going through the
AAA review process. The work group had gone through the issues including the risks involved. For RBC, the work group
was concerned with the investments from the investor perspective. The work group discussed whether convertibles were in or
out of the scope. Surplus notes and the impact on Total Adjusted Capital were also discussed.
Doug Barnert (Barnert Associates) indicated he would like to get some background and some understanding of how the
process would work. Mr. Berger said first, the work group was defining hybrids. Second, the group would identify the risks
associated with hybrids. Third, the group would look into differences in SVO ratings versus the rating agencies ratings.
Fourth, the group would look at the features of the securities as compared to pure equity. The work group would then
consider input from interested parties and consider different methodologies. Both factor-based and principles-based
approaches would be considered. Propose recommended methodology.
Mr. Felice asked about the construction of the group. Nancy Bennett (Ameriprise Financial) said the work group was
comprised of members AAA. The group consisted mainly of life actuaries with one property and casualty actuary. The work
group was currently trying to recruit a health actuary. Most of the members were company actuaries. One actuary had
previously worked for Standard and Poor’s. There were six or seven members currently. Four meetings had been held so far.
The group was meeting every Wednesday.
Mr. Barnert asked what provisions were being made for inclusion of small or medium-sized companies. Mr. Felice said the
Working Group would want as wide a participation as possible. Ms. Bennett said the AAA work group did include a person
from a small company. Any actuary could listen to the calls. Ms. Bennett said it would be at the discretion chair if interested
parties were included. Mr. Barnert felt that would be a shift in the normal process. Mr. Felice said the Hybrid RBC Working
Group was open to all input. Chris Anderson (Merrill Lynch) agreed it was a departure.
Ms. Patterson asked when the AAA meetings would be opened to participations. Ms. Bennett said the intent was to open up
once the work plan was completed. Ms. Bennett said it was never part of AAA bylaws to require interested parties. There was
no change to AAA processes regarding interested parties. The work group wanted time to formulate an un-biased view of the
issue. Ms. Bennett said the AAA had no vested interest in the decisions. The AAA meetings will open up in the next several
weeks. Mr. Barnert said he did not intend to imply that the bylaws had been changed. Mr. Barnert said the NAIC intention
part of AAA process won't be smaller companies. NALC and ACLI invited in for areas not relegated to actuaries only. Mr.
Felice said it still continues to be Working Group that controls the process and makes the ultimate decisions. The Working
Group charged the AAA to come up with work plan. The Working Group and interested parties will be providing input on
the work plan.
Mr. Felice said the Working Group would hold a conference call once the work plan was received. Mr. Barnert requested at
least a week would be needed to review work plan. Mr. Felice agreed that both regulators and interested parties would need
time to consider the work plan.
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Attachment
Financial Condition (E) Committee
12/12/06
2.
Discussion of Hybrid Risks
Mr. Felice said previously a New York memo on risks and a response from ACLI had been distributed. The Working Group
would be looking at the risks and whether any of risks are reviewed by rating agencies. Mr. Felice wanted to hear any
comments on the risks in the New York memo.
Mr. Anderson said the risks of hybrids were similar to risks that were well known and established in other types of assets.
One most significant risk is subordination. Preferred stock recovers poorly when in default. It is likely a claim would result in
no return. In addition, payments are deferrable for hybrids. Payment deferral was already accounted for in rating agency
ratings. Mr. Anderson said securities can have imbedded call options. The call option can lead to extension risk. Call options
had been around for many years. Those options were not explicitly factored into ratings for any type of security.
Mr. Anderson said work needs to be done on extension risk. But, that may not result in any significant differential in RBC
charge. Mr. Felice said the extent risks are reflected in rating agencies ratings would be a factor. Mr. Peltonen said extension
call risk not typically included in RBC. Mr. Peltonen said pricing volatility of hybrids was less than for common stock and
more than for fixed income. Mr. Anderson said a lot of other securities have that risk as well. Hybrids should not be singled
out.
Ms. Bennett said extension risk for CMO's was considered for C-3 Phase I. An additional piece of C-3 Phase I mortgage
backed securities. To some extent, the RBC currently does take that into account. Actuaries currently model asset and
liability matching. Those models would reflect call options. But, it was not known to what extent the call options would have
an effect. Ms. Bennett felt some items were already factored into RBC. Mr. Anderson agreed but wanted to make sure the
risks were explicitly considered.
Mr. Wake said one risk that would make a security as equity-like would be mandatory conversion. The subordination risk for
many securities was qualitatively different from regular subordination. Often, the loss of principle could occur before reach
default. Mr. Wake said debt-holder protection rights would be another risk related to the ability to block payments to junior
security holders. Mr. Felice said mandatorily convertible already receive equity treatment. Regular convertible securities
currently receive bond treatment. Mr. Felice felt that would be outside of the current scope.
Ms. Bennett asked whether anything unique from a tax perspective applied to the securities. Mr. Anderson felt there were not
any special tax issues for hybrids. Mr. Moriarity agreed. Mr. Felice said the Working Group may need to add another
category for hybrids. Mr. Wake said with current difference between debt and equity may need a more intermediate measure.
Mr. Anderson said for common stock, the risk reviewed was price volatility such as the common stock beta. For fixed income
securities, the likelihood of a payment schedule being realized is reviewed. Mr. Anderson said if it is felt the payment
schedule very uncertain a security may be rated a six similar to common equity rather than creating a new category. Mr.
Anderson said if the NAIC needs more gradation in the ratings, then that should be done. Mr. Felice felt some securities do
have equity-like characteristics. Currently, there is only a common stock category. The Working Group is looking at whether
another category is needed. Mr. Barnert said AAA work plan should provide some clarity at what equity-like characteristics
are. Mr. Wake said hybrids had existed in some form previously. Preferred stock was equity with a lot of debt-like
characteristics. Securities can be designed to behave many different ways and have been.
Diane Marchesi (Transamerica) asked whether the AAA was also looking at preferred stock. Mr. Felice said that was the case
the extent that identifying risks associated with them. Ms. Marchesi asked whether surplus notes would also be included. Mr.
Felice said they would be discussed. Whether surplus notes are reviewed separately would be something to discuss. Mr.
Barnert asked whether convertible debt should also be included. Mr. Barnert did not feel convertibles should be separated
out. The conversion may be far out in the future. There may be a lot of different terms used.
Ms. Bennett said from an actuarial perspective look at RBC as a way to capture risk through default and price volatility. The
AAA was thinking about all of the risks and impact on capital. The AAA will give recommendation on RBC charge and how
treated. Ms. Bennett said the AAA was not really considering classification. But, there may be some practical implementation
issues. Mr. Felice said classification was not determined by Capital Adequacy. Capital was assigned according to current
classifications. Mr. Anderson said it was most important to get risk assessed correctly and less important where the securities
show up. Mr. Barnert said the process would need to take into account where to classify the securities. Mr. Barnert said
classifications were important regarding investment limitations. Mr. Anderson agreed it was important to capture all of the
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Attachment
Financial Condition (E) Committee
12/12/06
risk factors. Develop factors that reflect the risk. It is less important how classified. Mr. Barnert said investment limitations
are important though.
Ms. Stock asked how the review process would work. Ms. Bennett said the AAA would be looking at different types of
hybrids and would see how to break out. Need to start out at a fairly granular level. If the AAA was not able to delineate risks
for the securities, then a principles-based approach might be called for. Mr. Wake said at one end of the spectrum was pure
debt and pure equity at the other end. In between are quite a few other options. The question was whether the rating agencies
correctly capture the risk for those in between.
Ms. Bennett asked for surplus notes need to look at any change to Total Adjusted Capital. Rating agencies do not give full
credit for surplus notes. For rating agency purposes, surplus notes have a cap put on them. Ms. Marchesi said rating agencies
also cap hybrid securities. The rating agencies limited hybrids to 15% of capital. Mr. Felice said the only hybrids issued by
insurance companies were surplus notes. At some point, it may be needed to consider the issuer perspective. Mr. Felice felt
that should probably be addressed separately from this discussion. Mr. Moriarity said if surplus notes were changed from the
issuer perspective state laws would need to be changed. Mr. Barnert said a similar argument could be made for convertible
debt. Ms. Bennett said it was now her understanding that surplus notes would only be reviewed from an investor perspective.
3.
Implementation of the Short-Term Proposal
Mr. Felice said an ACLI letter on implementation of the short-term proposal. Once the proposal becomes effective, cannot go
back and submit securities for removal of a notch. Mr. Felice felt the intention to set a fixed amount of capital for hybrids at
that time.
The Financial Condition (E) Committee call will be held Nov. 1, 2006. The Working Group could choose to do nothing. One
option to would be to set and effective date of Dec. 31, 2006. Another option would be to remove effective date language.
Finally, the effective date could be changed to Sept. 12, 2006 when Financial Condition (E) Committee adopted the proposal.
Ms. Stock asked what the implication of the third option. Ms. Stock asked whether that option open up to having a lot of new
issues being filed. Mr. Felice said any issue can be submitted until adopted in December.
Ms. Marchesi asked whether insurance companies able to submit any securities previously classified as common stock issued
prior to Aug. 18, 2005 for reconsideration. Ms. Marchesi said some securities classified as common stock where submitting
for an appeal. Mr. Felice said the normal SVO appeal procedures would apply. Ms. Marchesi said wanted to retain the right
remove notch for those securities. Mr. Felice said that should be the case there was nothing currently that limited the right to
appeal.
Mr. Barlow clarified the Working Group could make a motion to provide additional guidance to Financial Condition (E)
Committee or just take no action. Mr. Felice agreed.
Having no further business, the Hybrid RBC Working Group of the Financial Condition (E) Committee adjourned.
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© 2006 National Association of Insurance Commissioners
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