[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
IMPROVING TRANSPARENCY IN STATE
REGULATION OF INSURER INVESTMENTS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 20, 2006
__________
Printed for the use of the Committee on Financial Services
Serial No. 109-122
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31-551 WASHINGTON : 2007
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
EDWARD R. ROYCE, California NYDIA M. VELAZQUEZ, New York
FRANK D. LUCAS, Oklahoma MELVIN L. WATT, North Carolina
ROBERT W. NEY, Ohio GARY L. ACKERMAN, New York
SUE W. KELLY, New York, Vice Chair DARLENE HOOLEY, Oregon
RON PAUL, Texas JULIA CARSON, Indiana
PAUL E. GILLMOR, Ohio BRAD SHERMAN, California
JIM RYUN, Kansas GREGORY W. MEEKS, New York
STEVEN C. LaTOURETTE, Ohio BARBARA LEE, California
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut JOSEPH CROWLEY, New York
VITO FOSSELLA, New York WM. LACY CLAY, Missouri
GARY G. MILLER, California STEVE ISRAEL, New York
PATRICK J. TIBERI, Ohio CAROLYN McCARTHY, New York
MARK R. KENNEDY, Minnesota JOE BACA, California
TOM FEENEY, Florida JIM MATHESON, Utah
JEB HENSARLING, Texas STEPHEN F. LYNCH, Massachusetts
SCOTT GARRETT, New Jersey BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
J. GRESHAM BARRETT, South Carolina ARTUR DAVIS, Alabama
KATHERINE HARRIS, Florida AL GREEN, Texas
RICK RENZI, Arizona EMANUEL CLEAVER, Missouri
JIM GERLACH, Pennsylvania MELISSA L. BEAN, Illinois
STEVAN PEARCE, New Mexico DEBBIE WASSERMAN SCHULTZ, Florida
RANDY NEUGEBAUER, Texas GWEN MOORE, Wisconsin,
TOM PRICE, Georgia
MICHAEL G. FITZPATRICK, BERNARD SANDERS, Vermont
Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina
JOHN CAMPBELL, California
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
JIM RYUN, Kansas, Vice Chair PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
EDWARD R. ROYCE, California HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio JOSEPH CROWLEY, New York
VITO FOSSELLA, New York, STEVE ISRAEL, New York
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
GARY G. MILLER, California CAROLYN McCARTHY, New York
MARK R. KENNEDY, Minnesota JOE BACA, California
PATRICK J. TIBERI, Ohio JIM MATHESON, Utah
J. GRESHAM BARRETT, South Carolina STEPHEN F. LYNCH, Massachusetts
GINNY BROWN-WAITE, Florida BRAD MILLER, North Carolina
TOM FEENEY, Florida DAVID SCOTT, Georgia
JIM GERLACH, Pennsylvania NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida MELVIN L. WATT, North Carolina
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
RICK RENZI, Arizona MELISSA L. BEAN, Illinois
GEOFF DAVIS, Kentucky DEBBIE WASSERMAN SCHULTZ, Florida
MICHAEL G. FITZPATRICK, BARNEY FRANK, Massachusetts
Pennsylvania
JOHN CAMPBELL, California
MICHAEL G. OXLEY, Ohio
C O N T E N T S
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Page
Hearing held on:
September 20, 2006........................................... 1
Appendix:
September 20, 2006........................................... 17
WITNESSES
Wednesday, September 20, 2006
Conery, Kevin J., Senior Director, Merrill Lynch, on behalf of
the Bond Market Association.................................... 3
Hunter, Michael J., Executive Vice President and Chief Operating
Officer, American Council of Life Insurers..................... 5
Iuppa, Alessandro, President, National Association of Insurance
Commissioners.................................................. 7
APPENDIX
Prepared statements:
Conery, Kevin J.............................................. 18
Hunter, Michael J............................................ 34
Iuppa, Alessandro............................................ 42
IMPROVING TRANSPARENCY IN STATE
REGULATION OF INSURER INVESTMENTS
----------
Wednesday, September 20, 2006
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government-Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 10 a.m., in
room 2128, Rayburn House Office Building, Hon. Richard H. Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Kelly, Biggert, and
Hensarling.
Chairman Baker. I'd like to call the Subcommittee on
Capital Markets to order. On behalf of Mr. Kanjorski, I wish to
announce that he intended to be here, but he had matters that
required his attention, and he will not be here on time. His
office has given us the agreement to proceed with the hearing
in the absence of a minority member for the hearing this
morning. The rules require two members in participation, and so
I thank Mr. Hensarling for his willingness to participate.
This morning the committee meets to consider the issues
relative to State regulation of insurance products, improving
transparency of the regulatory methodologies, and to better
understand the work of the NAIC Securities Valuation Office.
Created in 1907, the office was intended to provide oversight
for securities issued in the insurance world, an important
role, and a role which has value to the broader market.
Recent events, however, have brought a tension to
regulatory decisions which had the unintended consequence of
devaluing particular securities in the market, and then
subsequently that rating or opinion being reversed having
significant adverse consequence in the confidence of holders of
this particular structure of securities device. The
observations that I make this morning come from a review of
testimony provided to date and correspondence with the office,
but it becomes clear that some revision in current processes
are warranted.
Today we will hear from stakeholders in the market, who
will express their own views on the matter, as well as a
representative of the NAIC, who has expressed a willingness and
desire to work with the committee and others to ensure that the
regulatory process is responsive to the identified problems.
The NRSRO's, which have the principal and primary duty for
evaluations of securities in the broader market have a clearly-
established process which is a stated methodology, and then an
informal process by which, before making public their ratings
to the broader market, will engage in discussions with
management of the rated company to determine if the factual
assessment made by the rating entity is in fact the
circumstances that management would agree as to the underlying
facts, not as to the conclusion reached by the rating agency
but only as to the factual material.
Despite the fact that I have had my own views for need for
reform of the NRSRO's, those two basic elements of their rating
process appear to be absent from the Securities Valuation
Office. In fact, there are quotes attributable to members of
the NAIC which indicate that the SVO does not consider outside
opinions in reaching their rating conclusions.
The result of this, I believe, has created unnecessary
uncertainty in the markets about particular types of security
structures. It is my hope today that we can reach some
conclusions regrading disclosure of methodologies, as to the
ability of the issuers of the rated securities to have an
informal ability to communicate with the SVO prior to reaching
a public stated position.
There is one other element that I would like to raise,
however, that I do not think has been raised by any others in
the public domain, and that is in the securities world if a
person has information and acts on that information prior to
general disclosure of that set of facts to the broader market,
that creates or triggers certain regulatory concerns, and that
really is at the base of my difficulty with this matter. It
appears that the unintended consequence of the current
valuation effort is to disclose a rating to a particular subset
of market participants not concurrent with all market
participants at the same time--not that it would be necessarily
called insider trading, because this is a regulatory function,
but as a matter of disclosure policy all stakeholders in the
market, whether there is action to be taken that either
increases or decreases the value of a public security, there
should be an absolute essential requirement to make that type
of determination and disclosure simultaneous to all affected
stakeholders. That does not now appear to be the case.
I look forward to working with the superintendent going
forward and to the NAIC and better understanding their
concerns. I believe I do understand their stated purpose. I
have actually gone to the Web site this morning and read
through the Securities Valuation Office guidelines to make sure
that I had an appropriate understanding, but there clearly is a
need for modest reform here to provide for stability in market
function, and I appreciate the panel's willingness to
participate this morning and look forward to hearing your
statements.
Mr. Hensarling, did you have an opening statement?
Mr. Hensarling. Mr. Chairman, I would like to note that
rarely has my presence been so welcome here before--
Chairman Baker. I second that.
Mr. Hensarling. I would just like to thank you and Ranking
Member Kanjorski for holding this hearing. I think it is a very
important topic that we will be discussing today. Clearly these
classification decisions made by the SVO are critical in
determining the amount of risk-based capital that our state-
regulated insurance companies must hold, which consequently, of
course, has to help determine the asset base which these
companies pay their claims as well as promoting a very
efficient and transparent capital market.
It is not a matter that has previously been on my radar
screen, but clearly the March 2006 decision of the SVO in their
classification of the Lehman Brothers ECAP hybrid securities as
common stock has raised the issue. We saw the impact that had
within our capital markets, and clearly I think that this
committee needs to look into how the decisionmaking process
works, and as we all know, sometimes a little bit of sunshine
goes a very long way in helping solve a certain amount of
challenges that we have, so I look forward to hearing from the
witnesses. Mr. Chairman, I yield back.
Chairman Baker. I thank the gentleman for his statement and
his presence this morning.
We will now proceed to our panel of witness. Let me first
express our appreciation. In our general platform of operation,
we request that your statement be limited to 5 minutes, if
possible. Your full formal statement will be made part of the
official record. Make sure that the button is pushed on the
bottom of the microphone, and we appreciate your being here.
Our first witness is Mr. Kevin J. Conery, senior director
of Merrill Lynch, but appearing here today on behalf of the
Bond Market Association. Welcome, sir.
STATEMENT OF KEVIN J. CONERY, SENIOR DIRECTOR, MERRILL LYNCH,
ON BEHALF OF THE BOND MARKET ASSOCIATION
Mr. Conery. Good morning. Chairman Baker and committee
members, thank you for holding this important hearing on
transparency in the State regulation of insurer investments. My
name is Kevin Conery, and I am a preferred securities
strategist at Merrill Lynch. It is a pleasure for me to offer
this statement today on behalf of the Bond Market Association,
the trade association for the $46 trillion dollar global fixed
income markets.
BMA members have high regard for the role of the NAIC,
which is the primary focus of this hearing. The NAIC and its
members, the State insurance regulars, play a critical role in
assuring the solvency of the Nation's insurance industry.
Recently, however, the NAIC Securities Valuation Office, or the
SVO, put a chill in the market for hybrid securities by
classifying as common equity a financial instrument well
established as fixed income security. Insurance companies are
an important source of demand for hybrid securities. The common
equity classification from the NAIC would require a
significantly higher capital charge against these securities
for insurers. This caused both issuers and investors to retreat
for a full 6 weeks in March and April of this year.
The price of the securities fell as insurance companies
were faced with the prospect of higher capital charges. Always
seeking the lowest cost of capital, issuers shied away from the
uncertain U.S. markets and looked abroad. With tens of billions
of dollars of hybrid securities in the pipeline, issuers are
right to ask themselves a key question--which country offers
the best environment to bring hybrid securities to market? As
long as the threat of regulatory uncertainty exists in the
United States, issuers will consider the option of going to
capital markets of the other countries.
Regulatory clarity is critical to maintaining the
competitiveness of U.S. capital markets. We are pleased that
the NAIC adopted an interim definition of hybrid securities at
a meeting last week. The definition expires January 1, 2008,
unless a permanent definition is crafted prior to that date.
This development has encouraged insurance companies to return
to the hybrid market in the near term at least. The overall
experience, however, illustrates a fundamental problem with the
SVO classification process. It lacks transparency.
A chief goal of BMA members is the development of policies
and practices that promote efficient and transparent capital
markets. A lack of transparency distorts prices, can cause a
misallocation of capital, and generally leads to market
inefficiency. Similar to what happened in March, if the NAIC
without explanation classifies as common equity hybrid
securities of the type long considered debt instruments,
insurance companies have no choice but to withdraw from the
marketplace. The loss of this key source of demand in turn
would distort prices and lead to a less efficient allocation of
capital.
If the SVO classification process were transparent, the
rationale behind its March decision would have been made
public, but far from being made public, this information was
provided only to certain parties compelled to maintain
confidentiality.
The SVO's reasoning still has not been publicly revealed.
The BMA believes that the NAIC needs to acknowledge that SVO
decisions can have a broad impact on the hybrid securities
market. The NAIC should develop a system similar to that
employed by other capital regulators, such as the Federal
Reserve Board or the Securities and Exchange Commission, those
that make clear what criteria are involved in evaluating
securities in addition to publicly-announcing the valuation
decision.
Such an announcement can come in the form of Web site
postings or press releases, so long as the information is
freely accessible to all market participants. Consider that
rating agencies, while not a capital regulator, do make
decisions and provide information that have broad effects on
the market, including the market for hybrid securities. Rating
agencies' decisions are always publicly available and their
methodologies clearly disclosed.
We acknowledge that the NAIC has made some efforts to
become more transparent at the industry's request. Since May
the SVO has posted classification notices on its Web site. The
reasons for these classifications unfortunately are still not
made public. We hope to continue a dialogue with the NAIC as it
moves towards consideration of how to create a more transparent
classification process. Changes that lead to increased
transparency, including the conveyance of information about
decisions in policy, are best for all markets and all
investors.
Mr. Chairman, thank you again for the opportunity to
testify here today. I look forward to any questions that the
committee may have.
[The prepared statement of Mr. Conery can be found on page
18 of the appendix.]
Chairman Baker. Thank you for your statement, sir.
Our next witness is Mr. Michael J. Hunter, the executive
vice president and chief operating officer for the American
Council of Life Insurers.
Welcome.
STATEMENT OF MICHAEL J. HUNTER, EXECUTIVE VICE PRESIDENT AND
CHIEF OPERATING OFFICER, AMERICAN COUNCIL OF LIFE INSURERS
Mr. Hunter. Thank you, Mr. Chairman, and members of the
committee. I am here today on behalf of ACLI's 377 members,
which account for 91 percent of the industry's total U.S.
assets. ACLI members offer life insurance, annuities, pensions
including 401(k)s, long-term care insurance, disability income
insurance, reinsurance, and other retirement and financial
protection products.
As investors holding approximately $4.2 trillion of
securities, or approximately 12 percent of the total
investments in the United States capital market, actions and
decisions regarding the regulatory oversight of our investments
are critical to the business operations of ACLI member
companies, the customers we serve, and arguably our Nation's
economic stability.
As you know, the insurance industry is state-regulated.
Companies operate under the supervision of each State in which
they are licensed. The Securities Valuation Office is an
instrumentality of the NAIC, which is an association of State
insurance commissioners and is charged with examining the
credit quality and value of insurers' investment portfolios.
We understand that one reason that this committee has
called for this hearing is to better understand the decisions
made earlier this year by the SVO regarding hybrid securities.
These decisions created such a level of uncertainty in the
capital markets that holders of these securities experienced a
substantial decrease in market value as well as a limited
ability to trade in the securities.
I believe a fundamental issue for the subcommittee to
consider is what role the SVO should play in the ratings and
valuations of securities held by insurers and exactly how that
role should be carried out.
Before moving on, I want to acknowledge that as of today it
appears that a very workable short-term solution to the hybrid
securities situation has been reached. This was accomplished
thanks to extraordinary efforts of both the industry and NAIC
leadership over the last few months. I want to particularly
compliment and commend Superintendent Iuppa on the vital
leadership role he played to help us get to this positive
outcome.
A bit of history. The SVO was formed by the NAIC in 1942 to
value investments made in private and public companies. In the
late 1990's, the NAIC realized that a more effective way of
valuing securities would be to rely on the values provided by
nationally-recognized statistical rating organizations--
NRSRO's. So today insurers rely on NRSRO's to determine the
value and classification of their securities. In the event that
a security is not rated by an NRSRO or a State regulator
requests the review of a previously-rated security, the SVO
will value and classify that security.
To understand the importance of the classification of
securities to an insurer, one must understand the NAIC's risk-
based capital system, or RBC. This system uses a formula to
establish the minimum amount of capital necessary for an
insurance company to support its business operations. Computing
risk-based capital helps determine when and what actions
regulators should take in the event a company's actual capital
and surplus falls below its calculated minimum.
All securities are classified as either debt/preferred
stock or common stock. A highly-rated debt instrument or
preferred stock with a market value of a million dollars would
require a company to allocate $3,000 for risk-based capital,
while a common stock of equal market value would require that
$300,000 be allocated.
Due to the extremely-high capital requirement for common
stocks and the risk-averse nature of life insurers, ACLI member
portfolios contain substantially more debt securities than
common stock.
The SVO's recent actions on hybrid securities illustrate
the effect its decisions can have on both insurers and the
capital markets. We are concerned with the process and lack of
transparency at the SVO and we call on the SVO to adopt and
apply a more transparent, open process by which it classifies
securities, disseminates those decisions to market
participants, and provides clarity as to why and how these
classifications are made.
When the SVO reclassified several securities from debt to
common stock in March, investors were left to wonder what
prompted the change. Industry immediately requested that the
SVO communicate the additional risks it perceived the
securities contained that are not considered in the rating
process of the NRSRO's. As of today, the SVO has yet to respond
to this request.
When the SVO acts on a request to rate a security, only the
entity that made the request will receive the decision. Other
insurers holding the security, issuers of securities, dealers
and investors are not notified of the decision. We are at a
loss to understand the public policy purpose behind this.
The SVO should disclose the basis for its decisions by
public dissemination as such information is material to the
market and information disclosed unevenly can certainly erode
investor confidence.
Additionally, the entity receiving this information is
prohibited from sharing the information with other investors or
issuers. As insurers or other investors learn eventually of an
SVO classification, they are unable to obtain a clarification
as to what factors led to this decision. We do not see that a
legitimate public policy purpose is served by this
confidentiality.
In the case of hybrid securities, the SVO began a process
by which all classification decisions are posted in a report on
the NAIC Web site. We want to applaud this move and we strongly
support it. However, the system is not in place for other SVO
rated securities, and, as previously noted, the empirical basis
for these ratings is not disclosed.
SVO staff has stated publicly that their designations are
not suitable for use by anyone other than regulators. This is a
completely unrealistic and impractical position to take, as we
have recently seen SVO actions do have an immediate and
significant impact on capital markets. This stance does nothing
more than foster a lack of confidence in the integrity of the
process within the industry and the marketplace.
In summary, we would like to leave the subcommittee with
three main points:
(1) Buyers and sellers of securities must know in advance
when the SVO is analyzing a particular security or class of
securities. This will provide stakeholders the opportunity to
provide input to the SVO to ensure that a fully-informed
decision will be made;
(2) The SVO must publicly communicate the empirical basis
for all ratings decisions so that issuers of securities can
understand what risk characteristics the SVO has identified
that could lead to a different rating than that of the NRSRO's.
Investors will then be in a position to assess their investment
portfolios and make an informed decision as to whether they
wish to continue to hold the security or securities in
question; and
(3) The NAIC has shown a willingness to allow the use of
NRSRO ratings and expanding that system is one option for
consideration, leaving the SVO to focus solely on solvency
issues. However, should regulators not be willing to cede all
rating and classifications decisions to the NRSRO's, it is
imperative that an open, transparent system for SVO action be
implemented.
I thank the subcommittee and you, Mr. Chairman, for
inviting ACLI to participate in the hearing, and I would be
happy to answer any questions. Thank you.
[The prepared statement of Mr. Hunter can be found on page
34 of the appendix.]
Chairman Baker. Thank you for your statement, sir.
Our next witness is the Honorable Superintendent Alessandro
Iuppa, who appears here today in his capacity as president of
the National Association of Insurance Commissioners.
Welcome, sir.
STATEMENT OF ALESSANDRO IUPPA, PRESIDENT, NATIONAL ASSOCIATION
OF INSURANCE COMMISSIONERS
Mr. Iuppa. Chairman Baker, and members of the committee,
thank you very much for providing me with the opportunity to
present the views of the NAIC on transparency in the regulation
of insurer investments. I also want to thank you for making the
committee staff available to discuss some of the issues in
preparation for this hearing.
The financial regulation of insurance is essential to
consumer protection, and we do this job well. Without consumer
protection afforded by financial regulation, an insurance
policy may not be worth the paper it is written on. We serve
the public by means of independent and honest financial
oversight, safeguarding insurers' capacity to pay claims, and
we welcome the chance to dialogue with Congress and the
subcommittee on this complex issue.
I am confident that we would not be here today if not for
recent NAIC decisions related to hybrid securities--highly
complex, often customized, nonconventional financial
instruments that are constantly evolving.
We stand by our recent analysis, both on substance and the
process, and I will be happy to respond to your questions on
those aspects. Nonetheless, like any effective organization
working in a dynamic market, the NAIC membership has initiated
a review with respect to the issues of disclosure and
transparency of our classification process covering hybrid
securities.
Following the concerns raised by the ACLI and the Bond
Market Association about a complex product that in fact
represents a small portion of the overall financial market, the
NAIC responded by holding a public hearing in New York City to
gather the perspectives of rating agencies, insurers, trade
associations, and other interested parties. That particular
hearing attracted over 200 attendees.
At that meeting, the NAIC leadership appointed a special
working group led by the New York Department of Insurance to
evaluate the appropriate risk-based capital treatment of hybrid
securities and to develop both short and long term resolutions.
During our most recent national meeting at St. Louis, which
was held last week, the NAIC adopted the short-term resolution
for the year-end financial statement filing. That resolution
essentially provides for the classification and reporting of
recently issued hybrid securities as preferred stock and the
regulatory with some adjustment to account for investment risks
not accounted for by national credit rating agencies.
Going forward, the special hybrid Risk Based Capital
Working Group will further study the characteristics of hybrid
securities and develop a permanent solution. I hope you will
agree that we have made good progress on a substantial
financial issue in a short timeframe with the support of both
the ACLI and the BMA.
In the interim 3 months, while the working group completes
our review, there are other actions that market participants
can take to improve the current situation within the existing
regulatory framework.
First, I would strongly encourage insurers to use the SVO's
Advance Rating Service. By using the ARS insurance companies
and their financial advisors, you can eliminate most, if not
all, surprises by learning in advance how these programs will
be classified by the SVO. I would also encourage insurers and
producers of hybrids to take advantage of the Automated
Valuation Service, the AVS. Like federally-regulated rating
organizations the NAIC offers a subscription service that
allows subscribers to access SVO determinations as they are
issued.
In response to the concerns of the Bond Market Association
and others, we took the unusual step of posting a number of our
rulings on hybrid securities on the SVO homepage and we did
this without the normal subscription fee.
Finally, I would encourage the interested parties to
continue their active engagement with the NAIC membership
through our open and transparent process for establishing and
amending policies and regulatory practices including those
related to the SVO. Together we can make improvements that
contain consumer protections and a dynamic market.
With respect to the issue of disclosure and transparency of
the SVO's classification process covering hybrid securities,
the NAIC's Valuation of Securities Task Force, which is
comprised of financial solvency and investment experts, is
evaluating the guidance provided through SVO analysts, as well
as the communications practices revolving around those SVO
classification decisions. I think it is safe to say that as a
result of ongoing discussions, we better understand that the
range of interested parties may very well extend beyond
insurers, their financial advisors, and the regulatory
community, and we look forward to reporting back to the
subcommittee once the NAIC has reached its final decision on
the regulatory treatment of hybrid securities.
I thank you and look forward to your questions.
[The prepared statement of Mr. Iuppa can be found on page
42 of the appendix.]
Chairman Baker. Thank you very much, Mr. Iuppa.
Mr. Conery and Mr. Hunter, let me try to get a framework of
the market effect of this decision, and then the ultimate
reversal of the decision.
At the point at which it did become public, what is your
assessment of the financial consequences in the broader market?
There's been references made to devaluation of these
particular class of assets. Do either or both have some view as
to what the broad market consequence was of this instability?
Mr. Conery. If I may go first, Mr. Chairman, yes, there was
clearly market instability, market confusion, because once
again there was not any transparency as to why this decision
was made.
Broadly speaking, any security that looked approximately
like the Lehman ECAP structure also had its value decline. With
the rationale being unclear, the market entered a phase, as I
noted earlier, that it was largely shut down and there was very
little trading volume going on for awhile because people were
uncertain, so valuations were pretty wide, as often happens
when liquidity becomes less in a marketplace. But I think that
most people are thinking that the average cost for anything
that looked to be similar to a Lehman ECAP structure was
approximately at that time 30 to 40 basis points from most
issues.
Chairman Baker. And what in your estimate is the notional
amount of this class of securities in the market? Any way to
know that?
Mr. Conery. Well, one of the things that became
interesting, and this also goes back to the transparency issue
as well, because it was unclear what they were specifically
targeting, and initially when the market assumed, as did I
individually, that it was the ECAP structure that was the
problem that they were having, the market viewed it as a much
more narrow problem, okay?
As time went on, and more classifications came out and
became more apparent, especially into May and into June, and
people recognized it was structures well beyond the Lehman ECAP
structure, the market became much more concerned. So I would
say initially we're talking about a market size that was
probably only about $15 billion. By the time June was coming
around, you were talking about in market size that I would
conservatively estimate at about $100 billion.
Chairman Baker. Mr. Hunter, can you add or expand on that
view?
Mr. Hunter. Yes. I think that nobody would challenge the
proposition that markets respond negatively to two things, bad
news and uncertainty. And there was a mixture of both with
regard to the SVO decision.
I think our research indicates that at the nadir of the
activity with respect to these securities during the summer
that portfolios decreased by about a billion dollars industry-
wide. Portfolios have certainly rebounded but there were
negative impacts on companies that haven't been remedied by the
positive developments of recent weeks.
Chairman Baker. Are we back to the pre-April market
conditions?
Mr. Hunter. It's not my belief that we have returned to
pre-April. I'll let Mr. Conery opine on that as well.
Mr. Conery. Right now it depends upon which segment of the
market you are speaking about. I would say broadly you have
largely recovered as of today, this morning, and for the past
few days, pretty much where we were prior to April. However,
certain segments of the market have not responded as favorably,
basically, those that have more to lose by the interim
solution, for example.
The way the interim solution works, if you still got
classified as common equity initially and you had a Triple B
rating, you would get hit harder, so consequently those issues
have only recovered about half of what they lost, so they may
have recovered 20 of those 40 basis points.
Chairman Baker. Thank you. Mr. Iuppa, my reason for asking
that line of questions of the other two witnesses is just to
establish the market consequence of this regulatory action by
the NAIC, that many years ago the scope of influence and
residual effect in the market may in fact have been very minor,
but today market consequences are quite different.
As you indicated, these are sophisticated and technical
issues that require a level of sophistication in their
assessment. That also leads me to conclude that the inter-
related financial network that may be beyond the scope of the
insurance regulatory purview was adversely affected, although
unintentionally, by the rating for some duration in the market,
and even today there are certain classifications that have not
fully recovered.
I don't believe this is insoluable. I believe that the
model that has been created by the actions of the NRSRO's
generally is a blueprint for continuing this rating
responsibility and engaging in it in a manner which would not
necessarily roil the markets--primarily, the two issues being
simultaneous disclosure of ratings to all affected parties and
certainly not requiring confidentiality to those who benefit
from the information, and secondly, some disclosure of
empirical standards or methodology so that issuers can
understand when we go out into the regulatory world here is
what they are going to look at and here's the expectation so we
can structure our deal to meet those regulatory expectations.
I know you have made a statement in your comment today that
the NAIC is working toward resolution perhaps on both those
ends. Can you represent to us today when you think that the
regulatory revisions that you have described would actually be
made effective or will there be some interim report?
I come to this with some trepidation. We have not always
had a date certain target for other NAIC goals, and I just want
to make sure that this one of particular importance is targeted
and is described for the broader market in a way where there
can be a little more certainty about when this will be
resolved.
Can you respond?
Mr. Iuppa. Yes, I think I can. As I noted, we have asked
the VOS Task Force to come back to the broader membership with
a report.
Chairman Baker. Is there a deadline for that report?
Mr. Iuppa. I am getting to that.
Chairman Baker. Okay. Thank you.
Mr. Iuppa. I believe the last day for the NAIC meeting in
December is December 12th, so that NAIC leadership is expecting
to have that by December 12th, so that if we can't take action
in December, we can arrange to take action subsequent to that,
but I think the key is the NAIC leadership and there is a
commitment from the New York Department with regard to their
role as chairing this group to deliver to the broader
membership a report, and hopefully a recommendation, as to how
to address some of these concerns.
As I noted in my commentary, as a regulator it is difficult
at times to see beyond the regulatory blinders, if you will,
and I think we have drawn some inferences and some conclusions
that our actions do have a broader impact, and can have a
broader impact, in the broader marketplace, and we have to take
that into consideration as we look at the transparency and
disclosure issues going forward.
Chairman Baker. And I don't know the charge that the
committee has been given for the issuance of the December
report, but in the ``for what it's worth'' category, this
simultaneous disclosure and disclosure of empirical
methodologies is extremely important in order to have the SVO's
mission and operations consistent with other securities
regulators.
I hope that will be at the forefront of the committee's
effort--and my time has long expired.
Mrs. Biggert?
Mrs. Biggert. Thank you, Mr. Chairman. While we heard that
NAIC doesn't announce when the classifications are made and
that parties that are interested in determining a current
designation pay a fee to actively monitor a NAIC database, this
materially makes material information non-public, which--can
this benefit some of the market participants to the detriment
of others then, the way that this was set up?
Mr. Iuppa. Would you like me--
Mrs. Biggert. Yes, Mr. Iuppa.
Mr. Iuppa. Well, I guess on a purely analytical response, I
guess the answer is probably yes, because if some segment of
the market doesn't have information that is available to
others, those that have the information can be perceived to
have been advantaged.
Mrs. Biggert. And you said that some of the classification
changes have been put up on the Web site about some securities
and not others. Does this make a difference then? How do you
choose which one you are going to put up on the Web site?
Mr. Iuppa. Well, a couple of things. I want to clear up
what may be one misconception. I have heard several times today
that the NAIC reversed its initial analysis on some of the
hybrids. That is not really what happened. We did not
necessarily reverse those rulings but we have worked towards a
sort of interim solution with them.
With regard to the availability, like most of the rating
agencies you can subscribe to get access to the information as
it is issued, and that has been our general practice with
regard to the ratings and classifications on securities.
In this particular case, as a result of some of the
discussions we have had since I will say early June--in fact, I
can recall sitting down with some of the CEOs and investment
people at a meeting that ACLI organized here in Washington,
talking about this early in June, we decided to go ahead and
put some of that classification information regarding the
segment of hybrids out on the Web site.
Typically, in the past, we would not have done that. That
would have been available to those who subscribed to the
service, so that that may ultimately be one of the ways to
disseminate this information.
Mr. Conery. If I may--
Mrs. Biggert. Mr. Conery.
Mr. Conery.--just one point, just regarding fact. Thank
you. We note very clearly it was a significant improvement to
have the postings on the Web site, but we not only would
challenge the point that some of the decisions regarding the
actual classifications of certain issues were not reversed. I
would agree with that point with respect to newer issues, but
in some cases some of the classifications they were posting in
fact were on securities that were issued 7, 8, 9 years ago that
previously had been classified as either preferred stock or, in
some cases, debt. So clearly there was a change in this whole
methodology, which in part has created this whole concern about
what is their methodology and lack of transparency.
Mrs. Biggert. Was there anything negative when something
was not put on the Web site or was left off? Did people have
concerns about the value of those hybrids?
Mr. Conery. Well, it would be people who tried to make
conjecture, and I would emphasize it was conjecture or market
best estimate in terms of what other securities were likely to
be impacted. I can say that most investors as well as most
broker dealers have their own internally generated set of lists
that they thought were likely suspects to be classified. But
clearly everybody's list differed slightly.
Mrs. Biggert. Mr. Iuppa, you said that you had the special
working group and asked for it. This was in July. Was this the
time that you asked for a comment period, or was this earlier
that there was a comment period open for people to talk about
the hybrid securities and the classification?
Mr. Iuppa. It was actually earlier than the meeting itself,
because we were getting comments broadly from interested
parties subsequent to our June meeting, which was held here in
Washington. But it was at that June meeting that we decided the
need to have a special interim meeting of the VOS Task Force to
air out and in a formal way obtain comments and input from
interested parties. At that hearing on July 17th, I believe it
was, is when the NAIC leadership directed that a special
working group be put together that was tasked with what I would
describe as financial and investment experts within the
regulatory community to work with the interested parties to
develop a solution.
We didn't say develop a short and a long term. We said come
to us with a solution. The consensus was the best way to deal
with it is to deal in the short term with the financial
reporting for risk-based capital and also to put together a
long term solution as well.
Mrs. Biggert. Did you hear from a large number of the
industry?
Mr. Iuppa. I estimated, and I believe it is conservative,
that there were over 200 people at that meeting in New York.
The real number was probably considerably higher than that.
Mrs. Biggert. I see.
Mr. Iuppa. The answer is yes.
Mrs. Biggert. Okay. I have one more question.
Mr. Hunter, it appears from the testimony that life
insurers are major investors in hybrid securities. These
securities seem to be very attractive to your member companies,
but did this change, then, with--what effect did these
regulations--or the reclassification, did that cause real angst
that suddenly something that people thought was valued for a
period of time--you know, the length of time that they would be
held, how did that affect your companies?
Mr. Hunter. Well, clearly insurers are significant
consumers of hybrid securities. They are uniquely suited to the
challenge that insurance companies have to comply and be in
compliance with the risk-based capital systems that monitor
reserves and because of the fact that so much uncertainty
developed around these decisions, there was clearly a
withdrawal from insurers investing in this marketplace and it--
you know, capital flows freely, and I guess one of the
unfortunate elements that maybe is of national concern is that
you have these investments flowing into other parts of the
world.
So there's clearly a very thoughtful and well-established
mechanism and routine that was placed in some degree of
disarray this past summer. As I said earlier, Congresswoman, we
really want to give a lot of credit to the leadership of
Superintendent Iuppa and others who have taken steps to provide
a solution that provides more certainty in the marketplace with
the hybrids.
Mrs. Biggert. So you think that the short-term proposal
then will send the right message to the capital markets?
Mr. Hunter. Well, it's been very helpful. You know, where
we go from here, however, is critical. You know, my experience
in government and the analog that I think is most applicable is
that of a rulemaking or the promulgation of a regulation. You
have adequate notice that's provided to stakeholders of regard
to what's at issue. There is an opportunity for comment,
possibly for hearings. And then you have a decision that is
public and the rationale therefore is provided as a part of
that decision. We think that very basic framework is one that
will address concerns of our companies.
ACLI is every bit as committed to State regulation as they
are to an initiative for an optional Federal regulator. We
don't support an EFC, an Exclusive Federal Charter, just to
make that record. We are going to have a number of companies
chartered at both the State and Federal level, whatever happens
going into the future, so we are committed to this process and
committed to working with the other commissioners in the States
to improve it.
Mrs. Biggert. Thank you. Mr. Conery, do you think the
proposal sent the right message to the capital markets?
Mr. Conery. Well, clearly the insurance companies have
begun to return to most areas of the market, so in that sense
it has sent the right message, but people need to recall that
it is an interim solution. It is a temporary solution. They
have not yet said what that permanent solution will be relative
to the temporary solution.
All along their dialogue has been saying that they are
looking for a risk-based solution, which we are not sure
exactly what that means, because they haven't chosen to define
what risks they are talking about at this point in time, so
it's certainly a move in the right direction relative to where
we were back in May and June of this year, we're cautiously
optimistic that it is the right solution for the interim, but
we have a note of concern that it is a temporary solution.
If I could just make two quick clarifications on the
characterization from the side of the BMA.
The BMA's position on the interim solution was not that we
supported it, because we had our own proposal out there to the
NAIC and to the working group. We did not object to the interim
solution. I would say the same is still true. It is not that we
support it as a solid risk-based solution, but we do not object
to it, as we acknowledge that it is the least harmful of the
other solutions that were out there.
I would also note, too, that while we have been open to
talking with the NAIC, I would also recommend, too, that as we
go forward and down this road with the NAIC, that probably it
should be noted that working together should include less of a
monologue and more of a dialogue.
Mrs. Biggert. Thank you. Thank you, Mr. Chairman. I yield
back.
Chairman Baker. I thank the gentlelady.
Mr. Iuppa, I want to return to an observation I made
earlier, and didn't cover with you, and I believe I am
understanding the existing process that constrains the
disclosure methodology to a subscription base with the NAIC.
Those are people to whom they pay a fee to which you give this
opinion about financial quality, as contrasted with an NRSRO,
who assesses a fee directly--in this case it would be on the
insurance company, perhaps on the issuer--and there is no
subscription base.
And so in looking at the model and potential revisions, if
the NAIC was to move away from a subscription-based system to a
fee-based system on the company and/or issuers, then there
would not be this self-imposed constraint on who gets access to
that data, and then the work would occur with the rated entity
or rated product and prior to public disclosure some discussion
takes place about how these conclusions were reached, not that
that affects the ultimate decision by the SVO.
But then when the ``final final'' is made, it goes to
everybody. That really is the NRSRO model and the only other
addition would be just the disclosure of the empirical data
that goes into the underlying assessment.
I may be well beyond my expertise on the subject, but that
appears to be at least operationally what is causing this
differential set of disclosure standards. So as you go forward,
I would love to visit with your team better understand, and I
did not request but would do so on the committee's behalf that
at such time as you are final filed report is in receipt that
the committee be given the opportunity to read and understand
that set of findings as well.
We want to make sure going forward that we are working
toward a mutual end goal that doesn't impair the NAIC's ability
to protect the public interest, but we have a view toward
stability in the capital markets. I have extreme concern about
global competitiveness issues and particularly where I believe
it to be a regulatory set of standards that causes people to
make investment judgments elsewhere. We certainly want to do
our best to mitigate those wherever possible.
But, as others have said, I want to express to you our
appreciation for your courtesies, your staff meeting with ours
was most helpful, we believe. We would like to continue in that
manner going forward and to try to get resolution on this by
the end of the year at the latest.
Unless there is anyone who has further comment--yes, sir?
Mr. Iuppa. If I may just a clarification. When I said that
we hadn't reversed any of the decisions, I do want to point out
that I, too, I guess may be in over my head a little bit, but
there were about eight securities that were revised as a
result, and these were older securities that have previously
been in place.
I certainly appreciate, you know, the guidance that you are
giving us with regard to moving forward. As I noted in my oral
comments, I think that our definition of interested parties is
probably a bit narrower than what may really be out there, and
I think one of the challenges for us to reconcile our
regulatory responsibilities with the broader responsibilities
we have as financial regulators.
I certainly want to acknowledge and look forward to State
insurance regulators being compared commensurately with the
Federal Reserve and the SEC when we come before the committee
in the future.
Chairman Baker. Well, I would say that in the past some
have described the ``butterfly wing effect'' that takes place
somewhere around the world. What has happened to the SVO? They
have now become the ``elephant's foot'' and they really have a
direct and meaningful impact when that foot hits the ground,
and we just want to make sure that we know where the elephant
is, and where he is going, and we only want to feed it and make
it happy. We don't want to cause people to take their capital
and go elsewhere, perhaps to a less threatening environment, so
we can get there, I think, and I appreciate the willingness to
consider these proposals and to make whatever you think is the
best regulatory judgment.
I thank our witnesses and our meeting stands adjourned.
[Whereupon, at 10:58 a.m., the hearing was adjourned.]
A P P E N D I X
September 20, 2006
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