[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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                 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

                              ----------                              
                                                                   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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