States review requiring insurers to hold more capital against riskier mortgage bonds

The Wall Street Journal reports that state insurance regulators are examining requiring insurers to hold more capital against riskier mortgage backed securities.

In a White Paper recently released by the National Association of Insurance Commissioners (NAIC), in its concluding remarks the NAIC observed:

There are two ways to implement change in the way the RMBS market performs. Government can enact laws and regulations requiring the reporting of certain data and insist on a level of transparency that sellers of RMBS must meet, or the private sector can recognize the market is not working well and an alliance of buyers, regulators and the public can insist on greater transparency and effective disclosure of sufficient information to allow RMBS investors and regulators to have greater confidence in the market. 

If a private sector solution is developed, insurance regulators could influence its success by providing greater credence to assets ... [that] provide collateral performance disclosure on a more frequent basis. 

Regulators might want to give greater credence, perhaps in the way of reduced capital requirements, to insurers who invest in assets with greater transparency both through more frequent disclosure....  Improving transparency would be a good thing for insurers, regulators and the capital markets.... 

From an insurance regulatory perspective, the goal is to improve the knowledge insurers have regarding their RMBS holdings. The true value of RMBS holdings should be readily available to insurance regulators charged with monitoring solvency.

The goal to improve the knowledge insurers have regarding their RMBS holdings is simply a restatement of the European Capital Requirement Directive Article 122a's 'know what you own' requirement for commercial and investment banks.

From the White Paper, disclosure which allows the insurers to know what they own has two elements.

• First, a structured finance security would report on an observable event basis any activity like a payment or delinquency that occurs with the underlying collateral before the beginning of the next business day.  This is a change from the current once-per-month or less frequent reporting.

• Second, the disclosure would include all data fields tracked by the originators and servicers while protecting borrower privacy consistent with HIPAA patient privacy standards.  This is a change from the current focus on data templates that don't include all non-borrower privacy protected data fields.  After all, why exclude any non-borrower privacy protected data field that the experts, the originators and servicers, confirm is useful and relevant by spending money to track?

There are two reasons that the NAIC white paper has effectively set the global disclosure standard for structured finance.  

• First, the market depends on the capacity of insurance companies as buyers.  Deals that don't provide sufficient disclosure will not be economically attractive for insurance companies to buy due to the amount of capital they need to hold against the security.

• Second, setting capital standards for insurance companies based on disclosure effects the entire buy-side.  Non-insurance company portfolio managers have an incentive to adopt these standards as it reduces their risk of an adverse finding should litigation occur related to losses on these securities.

From the Wall Street Journal article,

State insurance regulators are considering changes that would require U.S. insurers to hold more capital against some of the riskier mortgage bonds they have been scooping up lately as high-yielding investments. 

The moves under discussion could increase by billions of dollars the total amount industrywide that insurers including American International Group Inc., MetLife Inc. and others must hold to protect policyholders, estimate some analysts. 

The changes could be implemented later this year by the National Association of Insurance Commissioners, an organization of state officials that sets solvency standards. 

The shift, currently under study by an NAIC task force, would make it costlier for insurers to hold certain bonds backed by subprime mortgages and other risky home loans....

More importantly, the shift would set the global standard for disclosure for all asset backed securities ranging from covered bonds to mortgage-backed securities.

If the security has observable event based reporting, insurers and any other market participant could know how the underlying collateral was currently performing.  With access to this information, the insurers could make investment decisions.

If the security doesn't have observable event based reporting, insurers don't know how the underlying collateral is currently performing.  Without current performance information, insurers are blindly betting on the value of the security.

It makes sense that the regulators would require insurers to hold less capital against an investment where they had access to all the useful, relevant information in an appropriate, timely manner and more capital against a blind bet.

Many insurers "are looking for ways to enhance yield" and mortgage-bond yields are very attractive relative to other assets, says John Melvin, global head of insurance fixed income portfolio management at Goldman Sachs Asset Management. He adds that the regulatory capital treatment is "important" in insurers' decision to buy these securities. 

Set the capital requirements high enough and insurers cannot buy bonds where they are blindly betting.