Fitch Updates U.S. Insurance Surplus Note Equity Credit Treatment
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Source: | Business Wire |
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CHICAGO--(BUSINESS WIRE)-- In conjunction with its implementation of changes in hybrid securities rating criteria announced on Dec. 29, 2009, Fitch Ratings is reducing its equity and capital credit treatment for surplus notes issued by U.S. insurance companies, as opposed to lowering the ratings of the surplus notes. Fitch previously announced that most preferred and hybrid securities issued by insurance holding companies and operating companies were expected to be downgraded by one notch from their current ratings to reflect going-concern loss absorption, such as deferral risk. These downgrades were announced by Fitch today in a separate press release. Fitch also previously announced that it was evaluating whether exceptions may be appropriate and specifically cited surplus notes issued by regulated U.S. insurance operating companies as an instrument to be reviewed.
Fitch has completed this evaluation of surplus notes and has concluded the following:
--U.S. surplus notes will not be subject to the one-notch downgrade linked to their deferral feature, as Fitch has concluded that these instruments do not provide material going-concern loss absorption to the issuing insurer. This is based on a review of the timing of actual regulator-initiated deferrals for insurance companies under stress which indicates regulators generally have not initiated deferrals early enough to allow the insurer to avoid a broader regulator intervention or insolvency.
--U.S. surplus notes will no longer receive 'equity credit' in financial leverage (i.e. debt to capital) calculations. Previously, Fitch applied 75% equity credit for long-dated surplus notes in its financial leverage calculations.
--U.S. insurance regulators provide 100% 'capital credit' for surplus notes in the NAIC risk-based capital ratio based on the combination of their deep subordination to policyholder obligations in liquidation, and their deferral option. To reflect its updated views on the limited value of the deferral option, Fitch will reduce the 'capital credit' for surplus notes under its risk-based capital model (Prism) and operating leverage ratios. Capital credit will be 75% in cases in which surplus notes represent up to 15% of total statutory surplus, with any amounts above 15% receiving 50% capital credit. Previously, regardless of the amount of surplus notes, capital credit was uniform at 75% in Fitch's risk based capital model, and 100% in operating leverage ratios.
--When surplus notes exceed approximately 15% of total statutory surplus, Fitch will continue its practice of either expanding surplus note notching (i.e. rating the surplus note lower than the typical two notches below the Insurer Financial Strength (IFS) rating) and/or lowering the IFS rating of the issuer.
U.S. surplus notes issued by regulated insurance companies to third party investors have existed in the marketplace for about 20 years. Therefore, Fitch believes these instruments have been tested through various economic, investment and insurance cycles, including the most recent financial crisis. While the interest payments can be deferred at the option of the regulator, in reviewing the timing of actual regulator-initiated deferrals historically, Fitch has concluded that regulators generally do not exercise this option until the point of broader regulatory intervention.
Within its rating methodology Fitch continues to generally view the U.S. state regulatory system as affording 'strong' protection to policyholders via upstream dividend restrictions and the seniority of policyholders in a liquidation. However, in the case of surplus notes Fitch observes that regulators have been shown to be more cautious in exercising their deferral options as companies come under stress. Fitch suspects this relates to concerns by regulators that regulator-initiated deferrals on surplus notes could create a perception and confidence problem for the insurer in the marketplace, and potentially worsen their financial situation, as opposed to improving it.
As a result of its updated analysis of regulatory behavior and likely market perceptions in the U.S., Fitch now views surplus notes as being more debt-like, as opposed to equity-like, from the perspective of both investors in surplus notes and the insurance companies that issue them. Therefore, going-concern loss absorption, such as deferral risk, is not an additional risk assumed by the investor that is not already factored into the instrument rating. However, this also means that surplus notes provide limited financial flexibility to insurance companies as they start to experience financial stress. As outlined above, Fitch concluded that the best way to address its updated view is to keep surplus notes rated the same as they were previously, but to reduce the equity and capital credit provided to these securities.
Fitch has differentiated its approach to 'equity credit' and 'capital credit' for U.S. surplus notes based mainly on the accounting statements used in applying each concept. Equity credit is typically applied to financial leverage ratios based on U.S. GAAP accounting principles, which apply a 'going-concern' approach to the valuation of shareholders' equity and capital. In contrast, capital credit is applied to capital adequacy ratios based on Statutory Accounting Principles, which apply more of a 'liquidation approach' in the valuation of statutory capital. Thus, Fitch recognizes the loss absorption surplus notes provide in liquidation (due to their deep subordination to policyholder obligations) in its approach to capital credit, which is a liquidation-based concept, compared to its approach to equity credit, which is a going-concern concept.
Additional information is available at 'www.fitchratings.com'.
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE.
Fitch Ratings, Chicago
Julie Burke, CPA, CFA, +1-312-368-3158
James B. Auden, CFA, +1-312-368-3146
Douglas L. Meyer, CFA, +1-312-368-2061
Media Relations, New York
Brian Bertsch, +1-212-908-0549
[email protected]
Source: Fitch Ratings
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