2Reducing the reliance on ratings in financial regulation has been a key element of the world-wide regulatory agenda following the poor performance in the financial crisis of ratings onstructured products by major credit rating agencies (CRA). Most notably, the Dodd-Frank-Actin the U.S. explicitly mandates federal agencies to remove references to ratings from rules to theextent possible. So far, the mandate of “replacing ratings” has not received much traction,mainly because of the lack of tested, viable alternatives (OCC, 2012).This paper aims to contribute to the search for viable alternatives to ratings by analyzing afundamental change in how capital requirements work for U.S. insurers. In 2009, the NationalAssociation of Insurance Commissioners (NAIC)
overhauled the system for capital requirementsfor structured securities: One of the key features of the reform was to replace ratings throughrisk assessments by PIMCO (for residential mortgage-backed securities, RMBS, since 2009) andBlackRock (for commercial mortgage-backed securities, CMBS, since 2010).
In this new systema second important feature was instituted: capital requirements do not only depend on
“expected loss” measures provided by PIMCO and BlackRock, but also are also adecreasing function of the
book value. Roughly speaking, the new regulationachieves that an insurer’s capital requirement for a security equals the difference between thebook value of a security and the “intrinsic value” based on the risk assessments. As our analysisreveals, both of these components are important to understand our results.This regulatory change in capital regulation should offer insights that are relevant above andbeyond the insurance industry, in particular for the banking industry. The new model, based oncredit risk measures for which the “regulator pays” (instead of using credit ratings for which the“issuer pays”), may offer a method for replacing ratings in financial regulation more generally.The insurance industry’s experience provides a laboratory for assessing the costs and benefits of one particular alternative to rating-contingent regulation. How good are the alternativemeasures of credit risk? Can the apparent conflicts of interest involved when regulation relies onrisk assessment performed by large investors be handled effectively by the regulator?Additionally, the change occurred at a time of severe stress for the industry, and thus providesan opportunity to study the political economy of financial regulation under imperfect conditionsand with conflicting agendas.Why did the regulator target the regulation towards the RMBS and CMBS markets? First,structured securities represent a key component of insurers’ asset portfolios: in 2012, structuredsecurities were 18.5% of assets (RMBS and CMBS constituted about half of this), second only tocorporate bonds, and ahead of government bonds, stocks, real estate, etc. Because many assetsin insurance companies’ portfolios are safe (e.g., treasuries, agency MBS) and carry the lowestpossible capital requirements, non-agency MBS represent most of the capital requirements forinsurers, in particular after unprecedented downgrades of RMBS securities whose capitalrequirements were mechanically related to ratings (under the old system). The officially stated
The NAIC is a coordinating body for state level regulators. Despite lacking formal authority, forpractical purposes, the NAIC, does much technical regulatory work, such as developing and implementingthe risk based capital system.
For non-structured securities, ratings are still used.