Regulatory Update: Hybrid Securities and Risk Based Capital October 19, 2006

Transcription

1 2006 Annual Meeting & Education Conference American College of Investment Counsel New York, NY Regulatory Update: Hybrid Securities and Risk Based Capital October 19, 2006 Chris Anderson Merrill Lynch Global Markets & Investment Banking Elizabeth J. Byrne Life Insurance Council of New York, Inc. Dominic Guillossou Metropolitan Life Insurance Company Matti Peltonen New York State Insurance Department

2 Hybrid securities 10/19/06 Matti Peltonen, New York State Insurance Department Dominic Guillossou, Metropolitan Life Insurance Company Beth Byrne, Life Insurance Council of New York Chris Anderson, Merrill Lynch Global Markets (Moderator)

3 Hybrid Securities: Background Basil guidelines, October 1998, for Tier Is Non-cumulative dividends Legally perpetual Subordinated to all depositors and general creditors Available to absorb losses Five year (minimum) call protection Rate step-up permitted one time, after ten years at + 100bp or 50% of initial spread Result: Yankee issuance, >100 issues bn bn bn bn 2

4 Hybrid Securities: Background The constituencies: Issuers Regulatory authorities Rating agencies Tax authorities Accounting Investors (institutional / non-institutional) Usually symmetric treatment -- but not always 3

5 Hybrid Securities: Background Continuum: less -- or more credit toward computation of capital -- depends on the entity Senior debt Sub debt (20 yr NC10 deferrable) US Trust Preferreds (30 year trust issued cumulative) Debt/Equity Hybrid with and without a trigger Surplus Notes Preferred Stock (perpetual, non-cumulative) Common Stock 4

6 Hybrid Securities: Background Today s focus: Yankee Tier 1 (Coupon Step and Non-Step; bank and insurance- issued) Perpetual Preferred Stock/Shares US Trust Preferred / Capital Securities Debt-Equity Hybrid Securities with Mandatory Deferral Triggers Debt-Equity Hybrid Securities without Mandatory Deferral Triggers 5

7 Hybrid securities: Background Particularly these examples -- DEBT-EQUITY HYBRID with mandatory triggers US Deductible Hybrid Capital with a trigger, year subordinated debt, either issued directly or through a trust, with ability to optionally defer on a cumulative basis and requirement to stock settle ("Alternative Payment Mechanism" or "APM") if the issuer breaches the Mandatory Trigger - a predetermined financial trigger, ranking subordinated to US Trust Preferred but senior to preferred stock. DEBT-EQUITY HYBRID without mandatory triggers US Deductible Hybrid Capital without a trigger: 60 year subordinated debt, either issued directly or through a trust, with ability to optionally defer on a cumulative basis for up to 5 years and requirement to stock settle ("Alternative Payment Mechanism" or "APM") thereafter. There is no mandatory trigger, ranking subordinated to US Trust Preferred but senior to preferred stock. 6

8 Hybrid ACIC 10/19/06 Matti Peltonen Chief Risk Management Specialist Capital Markets Bureau New York State Insurance Department MPeltone@ins.state.ny.us

9 Hybrid securities: Definition Securities with characteristics of debt and equity Issued to raise rating agency and/or regulatory capital. Issued to provide protection to senior debt holders Exclude (statutory accounting is already clear): o o o 1) Surplus notes Subordinated debt with no coupon deferral features. 2) Traditional" preferred stocks, including e.g. those which a) do not allow tax deductibility for dividends in the U.S. b) are issued as preferred stock, not through a trust or a special purpose vehicle 8

10 Hybrid securities: reporting FE (filing exempt) rule permits insurance companies to translate an NRSRO rating into a NAIC designation, without filing the security with the SVO Despite FE, companies must report investments in correct RBC/classification bucket (bond/preferred/common/ other ) NRSRO = Nationally Recognized Statistical Rating Organization 9

11 Hybrid securities: reporting Insurance companies did not consider the debt/equity guidelines when filing hybrids (filed them predominantly as bonds) According to NRSROs (and many investors), most hybrids are (in terms of risk) like preferred stocks Most hybrids had never been classified by the SVO (especially since the FE rule) NY State Insurance Department required some hybrids to be filed in order to clarify/enforce the existing rules NAIC = National Association of Insurance Commissioners SVO = Securities Valuation Office of the NAIC 10

12 2006 SVO classified the Lehman E-CAP as common stock on 3/15, followed by other new hybrids (EIVs and secondary market) and some Tier 1 trust preferreds To date, 100+ hybrids have been classified, about 1/3 of those as common stock (in addition to some EIVs) Hybrid classification is difficult, due to the blended risk features: resulting classification did not necessarily achieve the accurate RBC charge the rules were not created with hybrids in mind EIV = Emerging Investment Vehicle RBC = Risk-Based Capital 11

13 Symmetry Issuer s perspective Hybrids are up to 75/100% capital from the rating agency perspective Hybrids work like equity during severe financial stress Investor s perspective The probability of severe financial stress is low Risk = probability of loss x severity of loss Summary: What is equity for the issuer, need not be equity for the investor 12

14 2006 The E-committee formed the Hybrid RBC Working Group Goals: short-term solution for filing hybrids on 12/31/06 Long-term solution: determine what risks are, how hybrids should be filed, and apply an appropriate RBC charge to hybrids RBC: to be determined by the American Academy of Actuaries 13

15 Hybrid risks What risks are not reflected in the NRSRO ratings, already notched below the issuer rating? Does the incremental spread (higher yield than similarly rated senior debt) mean hybrids have more risk? Lack of historical data, especially on the new features, how hybrids fare during financial stress 14

16 Hybrid risks? Credit: notched, but ratings not equal to senior ratings, hybrid ratings (may) fall faster Payment deferral: optional, mandatory, cumulative/non-cumulative May be used before than what the rating would indicate In a takeover, the likelihood of using deferral increases Is alternative settlement mechanism a risk factor for the issuer? Regulatory: Different regulatory regimes Regulators protect the issuer, to detriment of hybrid investors? Extension Impact on ALM: volatility, unpredictable use (e.g. replacement language) Market disruptions Used as arbitrage to replace common stock: do hybrids take stock risk? As amount outstanding increases, does the volatility increase? Legal New features untested by courts 15

17 RBC (Risk-Based Capital) In 2005 filings, classification as preferred stock had no RBC impact (same as bonds) Preferred classification has an impact on accounting (mark-to-market), depending on rating Classification as common stock impacted both RBC and accounting treatment (markto- market) Focus has been on the RBC charge (not classification) 16

18 Hybrid Working Group s short-term solution: All defined hybrid securities are reported as preferred stock Hybrids issued after 8/05 + those classified as common stock by the SVO in 2006 are notched down 1 NAIC designation All future hybrids are notched 1 NAIC designation, unless they are filed with the SVO and classified as preferred or debt 17

19 RBC charge / NAIC designation (Net of Tax) P&C Bond Pref 1 0.3% 0.3% 2 1.0% 1.0% 3 2.0% 2.0% 4 4.5% 4.5% % 10.0% % 30.0% Life Bond Pref 1 0.3% 0.3% 2 1.0% 1.0% 3 3.4% 3.4% 4 7.4% 7.4% % 17.0% % 19.5% Life: 3 and higher subject to AVR NAIC1: AAA-A 2: BBB 3: BB 4: B 5: CCC-C 6: D 18

20 Debt/Equity Guidelines The NAIC Financial Conditions Network requires different risk-based capital factors and reserves based on investment classification as debt instrument, preferred equity or common equity. Increasingly, debt and equity characteristics are combined in single instruments to blur lines between these three classes (e.g., a security may be characterized as debt even though the legal significance or likely economic result of certain of its provisions are more closely associated with preferred or common equity). VOS TF understands the need to provide guidelines to assist the SVO to classify filed securities appropriately and as consistently as possible. (SVO P&P Manual, Part Seven) 19

21 SVO Purposes and Procedures Manual: Debt/Equity Guidelines The 3 security profiles derive from considerations of these expectations and rights: The status accorded the holder of the instrument as either a creditor or as the holder of a corporate residual interest; The right or ability to influence issuer management; The deferability of periodic payments; The cumulative/non-cumulative nature of payments that have been deferred or defaulted upon; The basis for establishing an expectation as to maturity or redemption of the claim; and The nature of a claim in an involuntary redemption such as bankruptcy, liquidation or reorganization as either a debt claim or an equity interest. 20

22 Debt/Equity Guidelines (D) Factors / Criteria Not Listed in Guidelines: The SVO may incorporate factors or criteria not listed in the published guidelines in its analysis, although such factors are generally considered subsidiary to the published guidelines. (SVO P&P Manual, Part Seven) 21

23 Debt/Equity Guidelines (G) SVO's Exercise of Discretion These guidelines cannot anticipate or predict all variations of future innovations in the structuring of securities. SVO is charged with analytical responsibility for categorizing securities and may exercise its discretion to attain the purpose of these guidelines, subject to Part Two, Sections 3(c)(i) and (ii). Insurers may utilize the Emerging Investment Vehicle process described in Part Two, Section 3(c)(iv) to obtain guidance on the issues discussed in these guidelines. (SVO P&P Manual, Part Seven) 22

24 Hybrid securities 10/19/06 Dominic Guillossou Director Investment Grading Trading Metropolitan Life Insurance Company

25 Table of contents Why MetLife invests in hybrids Strategy Holdings Inherent risks Analysis Risk Management 24

26 Why MetLife invests in hybrids Spread business choice of risk Credit Duration Structure Relatively attractive risk adjusted spreads Increased yields Issuer diversification 25

27 Strategy Preference to go down in structure for highly favored issuers rather than lower rated issuers to pick up yield Mostly in financial institutions and to a lesser extent utilities and REITs No exposure to industrials Invest across the hybrid continuum Manage hybrids with an eye towards value while being cognizant of notching implications 26

28 Investment Grade Hybrids Holdings represent roughly less than 3% of total assets Yankee Tier 1 < 1.4% U.S. Capital Securities <.7% Surplus Notes <.5% Upper Tier 2 <.4% Traditional Preferred <.3% 27

29 Inherent Risk Credit (Captured by the NRSROs) Subordination Deferral Optional Mandatory Cumulative vs. Non-cumulative Extension Not credit risk and therefore not captured by the rating agencies Industry acknowledges the need for further review and analysis but its NOT credit risk 28

30 Analysis Credit Research analyst Structure Trader Legal Accounting Cash flow / Asset adequacy Actuary 29

31 Risk Management Economic capital model Limits by issuer Driven by ratings and duration Ongoing oversight by management 30

32 Hybrid securities 10/19/06 Beth Byrne Senior Vice President Life insurance Council of New York / bbyrne@licony.org

33 Table of Contents The interim solution The ultimate solution (prospects) Next steps Range of possibilities: Possible/likely outcomes 32

34 The Interim Solution NAIC Definition of Hybrid Securities: Securities whose proceeds are accorded some degree of equity treatment by one or more of the nationally recognized statistical rating organizations and/or which are recognized as regulatory capital by the issuer's primary regulatory authority. Hybrid securities are designed with characteristics of debt and of equity and are intended to provide protection to the issuer's senior note holders. Hybrid securities products are sometimes referred to as capital securities. Examples of hybrid securities include Trust Preferreds, Yankee Tier 1s (with and without coupon step ups) and debt-equity hybrids (with and without mandatory triggers). For 2006 this definition of hybrids specifically excludes: Surplus notes (file in Schedule BA) Subordinated debt issues which have no coupon deferral features (file in Schedule D - Part 1) "Traditional" preferred stocks (file in Schedule D - Part 2 - Section 1), including (but not limited to) issues which: a) for U.S. issuers do not allow tax deductibility for dividends; and b) are issued as preferred stock of the entity or an operating subsidiary, not through a trust or a special purpose vehicle. The 2006 exclusions defined above may be modified during the long-term review of risk components. 33

35 The Interim Solution Effective on the date this proposal is adopted by the full NAIC [or E Committee], until the earlier of 1/1/08 or adoption of a long-term proposal by the NAIC, the following short -term proposal is recommended: All defined hybrid securities are reported as preferred stock. All hybrid securities issued after 8/18/2005 and those hybrids classified in 2006 by the SVO as common stock are notched down by 1 NAIC designation. Those hybrid securities classified by the SVO as preferred stock in 2006 will not be notched. Those hybrid securities classified by the SVO as debt in 2006 will be reported as debt and not notched. All future FE hybrids issued subsequent to the effective date of this proposal will be reported as preferred stock and notched down 1 NAIC designation, unless they are filed with the SVO and classified as debt or preferred stock by the SVO (in which case they are reported as debt or preferred stock appropriately with no notching). An Insurer holding a "notched" hybrid security issued subsequent to the effective date of this proposal may request SVO review of the security in an attempt to eliminate the notch. For hybrid securities filed with the SVO, the designation assigned by the SVO must be used by the insurer. As per normal practice, SVO classification will apply to all holders of the security. 34

36 The Interim Solution No hybrids are common equity -- reversing the previous SVO decisions No hybrids notched by more than one NAIC notch Defined hybrids issued pre- 8/18/2005 are preferreds, but not notched (by one) unless previously classified as common by the SVO (grandfathered) Post- 8/18/2005 presumed to be notched by one notch -- unless there is relief 35

37 The Ultimate Solution Risk-Based Capital Does it have to do with Risk? What are the risk elements? Deferral Subordination Extension (embedded call option) X Anything else? Or is it about what industry can live with? 36

38 Next Steps Hybrid Securities (E) Committee The American Academy of Actuaries (did extensive work to develop the framework and risk factors of RBC in the 1990 s) Expect some input from the rating agencies and the NAIC now recognizes that its decisions affect more than insurers 37

39 Range of Possibilities The status quo? Industry has shown it can live with the interim solution It s not risk-based But is there a will to change? And time to change? A real risk-based solution Requires real effort Requires focus 38

40 Range of Possibilities Then there s always Left Field Despite questions from industry for the last six months attempting to agree on the relevant risk elements. Lingering concern: If there s a higher return is there higher risk? But what about other risks? Does this open the box for risk charges for liquidity, call, complexity, etc.? Big projects take lots of time and focus 39

41 Hybrid securities 10/19/06 Matti Peltonen, New York State Insurance Department Dominic Guillossou, Metropolitan Life Insurance Company Beth Byrne, Life Insurance Council of New York Chris Anderson, Merrill Lynch Global Markets (Moderator)