Moody's Investors Service's system of rating insurers has always been based on more than just capital requirements, the agency said yesterday in a teleconference held to respond to market reaction to recent rating decisions.
Discussing its move to put triple-A rated insurers Assured Guaranty Corp. and Financial Security Assurance Inc. on review for a possible downgrade, Moody's said that an insurer's capital adequacy - which the market tends to focus on - counts as just one part in its rating criteria. The agency said franchise value and strategy, portfolio characteristics, profitability, and financial flexibility all factor into any rating decision.
The comments come as a response to insurance executives and others who have complained that downgrades have been based on changing criteria. Moody's, for instance, recently placed Assured on review for downgrade even though the insurer exceeds Moody's triple-A target capital adequacy level by $120 million.
"Some think if a guarantor meets Moody's requirements for a given rating category then it automatically receives that rating," said Moody's managing director Jack Dorer. "Instead, capitalization is a necessary but insufficient condition for a financial guarantor rating."
Moody's also said it may consider making changes to its insurer rating criteria. If it decides changes are needed, Moody's will then likely ask market participants for input before making its final decisions.
"This really was meant to be a direct statement that we're looking at certain aspects of the methodology to determine if we should reconsider those aspects," Dorer said in an interview after the teleconference.
Both Assured and FSA could meet claims payments with a reliable level of certainty, but changing market demand and exposure to certain large and complex products may introduce a degree of volatility not consistent with a triple-A rating, Moody's said. Moody's said it will finalize its ratings decisions by early September.
Moody's expressed concerns about how a changing market will impact both Assured and FSA. The structured finance business has "ground to a virtual halt" and a company's ability to work in the municipal market has proven to be sensitive to its credit profile, Dorer said.
"As we've seen with other guarantors, not much has to go wrong for a company's fortunes to turn on a dime," Dorer said.
Even though both FSA and Assured largely avoided the collateralized debt obligations of asset-backed securities that have led to the downgrades of other insurers, they have exposure to other types of structured financial products.
FSA has already taken loss reserves on home-equity line of credit and alternative-A mortgage transactions and also has large exposures to corporate CDOs.
In addition, Moody's again questioned Assured's $40 billion exposure to corporate CDOs. Assured countered last week that a large portion of the debt is rated triple-A by the rating agency itself.
But the complexity of the financial instruments means past performance may not be a good way to judge the risk going forward, Moody's indicated.
"While these exposures have performed within expectations to date, the sheer size of these portfolios and their correlated sensitivity to detrimental performance among corporate borrowers in economic downturns could result in meaningful capital depletion if a few of these transactions were to sustain meaningful losses," said Moody's senior vice president Arlene Isaacs-Lowe.
A municipal-only guarantor would have a more likely chance of earning a triple-A rating than an insurer that also works with structured products, said senior vice president Stanislas Rouyer. He noted, though, that rising fiscal pressure on governments and competitive pressures could make a muni-only business more risky in the future. A number of current insurers have considered creating muni-only subsidiaries, while a number of new participants have said they may enter the market.
Market participants have told Moody's insurance penetration could return to a level of as high as 35% if muni-only, triple-A insurers populate the market, Dorer said in an interview. Just under 23% of new issues have been wrapped this year, compared to nearly 48% at this point in 2007, according to Thomson Reuters data.
Moody's also supported claims that double-A insurers could exist in the market. Depending on the entrance of new triple-A insurers, a large portion of the municipal market, such as smaller issuers, could still benefit from having double-A insurance, Rouyer said.
In regards to Security Capital Assurance Ltd.'s recent deal with Merrill Lynch & Co. to terminate eight credit default swaps for $500 million, Moody's vice president James Eck said it was a "clear positive." Commutations by other insurers could benefit both the insurers and counterparties by reducing uncertainty, he said.
In other insurer news, Fitch Ratings downgraded Financial Guaranty Insurance Co. to CCC from BBB and placed its rating on evolving watch. Fitch said it based its decision on the likelihood of further deterioration of its business of mortgage-backed debt.