The National Association of Insurance Commissioners is planning to hold a conference next month to evaluate whether the current ratings methodology used for public finance credits accurately reflects all long-term risks.
The NAIC represents state insurance regulators who oversee insurance companies that for tax and other reasons buy municipal bonds. The organization is not seeking to have any ratings changed, but it is looking for clarity on whether ratings assigned by the major agencies appropriately reflect certain risks to bond issuers, such as unfunded pension obligations, health care costs, infrastructure needs, and revenue instability.
“Our purpose is not to try to change what rating agencies do — as we don’t regulate them, we don’t have that kind of influence,” said Matti Peltonen, bureau chief of capital markets at the New York Insurance Department, which is co-sponsoring the event on Nov. 18 with the Illinois Department of Insurance.
“The purpose is to evaluate how we use ratings — is that still appropriate?” he asked. “Are the risk-based-capital factors accurate when looking forward?”
Representatives from the rating agencies are expected to participate. The NAIC created a rating agency working group in February 2009 to monitor insurers’ reliance on the agencies. The group held two conferences last year focused on structured finance and hosted a conference call on municipal market ratings.
Next month’s meeting, set to be held in New York, will mark its first all-day, comprehensive review of public-sector ratings. Muni participants have placed more emphasis on the underlying ratings of bonds since 2008, when most of the monoline insurers were downgraded to junk.
The downgrades caused many bonds to have their ratings withdrawn. That left property and casualty insurance companies holding the bonds in a bind, as they had no underlying ratings to help them perform risk-based capital assessments on the credit quality of the securities they hold.
The NAIC has provided numerical rating designations for bonds since 1947, but in June 2008 it began playing a more active, and less reliant, role. For the first time, it began providing designations that were higher than the ratings provided by a credit rating agency.
In its mandate, the rating agency working group says municipal bonds without a strong credit enhancement “are not actively traded, which reduces if not eliminates any pricing discovery, and accuracy, the bonds might have had when insured and more liquid.” It says an alternative valuation may need to be developed.
“The ultimate goal,” Peltonen said, “is for the risk-based capital charges to reflect risk accurately — what losses can we expect a portfolio of a certain kind to generate?”
According to Moody’s Investors Service, the average five-year historical cumulative default rate between 1970 and 2009 for investment-grade municipal debt was 0.03%, compared to 0.97% for corporate issuers. For speculative-grade debt, the rates are 3.4% and 21.4%, respectively.
But Peltonen said relying on history may not be appropriate in light of the unprecedented challenges facing state and local governments.
“Traditionally, the only way to measure performance is by looking at the history,” he said. “But at the same time, we know muni finances are turning worse, so I don’t know whether it’s enough just to look at the history. What we’re trying to evaluate is [whether there is] more to the picture that we should be taking into account?”
A February study by the Pew Center on the States found a $1 trillion gap between promised state retirement benefits and current funds as of June 30, 2008. It said “only a handful” of states have set aside any meaningful funding and it criticized states for “a lack of discipline.” The daunting gap does not reflect the second half of 2008 when “pension fund investments were devastated by the market downturn.”
All three major credit rating agencies say their ratings reflect such risks.
“We look forward to meeting with the NAIC to explain our rating approach to the municipal bond sector,” said Mark Tierney, a Standard & Poor’s spokesman. He said his agency undertakes “comprehensive ongoing surveillance of this sector, including the monitoring of obligations such as pensions and health care.”
Daniel Noonan, a spokesman from Fitch Ratings, pointed out that Fitch’s methodologies for municipal bonds are “transparent and timely, and the ratings properly reflect the complexity of this market.” He added: “Fitch has worked closely with the NAIC on a number of forward-looking issues since the crisis, and we hope this hearing on municipal bonds will be equally constructive.”
Michael Adler, a spokesman for Moody’s, said the municipal market faces important challenges that Moody’s analytical approach recognizes.
“We have been publishing frequent commentary which provides greater color on our perspective, and we hope to continue our constructive dialogue with the NAIC regarding our views,” he said.
Peltonen wouldn’t comment on whether he thought municipal bond ratings are too high. “We have concerns, but we’re trying not to make assumptions before we hear them out,” he said. “It could well be that rating agencies are taking all this into account, that they are critical enough about muni bonds. We just want to be able to evaluate that.”
