WASHINGTON - A group of state insurance regulators next month will begin providing substitute credit ratings for some of the municipal bonds held by insurers, to prevent a possible sell-off of those bonds due to the credit crunch.

The ratings, to be issued by the securities valuation office of the National Association of Insurance Commissioners, could be used as a substitute for the ratings provided by credit rating agencies on bonds backed by downgraded insurers, to determine so-called risk capital assessments. These assessments determine how much capital insurers must set aside based on the risk associated with each of their investments.

NAIC is taking action because many of the insured bonds held by insurance companies had their ratings withdrawn after the bond insurer guaranteeing the security was downgraded to junk status and had no underlying rating to fall back on. So far, only three insurers - Financial Guaranty Insurance Co., CIFG Assurance NA, and ACA Financial GuarantyCorp. - have had at least one of their ratings downgraded to junk status, but NAIC is concerned that more bond insurers could follow suit.

"This change puts us in a position to address proactively any issues if there is further degeneration in the overall bond insurance market," said Wisconsin state insurance commissioner Sean Dilweg, who introduced the proposal.

Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, said the NAIC's proposal is "very significant" for insurance companies who have investment-grade standards for their holdings. When the bond insurers were downgraded, it left many insurers who own munis in a "very exposed place" because of the expectation that they may have to post additional capital, he said.

"Rather than be forced to allocate capital at levels that might not reflect their true credit quality, they're going to step in and provide a substitute rating," he said.

Collectively, the insurance industry holds about $420 billion of municipal bonds, about $145 billion of which are wrapped by insurance, according to the NAIC. The biggest holders of munis are life and casualty insurance companies, which are taxed at rates that make munis favorable investments for them.

An analyst at an insurance company that is one of the largest purchasers of municipal bonds in the industry said that munis are popular tools used to offset more risky investments in an insurers' portfolio. The analyst, who did not want to be identified, said munis provide the best after-tax, risk-adjusted return for the credit quality the insurance companies take on when they purchase them.

The NAIC has provided numerical "designations" for muni bonds for insurers for about a century, but previously was unable to provide designations that were higher than the ratings provided by a credit rating agency. Essentially, the proposal, which the NAIC plans to implement before final approval it in September, will "decouple" the NAIC rating from the rating agency process, said Michael Moriarty, deputy superintendant in the New York State Insurance Department. And instead of rating the security for insurers, NAIC will be assessing the creditworthiness of the municipality or authority that issued the debt, he said.

Under the proposal, the NAIC will provide numerical ratings on a scale of 1 to 6. Munis rated "1" or "2" will be considered investment grade, with "1" equivalent to A-minus, A3, or better, while "2" will be equivalent to triple-B. Meanwhile, ratings 3 through 6 will be considered below investment grade, with a "6" being considered a "near default bond," according to Mikaela Reck, public information officer for Dilweg.

Moriarty said that the NAIC's securities valuation office will review public records and financial statements to come up with a rating in about a week's time, depending on the size of the municipality or authority, stressing that it will not be as in depth as a review by a credit rating agency.

"It would be kind of a 'light' rating agency type of review, but we feel it would give a fairly accurate assessment of the creditworthiness for the calculation of the risk-based capital that the company is required to hold," he said.

Market participants said yesterday that the NAIC's proposal was a step in the right direction.

But the analyst at the insurance company had mixed feelings about the proposal. He said many research analysts have been laid off in recent years as the market has come to rely more heavily on ratings from the nationally recognized credit rating agencies and fewer buy-side firms are performing their own analysis of underlying muni credits, he said.

"NAIC needed to do something and they'll probably do an okay job, but the bottom line is the marketplace needs to step up and begin to evaluate assets again," he said.

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