Don’t give life insurers an easy out

September 25, 2009

As G20 nations discuss ways to force banks to fatten their capital reserves, the U.S. life insurance industry is lobbying for the opposite. It wants capital requirements against soured mortgage bonds eased, and is using the current outcry against the rating agencies to argue its point.

This sends the wrong message. Regulators should resist such a call to ease up on an industry that had no business making such disastrous investment decisions in the first place.

Insurers loaded up on residential mortgage-backed securities during the boom years when few questioned the potential pitfalls of holding bonds backed by subprime home loans.

At the end of last year, they held more than $145 billion of such loans, according to the American Council of Life Insurers, which is lobbying regulators for an easing of capital requirements.

This year, ratings downgrades have forced insurers to set aside more precious regulatory capital to better buffer against potential losses — something the ACLI thinks is unfair because it doesn’t like the models being used by the rating firms.

It wants regulators to hire an independent third party to put into effect what it considers to be a better measure of risk. This measure would also be more favorable to the industry since it would lower capital requirements.

The ACLI says its suggested model would better estimate the severity of potential losses rather than focus primarily on the probability of losses, as existing ratings do, according to its proposal posted at the National Association of Insurance Commissioners (NAIC) website.

To be sure, rating agencies lost much of their credibility after they gave triple-A ratings on securities that soon imploded, but so have the insurers. They packed their investment portfolios with mortgage bonds as well as commercial real estate debt, which is in the middle of its own slow-motion train wreck.

In AIG’s case, it actually used borrowed funds through its securities lending business — also a questionable business for an insurer to be in — to invest in mortgage bonds. Those securities now sit on the Federal Reserve’s balance sheet.

Not to play down insurers’ current hardship, but scrapping ratings from the likes of Moody’s Investors Service and Standard & Poor’s for an industry-approved model would be foolhardy. If insurers can shop for more friendly ratings, what would stop other financial institutions from lobbying their regulators for the same kind of treatment?

It’s also not the time to be arguing for lower capital requirements when the financial system and economy are still on the mend from last year’s battering.

Instead of focusing on ratings, the regulators should be more worried about curtailing the type of securities insurers can invest in. Arguably, they shouldn’t have branched out into such complicated securities in the first place.

If they need an elaborate model to estimate losses, then the NAIC should tell insurers to steer clear. After all there’s plenty of debt backed by the government to go around.

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