Given the continued volatility in the Eurozone, European banks have been downgraded in recent months and are at risk for additional downgrades by one or more of the nationally recognized statistical rating organizations (NRSROs). U.S. bank ratings have also been lowered, or are at risk of downgrade, due in part to the impact of a weak global economy on their earnings prospects, as well as their exposure to the sovereign debt of Eurozone countries. In addition to the fundamental issues related to their core banking operations, the lower ratings could force banks to post additional collateral or possibly face the unwind of related derivatives transactions.

The latter could also impact insurers with respect to their derivatives exposure. Certain state laws require that derivative counterparties (i.e., banks) maintain a minimum credit rating. That is, insurers are not permitted to enter and have exposure to derivative transactions with counterparties that do not meet a minimum rating threshold. Upon the downgrade of a counterparty's rating below the minimum threshold, to be in compliance with applicable state laws, the insurer may be required to terminate, or unwind, any derivative transaction with the counterparty or request a waiver for the said requirement from the regulator. A forced unwind would result in the insurer having to replace the counterparty with one that is "approved" by applicable state law in terms of minimum rating requirement, among other factors, or abandon the derivative transaction altogether, either of which could be costly. Given that approximately 90% of the insurance industry's derivative transactions are used for hedging purposes, there are additional implications from a risk-management standpoint.

Therefore, the states should be cognizant of their applicable derivatives use laws and the potential impact of bank ratings downgrades. In addition, other bank-related investments that might be linked to ratings or have minimum counterparty ratings requirements, such as letters of credit, might also be impacted by the potential for lower bank ratings. The NAIC Capital Markets Bureau will continue to monitor any related trends pertaining to this topic.

Given the current environment in Europe, and as a means to ensure access to funding, some European banks have entered into "liquidity swaps." These liquidity swaps involve European banks selling (the illiquid) securities to counterparties (i.e., investment banks or insurance companies) in exchange for a discounted value of government bonds or other liquid assets. In turn, the European banks utilize these swapped liquid assets as collateral to secure loans from the European Central Bank (ECB).

Demand for liquidity swaps has increased in Europe in recent months, particularly between European banks and insurers. According to a guidance consultation paper written by the United Kingdom's Financial Services Authority (FSA) in July 2011, liquidity swaps between European banks and insurers are an increasing trend, causing the FSA to become concerned about the spread of systemic risk (that is, resulting in continued collapse of the financial system) in Europe. The suggested rationale is that liquidity swaps offer a solution to insurers' search for yield, and they also fulfill the banks' need for liquidity. For a fee, the banks can pledge illiquid structured assets (at a discount) in return for liquid collateral.

The FSA also is concerned about the interconnectedness between the insurance and banking sectors, meaning that a bank failure could also cause distress or failure among connected insurance companies. Thus far, we have not seen any evidence that insurers in the United States have engaged in this activity. However, the Capital Markets Bureau believes that liquidity swaps could present issues to be concerned about if U.S. insurers become active in this market. If U.S. insurers did become involved in this market, then they might be reported as either a repurchase agreement, which we do not view as appropriate, or as a sale and long-term purchase commitment.