The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of US insurance companies. A list of archived Capital Markets Bureau Special Reports is available via the index
The Insurance Industry’s Investments in Residential Mortgage-Backed Securities
The U.S. insurance industry has historically been a significant investor in residential mortgage-backed securities (RMBS). The following table is a breakdown of the industry’s exposure as of year end 2010.
The majority of the industry’s exposure (74%) is in agency-backed paper — Fannie Mae (chartered as the Federal National Mortgage Association or FNMA), Freddie Mac (the Federal Home Loan Mortgage Corporation or FHLMC) and Ginnie Mae (the Government National Mortgage Association or GNMA) — which have the backing of the U.S. government. The remaining exposure, $127.8 billion in book/adjusted carrying value (BACV), consists of non-agency, or private label, securities. The above table also includes a relatively small exposure in home equity loan securitizations, though often these are not considered part of the RMBS market because of their relatively unique characteristics. The U.S. insurance industry’s exposure to RMBS totaled $499 billion at year-end 2010, a 4% decline from year-end 2009’s total of $520 billion. Agency RMBS exposure increased modestly year-over-year for 2010, from a total of $364 billion to $371 billion. Non-agency exposure, on the other hand, declined more significantly to $128 billion from $151 billion as of year-end 2009.
The reduction in exposure in non-agency holdings is not surprising, given that there has been nearly no new issuance in the past few years. In the meantime, existing holdings declined as a result of amortizations, as well as disposition activity and selected revaluations due to ongoing credit concerns. (Valuation guidance under SSAP No. 43R—Loan-Backed and Structured Securities – Revised, requires an insurer to reduce its carrying value by taking a realized loss through an other-than-temporary impairment (OTTI) or an unrealized loss by marking a bond to fair value.) On the latter point, as previously reported, the insurance industry took impairments and negative fair value revaluations in 2009 that totaled approximately $15 billion. The industry followed up in 2010, with additional impairments of approximately $480 million. However, improvements in liquidity and market sentiment also allowed the insurance industry to record fair value improvements that almost entirely offset the impairments taken.
It is also worth noting that the industry has significant holdings in the direct issues of Fannie Mae and Freddie Mac.
RMBS Modeling for Non-Agency Holdings
Beginning with year-end 2009, the NAIC changed the process by which state-regulated insurance companies determined risk-based capital (RBC) charges for non-agency RMBS. Previously, individual RMBS holdings were assigned an NAIC designation based on a formulaic translation of ratings from nationally recognized statistical rating organizations (NRSROs). For 2009 and 2010, the NAIC decided to instead model each individual RMBS holding, numbering approximately 20,000 securities, based on a common set of economic scenarios. The scenarios were adopted at the end of each year, after public exposure and discussion, by the Valuation of Securities (E) Task Force (VOSTF) and its parent committees. For both 2009 and 2010, five different scenarios were used and each translated into expectations for changes in home price values over the near and longer term. The assumptions used for the two years are detailed in the following table:
At the NAIC’s 2011 Spring National Meeting, the VOSTF expressed the intention to follow the same process for year-end 2011, with the expectation that the current procedure would be continued for the foreseeable future.
This process not only reduces the NAIC’s reliance on the NRSROs, but it also increases regulatory oversight of the process and ensures greater consistency over how NAIC designations are determined. In addition, it draws a comparison of the insurers’ BACV price to the expected recovery value for a particular holding. The NRSRO process had assumed that all bonds were purchased and held at par value. In what has been, since 2008, an extremely volatile marketplace for RMBS, this has rarely been the case. Instead, purchases are made at prices significantly different from par. In addition, statutory accounting guidance requires a regular review of holdings and, where appropriate, impairments are taken to reflect recovery expectations. Certain holdings also are required to be held at the lower of cost or market value. Given historically high levels of delinquencies, defaults and foreclosures on residential mortgages nationwide, this has had a substantial impact on the overall market of RMBS, including those holdings of the insurance industry. A dramatic decline in liquidity also has had an additional negative impact on the market value of holdings.
Each individual RMBS held by an insurer was modeled using these different scenarios, utilizing loan-level details (dated as of November in each respective year) on the individual assets underlying the RMBS. Modeling results were delivered to insurers at the end of December for each of their respective holdings.
A comparison of the modeling results for 2010 vs. 2009 reveals that the average expected recovery value of the insurance industry’s holdings for securities that were held in both years decreased modestly, from 83.29% to 80.61%.
The breakdown by NAIC designation, shown in the table above for 2010, is not materially different from the results at the end of 2009, when 78.3% of the insurance industry’s exposure received an NAIC designation of 1 or 2.
In considering the results, it is important to note not only the average of expected recovery values for each NAIC designation grouping, but also the relationship between those average expected recovery values and the average BACV prices for that NAIC designation. In the case of bonds receiving an NAIC 1 designation, the average BACV price is approximately 7.4 points below the average expected recovery value. The relationship reverses in the case of NAIC 2 and the margin of differential increases as the table progresses down to NAIC 6.
Using this modeling process, the relationship between the average BACV price and the average expected recovery value drives the differentials in NAIC designations, as opposed to the process employed prior to 2009, which relied on NRSRO ratings. The table below focuses on these differentials:
Following the same logic, bonds that received a higher, or better, designation than what otherwise would have resulted using NRSRO ratings had a BACV price significantly below the average expected recovery values. A significant percentage of bonds, 37.9%, reported the same designation. And, finally, a relatively small percentage was assigned a lower designation with the current procedure. The bonds that received a lower designation had a higher BACV price than the expected recovery value.
Prospects for the Future
There are indications that delinquencies in residential mortgages might be stabilizing. However, concerns continue to be prevalent. General home price indices have yet to show any significant or consistent strength. Without sustained improvement, the possibility of a further uptick in defaults will overhang the market. These concerns were highlighted in our previous special report titled, “Continuing Concerns for the Housing Market and Residential Mortgage-Backed Securities.”
As the insurance industry’s total exposure to RMBS has declined in recent years, especially in non-agency RMBS, an additional question is whether that trend will continue. Mortgage originations in general continue to be well below their peak in 2003–2005. Securitization of non-agency residential mortgages has been almost non-existent. At the same time, the federal government is discussing the prospect of unwinding Fannie Mae and Freddie Mac, and is looking to the private market to replace that capital. The beginning stages of that discussion were highlighted in another special report titled, “Issues and Challenges in Reforming the U.S. Housing Finance Market.” The non-agency securitization market’s ability to replace that capital will be impacted by rules regarding risk retention. However, if that is the long-term solution, it is difficult to imagine the insurance industry not playing a prominent role as a provider of long-term capital.
Questions and comments are always welcome. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org.
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