The regulatory treatment of hybrid securities held by insurers has recently received significant attention from the capital markets and the insurance industry. Hybrids are complex, uniquely structured instruments with characteristics of both equity and debt. Typically, they have an extended maturity or no maturity and are callable at the issuer's option after a defined period of time. In the issuer's capital structure, hybrids generally rank senior to common equity and may in some circumstances rank pari passu with preferred stock. Hybrids typically allow the issuer to defer payments during times of financial distress.
In March 2005, the Securities Valuation Office (the "SVO") of the National Association of Insurance Commissioners (the "NAIC") classified certain hybrids as common equity, which, according to interested parties, has created two issues in the market for such securities: (1) insurers will disfavor the securities as investments because common equity treatment adversely affects their risk-based capital ("RBC") calculations and (2) the SVO's classification disclosure procedures have led to inconsistencies in the availability of information to market participants.
A. The SVO and Classification. The SVO performs credit quality assessments and valuations of securities held by insurers. Securities filed with the SVO for valuation purposes are assigned an NAIC rating designation (1-6) unless the security is filing exempt ("FE"). Bonds or preferred stock with unqualified ratings from a Nationally Recognized Statistical Rating Organization ("NRSRO") (e.g., Moody's or S&P) and common stock publicly traded on a national exchange are FE.
In 1996, classification guidelines were developed by the NAIC in response to challenges presented by hybrids. Requests for the classification of a security as debt, preferred or common equity can be submitted to the SVO by regulators, issuers and insurers. The guidelines provide three securities profiles (debt, preferred or common equity), which an SVO analyst will use to compare five factors of a security: contractual promise, rights, periodic payments, maturity/redemption and involuntary redemption. The analyst also looks to the totality of the security and its economic context to determine whether other factors suggest a classification.
Securities classifications and rating designations affect the RBC factors applied to insurer investments. Insurer investments in securities are assigned risk factors under the RBC rules intended to capture the risk of default of interest or principal and fluctuations in fair value. RBC factors for debt/preferred stock are significantly lower than those for common stock. (For example the RBC factor for unaffiliated debt held by a life insurer is 0.4% compared with a 30% RBC factor for common stock.) In addition, RBC factors for highly rated securities, such as securities with an NAIC 1 designation, are lower than those applied to lower rated securities.
B. Regulatory Developments and New Classifications. Prior to 2006, insurers generally reported hybrids as bonds. However, in the spring of 2005, the New York State Insurance Department ("NYID"), chair of the NAIC's Valuation of Securities Task Force (the "VOSTF"), expressed concern that insurers were improperly classifying hybrids. In the fall of 2005, the NYID asked a domestic insurer to file a particular hybrid security with the SVO for classification. On March 15, 2006, the SVO notified the NYID that the security in question should be classified as common equity. Thereafter the NYID instructed certain insurers to report other hybrid securities to the SVO for classification and requested that the SVO draft an explanation of its classification process, which was posted on the NAIC website (See "Statement on Classification Analysis," available at www.naic.org).1
Market Concerns Created By SVO Classifications Of Hybrids As Common Equity
The NYID's direction to domestic insurers to reclassify certain hybrids in accordance with SVO guidance generated significant reactions from the financial press and capital markets participants. Concerns were raised about the classification process for hybrids, the disclosure of classification information, and the authority of the SVO to issue the Statement on Classification Analysis.
A. Arguments for Classification of Hybrids as Debt or Preferred Equity.
Interested parties testified that hybrids should be treated as debt or preferred equity because they are traded and function like fixed income securities in terms of regular periodic payments, a defined interest rate and the expectation that principal will be repaid. Furthermore, the issuer's credit quality should be factored into the SVO analysis because, interested parties argued, although in times of financial distress hybrids can function like common equity, the likelihood of that happening is remote for highly rated issuers.
B. Effect on Insurers and the Market for Hybrids.
Insurers represent a large percentage of the current market for hybrids, and interested parties argued that the uncertainty surrounding SVO classification has created market inefficiencies. If hybrids are treated as common equity, the resulting RBC treatment and capital reserve requirements would require insurers to seek a much greater return on such securities. For smaller insurers, common equity treatment could result in a downgrading of their portfolios despite the high credit rating of the securities they own. Consequently, insurers have either sold their holdings or have not participated at all, thus lowering prices and decreasing the liquidity of the instruments.
C. Limited Disclosure of Classifications Creates an Asymmetry of Information in the Marketplace.
Interested parties requested transparency in SVO operations - specifically publication of SVO classifications in press releases and website postings - and increased disclosure regarding the rationale behind each such classification or reclassification. Difficulties faced by investors in accessing this information is reported to create an asymmetry of material information in the marketplace. In some cases, issuers have remedied the inequality of information on an ad hoc basis by issuing press releases stating the classification determination by the SVO (and sometimes by filing a Form 8-K or 6-K).
In response to these concerns the NAIC formed the Hybrid RBC Working Group (the "Hybrid WG"). The Hybrid WG and interested parties prepared a definition of "hybrids" and a proposed RBC treatment in 2006 (the "Short Term Proposal"). The Short Term Proposal was adopted by the RBC WG and its parent committee, the Financial Conditions (E) Committee, at the Fall 2006 NAIC Meeting held in St. Louis. Note, however, that in order for the treatment to become operative, the Short Term Solution must be adopted by the full NAIC at a Plenary meeting. The next scheduled Plenary meeting will take place at the NAIC Winter National Meeting (December 9-12 in San Antonio); however, a Plenary vote may be scheduled before such meeting.
A. Short-Term Proposal - Definition of Hybrids.
Under the Short Term Proposal, "Hybrids" are defined as:
Securities whose proceeds are accorded some degree of equity treatment by one or more of the NRSROs and/or which are recognized as regulatory capital by the issuer's primary regulatory authority. Hybrid securities are designed with characteristics of debt and of equity and are intended to provide protection to the issuer's senior note holders. Hybrid securities products are sometimes referred to as capital securities. Examples of hybrid securities include Trust Preferreds, Yankee Tier 1s (with and without coupon step-ups) and debt-equity hybrids (with and without mandatory triggers).
For 2006, this definition of Hybrids specifically excludes:
Subordinated debt issues with no coupon deferral
"Traditional" preferred stocks, including (but not limited to) issues which:
- for U.S. issuers do not allow tax deductibility for dividends; and
- are issued as preferred stock of the entity or an operating subsidiary, not through a trust or a special purpose vehicle.
The 2006 exclusions may be modified during the long-term review of risk components.
B. Short-Term Proposal - RBC Treatment.
The following scenario for the reporting and RBC treatment of Hybrids was adopted by the regulators without significant objection from the industry. The Short Term Proposal will be effective on the date it is adopted by the full NAIC (or when adopted by the E Committee) (the "Effective Date"), and will remain effective until the earlier of 1/1/08 or adoption of a long-term proposal by the NAIC.
Preferred Stock Classification of Hybrids - All Hybrids are to be reported as preferred stock except that Hybrids classified by the SVO as debt in 2006 will be reported as debt. (Accordingly, Hybrids classified by the NAIC in 2006 as common will be reported as preferred.)
Notching of Hybrids Issued After 8/18/05 and Before the Effective Date - All Hybrids issued after 8/18/2005 and those Hybrids classified in 2006 by the SVO as common stock are notched down by one NAIC Designation. Those Hybrids classified by the SVO as debt or preferred stock will not be notched.
Classification and Notching of Hybrids Issued After the Effective Date - All FE Hybrids issued subsequent to the Effective Date will be reported as preferred stock and notched down 1 NAIC designation, except that such securities filed and classified as debt or preferred stock by the SVO will be reported as debt or preferred stock appropriately with no notching. An insurer holding a "notched" Hybrid issued subsequent to the Effective Date may request SVO review of the security in an attempt to eliminate the notch. For Hybrids filed with the SVO, the designation assigned by the SVO must be used by the insurer. As per normal practice, SVO classification will apply to all holders of the security.
C. Effect on Tax Treatment of Hybrids.
For U.S. tax purposes, an instrument is generally classified as debt or equity using criteria established in a series of court decisions. In Notice 94-47, the Internal Revenue Service added to the list of criteria "whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes." Although the IRS might seek to bootstrap an SVO equity classification as a factor in the tax analysis, the Notice 94-47 criterion is of dubious authority under case law, and where the security's treatment under another regulatory regime materially differs from settled tax principles, the relevance of such treatment is not apparent. Therefore, it is doubtful that an SVO determination of equity status for a hybrid would bear significantly on the classification of the instrument for U.S. federal income tax purposes.
The Short Term Proposal will very likely be adopted by the NAIC at or before the NAIC Winter National Meeting. In the coming months, the NAIC will undertake the formulation of a long-term proposal for the definition and RBC treatment of hybrids. Risk factors for RBC purposes identified by the NYID and potentially subject to further examination include: the risk that any extension by the issuer making the hybrid a long-dated or perpetual security may adversely impact market value; the complexity, non uniformity and lack of historical data on Hybrids; the risk that the issuer's regulator will act to protect the issuer to the detriment of the investor; rating volatility and price volatility. In addition, a preliminary proposal related to SVO transparency is scheduled to be presented at the NAIC Winter National Meeting. For the near-term however, given the general acceptance of the Short Term Proposal by interested parties, it appears that, when adopted, the proposal will restore certainty and predictability to the treatment of hybrids by insurers.
1Since March, the SVO has issued eight reports detailing classifications and reclassifications performed in 2006 of 88 Hybrids of which 31 were classified as common equity.
Leah Campbell is Of Counsel and Serge Benchetrit is Partner in the Corporate and Financial Services Department, and Richard Reinhold is Partner in the Tax Department, of the New York office of Willkie Farr & Gallagher LLP. The authors thank Corporate Associate Andrew Marinello for his assistance in the preparation of this article.