State Insurance Regulators Approve Municipal Bond Credit Rating Reform

June 2, 2008

State insurance regulators and their National Association of Insurance Commissioners (NAIC) moved forward this weekend with a regulatory response that they hope will help the municipal bond market by reducing pressure on insurance companies to sell bonds insured by downgraded bond insurers.

The reform, which takes effect July 1, will permit substituting a credit rating from the NAIC Securities Valuation Office (SVO) for the rating from a credit rating agency.

“We know that many municipal bond credit ratings are no longer accurate because they are based on the downgraded rating of the bond insurer, not of the municipal issuer. So we are stepping in to make sure that insurance companies have accurate ratings. The SVO has the tools to fairly rate municipal issuers,” said Wisconsin Insurance Commissioner Sean Dilweg, who made the proposal.

“Removing the current restrictions on our rating unit will permit insurance companies to submit downgraded municipal securities to it. The unit, where appropriate, will now be able to assign the correct rating to those municipal bonds. That will benefit both insurance companies and municipal issuers,” said New York State Insurance Superintendent Eric Dinallo, who chairs the NAIC Valuation of Securities Task Force.

Currently, when a bond insurer is downgraded, the municipal bonds it insures receive the same lower rating. That lower rating can result in the new rating for the bond being below the actual creditworthiness of the municipal issuer.

The downgrading of bonds they hold can create problems for insurance companies. At a minimum, companies would have to reserve more capital against the downgraded bonds, because reserves are determined by the risk of the investment. That reduces their appetite for municipal bonds. If bonds are downgraded to below investment grade, some insurance companies will no longer want to hold them. If many companies sell downgraded bonds, they would likely push down the market price and have to take a loss on the bonds. This could also increase municipalities’ cost of raising funds.

To avoid these problems, insurance company investors will be allowed to submit their municipal bonds to the SVO for credit assessment. Previously, the SVO was not permitted to assign a credit rating higher than that assigned by a rating agency. The new procedure would allow the SVO to determine its own rating based on its own analysis of the issuer’s financial strength.

Source: NAIC

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