Structured Securities Project

Last Updated: 5/9/2024
Issue: The financial crisis and the collapse of the housing market greatly impacted the mortgage-backed securities market, as delinquency and loss performance of residential mortgage-backed securities (RMBS)rapidly deteriorated to a degree that far exceeded the level of default expectations of credit rating agencies. By the time rating agencies reacted to the flaws of their modeling processes to adjust to the new market realities, an unprecedented massive ratings correction was necessary. The loss of market confidence on the Nationally Recognized Statistical Rating Organization (NRSRO) credit ratings and the aggressive downgrading actions that followed, directly impacted insurers’ RMBS investment portfolios and the assessment of their risk-based capital (RBC) charges which are tied to NAIC designations mapped to NRSRO credit ratings. In 2009, the NAIC initiated its Structured Securities Project to assist state insurance regulators in establishing a new methodology to determine RBC requirements for the RMBS and commercial mortgage-backed securities (CMBS) held by insurers.

Overview: By the middle of 2009, credit ratings of mortgage-backed securities had plummeted and the issuance of new mortgage securitizations had stalled. Following NRSROs’ radical revisions of their RMBS loss expectations (often revised to 20 times as high as the original loss estimates), and their downgrades of nearly 70% of all originally AAA-rated securities to non-investment grade levels, questions were raised about the extent of regulatory reliance on credit ratings. A key piece of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the elimination of credit ratings from financial regulation. 

The NAIC through its Securities Valuation Office (SVO) has its own credit rating scale, running from NAIC-1 (lowest risk) to NAIC-6 (highest risk, near or at default). All securities in insurers’ portfolios use these designations and their related factors to assess solvency capital requirements. While the SVO still evaluates non-rated securities and assigns appropriate risk designations, all rated securities, including RMBS and other securitizations prior to the crisis, had designations mapped directly to NRSRO ratings. 

Continued reliance on NRSRO ratings for year-end 2009 designations would have resulted in a nearly six-fold increase in life insurers’ RBC for mortgage-backed securitizations. A CIPR study reported that RBC charges for life insurers would have jumped from about $2 billion to more than $14 billion. The huge impact that the NRSRO ratings-based regulatory process for determining RBC had on insurance companies, along with the recognition of the data and methodological shortcomings that rendered NRSRO credit ratings inaccurate, necessitated the development for an alternative methodology. 

The alternative approach that was adopted by the NAIC in 2009 involved a new process to enable a more precise assessment of the value of RMBS held by insurers. The new approach for the valuation of insurer-held non-agency RMBS called for modeling each individual holding from a universe of 22,000 securities starting with filing year 2009 and continued each year since. The baseline for these scenarios was developed in conjunction with third-party financial modelers, using a set of economic assumptions and probabilities that reflect consensus on current market conditions while stressing it to best estimate meaningful differences in valuation across all scenarios. In 2010, the RMBS assessment process was expanded to include CMBS holdings. 

The financial modeling process is based on the selected vendor’s proprietary financial model providing the basis for the following analytical steps. The NAIC Structured Securities Group (SSG) considers this process as flowing through four analytical tasks: 1) macro-economic model; 2) loan credit model; 3) waterfall; and 4) valuation. There have been no changes in the result for ordinary RMBS since 2009. However, beginning with 2014, the NAIC SSG was empowered by the Valuation of Securities (E) Task Force to analyze credit risk transfer (CRT) securities issued by Fannie Mae and Freddie Mac. A detailed description of the analytical process of the SSG can be found at the CIPR study on the private-label mortgage securitization market challenges and the implications for insurers and insurance regulation. 

Third-party financial modelers have assisted state regulators in the assessment of RMBS, and more recently CMBS, holdings by U.S. insurance companies. They work with the NAIC to develop expected losses for each RMBS and CMBS individual holding. This allows state insurance regulators to map their RMBS and CMBS holdings to the appropriate RBC designation and accompanying solvency requirement. Additional information as well as reporting information can be found on the Structured Securities Reporting webpage.