New Risk Assesments for Life Lenders

September 25, 2013

Did you know that there are new risk assessments for life lenders?

On July 17, 2013, the Financial Condition Committee of the National Association of Insurance Commissioners (NAIC) adopted new rules for monitoring Risk-Based Capital (RBC) for commercial mortgages in good standing held by life insurance companies. These new rules replaced the Mortgage Experience Adjustment Factor (MEAF) which had been the prior standard.

Critics of the MEAF standard had argued that under certain market conditions, use of the MEAF could magnify even minor differences amongst insurance companies. Unlike the prior MEAF structure, the new rules will reflect the migration of loans to different risk cohorts over time, resulting in a natural increase to RBC as market conditions deteriorate and a reduction of RBC when market conditions are favorable. This will provide companies with a greater ability to plan appropriate capital use and allocation.

The goals of developing the new standards were as follows:
1. Improve the objectivity of the regulatory tool used to assess RBC.
2. Objectively evaluate the risk level of individual commercial mortgages.
3. Assess risk using loan-level information.
4. Appropriately distinguish between differing levels of credit risk.
5. Derive RBC factors for each risk category.

The new standards will determine the RBC component for a life insurer’s portfolio of commercial mortgage loans using a process similar to that now used to assign capital charges to corporate bonds.

New Measures to Assess Risk of Default
Standard and familiar commercial mortgage industry measures, specifically debt service coverage (DSC) and loan-to-value (LTV), were adopted as good indicators of default probability. RBC for performing commercial mortgages will therefor be based on these two measures; however, RBC for non-performing loans will continue to be computed as before.

The new risk assessments for life lenders will asses the risk of assets held by life companies so that regulators will be able to identify weakly capitalized companies. Capital requirements will change over time as loan characteristics and portfolio composition evolve with market conditions.

This approach is similar to the method used in the banking industry to asses regulatory capital requirements for CRE loan assets by focusing on the ability of borrowers to make payments as required by the terms of the loan.

Components of the New Model
The new model consists of the following components:
1. Establish five risk cohorts for commercial mortgages in good standing and assign an RBC charge to each cohort.
2. Assign each loan in good standing to one of the risk cohorts based on its DSC and LTV.
3. Apply the assigned RBC factor to the statutory carrying value of each loan, and sum the result in order to determine the RBC for commercial mortgages in good standing of he company.
4. Assign mortgages over 90 days past due or in the process of foreclosure to a sixth and seventh category, and apply factors of 18% and 23% respectively to the statutory carrying value.
5. Assign Farm/Ag loans in good standing to one of the five risk categories based on LTV only.

Analytical Tool—CMM
Commercial Mortgage Metrics (CMM), an analytical model developed and owned by Moody’s Analytics, will be used to evaluate future credit risk for commercial mortgages. CMM analyzes credit events which fundamentally depend on the financial condition of the borrower to make required payments, including the value of the underlying collateral, the market in which the collateral is operating, and the level of associated debt.

CMM uses algorithms to assess the likelihood of default based on commercial mortgage loan experience tracked from the 1970’s through 2010. Data tracked includes both loan level data and aggregate default rates for loans held by life companies, banks, and CMBS.

Debt Service Coverage (DSC)
Research has shown that DSC is a powerful predictor of commercial mortgage default risk and it is a largely objective calculation that uses actual revenues and expenses of the collateral to determine NOI. For the purpose of RBC , DSC will be calculated as the ratio of the property’s NOI to the loan’s standardized debt service.

NOI will be developed using standards provided by the CREFC Methodology for Analyzing and Reporting Property Income Statements. NOI will be adjusted to a 3 year rolling average for the DSC calculation. Standardized debt service will be determined based on a fixed 25 year amortization and either the actual interest rate for the fixed rate loans or the higher of the current rate or the average rate over the prior 12 months for variable rate loans.

There are additional rules for calculating DSC in special situations such as Cross Collateralization or Unavailable Operating Statements resulting from loans on owner occupied properties, borrower not providing annual operating statements, construction loans, non-senior financing, credit enhancements, or non-income-producing land.

Loan to Value (LTV)
LTV, which is a predictor of both default risk and severity of loss, will be determined by diving the current principal balance of all pari pass and senior debt by the current property value. Current property value will be determined by adjusting the appraised value from loan origination by any change in value of the NCREIF Real Property Price Index from the time of origination to the time of the measurement.

Restructured Loans
Life company lenders have significant flexibility when managing commercial mortgages to respond prudently to changes with a borrower, the property, or the economic environment. As portfolio lenders, life companies are not typically limited by REMIC rules or other provisions that restrict loan modifications. Under the new rules, performing modified commercial mortgages, or restructured loans, will be treated the same as other commercial mortgages that are not restructured.

Documentation and Confidentiality
This new program will be based on values and analyses that are not part of a life company’s annual statement. Documentation will be available to the insurance commissioner to examine on request as part of the RBC report; however, confidentiality of the documentation of these calculations will be protected as required under state statutes.

In light of tightening regulatory scrutiny throughout the financial industry, the NAIC has taken a proactive step to improve the method of monitoring life company portfolio commercial mortgage loans in order to determine appropriate levels of risk based capital. This forward looking move should provide a more objective and realistic assessment of commercial mortgage default risk, and these new risk assessments for life lenders should continue to provide for the safety and soundness of life companies that make commercial mortgages now and in the years ahead.

by David M. Rosenthal