Standard & Poor's Corp. receritly revised its soft capital criteria for bond insurers, a move that could spur them to use a more diverse group of reinsurance providers.

The rating agency will now give 70% risk transfer credit to AA-rated reinsurance and a 30% credit to A-rated reinsurance, the firm said in a report issued Aug. 16.

At the same time, the rating agency presented new formal criteria on single-risk guidelines for third-party capital-support relationships.

Standard & Poor's defines soft capital as third-party arrangements made by the bond insurers to pay claims or make capital contributions. The arrangements are used by the insurers as a substitute for hard capital, which consists of policyholders' surplus and contingency reserves.

Until the revision, primary bond insurers received only 50% credit for AA-rated reinsurance and no credit for A-rated soft capital. Triple-A rated reinsurance will continue to be given 100% credit.

In the rating agency's depression model, it is assumed that the primary insurer will have to pay a certain percentage of claims due with resources of its own for other than AAA-rated reinsurance, depending on the underlying strength of the provider.

An increase in credit for AA- and A-rated soft capital essentially means the primary insurers can operate with less hard capital retention for non-AAA soft capital than in the past, according to Robert E. Green, a director in the Standard & Poor's financial guaranty/ mortgage banking group.

Asset Guaranty insurance Co., which obtained a double-A rating from Standard & Poor's earlier in August, is expected to be one of the primary beneficiaries of the revised criteria, market sources say.

Asset Guaranty is the sister company of Enhance Reinsurance Co. Enhance's long-standing relationships with the primary insurers plus its knowledge of the industry could give Asset Guaranty an advantage over AA-rated multiline reinsurers, some industry observers speculated.

A spokeswoman for the company said, however, that it is "premature" to speculate on how the revision will affect Asset Guaranty's

Depression Models

The agency was prompted to change its criteria based on the results of various depression model studies, Green said.

"The trends we saw in respect to defaults in comparison with our criteria for reinsurance didn't seem to fit. The existing criteria seemed to be conservative," he said. "We had to make an adjustment to better reflect the operating environment the stress test takes place in."

The financial guaranty industry's solid track record since the criteria were initially developed in the mid-1980s also prodded Standard & Poor's to refine the policy, Green said.

When the soft capital criteria were first developed in the mid-1980s, Municipal Bond Investors Assurance Corp. and AMBAC Indemnity Corp. were the only primary insurers with established track records, he said.

In addition, the rating agency assumed that financial guaranty activity was only a niche business for multiline reinsurers. Standard & Poor's report says these factors, in conjunction with the seven-year depression model, "made the durability of cessions to third parties a key consideration with respect to earlier criteria."

Since then, Green said, the industry as a whole has grown, additional players have established themselves, and relationships between soft capital providers and the primary insurers have matured.

The new criteria should help boost the industry's margin of safety by several percentage points, Standard & Poor's report says. The new credit criteria should also encourage the primary firms to make use of new soft capital providers, and the industry would benefit from an increased diversity of soft capital providers, the rating agency said.

"The dynamics have changed and the monolines will be more inclined to possibly target some new players," Green said. "Credit for A-rated providers certainly opens up that universe and greater credit for double-As improves pricing and credit risk."

Pricing Dynamics

It is too early to determine the impact of the new criteria, Green said, because "all parties involved will have to take time and look at the dynamics in terms of pricing."

Banks and multiline reinsurers are expected to comprise the majority of new soft capital providers targeted by the primaries, Standard & Poor's said. That should help mitigate the risks of "simultaneous worst case operating environments for a primary company and its soft capital providers," the report says.

At the same time it publicized the new criteria, the rating agency also announced formal single-risk guidelines for third-party capital-support relationships.

Standard & Poor's has developed tests that evaluate the performance of each primary insurer's single largest soft capital provider in two scenarios: A "nondepressionary" downgrade and a depression-driven default. The impact on the primary insurers' margin of safety is evaluated in both instances, with an adjusted margin of safety below 1.2 times considered a single-risk violation.

When the new criteria were applied, both Financial Guaranty Insurance Co.'s and Connie Lee Insurance Co.'s margins of safety dropped to where a violation might occur. Green said. However, both firms are expected to comply with the new guidelines by the end of the year, he said.

"We did not categorize either as a violation in recognition of solid years both companies are having in terms of earnings, dividend plans -- which are modest if any -- and corresponding high capital retention plans," Green said.

And an extra layer of protection is present in FGIC's case, Standard & Poor's officials noted.

FGIC's adjusted margin of safety reflects the hypothetical loss of its $150 million capital commitment provided by General Electric Capital Corp. In the event of a downgrade of GE Capital, a trigger mechanism in the structure provides for an immediate cash infusion to FGIC if its rating is threatened.

"This conservative trigger mitigates much of the longer-term risks associated with relying on third parties," the report says.

For the other players, the new criteria had the most dramatic impact on Capital Markets Assurance Corp., whose margin of safety fell to 1.5 to 1.6 times from 1.9 to 2.0 times. The margin is "still well above the single-risk threshold and average margin of safety for the industry," report says.

Aaron Task is a reporter for The Guarantor, a weekly newsletter of The Bond Buyer.

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