The National Association of Insurance Commissioners has hired Pimco, a unit of Allianz SE, as a third-party financial modeler to help state regulators determine the risk-based capital requirements that insurers face when they invest in residential mortgage-backed securities.

The NAIC is also still considering launching its own Nationally Recognized Statistical Rating Organization.

U.S. insurers owned about 18,000 residential mortgage-backed securities at year-end 2009. The new model will produce expected losses on those securities, which will help insurers match their holdings to the appropriate NAIC designation and accompanying risk-based capital requirements.

Pimco will work with regulators to develop a set of price ranges for designations one through six -- the NAIC's version of a credit rating -- that insurers will use to calculate the risk-based capital charges for each specific security they own. These designations will apply to year-end 2009 statutory reporting.

"It's critical to our solvency evaluation," Connecticut Insurance Commissioner Thomas R. Sullivan said. "To determine the health of the enterprise, we look at its [risk-based capital] level based on those capital charges. If the RBC levels drop, it's a warning sign to regulators to look more closely."

The NAIC selected Pimco after evaluating more than 20 proposals from various companies. "The NAIC's objective was to identify a vendor with a sound assessment methodology, proven ability to process a large amount of transactions in a very short time frame and processes and procedures in place to address potential conflicts of interest -- all at a cost-effective price," the NAIC said in a statement.

Ten years or more ago, the NAIC's Securities Valuation Office -- which is charged with evaluating the quality of insurance company investments -- used to rate all the assets held by insurers, but with the emergence of structured securities such as mortgage-backed securities and other new asset classes, that work became "extraordinary," Sullivan said.

So the NAIC set up an equivalency standard based on the ratings that the securities received by the Nationally Recognized Statistical Rating Organizations. (A.M. Best Co. is an NRSRO, but does not rate mortgage-backed securities.)

"That works fine and dandy if you can rely on the NRSRO. But if you pull the rug from the ability to rely on the NRSRO, it becomes challenging," Sullivan said.

As announced earlier this year, the NAIC action is designed to reduce regulators' reliance on traditional NRSROs and reflects a "loss of confidence" in the ratings for these securities that they produce, the association said (BestWire, Nov. 10, 2009).

Sullivan said the NAIC was also still considering creating its own NRSRO.

"We have not abandoned that prospect, and we continue to deliberate over that," Sullivan told BestWire. "What we do here [hiring Pimco] will impact year-end 2009 for financial reporting purposes. We are still deliberating over long-term solutions and evaluating all options. That is one...that would limit our dependence on the NRSROs."

Newport Beach, Calif.-based Pimco is a global investment management firm that manages investments for an array of clients, including state, municipal and union pension and retirement plans, individual and investment saving accounts, and public sector reserve management. Pimco said it has more than 1,200 employees. Attempts to reach the company for comment were not immediately successful.

In 2000, Pimco was acquired by Allianz SE, a large global financial services company based in Germany. Pimco said on its Web site that it operates as a separate and autonomous subsidiary of Allianz. Attempts to reach Allianz Life Insurance Company of North America were not immediately successful.

In a September NAIC hearing, a panel of insurance industry and ratings experts said the current use of ratings in insurance regulation and risk management is fundamentally flawed and in need of reform (BestWire, Sept. 25, 2009). The hearing closed with panelists urging more competition and the elimination of barriers to entry for new ratings agencies.

The NAIC cited the failure of ratings agencies to note problems with mortgage-backed securities until late 2007, more than two years after the problems first began to appear. The association also cited concerns about the "inherent conflict" of the issuer-pays ratings model.

A Valuation of Securities Task Force call, which is open to the public, is scheduled for Nov. 30 to discuss the model assumptions, which is a critical component of the new methodology. There will also be a task force briefing at the NAIC Winter National Meeting on Dec. 7 in San Francisco.