S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Other CriteriaBond Insurance AdministrationThe Public Finance Department’s bond insurnace administration group is a keyintermediary between the insurance companies, the issuers, the bond market,the bond insurer ratings group, and the investor community, coordinating theactivities associated with providing insured and underlying credit ratings for newbond issues.Issuers must request a Standard & Poor’s rating on insured transactions. Inthose instances when an issuer does not choose to have Standard & Poor’s ratethe insured transaction, Standard & Poor’s will not issue, publish, or automaticallyassign the insurer’s financial strength rating to the transaction.For both new issue and secondary market debt, Standard & Poor’s does notprovide any official rating for insured debt until, and unless, an executed final insurancepolicy is made available. In the new issue market-where an issuer and itsunderwriters or advisers are in the process of negotiating, selling, or closing on abond issuance and an insurance policy is expected but not yet final-unless arequest for an underlying rating was made to Standard & Poor’s, no representationof a rating should be used or made. Once an insured rating is requested and thepolicy has been executed and presented to Standard & Poor’s, the enhanced ratingon the issue can be established.For debt issuers utilizing bond insurance, but with parity debt rated by Standard& Poor’s on an uninsured basis, it is necessary to submit the relevant transactiondocuments to Standard & Poor’s, in addition to the insurance company. Standard &Poor’s must review the proposed debt issuance to assess any outstanding, uninsuredparity debt ratings. In certain instances, issuers may plan to go to market on anuninsured basis but later change their mind and choose to use bond insurance. Inthose instances, the rating released on the debt issue may initially be based on theissuer’s own credit quality (uninsured rating), and is then subsequently revised toreflect the insurer’s financial strength rating once a policy has been issued byan insurer.All bond insurance policies are expected to cover 100% of scheduled principaland interest on a timely basis. Such policies should constitute an unconditional,irrevocable, and legal, valid, and binding obligation of the insurer in effect for thelife of the issue. If the primary credit obligor fails to make a payment, timely paymentis assured to bondholders by providing sufficient time under the terms of thepolicy for the trustee to notify the bond insurer. If an issuer defaults, there is nomandatory acceleration of liability, and payments will continue to be made by theinsurer based on the original schedule. The risk of monies being recaptured froma bondholder if the primary obligor becomes bankrupt (preference risk) mustbe covered in the insurer’s standard policy, in an endorsement, or by theissue’s structure.For help with public finance-related administrative issues and assistance inreaching bond insurance administrative personnel located in other ratings groupsat Standard & Poor’s, please call (1) 212-438-2074.Hurricane Katrina, it was assumed that hardest hitcredits generated claims immediately. For remaining,severely affected credits in the region, assumptionswere made about ratings declines, which carriedwith them higher capital charges.Losses can be moderated by various forms of soft(third-party) capital, such as business that has beenceded (reinsured) to third parties. Losses might alsobe moderated by unconditional, irrevocable banklines of credit. As in reinsurance, credit for thesefacilities is based on the credit quality of the bankand the appropriate structuring of the documentationso that the facility works in the context of ourmodel’s assumptions and requirements. A finalform of third-party capital for the industry is custodialtrust contingent preferred stock facilities. Ingeneral, the mechanics of these facilities establishtrusts that then enter into agreements that allow abond insurer to put its preferred stock to the trusts,at which time holders of the trust securities willbecome holders of the bond insurer’s preferredstock. Prior to that time, the trusts must be investedin high-quality (AAA/A-1+), short-term liquidassets. In terms of the dynamics of the model, reinsuranceand line of credit remittances are viewed asreductions to overall losses. Conversely, the contingentpreferred stock facilities are viewed as an additionto capital because of the issuance of bondinsurer preferred stock and corresponding receipt ofcash from the trust.Investment incomeExisting investments earn at their embedded rateand new investments earn at assumed conservativerates of interest throughout the forecast period.During the depression years, investment income isreduced to reflect defaults on non-‘AAA’ ratedbonds held for investment. Common stocks and allsecurities rated below ‘A’ are assumed to becomeworthless at the beginning of the depression. Lossesfrom the sale of investments are recognized in (1)the first two years of the depression because ofassumed interest-rate movements that result in aninverted yield curve and long-term rates rising atleast 600 basis points, and (2) throughout thedepression on certain less-than-top-rated instrumentsto reflect reduced liquidity in the markets.Premium written and earnedFor existing business, premiums are written andearned at their imbedded premium rates. For thegrowth book of business, premiums reflect currentmarket conditions and business plans. Because ofintense competition among insurers for many years,premium rates became a focus of attention regardingthe ability of insurers to maintain their capitaladequacy. In an environment where competitiveforces are causing premium rates to decline,Standard & Poor’s model picks up a significantamount of the effect of changing premium ratesbecause it forces the insurer to write new businessfor three years before the depression starts.Margin Of SafetyThe culmination of all the assumptions associatedwith the creation of a worst-case balance sheet andincome statement is the company’s ending, postdepressioncapital position. While important in its own right,and while solvency following a severe claims-payingenvironment is expected for an ‘AAA’ company, the310 Standard & Poor’s Public Finance Criteria 2007