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Rating Action:

Moody's changes review of River Lake III's insurance-linked securities to possible downgrade

29 Jun 2009

Approximately $750 million of securities affected

New York, June 29, 2009 -- Moody's Investors Service announced that it is continuing its review of the ratings of $750 million of insured insurance-linked securities issued out of a series of trusts ("Trusts") associated with River Lake Insurance Company III ("River Lake III"), but changing the direction of the review to possible downgrade from direction uncertain. River Lake III is sponsored by and wholly-owned by Genworth Life and Annuity Insurance Company (GLAIC, A2 for insurance financial strength/negative outlook), which is ultimately wholly-owned by Genworth Financial, Inc. (Genworth, NYSE: GNW, senior debt at Baa3/negative). The change in review direction affects $250 million of INC Term Securities, Series RLIII 2006-1 ("Term Securities", senior debt at A2) due 2036 and five separate $100 million of INC Money Market Securities, Series RLIII 2006-1 through 5 (collectively referred to as "MM Securities", senior debt at A3) each due 2036. The Term Securities are issued out of Insurance Note Capital Term RLIII 2006-1 and the MM Securities are issued out of Insurance Note Capital MMS RLIII 2006-(1 though 5).

Moody's said the change in review direction to possible downgrade is driven primarily by the adverse impact on the securities' estimated probability of default (PD) due to the significant increase in expected credit losses on the residential mortgage-backed securities (RMBS) in River Lake III's investment portfolio, as well as the higher (almost 200 basis points per annum) funding costs associated with the ongoing Dutch Auction failure affecting the MM Securities, which may continue for the intermediate- to long-term. In addition, the model previously used to monitor the transaction had a downward bias in its estimate of PD and expected losses (EL) which has since been corrected.

These adverse factors are somewhat offset by the actions taken by Genworth including recapture of business, potential future recaptures, obtaining approval for River Lake III's reinsurance trust to be trued-up on a book value basis, and other measures under consideration. The Term Securities and MM Securities benefit from the recapture of about 25% of the total statutory reserves to-date and approximately 20% of additional statutory reserves expected to be recaptured in the next two years by GLAIC, which is the ceding company in the underlying reinsurance agreement with River Lake III.

The rating agency commented that the net impact of these offsetting developments is a deterioration in the transactions' cash flows, impacting in particular the estimated PD of the securities, thus resulting in the change of the direction of the review to possible downgrade. Moody's said that the elevated expectations of investment losses and the higher funding costs could result in a multi-notch downgrade of the securities, especially for the MM Securities which are directly impacted by the Dutch Auction failure.

Moody's said that the focus of the review will be on refining its assessment of the potential economic losses of River Lake III's investment portfolio and the impact of such losses on the EL and PD of the securities evaluated under various scenarios, the impact of the sponsor on the ratings, and the differentiated impact of the Dutch Auction failure on the two classes of securities. According to Shachar Gonen, Moody's Analyst, "During our review, we will evaluate the impact of any potential actions that GLAIC may take to protect its interest in the transaction, as well as the dependency of the transaction on the credit profile of Genworth and GLAIC, and the extent to which this may effectively cap the ratings. Some of the changes currently under consideration could be very favorable to the credit profile of the notes, but would not be expected to result in revised ratings higher than those currently assigned."

The rating agency stated that the ratings of the securities are meaningfully influenced by estimates of expected loss and probability of default derived under various scenarios using stochastic modeling of the insurance cashflows of the term life business reinsured to River Lake III and the performance of the underlying invested assets. The actuarial performance of the underlying level premium term business supporting the reserve funding structure has been consistent with Moody's expectations, and has not contributed to the credit deterioration of the transaction. In addition to the higher cost from the MM Securities' Dutch Auction failure, the concentration of invested assets in mortgage-backed securities (approximately 20% of book value at 12/31/08) has contributed materially higher expected loss content than previously expected. Furthermore, higher expected losses on other structured securities and corporate bonds as a result of the recession will place additional pressure on the ratings.

Moody's current rating action, to change the direction of the rating review to possible downgrade, also reflects a correction of an error contained within a model used to monitor the transaction. Since 2008, Moody's had rated these securities in part based on output from a model with an error that understated both the EL and PD of the securities. Giving consideration to the various scenarios suggested by a corrected model, the ratings on the Term Securities and the MM Securities would likely have been lower by multiple notches. However, actions taken by Genworth to-date have improved the credit profile of the securities and served to offset deterioration in the transaction that had been understated by the previous monitoring model. The review will consider updated performance of the securities under various scenarios derived using the corrected model as well as the impact of actions taken by Genworth to support the transaction, as detailed above.

On the positive side, Moody's noted the Term Securities and MM Securities are no longer negatively impacted by collateral payments required for changes in the market value of the investment assets due to recent changes which required regulatory approval. As such, River Lake III is able to carry assets in its regulatory reserve trust account on a book value basis, thereby eliminating the need to true-up assets due to mark-to-market value declines; previously, there was the risk of erosion of the capital of River Lake III from required true-up transfers of unencumbered assets into the reserve trust account to the point of a breach of a capital covenant and a resultant event of default.

The rating agency also cited as a positive the benefit from the multiple recaptures of portions of the business ceded to River Lake III executed by GLAIC. The amount of regulatory reserve relief provided by the transaction to GLAIC is effectively capped by the amount of outstanding surplus notes ($750 million) issued by River Lake III as part of the transaction. By recapturing the "excess" portion of the reinsured business, GLAIC can seek alternative solutions to obtain maximum regulatory relief from the underlying regulatory reserves. The recaptures, in turn, benefit the holders of the securities because (1) GLAIC must pay a penalty fee to River Lake III when it recaptures business, (2) the capital associated with the recaptured business remains with River Lake III, and (3) the mortality risk exposure in the transaction is reduced post-recapture because of the smaller remaining inforce.

River Lake III, a special purpose captive reinsurer sponsored by and wholly-owned by GLAIC--an operating company of Genworth--was established for the purpose of financing collateral for the excess statutory reserves associated with distinct blocks of business ceded by GLAIC. The reinsurance agreement between GLAIC and River Lake III covers defined blocks of level premium term life policies subject to the statutory reserve requirements of Regulation XXX.

Surplus notes issued by River Lake III are held by the Trusts, which have issued the Term Securities and MM Securities--with payment terms identical to the surplus notes--in order to fund the excess reserve requirements of GLAIC. According to the rating agency, the primary source for River Lake III to service its surplus note payments is the investment cash flows received on the assets that River Lake III has acquired with the proceeds of the securities issuance, and to a much lesser extent, reinsurance profits. The acquired assets are held as collateral in a regulatory reinsurance credit trust account for the purpose of securing the statutory reinsurance reserve credit that GLAIC takes with respect to its reinsurance transaction with River Lake III.

Moody's ratings on securities that are guaranteed or "wrapped" by a financial guarantor are maintained at a level equal to the higher of a) the rating of the guarantor or -- as in this case -- b) the published underlying rating. The A2 rating for the Term Securities and the A3 ratings for the MM Securities reflect this modified "credit substitution" approach and are equal to the underlying ratings on these securities. Moody's approach to rating wrapped transactions is outlined in Moody's Special Comment entitled "Assignment of Wrapped Ratings When Financial Guarantor Falls Below Investment Grade" (May, 2008). All of the securities are insured under a financial guaranty policy, which covers timely interest payment and ultimate principal payment, provided by Financial Guaranty Insurance Company (FGIC, not rated).

The following ratings were changed from review with direction uncertain to review for possible downgrade:

$250 million INC Term Securities, Series RLIII 2006-1 debt rating of A2;

$100 million INC Money Market Securities, Series RLIII 2006-1 debt rating of A3;

$100 million INC Money Market Securities, Series RLIII 2006-2 debt rating of A3;

$100 million INC Money Market Securities, Series RLIII 2006-3 debt rating of A3;

$100 million INC Money Market Securities, Series RLIII 2006-4 debt rating of A3;

$100 million INC Money Market Securities, Series RLIII 2006-5 debt rating of A3.

The last rating action on the Term Securities and MM Securities associated with River Lake III occurred on April 9, 2008 when Moody's upgraded the ratings on the securities—Term Securities to A2 from Baa3, and MM Securities to A3 from Baa3—and placed all the ratings under review with direction uncertain. The upgrades reflected the change from basing the ratings on the ratings of FGIC to the underlying ratings of the securities in accordance with Moody's modified "credit substitution" approach.

The Term Securities' and MM Securities' ratings were assigned by evaluating factors believed to be relevant to the credit profile of the Term Securities and MM Securities such as (i) the demographics and actuarial experience of the referenced block of (re)insurance business, (ii) relevant industry experience for similar products/underwriting, (iii) review of independent actuarial report, including assumptions underlying projected cash flows, (iv) expected loss and probability of default estimated via stochastic modeling of the insurance cashflows and the performance of invested assets, and (v) other factors believed to be applicable to the assessment of the creditworthiness of the transaction, such as a review of the structural, legal, and regulatory risks.

Other methodologies and factors that may have been considered in the process of rating these securities can also be found at www.moodys.com in the Credit Policy & Methodologies directory, in the Ratings Methodologies subdirectory.

For more information, visit our website at www.moodys.com/insurance.

New York
Robert Riegel
Managing Director
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Shachar Gonen
Analyst
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Moody's changes review of River Lake III's insurance-linked securities to possible downgrade
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