Methodology. Rating U.S. Structured Finance Transactions

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1 Methodology Rating U.S. Structured Finance Transactions december 2014

2 CONTACT INFORMATION Chris D Onofrio Senior Vice President, U.S. ABS Global Structured Finance [email protected] Chuck Weilamann Senior Vice President, Head of U.S. ABS Global Structured Finance [email protected] Kathleen Tillwitz Managing Director, Head of U.S. & E.U. Operational Risk Global Structured Finance [email protected] Claire Mezzanotte Group Managing Director Global Structured Finance [email protected] RELATED RESEARCH Legal Criteria for U.S. Structured Finance Operational Risk Assessment for U.S. ABS Servicers Operational Risk Assessment for U.S. ABS Originators DBRS Unified Interest Rate Model for U.S. Structured Finance Transactions DBRS Master U.S. ABS Surveillance Methodology DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 Rating U.S. Structured Finance Transactions TABLE OF CONTENTS Scope and Limitations 4 Executive Summary 4 Operational Risk Review 5 Collateral Analysis 6 Transaction Financial Structure 7 Transaction Legal Structure 11 Cash Flow Analysis 12 Exhibit 1: Scope of Asset-Specific Commentaries/Detailed Press Releases 14 Appendix I: U.S. Consumer Loan ABS Transactions 15 Table 1: Summary of Typical U.S. Consumer Loans Multiples by Rating Category 17 Appendix II: U.S. Healthcare Receivables ABS 17 Appendix III: U.S. TV Programming Licensing Rights 23 Table 1: Summary of Typical Network Agreement Declines by Rating Category 26 Appendix IV: U.S. Insurance Premium Finance 27 3

4 Scope and Limitations DBRS evaluates both qualitative and quantitative factors when assigning ratings to a U.S. structured finance transaction. This methodology represents the current DBRS general approach for rating securitizations issued in the United States (with collateral originated in the United States). It describes the DBRS approach to analysis, which includes: (i) a focus on the quality of the sponsor/servicer, (ii) evaluation of the collateral pool and (iii) utilization of historically employed credit evaluation techniques. This report also outlines the asset class and discusses the methods DBRS typically employs when assessing a transaction and assigning a rating. It is important to note that the methods described herein may not be applicable in all cases. Further, this methodology is meant to provide guidance regarding the DBRS methods used in the sector and should not be interpreted as prescribing a rigid template, but understood in the context of the dynamic environment in which it is intended to be applied. Executive Summary The following methodology summarizes the DBRS approach typically used for rating structured finance transactions. This methodology provides a general guideline for the analysis of U.S. structured finance transactions and is complementary to, and may be used in conjunction with, the DBRS asset-specific rating approaches. In cases where DBRS primarily relies on this methodology for the basis of an initial rating in a new asset class, an asset-specific appendix, commentary or a press release 1 is published concurrently with the issuance of the transaction rating(s). The appendix, commentary or press release provides readers with a description of the key analytical considerations made in the rating of the transaction. DBRS generally issues an asset class specific methodology when market issuance and rating activity are sufficient to define the asset class. The key analytical considerations evaluated by DBRS generally include the following: Operational risk review; Collateral composition and historical performance; Transaction capital structure and priority of payments; and Legal structure and opinions. For each target rating, DBRS evaluates the risk related to the sponsor, other parties involved and the characteristics of the proposed collateral. DBRS performs an operational risk review of the key parties involved in origination and servicing of the assets to be included in the transaction. The operational risk review provides insight into the process that impacts the performance of included assets. DBRS analyzes the proposed financial structure under various cash flow stress scenarios to determine the ability of the transaction to repay the related securities. DBRS reviews the transaction s legal structure and opinions to assess that all necessary steps have been taken and no subsequent actions are needed to protect the issuer s interests in and to the assets Please see Appendix 1 for a general outline of the topics to be considered for inclusion in an asset-specific commentary or detailed press release.

5 Operational Risk Review ORIGINATOR REVIEW The originator review process evaluates the quality of the parties that originate the loans (leases or receivables) that are about to be securitized in a transaction rated by DBRS. While DBRS does not assign formal ratings to these processes, it typically conducts operational risk reviews to assess if an originator is acceptable and incorporates the results of the review into the rating process. DBRS typically begins the initial originator review process by sending a questionnaire to the company that outlines the topics to be covered during the discussion with management and includes a list of documents to be provided such as organizational charts, financial statements and underwriting guidelines. In instances where DBRS determines that the originator is below average, issuers may incorporate certain structural enhancements into a proposed transaction such as additional credit support or a third-party firm to provide the requisite representations and warranties so that DBRS can rate the transaction. In the event that DBRS determines that an originator is unacceptable, it may refuse to rate the deal. The originator review process typically involves a review and analysis of the following: (1) Company and management (2) Financial condition (3) Controls and compliance (4) Origination and sourcing (5) Underwriting guidelines (6) Technology For details on the originator review process, please refer to the DBRS methodology Operational Risk Assessment for U.S. ABS Originators. SERVICER REVIEW The servicer review process evaluates the quality of the parties that service or may conduct backup servicing on the loans (leases or receivables) that are about to be securitized in a transaction rated by DBRS. While DBRS does not assign formal ratings to these processes, it typically conducts operational risk reviews to assess if a servicer is acceptable and incorporates the results of the review into the rating process. DBRS typically begins the initial servicer review process by sending a questionnaire to the company that outlines the topics to be covered during the discussion with management and includes a list of documents to be provided such as organizational charts, financial statements and performance statistics. In instances where DBRS determines that the servicer is below average, issuers may incorporate certain structural enhancements into a proposed transaction such as additional credit support, dynamic triggers or the presence of a warm or hot backup servicer so that DBRS can rate the transaction. The servicer review process typically involves an analysis of the following: (1) Company and management (2) Financial condition (3) Controls and compliance (4) Loan administration (5) Customer service (6) Account maintenance 5

6 (7) Default management Collections Loss mitigation Bankruptcy Fraud (8) Investor reporting (9) Technology For details on the servicing review process, please refer to the DBRS methodology Operational Risk Assessment for U.S. ABS Servicers. Collateral Analysis As part of the rating process, DBRS evaluates the quality of the proposed collateral. As part of its analysis, DBRS may develop a base case loss expectation (also referred to as an expected loss figure) for each proposed pool. In certain transactions, instead of a base case loss expectation, DBRS may develop base case expected cash flows giving effect to existing contractual receivables at closing and expected future cash flows to be realized post-closing. DBRS analyzes issuer specific performance history and pool-specific characteristics provided by an issuer. DBRS may also look to compare the issuer s performance to that of other issuers within the same or similar market. DBRS uses this historical data and information to assess future performance. Preferably, DBRS expects issuers to provide loss and/or realized cash flow information, as described below, that covers asset performance during various economic cycles. This enables DBRS to evaluate the impact that general economic factors may have on collateral performance and assess volatility over time. DBRS may also analyze the origination and future revenue generation strategies which have been employed by the originator in the past to evaluate the degree of applicability of the past performance to the collateral securing a structured finance transaction. DBRS typically receives pool stratifications that provide a summary of asset characteristics such as interest rate, original and remaining term, obligor credit scores, seasoning and any other characteristics necessary to evaluate the credit quality of an asset pool. Ideally, the characteristics of the underlying assets that generate the historic performance data should mirror the characteristics of the proposed pool as closely as possible; however, DBRS recognizes that pools with similar summary characteristics can demonstrate different performance. DBRS prefers that originators/sellers have the reporting capability to provide static pool performance data that can be stratified by various attributes. In cases where sufficient performance detail has been provided, DBRS may refine its analysis by using the data to determine a more precise loss and/or cash flow estimate for each distinct component of the pool and then use this result to develop an expected loss and/or cash flow generation expectation for the securitized pool based on the relative contribution of each segment. 6 HISTORICAL PERFORMANCE In the assessment of expected collateral performance, DBRS typically analyzes historical performance data provided by the originator/seller and compares the originator s experience to the performance of the industry peers as well as general economic trends. DBRS utilizes this historical data and information to assess future collateral performance. Preferably, DBRS expects originators to provide separate default and recovery or realized cash flow (gross and net of realization expenses) information (as applicable) that covers asset performance during various economic cycles. This data and information assists DBRS in evaluating the impact that general economic factors may have on collateral performance. By evaluating defaults and recoveries separately, DBRS can gain additional insight into the unique factors that affect default and recovery rates. In addition, DBRS can also better understand the volatility drivers behind each set of data and information and develop more refined rating stresses. Separating the realization expenses

7 from the gross realized cash flows may provide better insight into the projected ability of a specialpurpose entity (SPE) to service its debt obligations after paying the fixed and expected servicing and/ or asset management expenses during the recessionary periods. To the extent that only net loss or gross realized cash flow data are available, DBRS typically applies adjustments to the data presented that take into account historical recoveries and/or realization/asset management expenses. DBRS seeks to receive historical data with granularity across the key risk components of the pool. Such granularity may include defining appropriate stratifications or pooling data by cohort relevance. While aggregate pool characteristics may differ by transaction, sub-pools within the aggregate pool likely share characteristics which aid in the determination of expected losses or expected future cash generation of the pool. DBRS may request an issuer to segregate historical static pool performance data and the proposed securitization pool into sub-pools of these common collateral characteristics. In cases where sufficient performance detail has been provided, DBRS may refine its loss and/or cash realization analysis by using the data to determine an estimate for each distinct sub-pool, then use this information to develop an expected loss and/or cash flow generation expectation for the securitized pool based upon the relative contribution of each sub-pool. DEVELOPING A BASE-CASE LOSS EXPECTATION While it may vary by asset class, originator or sector, typically, DBRS requests three or more years of performance history from an asset originator to perform a rating analysis. In the absence of static pool data, DBRS requests supplemental data to determine its loss projection. Where the performance history for the originator s assets is insufficient, DBRS may consider proxy data such as the performance of similarly originated assets from a different originator (or originators) deemed comparable. In cases where originator-specific data is unavailable, DBRS is likely to use a higher expected loss and/or lower realized cash flow projections than would otherwise be the case. DBRS may also seek additional data from industry sources to assist in development of an expectation for defaults and losses. In the absence of adequate comparable performance information, DBRS may decline to rate the transaction. DBRS assesses the provided loss performance information to determine if the attributes of the proposed pool are similar to the attributes of the pools underlying the performance data. If the data is deemed sufficient, DBRS may use the provided performance data to construct an expected loss and/or cash flow generation projection. DBRS generally determines estimates that reflect historical performance of the relevant assets and, where appropriate, adjusts for other drivers of performance. DBRS may consider factors affecting performance such as the economic environment and changes in origination or servicing practices during the life of the assets. DBRS may also consider performance of other originators operating in the same markets and examines the volatility of losses for similar vintages. Transaction Financial Structure The DBRS rating analysis focuses on the assessment of proposed credit enhancement supporting the debt obligations issued in connection with the transaction. Credit support may be soft, which includes enhancements that support the transaction s obligations, if and when they are available, or hard, which are enhancements directly available to support the transaction obligations. One typical form of soft credit support in U.S. structured finance transactions is excess spread. The hard credit enhancement may be represented by amounts on deposit in reserve accounts, liquidity facilities or standby letters of credit (LOCs) from highly-rated entities, overcollateralization (OC) and subordination. 7

8 DBRS may consider other forms of credit enhancement in its rating analysis. One such credit enhancement, although less common, is the use of an insurance policy to provide credit support. The insurance policy may be in the form of a surety bond, which would provide an irrevocable guaranty of the payment of timely interest and ultimate principal. DBRS assesses the form and sufficiency of a proposed transaction s credit enhancement in the rating analysis. The typical forms of enhancements are described in more detail in the following sections. FORMS OF CREDIT ENHANCEMENT Excess Spread Excess spread is a form of soft credit enhancement that is created within the transaction. Excess spread is interest generated by the assets that exceeds the cost of funding on the offered notes. The difference, net of transaction expenses such as servicing, trustee and professional fees, is commonly referred to as excess spread and is available on a periodic basis to absorb losses. Any changes in cash flows because of losses are first covered by excess spread. Since excess spread is based on anticipated but uncertain collateral collections, it is subject to variability based on the performance of the collateral relating to the underlying obligors failure to pay in a timely fashion. After all of the obligations prescribed by the transaction structure are satisfied, remaining excess collections may be released. Consequently, periodic excess spread is only available to cover losses incurred during that same period. Cash Reserve Accounts A cash reserve account is a form of hard credit enhancement that is available to pay interest, and sometimes principal, on the transaction obligations. 2 Reserve accounts are included in most U.S. structured finance transactions and are typically sized as a percentage of the collateral or debt outstanding, and are funded either at the outset of a transaction or over time through the transaction cash flows. Reserved amounts provide additional credit support to the transaction and may be applied to allow the transaction to successfully perform under stressed scenarios or to address transaction-specific risks or current market conditions. As principal amortizes and seasoning increases, reserve account balances are sometimes designed to decline over time. Overcollateralization OC is another form of hard credit enhancement which acts as loss protection, absorbing losses before any shortfalls are allocated to investors. OC represents the excess of asset collateral value over the outstanding balance of the SPE debt obligations. A transaction may have OC at closing and/or OC may build to a pre-specified target level based on amortization of the notes with available cash flows. OC may be sized as a percent of the initial pool balance or as a percent of outstanding pool balance, the latter allowing, in some cases, for the release of excess collections if the OC target level has been achieved. Declining OC structures often utilize an OC floor, which is typically expressed as a percentage of the initial collateral balance and provides back-ended protection to the rated notes. Subordination Subordination is also a form of hard credit enhancement that creates a cushion for losses from the related collateral in excess of OC. Subordination is created by a more junior class of notes that is subordinate in the right to receive amounts available for payments. These junior classes are available to absorb losses and therefore act as additional support for the more senior classes. DBRS analyzes any structural provisions within a transaction that specify and/or modify the availability of these junior classes to act as credit support for the more senior classes. Letters of Credit, Liquidity Facilities and Third Party Support Agreements A letter of credit or a liquidity facility is an agreement between a provider, usually a bank or other financial institutions, and the SPE as the beneficiary. Under the terms of the contract, in defined circumstances, the provider will forward funds directly to the SPE in satisfaction of its third-party obligations. LOCs 8 2. Please refer to the DBRS publication Legal Criteria for U.S. Structured Finance.

9 can also be used as credit enhancement if they represent contractual obligations between the SPE and the provider independent of the conduct or status of the third party and can be used like the reserve account to cover any payment shortfalls. In some instances, the LOCs or liquidity facilities serve only as a source of temporary liquidity (and not credit enhancement) for a transaction, whereas any funds drawn under such LOCs or facilities are repaid senior to interest and principal on the SPE s debt obligations as soon as collection proceeds become available. DBRS considers the degree to which credit can be assigned to protection provided by such structural enhancements, taking into account the rating sought for a transaction. DBRS has described its approach to certain third-party support agreements in DBRS: Guarantees and Other Forms of Explicit Support. In addition to forms of support agreements discussed therein, a thirdparty support agreement may include insurance, reinsurance, purchase obligations and residual value guarantees. Third-party support agreements may also be combined or aggregated to formulate a portion (or even all) of the credit enhancement for a transaction. In cases where multiple support agreements formulate credit enhancement for a transaction, DBRS will consider the relative benefit or contribution to credit enhancement from such agreements and their impact on the target rating. PRIORITY OF PAYMENTS The priority of cash flow payments for a U.S. structured finance transaction depends on the type of payment structure employed in that transaction. On a periodic basis, collections realized from the assets are aggregated and then distributed to noteholders based on the priority of payments established in the transaction documents. Interest and principal collections may be passed through the payment waterfall separately or may be aggregated in a manner such that principal and interest collections are combined as available funds and then subjected to a payment waterfall. Once the amount of available funds is determined, such funds pass through a payment waterfall that allocates collections in descending order of priority. Recurring transaction expense items, such as servicing and trustee or transaction management fees, are commonly senior in the waterfall, after which noteholders receive interest and principal. The allocation of interest to noteholders is typically sequential. There are two common methods for allocating principal payments in a transaction structure sequential and pro rata pay. A sequential pay structure provides for all principal collections to be allocated to the senior most class and the shortest maturing class in the case of time tranche senior classes, until it is paid in full. Once paid, available funds are then directed to the next most senior class outstanding. Losses in excess of the available credit enhancement are absorbed by the junior most tranche. Once the junior most tranche is written down, the losses are absorbed by the second most junior tranche in the structure. Notes that carry the same rating typically receive distributions on a pari passu basis and writedowns are applied pro rata. An example of the typical payment priority under a sequential pay structure may be as follows: (1) Trustee, custodian, backup servicer and other fees up to a specified limit (as applicable); (2) Servicing fees and any servicing transition fees to any successor servicer up to a specified limit (if applicable); (3) Interest in order of seniority 3 ; (4) Principal in order of seniority 4 ; (5) Amount, if necessary, to be deposited into the reserve fund to bring it to the required reserve amount; (6) Additional amounts owed to the trustee or servicer above the specified limits in 1 and 2 above; and (7) Any remaining amounts to the entity completing the securitization. 3. In a transaction involving an interest rate swap, net swap payments other than swap termination payments typically rank pari passu with interest payments on securitization debt obligations. 4. Swap termination payments, when a securitization issuing entity is the defaulting party, generally are expected to rank pari passu with principal payments on securitization debt obligations; however, in cases when a swap counterparty is the defaulting party, the swap termination payments are generally expected to be subordinated to payments of interest and principal on the rated securities. 9

10 A pro rata pay structure allows for principal collections to be allocated to senior and subordinate tranches concurrently, based on each respective note s proportionate share of the capital structure. Pro rata pay structures may include a trigger mechanism that changes allocation of principal in the event performance deteriorates. If the trigger is breached, the subordinate tranches are typically locked out and principal payments are allocated to the senior most tranche. Transaction provisions may also provide for a mechanism that allows for trigger breaches to be cured, causing principal payment allocations to revert to the original payment priority. Similar to sequential pay structures losses in excess to the available credit enhancement often result in a writedown of the most junior class. TRANSACTION PERFORMANCE THRESHOLDS AND TRIGGERS Depending on the structure of a transaction, performance thresholds or triggers can mitigate the risk of deteriorating collateral performance. Performance triggers are designed to increase credit enhancement levels beyond what is initially included in the transaction, enabling the transaction to absorb more losses or to change payment priorities to accelerate repayment of the rated notes and/or create added protection for the more senior tranches. Triggers may also provide a useful basis for effectuating cash flow stresses. The degree to which triggers are beneficial in building additional credit enhancement or changing payment priorities depends on the level at which the triggers are set and the available transaction cash flows. Transaction triggers may be based on managed portfolio and/or transaction pool performance and may measure levels of current delinquencies, defaults and/or losses as well as cumulative defaults and/or losses. Other kinds of triggers can be based on the maintenance of certain enhancement levels at or above pre-defined levels. DBRS assesses the transaction cash flows which incorporate transaction trigger mechanisms in its rating analysis. ASSET ELIGIBILITY CRITERIA It is common for U.S. structured finance transactions to have eligibility criteria incorporated in the transaction documents that establish a standard for asset quality and are also an important part of maintaining consistency of asset quality for transactions where new assets are permitted to be added to the transaction. Common eligibility criteria that may be in a U.S. structured finance transaction often include, among other metrics, the following: Minimum and maximum terms of the assets Limitations on the severity of delinquency (e.g., receivables must not be more than 30 days past due) No assets in charge-off or related obligor in bankruptcy Minimum and maximum asset balance Minimum interest rate or excess spread levels Geographical limits and concentrations Obligor concentrations Asset type concentrations Limits on newly originated assets Assets have been originated in accordance with existing investment guidelines and/or credit policies and all applicable laws The originator has legal title to the assets and there are no liens or encumbrances on the assets (other than certain permitted liens) FINANCIAL COVENANTS Certain transactions may include financial covenants related to the financial stability of the originator and/or servicer during the life of a structured finance transaction. To the extent that a transaction includes such covenants, DBRS assesses the potential impact of financial covenants and how they relate to the financial health of the originator and/or servicer during the remaining life of the proposed transaction. In the event that a proposed transaction does not include sufficient financial covenants, the issuer may incorporate covenants that assist in the rating of the transaction. If DBRS determines the proposed financial covenants are insufficient, DBRS may decline to rate the transaction. 10

11 Transaction Legal Structure DBRS analyzes the legal structure of the proposed transaction by reviewing the primary and ancillary transaction documents as well as all relevant legal opinions. LEGAL STRUCTURE The legal structure of U.S. structured finance transactions may differ depending on a number of factors. This includes whether a transaction is a one- or two-tier transfer of assets. This refers to the number of times the assets are transferred before residing with the SPE issuer of the rated debt. In a two-tier transaction there is an intermediate SPE, which is usually the depositor who borrows from the issuing SPE to acquire the securitized assets from the originator and deposits or sells the assets to the issuing SPE. Transactions may also differ in terms of the parties involved in the transaction and their roles. DBRS reviews a transaction s legal structure to assess that all steps have been taken to isolate the collateral pool from the risk of bankruptcy of the entity sponsoring the securitization. BANKRUPTCY REMOTE SPECIAL-PURPOSE ENTITY AND RECEIVABLES TRANSFER U.S. structured finance transactions are rated based on the credit quality of a segregated pool of assets. For a security to achieve a higher rating than what could be achieved as a secured loan from the entity executing the securitization, the assets must be isolated from the financial risk of the originator and beyond the reach of its creditors in the event of a bankruptcy. To accomplish this, the assets will be expected to be transferred on a true sale basis to a bankruptcy-remote SPE, whereby they would not become part of the bankruptcy estate of the originator or would not be expect to be subject to an automatic stay under the Bankruptcy Code 5. In addition, DBRS reviews the transaction for the legal steps have been taken to transfer the receivables and all of an originator s rights and interest in the assets to the SPE. DBRS reviews legal opinions for (1) whether the transfer of the assets to the SPE constitutes a true sale such that the securitized assets would not be consolidated with those of the originator in the event of the originator s bankruptcy, and also (2) that the indenture trustee has a first-priority, perfected security interest in the assets which secure the SPE s obligations to the noteholders. COUNTERPARTY MINIMUM RATING CRITERIA Securitization transactions may rely on the performance of third parties such as servicers, swap counterparties, liquidity providers, trustees or account banks. DBRS assesses the creditworthiness of the counterparties to ensure that each participant maintains financial strength commensurate with transaction ratings. LEGAL FINAL MATURITY DATES DBRS assesses terms of the transaction and considers the ability of the transaction to pay interest as required on each payment date and to repay principal on the legal final maturity date. The legal final maturity date for a security is the last possible date that a security could be paid off in full. The legal final maturity date determination typically considers all cash flow stress scenarios that may extend the maturity of a security. The considerations include payment deferrals, extensions, legal and/or procedural recovery delays and other considerations that could potentially delay receipt of receivable payments and maturity dates. The specific legal final maturity dates for rated securities are evaluated for each transaction. For a description of the legal considerations for U.S. structured finance transactions, please refer to DBRS s Legal Criteria for U.S. Structured Finance, at 5. The current Bankruptcy Code was enacted in 1978 and became effective on October 1, The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 enacted several significant changes to the Bankruptcy Code. The most recent changes to the Bankruptcy Code were signed into law on April 20, 2005, and became effective on October 17,

12 Cash Flow Analysis DBRS performs cash flow analysis to determine what the credit enhancement levels and transaction structure warrant in terms of a rating level. The cash flow analysis by DBRS replicates the transaction priority of payments waterfall and trigger mechanisms, if applicable. DBRS may apply a variety of stresses to the cash flows to simulate the impact of adverse conditions during the remaining life of the assets. The cash flows may be expected to withstand a stress loss level, or a haircut to a base-case cash flow, commensurate with a specific rating level. The multiple of the expected loss or the magnitude of the cash flow haircut that a given class of debt withstands varies based on a set of factors including the absolute level of a proposed pool s collateral quality and expected loss figure, industry position of the sponsor, results of an operational risk assessment of the originator and/or servicer, sufficiency and quality of the issuer provided and DBRS-sourced data and information, structural features of a transaction and future economic conditions. The stress levels applied by DBRS and the multiples and/or haircuts used to achieve a specific rating level are asset and issuer specific and are determined for each transaction. DBRS cash flow analysis typically involves combinations of stresses on key assumptions, including the following: TIMING OF DEFAULTS/LOSSES DBRS may use one or more default or loss timing curves, based on historical performance of the assets, for the distribution of defaults or losses over time. These curves are combined with various prepayment and interest rate assumptions to produce several scenarios. RECOVERY TIMING DBRS typically lags recovery timing to reflect the likely delay in realizing proceeds from the disposition of defaulted assets. Scenarios often incorporate delays in receiving recoveries that could occur due to the length of the liquidation process, assumed servicing disruption or transition. TIMING OF CASH FLOW GENERATION STRESS Similar to default timing curves, DBRS may use several timing curves based on historical performance of the assets for the application of haircuts to the projected cash flows to be generated in the future. In case of assets with a longer useful life, DBRS may model several stressed periods, over which haircuts of different severity may be applied during the life of a transaction. These curves are often combined with various prepayment and interest rate assumptions to produce several scenarios for use in cash flow modeling. PREPAYMENTS Prepayment speed, which can be expressed using either Absolute Prepayment Speed or Conditional Prepayment Rate, measures the rate at which borrowers make their principal payments in excess of required amounts. Prepayments reduce the outstanding principal balance of the collateral pool, which may result in reduced amounts of excess spread. In such instances, the faster prepayment speed, the larger the amount of excess spread that is depleted. DBRS may look to receive monthly principal payment rate data to develop prepayment rate assumptions. This assumption may be adjusted, based on asset class performance factors or general economic factors and may be subjected to stress ranges commensurate with the requested rating of each class in cash flow analysis. 12 RESIDUAL REALIZATION / COLLATERAL LIQUIDATION PROCEEDS For U.S. structured finance transactions which advance against booked residual values or rely on the value of the pledged collateral for repayment of the debt, DBRS may incorporate residual and/or collateral liquidation assumptions in its cash flow modeling scenarios. DBRS may apply a haircut to a corresponding base-case assumption, such as booked residual or an appraised liquidation value, commensurate with the requested rating level. In addition, DBRS may lag collateral realization timing to reflect the anticipated

13 delay in realizing proceeds from the disposition of the collateral assets. The magnitude of stresses applied by DBRS may be dependent on a variety of factors including: collateral type, strength of foreclosure and liquidation right provisions, initial value assigned to collateral, historical performance of collateral realization and/or availability and proven accuracy of the third-party valuation sources. INTEREST RATE RISK DBRS may stress transaction cash flow to compensate for the interest rate risk the transaction may be subjected to during the life of the assets. There are two main types of interest rate risks that DBRS considers: Interest Rate Mismatch Interest rate mismatch (fixed versus floating) occurs when the interest rate terms on the underlying collateral (i.e., asset yield) are different from the coupon on the notes issued (i.e., cost of funds), or where the assets are non-interest bearing. Basis Risk Basis risk arises when the basis for calculating interest charged on the securitized assets or swap contract is different from the basis for calculating interest charged on the notes issued (e.g., Prime Rate versus London Interbank Offered Rate (LIBOR)). Basis risk may also arise where the index is the same but tenors are different (e.g., assets paying one month LIBOR and liabilities paying three-month LIBOR). If the proposed transaction does not include a derivative agreement to hedge interest rate risk, DBRS may apply additional stresses to the transaction cash flows to simulate a stressed interest rate environment. To quantify the effect of interest rate risk on a proposed transaction, DBRS typically runs a series of interest rate curves to test the sensitivity of any unhedged portion of the structure to interest rate volatility. The interest rate curves are based on the DBRS Unified Interest Rate Model (UIRM) 6 and typically reflect both upward and downward stresses. An interest rate stress curve is typically applied to the cash flow scenario analysis for each requested rating category. Basis risk can also occur where the date for setting the interest rate on the assets differs from the date on which the rate is setting for the interest rate on the liabilities. This risk can be increasingly acute as leverage for a transaction increases. DBRS will analyze historical movements on related indices and may apply additional stress to assess the impact on the transaction of a sharp untimely inverse rate movement. FOREIGN CURRENCY RISK DBRS assesses risks that arise when the cash flows collected from the collateral are in a different currency than the required payments on the issued debt. In circumstances where this risk exists, and no acceptable derivative agreement is included in the transaction structure to mitigate the risk, DBRS may apply additional stresses to the transaction cash flows or may decline to rate a transaction. SWAPS / HEDGING In the event that a transaction relies on a derivative agreement to hedge interest rate or currency risk, DBRS reviews the transaction documentation, assess the quality of the counterparty relative to the DBRS counterparty financial strength expectations and consider the impact of the hedging arrangement in the rating analysis. For further details on the DBRS counterparty criteria, please refer to the DBRS Legal Criteria for U.S. Structured Finance Transactions with respect to transaction counterparties, at SURVEILLANCE / MONITORING DBRS generally discusses its surveillance methodology in the DBRS Master U.S. ABS Surveillance Methodology. 6. Please refer to the DBRS publication Unified Interest Rate Model for U.S. Structured Finance Transactions. 13

14 Exhibit 1: Scope of Asset-Specific Commentaries/Detailed Press Releases The asset specific commentaries or detailed press releases outline the key analytical considerations when assigning ratings in a given asset class. The factors considered may include: Performance Metrics Credit Quality of Pool Transaction Structure Collateral yield Delinquencies Cumulative gross losses Recovery rate Recovery timing Cumulative net losses Static loss history Seller history and experience Collateral valuation Voluntary prepayment rate Historical realized asset cash flows Obligor characteristics (i.e., credit rating/score) Pool characteristics (geographic concentration, maturity profile, seasoning, contract APR, new vs. used, etc.) Asset characteristics (depreciation profile, market value, etc.) Revolving period Amortization period Eligibility criteria Concentration limits Priority of payments Interest PIK and/or note impairment provisions Transaction Triggers Credit Enhancement Cash Flow Factors Servicer termination events Commingling conditions Counterparty rating triggers Amortization events Performance triggers Legal Structure Documentation Transaction parties Representations and Warranties Covenants Legal Opinions Subordination Overcollateralization Cash reserve account Excess spread Letter of credit Liquidity facility Industry History Participants Current landscape General performance Base case cumulative loss assumption Base case cash flow generation assumption Timing of defaults/losses Recovery and time lag Prepayments Interest and basis risk considerations Method for stressing base case assumptions 14

15 Appendix I: U.S. Consumer Loan ABS Transactions This appendix highlights the key analytical factors that may be considered when assigning ratings to U.S. Consumer Loan ABS transactions. This appendix is a supplement to and should be used in conjunction with the DBRS methodology Rating U.S. Structured Finance Transactions. CREDIT FACTORS TO CONSIDER Collateral Performance Metrics Credit Quality of Pool Transaction Structure Delinquencies Defaults Recoveries Loss given default and recovery timing lag Cumulative net losses Prepayments Principal amortization Asset yield Pool characteristics (e.g., geographic concentration, obligor concentration, distribution channel, original term, remaining term, seasoning, credit balance, borrower quality, purpose of loan, installment/balloon) Eligibility criteria Volume and stability of historical originations and collateral characteristics Discrete (amortizing) or revolving collateral pool Note structure/payment priorities (sequential pay, pro rata, turbo) Lock-out period Servicing and back-up servicing Transaction Triggers Typical Forms of Credit Enhancement Cash Flow Assumptions Servicer termination events Commingling conditions Counterparty rating Lock-out events (e.g., amortization events) Termination events Asset yield maintenance Subordination Overcollateralization Cash reserves Excess spread levels and thresholds Letter of Credit Expected losses Multiples of Expected Loss for each rating Loss timing Recovery amount and timing lag Prepayments Interest rate risk and basis risk Consumer loans are typically unsecured, amortizing loans with scheduled equal payments. Borrowers are required to make equal payments at a frequency stipulated in the contract loan terms. Loan terms typically have a fixed rate of interest and generally are short term in duration. Consumer loans are commonly used for personal purposes, such as to consolidate debt or for purchases. Securitization transactions backed by consumer loans may include collateral pools that are discrete and have principal payments made by a large number of diversified individual obligors which are passed through to reduce bond principal outstanding. Any available excess cash flow is typically released to the seller. Release of excess cash flow may continue until a transaction mechanism, such as a lockout or a termination event (if applicable) occurs, typically based on pool or portfolio performance exceeding threshold levels. If a lockout event occurs, excess cash flow is no longer released to the seller, but instead may be used to build credit enhancement. Credit enhancement may be released if the threshold breach is cured. If a termination event occurs, excess cash flow is typically used to pay down the notes. Transactions may also be structured with a revolving period preceding the scheduled paydown of the notes. KEY PERFORMANCE METRICS Expected Losses Consumer loans are considered in default once they are delinquent for a defined period of time or are written off according to the originator s credit and collection policy. Net losses are the result of defaulted loans less any recoveries received. Due to the unsecured nature of consumer loans, recovered amounts are typically limited and the amounts depend on the means used to pursue defaulted balances. For cash flow modeling purposes, DBRS typically assumes a recovery rate of zero in the absence of recovery data to the contrary. In the event that the originator can provide historical data quantifying and supporting consistent recoveries, DBRS may consider incorporating partial credit for recoveries. 15

16 Prepayments Prepayments occur when obligors make principal payments in an amount greater than the required instalment payment amount. Prepayments reduce the outstanding principal balance of a loan; thereby reducing the amount of excess spread, but also possible future defaults and losses. Loans that prepay in full reduce the number of loans that may default going forward. Prepayments may arise as a result of a consumer s desire to refinance to take advantage of a more favorable interest rate. As it is often the better-quality obligors that have a higher likelihood of prepaying, higher prepayment rates may impact the amount and timing of pool cash flows. Accordingly, DBRS may stress a transaction s prepayment rate to assess the impact on excess spread as well as to evaluate the collateral pool for potential negative obligor quality migration due to prepayments. Asset Yield Portfolio yield is generated from finance charges, which include interest charges and other miscellaneous fees. The portfolio yield is calculated as the annualized average of the monthly income earned on the portfolio, divided by the receivables balance. The interest rate charged to borrowers can be a fixed rate or a floating rate based on a benchmark plus a spread. CASH FLOW ANALYSIS DBRS typically reviews at least three years of performance data of the seller to determine: (i) defaults; (ii) loss timing; (iii) recovery rate and timing lag; and (iv) pre-payment rates. When the performance history for an originator s assets is insufficient, DBRS may consider using proxy data, such as the performance of similarly originated assets, to determine the cash flow assumptions. The impact of a pool s seasoning is considered when determining the expected loss and loss timing. In the assessment of the historical performance data, and in cases where recoveries are an element of the analysis, DBRS typically estimates a recovery rate as well as a timing lag between the default and the expected recoveries, based on the length of the liquidation and recovery process. Once the expected case assumptions are established, DBRS applies stresses that correspond to the target rating levels. The cash flow scenarios incorporate a pool s assumptions and the structural elements of the transaction including transaction triggers, lock-out events and termination events or covenants that may impact the cash flows. The impact of a derivative product, when included in the transaction structure, is also taken into consideration. To evaluate proposed credit enhancement levels that support a target rating, the expected loss figure, as previously described, is stressed. The stress is applied as a multiple of the expected loss figure which, in turn, results in losses for each target rating s cash flow scenario. DBRS typically evaluates the results of the stress analysis under a variety of scenarios. To achieve a requested rating, the cash flow results are expected to withstand DBRS stresses appropriate for the rating. The multiples serve to protect the rated securities from much harsher and more stressful conditions than assumed within the expected case cash flow scenario. Table 1 indicates the typical range of multiples for U.S consumer loans securitizations. Multiples are designed to capture uncertainties and variables that may affect future transaction performance. The multiples in Table 1 are guidelines and may not be applicable in all transactions. 16

17 Table 1: Summary of Typical U.S. Consumer Loans Multiples by Rating Category Rating Prime Subprime AAA AA A BBB BB Appendix II: U.S. Healthcare Receivables ABS This appendix highlights the key analytical factors that may be considered when assigning ratings to U.S. Healthcare Receivables ABS transactions. This appendix is a supplement to and should be used in conjunction with the DBRS methodology Rating U.S. Structured Finance Transactions. CREDIT FACTORS TO CONSIDER Collateral Performance Metrics Credit Quality of Pool Transaction Structure Delinquencies Defaults Recoveries Loss given default and recovery timing lag Cumulative net losses Payment rate Asset yield Pool characteristics (e.g., geographic Typically revolving collateral pool concentration, obligor concentration, Note structure/payment priorities seasoning, credit balance, borrower (sequential pay, pro rata, turbo) quality, purpose of loan, installment/ Lock-out period balloon) Servicing and backup servicing Eligibility criteria Volume and stability of historical originations and collateral characteristics Transaction Triggers Typical Forms of Credit Enhancement Cash Flow Assumptions Servicer termination events Commingling conditions Counterparty rating Lock-out events (e.g., amortization events) Termination events Asset yield maintenance Subordination Overcollateralization Cash reserves Excess spread levels and thresholds Letter of Credit Expected defaults Loss timing Recovery amount and timing lag Prepayments Yield Interest rate risk and basis risk ASSET CLASS SUMMARY Healthcare receivables are in some ways similar to trade receivables, but with the payors being third parties (i.e., those not receiving the direct benefit of the health-care treatment). Most often, the payors are government entities or private insurance carriers. The receivables are created by health-care providers, such as hospitals, nursing homes, pharmacies, drug and alcohol rehabilitation programs, home healthcare agencies and physician practices (Service Providers). Often, these providers monetize the expected cash flow from these receivables by selling them to a finance company that specializes in funding health care-related receivables. Health-care finance lenders may use securitization to fund their operations. 17

18 The typical securitization consists of a revolving receivables pool and issuances of securities supported by a pledged security interest in the receivables. Because the payors of the receivables are mostly government entities (i.e., Medicare and Medicaid) and highly rated insurance companies (Payor(s)), the most significant risk in the securitization of health-care receivables is often not related to the ability of the Payors to pay, but instead related to the valuation of the securitized receivables and the quality of the securitization s seller/servicer. In this sense, the assets possess operating characteristics. As a result, the rating approach typically applied by DBRS to health-care receivables asset-backed securities (ABS) focuses on an assessment of: (1) The transaction legal structure; (2) The ability of the originator of the receivables to estimate the appropriate amounts billed; (3) The ability of the seller/servicer to monitor, evaluate and track the providers performance; and (4) The levels of credit enhancement in a transaction. The rating rationale for a health-care receivables transaction generally reflects the results of the operational risk review, the consistency of the legal structure and opinions with the DBRS Legal Criteria for U.S. Structured Finance, the assessment of the valuation methodology applied to the receivables and the cash flow analysis. If originated and processed properly, such receivables have a high degree of certainty of being paid. Accordingly, the origination and servicing of the platform, including fraud prevention, is typically reviewed. A cash flow analysis of a transaction usually provides further guidance on features of a transaction s structure and credit enhancement. Cash flow analysis is an important part of the quantitative review and allows testing to be performed on the available credit enhancement against the expected base case and stress case assumptions for the transaction. When performing the cash flow analysis, the key aspects of the transaction that affect the assumptions to be applied usually include the collateral mix (term loans versus revolving loans with payments coming from third-party payors) and the strength of the servicer (e.g., assumptions related to recovery percentages and time lags). INDUSTRY OVERVIEW Health-care receivables arise from medical services furnished by Service Providers. The typical pattern giving rise to health-care receivables is as follows: After furnishing medical services to a consumer, the Service Provider submits a bill to the Payor that covers the consumer s health-care expenses. The Payor processes the bill and determines the amount that it will pay. In general, the amount billed by the Service Provider is irrelevant to the Payor. The Payor determines the amount that it will pay based on predetermined schedules or formulas. In some cases, the Service Provider may collect a portion of the total bill from the consumer (the co-payment amount) and seeks amounts up to the balance of the bill from the Payor. After processing the bill, the Payor remits the amount that it is willing to pay and provides an explanation of how it determined the amount. Health-care service providers (and their lenders) need to be adept at working with many of the different reimbursement procedures of the government insurance programs and the private insurance companies. In addition, Service Providers continually need to review periodic changes and adjustments in the reimbursement systems. For example, the hospital insurance portion of the federal Medicare program uses a system where the amount that the government pays to a service provider is based on the specific services furnished to a consumer. The actual cost of furnishing the services is not taken into account in determining the amount that Medicare will pay. The system is called the prospective payment system and the process for classifying medical services is referred to as diagnosis-related group classification. 18

19 The payors of health-care receivables generally fall into two categories: public-sector and private-sector. Public-sector payors include Medicaid, Medicare and TRICARE (created in 1997 to incorporate, among other programs, the major pre-existing program for the armed forces: the Civilian Health and Medical Program for Uniformed Services). Medicare and TRICARE are federal programs with thirdparty intermediaries in each state handling claims processing. Although Medicaid is a federal program, it is administered on the state level, resulting in a variety of coverage and process requirements. Privatesector Payors include not-for profit groups, commercial insurance carriers and quasi-governmental entities. Examples of private-sector Payors are health maintenance organizations, Blue Cross/Blue Shield and self-insured health plans. COLLATERAL DESCRIPTION Generally, the amount remitted by Payors is less than the amount invoiced from the Service Provider due to a variety of systems and formulae. As a result, one of the more important responsibilities of healthcare finance lenders (and seller/servicers of healthcare ABS) is determining the remittance value for the receivables sold into a securitization. Seller/servicers need to understand and assess the capabilities of the Service Providers originating the receivables and be able to independently value the receivables to bill the appropriate amount for services rendered in order to be confident that the receivables are eligible for securitization and valued correctly. Because of a variety of factors that can dilute the receivables value, DBRS typically analyzes the valuation methodology applied by the seller/servicer when receivables are securitized, as well as the processes in place that monitor up to date on contractual allowances from the various Payors. Typically, once a receivable is generated as a result of the Service Provider rendering services, the Service Provider submits a claim for payment to an insurance company or Medicare/Medicaid. The Payor pays at a rate routinely stipulated in its contract with the Service Provider or published rates in the case of government programs; however, there may be some variance, which can lead to a shortfall or dilution. Examples of dilutive factors are government set-offs against Service Providers for unpaid taxes or fines, refusal of or reduced payments by an insurer or government program to a managed care program for non-compliance with the programs guidelines, claims rejections related to over-billings or exhaustion of benefits and false receivables stemming from fraud. DBRS usually evaluates a seller/servicer s valuation validation practices, which would typically include providing historical results of the methodology. Further, billing amounts payable by individual patients or unrated entities have historically not been included as eligible receivables in healthcare ABS or have only represented a small percentage (under 5%) of a collateral pool (restricted through concentrations included by issuers). DBRS typically accounts for this by reviewing the potential concentrations permitted for receivables supported by unrated exposures. TRANSACTION STRUCTURE Types of Transactions Given the short duration of health-care receivables, ABS transactions financing these assets have typically utilized bank warehouse structures and term financing with an embedded revolving feature, where receipts that remain after paying interest and fees are reinvested to purchase new receivables. New receivables are usually acquired in accordance with eligibility criteria incorporated by the issuer, which impose certain concentration limits by key asset characteristics. Unique Legal Considerations Properly obtaining and perfecting security interests in health-care receivables is necessary to creating a securitization. Because of the uniqueness of health-care receivables, certain specific steps must be taken to ensure security interests are obtained and perfected. 19

20 Medicare and Medicaid Receivables: Prior to a 1985 U.S. Court of Appeals for the Fifth Circuit decision, Medicare and Medicaid receivables generally were prohibited from being transferred to investors because of federal anti-assignment laws. The court s ruling approved a strategy to monetize health-care receivables by stating that so long as health-care providers retain control over the initial receipt and disposition prerogatives regarding Medicare and Medicaid payments, they will not be in violation of the federal antiassignment laws. To satisfy this requirement, the double lockbox was created. Specifically, the Service Provider must direct government Payors to pay all Medicare and Medicaid payments into a new account (lockbox #1) owned and controlled by the provider. The Service Provider then instructs the depositary bank for lockbox #1 to sweep all funds from lockbox #1 into lockbox #2 on a daily basis. Private Payors are directed to make payments into a second account (lockbox #2, or the collection account) owned and controlled by the receivables purchaser. Although the Service Provider must have the right to change these instructions, purchasers often provide that any such change will trigger a default under the Service Provider s contract with the purchaser. Private Insurance Receivables: Effective in most states July 1, 2001, the revised Uniform Commercial Code (UCC) included the concept of a definitive health-care insurance receivable. The language of the Article 9 subsections makes clear that securitizations of accounts to be paid by private insurance policies are covered by the UCC. By filing a financing statement, a provider can perfect the assignment of healthcare insurance receivables to the purchaser, thereby making the assignment superior to third-party claims (such as claims of the providers other creditors). Significantly, the revised subsections provide that any contractual or statutory restrictions on such assignments by Service Providers, as between the assignor (the Service Provider) and assignee (the purchaser), are ineffective, thus making the rights of a purchaser much more certain and more well-suited for securitization. Also, Article 9 clarifies how to perfect assignments of health-care insurance receivables from account debtors (the insurance companies) located in multiple jurisdictions. The combination of UCC Sections and provides for one central filing of a financing statement, generally in the state under the laws of which the debtor (the provider) is organized. Special Considerations for Not-for-Profits: In some securitizations, the Service Provider sells the receivables to the purchaser for a combination of cash and an equity interest in the purchaser. Such a structure can be particularly useful if the financing lenders and the Service Provider cannot agree on the appropriate discount to apply to the face amount of the receivables in determining the purchase price. By retaining equity interest, the Service Provider is entitled to recover any collections on the receivables in excess of the portion of the price funded by the lender. The combination of the loan proceeds and the equity interest that the purchaser issues to the Service Provider often makes it easier to conclude that the Service Provider has received fair value for the receivables. The equity interest typically makes up any difference. Not-for-profit Service Providers may find it more difficult to resolve a disagreement over an appropriate discount because in some transactions there may be regulatory, tax or other impediments to a not-forprofit healthcare provider s forming a for-profit subsidiary. The resulting dilemma may be overcome by the formation of a stand-alone, not-for-profit entity to which the parent or an affiliate of the not-for-profit Service Provider makes a deeply subordinated loan. The purchaser uses the subordinated loan, together with the lenders funds, to purchase the health-care receivables. The lenders lend what they consider to be an appropriate discount to fair value, but through the subordinated debt, the originator receives what it considers fair value for the sale. DBRS also typically reviews the representations and warranties which address that each health-care receivable is an eligible receivable as defined in the transaction and trust legal documents. 20

21 Transaction Triggers U.S. health-care receivables ABS transactions may utilize rating thresholds or trigger mechanisms whereby adverse performance of the underlying collateral results in a change to the initial cash flow structure. Triggers typically measure collateral performance and are designed as an early warning mechanism, which may adjust the initial cash flow structure to protect against an erosion of credit support. To the extent that a trigger is breached, typically reinvestment in new receivables ceases and the notes amortize. CASH FLOW ANALYSIS Default Stressing A risk normally inherent in health-care receivable securitization transactions is default and/or insolvency of the insurance carriers making the payments for services rendered. Health-care receivables ABS transactions usually have exposure to the insurance industry and often have high exposure among specific insurers. The eligibility criteria are typically reviewed to determine the optionality afforded by concentrations among the Service Providers. The concentrations generally are taken into account as part of the quantitative credit analysis. Typically, eligibility also includes concentration limits for Medicare and Medicaid, by insurance carrier ratings as well as by self-pay and worker s compensation claims. Limits are also typically included for state concentrations, which may provide diversity since states may offer support to a transaction through sponsored healthcare programs (e.g., Medicaid). The typical focus of the DBRS cash flow analysis for transactions in this sector relates to the probability of default and expected loss from the overall carrier exposures backing the transaction and how these affect the repayment of the rated debt. Default probabilities are derived from the ratings assessments for the obligors, which may be based on available public or private ratings, credit estimates or internal assessments. The analysis typically utilizes a DBRS proprietary model, the DBRS CLO Asset Model. Typically, based on the eligibility criteria as detailed in transaction legal documentation, DBRS constructs assumptions based on a pool exercising available optionality with reflective estimated defaults. The obligor rating (or, more precisely, the claims paying rating) measures the capacity of an insurance company to pay its policyholder claims as they fall due. The ability to pay claims is often higher than the long-term senior credit rating for an insurance company, since claims are paid ahead of all debt. Accordingly, amounts due are usually more likely to be paid than unsecured obligations of the same entity. Notional exposure is typically calculated as the maximum exposure to the obligor based on the eligibility criteria. A single correlation factor is normally used across all the carriers as they generally are in the same industry. The DBRS CLO Asset Model then provides estimates of defaults, which vary by rating level. The output from this analysis is utilized in a cash flow analysis to determine the ratings appropriate for a given credit enhancement level. Upon default of an insurance carrier, other mitigating factors may emerge, such as state insurance funds and the likelihood that any failing carrier would be succeeded by another. While these qualitative factors exist, they are not typically considered as part of the default analysis, but may be considered when determining potential recoveries following a default. Recoveries Expected respective recovery rates for each obligor exposure are estimated by DBRS based on the analysis of the originator s historical performance and taking into account the historical size and consistency of recovery expenses. 7 Furthermore, maintenance of compliance with these levels is typically included in the transaction documents and may be reported in each period s servicer report. DBRS typically assumes expected recoveries on defaulted Payors to between 50% and 70%, which may vary by rating level. 7. See the DBRS methodology Rating Methodology for CLOs and CDOs of Large Corporate Credit, as certain portions of the methodology may be applied when rating healthcare securitizations. 21

22 Loss Timing Loss timing is normally an important component of the cash flow analysis as it has an impact on the availability of excess spread to cover losses and other potential liquidity stresses. DBRS typically analyzes an issuer s historical performance data to assess an expected loss timing curve that reflects the reduced speed at which payments are received due to seasonal fluctuations or budgetary constraints, specifically for Medicaid-backed receivables. DBRS also normally applies front-ended and back-ended loss timing curves. The curves are developed to evaluate scenarios whereby losses materialize sooner or later than expected, as could be the case if the economy entered a recession shortly after a transaction closed or toward the tail end of the transaction s life. Cash Flow Analysis In addition to the basic DBRS cash flow analysis and the incorporation of the results from the DBRS CLO Asset Model, the cash flow analysis for health-care receivables also typically includes review of asset characteristics (i.e., collection rate, utilization rate and interest rate as well as default and recovery timing assumptions). DBRS typically evaluates the results of the stress analysis under a variety of scenarios. To achieve a rating, the cash flow results are expected to withstand DBRS stresses appropriate for the rating. RELATED RESEARCH: Rating CLOs and CDOs of Large Corporate Credit 22

23 Appendix III: U.S. TV Programming Licensing Rights This appendix highlights the key analytical factors that may be considered when assigning ratings to U.S. television (TV) Programming Licensing Rights ABS transactions. This appendix is a supplement to, and should be used in conjunction with, the DBRS methodology Rating U.S. Structured Finance Transactions. CREDIT FACTORS TO CONSIDER Collateral Performance Metrics Credit Quality of Collateral Transaction Structure Percent of contractual revenues Historical audience ratings Historical network license fees and sponsorship revenues Production costs Longevity and brand awareness of the program Type of programming i.e. live appointment viewing or scripted Stability of program airing on broadcast and cable networks Magnitude of foreign currency revenues Credit profile of network and sponsorship licensees Future revenue operating asset transaction Note structure/payment priorities (sequential pay, pro rata, turbo) Principal amortization prior to anticipated repayment date Credit profile of manager and back-up manager Transaction Triggers Typical Forms of Credit Enhancement Cash Flow Assumptions Manager termination events Commingling conditions Debt service coverage ratios Early amortization events Collateral valuation triggers Subordination Overcollateralization Cash reserves License fees and contract term upon network license agreement renewal Extent of sponsorship and other non-recurring revenues Network counterparty default Failure of program to air Interest rate and foreign currency risk TV programming encompasses a variety of content. The most common and widely seen programming is first-run TV series, which are licensed to air for the first time on over-the-air broadcast networks (ABS, NBC, CBS and Fox) and now more commonly on cable networks. Networks generally only commit to airing a first-run series one season in advance. After a first-run TV series has become popular and typically aired 100 episodes, the series may be sold into the syndication market where it airs as reruns on independent TV stations and cable networks. Syndication agreements may be multi-year contracts. Another type of TV programming is live event programming, such as award shows, events and sporting games. This type of content is sometimes referred to as appointment viewing, since consumers largely watch these programs live as opposed to recording and watching at a later time. These programs are licensed to broadcast and cable networks typically under long-term contracts. These programs often generate sponsorship revenues from leading national advertisers that seek to reach a mass market watching live event programming. Securitization transactions backed by TV programming generally represent monetizations of multiyear network license agreements (Network Agreements). In certain transactions, one or more Network Agreements may expire prior to final repayment of the rated notes. In such cases, a renewal of expiring Network Agreements is typically assumed at a license fee and for an additional term (which may coincide with the repayment of the debt). In the case of live event programming, sponsorship and other ancillary license agreements (Sponsorship Agreements) may also be included in the collateral package. Sponsorship Agreements are generally short term and may relate to one single airing of a program. Future sponsorship revenues may be assumed depending on the consistency of historical sponsorship revenues and the profile of advertisers that sponsored the program in the past. 23

24 Credit enhancement typically consists of subordination, a cash reserve and OC (which represents the excess of discounted securitized net cash flows 8 over outstanding note balance). These transactions also typically include performance triggers such as a debt service coverage ratio which measures realized revenues relative to required principal and interest payments and a contract coverage ratio which measures contractual revenues over the next year as a multiple of anticipated debt service over such period. A breach of either of these triggers will generally result in a cash trap event or early amortization in which excess cash flow is no longer released to the Manager (defined below), but instead may be used to pay down outstanding debt and/or build credit enhancement. The TV programming discussed above in many cases provides profit participations to the creative talent involved in the development and production of the content (i.e., actors, directors, producers and writers) as part of their compensation. Such talent participations have been monetized in the past in structured financings with terms similar to those discussed herein. KEY CREDIT CONSIDERATIONS Credit Profile of Manager In a securitization transaction, the Manager is typically the owner of the intellectual property related to the programming. In many cases, this entity is also the production company that produces the program being licensed. The Network Agreements and the Sponsorship Agreements are generally considered executory contracts since the program must be completed and available for airing so that the license fees are due and payable. Accordingly, the credit profile of the production company and its ability to produce the program during the life of the transaction is a key consideration. For this reason, many transactions include a backup manager which would assume the responsibility of Manager in certain events (i.e., manager termination events). Historical Audience Ratings Audience ratings are measurements of the number of households that watch a given program. Nielsen provides such ratings for TV and other forms of media; thus, audience ratings are commonly referred to as Nielsen ratings. Nielsen ratings largely determine the value of a 30-second advertisement in a program and therefore, by extension, are an important factor in the profitability of that program for the network. Accordingly, the rating for a TV program is a key consideration for networks and advertisers in deciding whether to license and sponsor a program; therefore, DBRS reviews the program s historical audience rating trends when determining assumptions for the renewal of Network Agreements and Sponsorship Agreements. Historical Network License Fees and Sponsorship Revenues The historical network license fees and sponsorship revenues realized by a TV program are another element DBRS reviews to assess the demand for the program and determine assumptions for the renewal of its Network Agreements and Sponsorship Agreements. In evaluating license fees and sponsorship revenues, DBRS considers the number of years the program has been generating such cash flows, the term of the Network Agreements over time and the percentage change in the network license fees at each renewal. Production Costs The cash flow available to pay interest and principal of the rated notes is typically the net of: (a) customary senior structured finance fees (e.g., trustee/servicing), (b) a management fee to the Manager, (c) participations and residuals 9 owed to the talent and (d) expenses related to the production of the programs. Since the Network Agreements and Sponsorship Agreements are executory and payment of the license fees is contingent upon delivery of a completed program, transaction structures usually allocate a portion of Both contractual cash flows at closing and assumed future cash flows less management fees, programming production expenses, participations and residuals and any other senior expenses. 9. Residuals are payments to the guilds for the benefit of its members (e.g., actors, writers, directors).

25 available cash flow under the waterfall to an account where the funds remain until drawn to fund production costs for the program. It is, therefore, important to understand the amount and variability of the production costs to assess if there are sufficient funds available over the life of the transaction to produce and complete the upcoming programs that generate the related network and sponsor license fees. U.S. STRUCTURED FINANCE PRODUCER/DISTRIBUTOR REVIEW AGENDA SUPPLEMENTAL ITEMS Overview of the development of new programming Overview of the production logistics for each program Manager s role in overseeing production Local and/or state government tax credits for production Strategy with respect to digital distribution Executory elements in the Network Agreements or Sponsorship Agreements other than delivery of the program Participations and residuals dispute handling procedures Overview of the actions taken to protect against theft of intellectual property LEGAL CONSIDERATIONS DBRS expects the issuer of the rated notes (Issuer) to be created as a bankruptcy-remote, special-purpose vehicle in a manner consistent with DBRS Legal Criteria for U.S. Structured Finance Transactions. In addition, DBRS will also consider intellectual property matters related to the transfer (via license or assignment) of the programming rights to the Issuer. DBRS expects that such transfer be treated as an absolute transfer to the Issuer. Nonetheless, it is possible that, in a bankruptcy proceeding of the Manager, a court could re-characterize the transfer as a secured financing such that the Manager is deemed to continue to own the programming rights. For this reason, the rated notes will also typically be secured by a security interest in the programming rights as well. DBRS expects to receive opinions to the effect that: (1) in a bankruptcy proceeding of the Manager, a court would not disregard the separate existence of the Issuer and require substantive consolidation of the assets of the Issuer with those of the Manager and (2) that the transfers of the programming rights to the Issuer would be characterized as absolute transfers and not as a secured financing. Furthermore, in the event of a Manager bankruptcy, if a bankruptcy court were to hold that the programming rights licensed or assigned to the Issuer are assets of the Manager s bankruptcy estate and the Manager rejects such license or assignment, then the Issuer is expected to assert its rights under Section 365(n) of the Bankruptcy Code to retain its rights under the license or assignment agreement. In certain transactions, there may not be an absolute transfer for bankruptcy purposes of the underlying programming rights. The assets transferred to the Issuer in this case are not the intellectual property rights associated with the TV programs, but rather an interest in the programming rights. Typically, the rated notes will be secured by a security interest in the programming rights in this case. CASH FLOW ANALYSIS The cash flow analysis for TV programming structured financing begins with a determination of aggregate cash flows, which consist of contractual amounts due under both existing Network Agreements and Sponsorship Agreements, as well as assumed future cash flows under Network Agreements and Sponsorship Agreements not contracted at closing. Any options in existing Network Agreements and Sponsorship Agreements are typically assumed not to be exercised and any related license fee is not included in the aggregate cash flows. DBRS also considers the credit quality of the existing broadcast and cable networks and the sponsorship advertisers and may apply a contracted payments haircut to account for potential licensee defaults. 25

26 DBRS considers various factors to determine the percentage change in license fees and contract term for assumed future Network Agreements and Sponsorship Agreements not in existence at closing. Such factors may include historical Nielsen ratings for a program and historical license fees and change in license fees upon renewal for any given program. DBRS may also consider macro-industry factors such as TV advertising spending over one or more economic cycles to determine reductions in license fees in stressed scenarios. DBRS may also assume that one or more programs are not aired and the related license fees are not paid because of events outside the manager s control (e.g., labor strikes, natural disasters). Once the aggregate cash flows are established, DBRS runs cash flow scenarios which incorporate the structural elements of the transaction including transaction triggers, rapid amortization events and covenants that may affect the cash flows. The impact of a hedge, when included in the transaction structure, is also taken into consideration. The table below indicates the typical decreases applied to Network Agreement license fees upon renewal of such agreements. The declines are designed to capture uncertainties and variables that may affect future transaction performance. The decreases to Network Agreement license fees upon renewal of such agreements in the table are a guideline and may not be applicable in all transactions. Since Network Agreements are typically long term (five to ten years) and Sponsorship Agreements are typically one-year agreements, the decrease applied to Sponsorship Agreements typically is based on the Network Agreement decrease and may be adjusted to account for the difference in term. TABLE 1: Summary of Typical Network Agreement Declines by Rating Category Rating Haircut A 25% to 35% BBB 15% to 25% BB 5% to 15% 26

27 Appendix IV: U.S. Insurance Premium Finance This appendix highlights the key analytical factors that may be considered when assigning ratings to U.S. Insurance Premium Finance ABS transactions. This appendix is a supplement to and should be used in conjunction with the DBRS methodology Rating U.S. Structured Finance Transactions. CREDIT FACTORS TO CONSIDER Collateral Performance Metrics Credit Quality Carriers Transaction Structure Delinquencies Defaults Recoveries Loss given default and recovery timing lag Cumulative net losses Payment rate Pool characteristics (e.g. geographic concentration, obligor concentration, carrier quality) Eligibility criteria Volume and stability of historical originations and collateral characteristics History and method of unearned premium recovery Typically revolving collateral pool Note structure/payment priorities (sequential pay, pro-rata, turbo) Lock-out period Servicing and back-up servicing Transaction Triggers Typical Forms of Credit Enhancement Cash Flow Assumptions Servicer termination events Commingling conditions Counterparty rating Lock-out events (e.g. amortization events) Termination events Financial Covenants Asset yield maintenance Subordination Overcollateralization Cash reserves Excess spread levels and thresholds Expected defaults Loss timing Recovery amount and timing lag Prepayments Yield Interest rate risk and basis risk ASSET CLASS SUMMARY Beginning in the mid-1990s, term securitizations backed by insurance premium finance loans have been a part of the ABS marketplace, becoming an important method of financing insurance for business assets. Insurance premium financing is structured as a loan extended to an obligor to pay for the premiums due on property and casualty insurance. The financing arrangement with the obligor requires monthly or periodic payments to the lender to repay the lump sum premium payment made by the lender to secure the insurance policy with an insurance carrier. Often, the premium is required to be paid in a lump sum by a lender (typically a finance company) to an insurance carrier. The amount of the premium is normally the cost to the obligor for a specific insurance contract. The financing arrangement also normally provides that the lender is entitled to any unearned premium due from the insurance carrier in the event of policy cancellation. The documentation may also include a limited power of attorney to permit the lender to cancel coverage under the policy. In the financing arrangement, it is customary for the obligor to make a down payment at the time of financing of between 5% and 25%. While all or a portion of the down payment is typically retained by the third-party agent network as a commission, it normally creates immediate OC between the unearned insurance premium and the loan extended to the obligor to pay for the insurance premium. The specifics of the insurance coverage, including the terms and cost, are typically negotiated and agreed upon without the involvement of the finance company. The finance company s business flow is usually derived from relationships with agents, brokers, or administrators that work with or on behalf of the policy providers. How an insurance premium finance loan is established: 27

28 (1) A person or company has a need for property and casualty insurance policy for a car the person or company owns; (2) The person or company arranges for an insurance policy with an insurance company that underwrites the policy; (3) The person or company is given the option of paying the lump sum payment for the full value of the policy premium upfront or financing the premium over time through a finance provider; (4) If the person or company chooses to finance the premium over time, the person or company will apply for the financing; (5) The finance company often relies on an agent network to generate lending opportunities, with the agent performing initial underwriting on the person or company. In the event the obligor fails to pay on the financing arrangement, the finance company looks to the insurance carrier, which has underwritten the policy, to cover its loss; therefore, the finance company may place less emphasis on the creditworthiness of the obligor under its financing loan; (6) The person or company enters an arrangement for the premium financing and becomes an obligor under the financing loan. The key characteristics of the financing loan include: (a) the amount of the financing does not exceed the lump sum value of the premium payment that will be fronted by the finance company to the insurance carrier; (b) the obligor makes a down payment typically between 5% to 25% of the total premium financing amount; and (c) the obligor pays the balance of the finance loan in equal installments over a period of time that is typically shorter than the term of the insurance policy (typically half to three quarters as long); (7) The finance company makes a lump sum payment to the insurance carrier to pay the full premium due on the policy at inception; (8) The obligor makes the down payment to the finance company and begins the installment payments on the finance loan; and (9) The finance company services the monthly collections from obligor. INSURANCE PREMIUM FINANCE AND UNEARNED PREMIUM The term of the premium finance loan is dependent upon the term of the insurance policy to provide protection for the finance company by creating excess premium coverage. The premium finance loan typically amortizes faster than the unearned insurance premium that has been paid (e.g., a six-month premium finance loan versus one year of insurance coverage), since the term for premium finance is generally one half to three quarters as long as an insurance policy. Consequently, at the time the premium finance loan is paid in full, a significant portion of the unearned insurance premium will still exist and continue to amortize. This creates an excess unearned premium amount, where the value of the unearned insurance premium exceeds the remaining financed amount. The primary risk to a transaction occurs when an obligor fails to pay on the premium financing loan and the corresponding policy must be cancelled. An obligor is generally entitled to cancel the policy at any time. In such an event, the insurance carrier is obligated to reimburse a pro rata share of unearned premium paid under the insurance contract to the lender. When the policy is cancelled, the insurance carrier ceases earning the premium that had been paid by the finance company. The finance company is typically entitled to be rebated the remaining balance of the premium (i.e., unearned premium); therefore, quantitatively, the risk to the finance company (aside from insurance carrier insolvency risk) equals the difference between the amount of unearned premium the finance company is owed at cancellation and the aggregate amount of the outstanding loan. As shown in Graph 1 below, an insurance policy covering 12 months may be financed over a six-month term. The premium is paid by the finance company upfront and, as shown by the dotted line, amortizes linearly over the full term of the policy. The solid line shows the premium finance loan amortizing at a faster rate than the amortization of the premium. As a result, excess unearned premium grows as the premium loan amortizes (the delta between the dotted and solid lines). 28

29 Graph 1 Graph 1 assumes an obligor purchases a property and casualty insurance policy for $4,000 with a down payment of $400 (or 10%) and an insurance premium loan of $3,600 casualty insurance policy. At inception, the policy premium has been paid for by the obligor but no insurance has been provided, thus the premium is unearned. As time passes, the insurance policy is used and the related premium is earned. In the above example, the insurance premium loan, originally $3,600, amortizes over time as the obligor makes its scheduled payments. The period of amortization for the insurance premium loan, which is shorter than the related insurance policy term, is six months. If the obligor fails to make a scheduled payment, the policy will be cancelled. The example assumes that the insurance policy is cancelled at the end of month two of the premium loan. At the time of cancellation, the amount of unearned premium owed to the finance company is $3,333 and is represented by the area below the dotted line as #1. The amount of the premium finance loan that remains outstanding is $2,400 and is represented by the area below the solid line as #2. Although the finance company has a potential loss of $2,400 on the premium finance loan, the finance company is protected against such loss by the amount of the rebate of unearned premium (which exceeds the amount owed on the premium loan). The worst-case scenario is typically if a policy is cancelled on day one, when the finance company has its full premium lump sum payment paid to the insurance carrier and the premium finance loan has not begun to amortize. Under such circumstances, however, the risk of loss to an investor is mitigated by the amount of down payment received by the finance company from the obligor, as well as the subordination, OC and reserve fund usually available to an outstanding series in the transaction structure. Also, it is common for finance companies to net out certain amounts of unearned premium they are owed on existing cancelled policies from new premium business they are paying out to an insurance company. INSURANCE CARRIER RISK The main source of recovery in a premium finance arrangement is the insurance carrier that provides the insurance policy; therefore, the claims paying ability of the insurance carrier is an important analytical consideration. DBRS reviews the claims paying ability ratings of the insurers and the diversity of such insurers in a transaction. Transactions typically include pools of loans of 20,000 or more relating to policies issued by 100 or more insurance carriers with concentration limits that can protect against exposures to insurers repre- 29

30 senting high concentrations of receivables, low ratings or other concentrations that introduce additional risk in the transaction. Generally, lack of diversity among insurers or high concentrations of lower-rated insurers could limit the rating of the transaction as the ultimate source of payment is the rebate of unearned premium from the insurers. Should a carrier become insolvent, the finance company would normally file a claim allowing them to be reimbursed for the unearned premium. The finance company would file as a general creditor of the insurance company. As a regulator, a state department of insurance can generally seek three types of orders for carriers facing financial distress or insolvency: supervision, suspension or liquidation. An order of liquidation is the most severe of the three and is issued only by a state court. Once granted, an order of liquidation cancels all outstanding policies and outstanding claims are processed by the guaranty association. Insurance codes vary at the state level, but in general, balances due from an insolvent domestic carrier may be covered by guaranty funds managed by the department of insurance in each state. Consequently, if the insurance carrier defaults (in the instance of U.S. carriers), the respective state s insurance guarantee funds may back the insurance carrier s obligations. While likelihood of recovery is increased because of the presence of such funds, the timing of payment is variable and can expose a transaction to timing delays. TRANSACTION STRUCTURE Types of Transactions Given the short duration of insurance premium finance loans, ABS transactions financing these assets have typically utilized bank warehouse structures and term financing with an embedded revolving feature, where receipts that remain after paying interest and fees are reinvested to purchase new receivables. New receivables are usually acquired in accordance with eligibility criteria incorporated by the issuer, which impose certain concentration limits by key asset characteristics. Transaction Triggers U.S. insurance premium finance ABS transactions may utilize trigger mechanisms whereby adverse performance of the underlying collateral results in a change to the initial cash flow structure. Triggers typically measure collateral performance and are designed as an early warning mechanism, which may adjust the initial cash flow structure to protect against an erosion of credit support. To the extent a trigger is breached, typically reinvestment in new receivables ceases and the notes amortize. ORIGINATION AND SERVICING REVIEW The risk of loss in insurance premium finance transactions usually focuses on the timely cancellation of policies in order to stop the insurer s earning of premium and for the remaining unearned premium to be rebated to the finance company. Accordingly, the servicer s operational capability is of importance when rating a potential transaction. DBRS conducts an operational review of the servicer to determine whether the quality of the systems and personnel are satisfactory to effectively manage the obligor and insurer relationships, track delinquencies, file cancellation notices in a timely fashion and properly track rebates from the insurers. 30 DBRS also typically assesses the origination process for the financing loans. Given that the policies being financed are pre-arranged through the insurance carriers, finance companies typically perform minimal underwriting; however, finance companies may maintain certain eligibility criteria for a financing loan to be made and/or included in a lending facility. Often, these eligibility criteria relate to the obligor being sourced through an approved channel (e.g., agent, broker or insurer with whom the finance company has a business relationship) and accepting standard terms of the finance company s loan product. To be considered as eligible collateral for a transaction, the receivables may need to meet other criteria, including compliance with certain concentrations limits (e.g., insurers, insurers ratings and geography). Although the underwriting may be minimal, fraud protection is important. DBRS expects sufficient protocols to be in place to minimize the opportunity for fraud, which could result in the policy being contested and a delay or refusal of the rebate of unearned premium.

31 CASH FLOW ANALYSIS DBRS typically reviews at least three years of performance data of the seller to determine: (i) defaults, loss proxies or such other indicators of credit performance (e.g., extended delinquency periods over 30, 60 or 90 days); (ii) default/loss timing; (iii) recovery rate and timing lag; and (iv) pre-payment rates. In the assessment of the historical performance data, and in cases where recoveries are an element of the analysis, DBRS typically estimates a recovery rate as well as a timing lag between the default and the expected recoveries, based on the estimated length of the claims recovery process or recovery following a carrier insolvency. The amount of collateralization may vary depending upon the composition of the collateral pool, but a minimum threshold amount is typically derived from historical loss rates for property and casualty insurance premium finance companies. Losses result from a failure of an insurer to rebate the unearned premium following an obligor default in payment on the financing loan. Historically, the recovery rate on such obligor defaults is between 97% to 99% (or more) because of the strength of the legal obligation of the insurers to rebate unearned premiums. The risks to recovery are generally the timing of the cancellation notice being delivered to the insurer, reliance on insurance agent intermediaries to collect unearned premiums and remit those to the finance company, and to a lesser extent, the insurer becoming insolvent during that period of time. To evaluate proposed credit enhancement levels that support a target rating, the expected loss figure, as previously described, is stressed. The stress is applied as a multiple of the expected loss figure which, in turn, results in losses for each target rating s cash flow scenario. DBRS typically evaluates the results of the stress analysis under a variety of scenarios. To achieve a requested rating, the cash flow results are expected to withstand DBRS stresses appropriate for the rating. The multiples serve to protect the rated securities from much harsher and more stressful conditions than assumed within the expected case cash flow scenario. Table 1 indicates the typical range of multiples for U.S consumer loans securitizations. Multiples are designed to capture uncertainties and variables that may affect future transaction performance. The multiples in Table 1 are guidelines and may not be applicable in all transactions. Table 1: Summary of Typical U.S. Insurance Premium Finance Loss Multiples by Rating Category Rating Category Loss Coverage Multiple AAA 5-6x AA 4-5x A 3-4x BBB 2-3x BB 1-2x B 1x U.S. STRUCTURED FINANCE ORIGINATOR/SERVICER REVIEW AGENDA SUPPLEMENTAL ITEMS General Administration: Technology and procedures for handling various payments Verification of insurance process Insurance claims processing Process for estimating the unearned premium claims amount Review of historical track record of unearned premium Procedures for ensuring data integrity Billing and payment processing and controls Tracking of unearned premium claims Role of brokers in the recovery of unearned premiums 31

32 Handling of disagreements with brokers/insurance companies Account reconciliation Use and reconciliation of lockboxes, bank accounts etc. Process for obtaining payments made to third parties Grading of insurance carriers Filing of UCC s 32

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