US insurance regulation sounds boring, but it’s incredibly important.
Part of the challenge is that insurers are regulated at the state level and standards are coordinated through the National Association of Insurance Commissioners, or NAIC.
But because US insurers have huge bond portfolios, any shift in regulatory focus can have large effects or highlight risks in a select group of firms, such as NAIC’s recent work on covered loan obligations, or CLOs.
First we should set the stage: Insurers were among the yield-seeking investors during the low-rate era. As a general rule, this has pushed insurers’ portfolios into lower-rated, longer-maturity securities as they seek to squeeze in extra yield.
For most insurers, this has remained within the bounds of investment grade markets. They are generally more likely to hold securities rated below investment grade (BBB and A) than those rated higher (AA and AAA).
Here’s what this trend looked like in the CLO market in late 2022, according to Barclays:
CLOs, or junk-rated floating-rate pool-backed securities, have been of particular interest to the NAIC, Barclays points out in a May note.
The regulator is reconsidering its risk assessments on CLOs and in the meantime has just proposed increasing its capital requirement for riskier tranches to 45% from 30%, Barclays said.
Barclays strategists downplay the importance of the interim change to the life insurance market and CLO as a whole. CLOs and other structured products represent a relatively small percentage of insurers’ portfolios, as strategists found in June 2022:
So they argue that insurers probably won’t sell just yet en masse:
We do not necessarily believe that the proposed interim charge will reduce the willingness or ability of most insurers to continue to hold their CLO positions. Life insurers own a very small portion of CLO capital outstanding, only about 0.5%. In the worst case scenario where they decide to reduce exposure, we would expect little effect on the CLO market in general.
Assuming the adoption of the current proposal, the sector aggregate [risk-based capital] the ratio would decrease by only 80 basis points and would still hover around 440%. Even a 100% charge would only dent the [risk-based capital] ratio of less than 4 percentage points, given the limited holdings of insurers of these risky tranches.
However, there are still a couple of big ways this could matter.
1) A handful of insurers can be significantly affected by this rule.
In January 2023, the NAIC’s Capital Markets Group released a stress test based on 2021 year-end CLO holdingsand found that “few insurers” Have “concentrated investments” in unrated and equity tranches of CLO.
It was particularly difficult for the regulator to model worst-case scenarios for “combined notes”, which are “a repackaging of all or a portion of the debt and equity tranches of CLOs, often into a special purpose vehicle (SPV)” which is most often a principal only security, according to the regulator’s handbook .
And while these risky CLO tranches represent a small fraction of insurers’ aggregate capital, insurers made up a good share (20 to 40%) of the market at the end of 2022, as shown in the table below:
2) Regulators could also increase charges on A- and BBB-rated CLO debt, which are rated investment grade but have far worse recoveries than high-end debt.
These are often called “mezzanine” as they absorb losses before the AA and AAA-rated tranches. And as shown in the table above, insurers own between 40 and 50 percent of those markets.
These markets, incidentally, were the main concern expressed by Barclays when regulators announced their review in July 2022. They said stricter capital requirements for mezzanine tranches could have a greater impact on CLO demand.
But for now, at least, the “few insurers” with the largest exposure to low-rated CLO tranches are the main cause for concern. In its January report, the NAIC said the riskiest CLO holdings were concentrated among 23 insurers. Barclays strategists, using more recent data, came to the following conclusion:
CLO’s equity holdings are concentrated in 22 life insurance groups. Even among these insurers, CLO equity investments make up a small percentage of their asset class investments held by regulated US opcos, about 9% on average. However, there are four insurers with more than 15% of their CLO investments in equity tranches, indicating that these investments could be more integral to their CLO investment strategy.
A decent share of these investments are held by insurers that Barclays classifies as “foreign”:
Obviously, following Figure 3, it appears that the large mutual insurers face the highest risk. But their holdings are “in line with their proportionate share of the industry’s capital,” the bank says. And Figure 4 shows that large mutual insurers are the best capitalized in the life insurance industry. (See the “Current RBC” column further to the left).
So foreign CLO owners are a potential source of concern.
This raises a question of what, exactly, is meant by a “foreign” US insurer. Do they mean that the insurer’s ultimate parent is based abroad? There are dozens of foreign life insurers operating in the United States. Somewhat outdated industry trade show reports Canada, Japan and Switzerland were among the biggies. But notably, Bermuda and the Cayman Islands also topped the list.
So let’s revisit that par from before, with our emphasis:
CLO’s equity holdings are concentrated in 22 life insurance groups. Even among these insurers, CLO holdings make up a small percentage of theirs investments in the asset class held by regulated US opcos, about 9% on average. However, there are four insurers with more than 15% of their CLO investments in equity tranches, indicating that these investments could be more integral to their CLO investment strategy.
Hmm. The phrase “held by regulated US opcos” sounds very specific and comes with a footnote:
We are specific in our reference to entities because some CLOs held by life insurers may be held by unregulated entities or opcos domiciled outside the United States.
Well then! Offshore entity! That solves everything, huh?* As always, please provide thoughts or let us know what we missed in the comments.
*This doesn’t fix it
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