Taking a CLOser look at insurers

US insurance regulation seems tedious but is incredibly important.

Part of the challenge is that insurers are regulated at the state level, and standards are co-ordinated through the National Association of Insurance Commissioners, or NAIC.

But because US insurers have massive bond portfolios, any shift in regulatory focus can have big effects — or spotlight risks in a select group of firms, like the NAIC’s recent work on collateralised loan obligations, or CLOs.

First we should set the stage: Insurers were among the investors stretching for yield during the low-rates era. As a general rule, that has pushed insurers’ portfolios into lower-rated and longer-dated securities as they look to squeeze out some extra yield.

For most insurers, this has remained within the bounds of investment-grade markets. They are generally more likely to hold securities rated in the lower tiers of investment grade (BBB and A) than those with higher ratings (AA and AAA).

Here’s how that trend looked in the market for CLOs at the end of 2022, according to Barclays:

CLOs, or securities backed by a pool of junk-rated floating-rate loans, have been of particular interest to the NAIC, as Barclays highlights in a May note.

The regulator is reconsidering its risk assessments on CLOs, and in the meantime just proposed raising its capital charge for the riskiest tranches to 45 per cent from 30 per cent, Barclays says.

Barclays’ strategists downplay the significance of the interim change for the life-insurance and CLO market as a whole. CLOs and other structured products are a relatively small proportion of insurers’ portfolios, as the strategists found back in June 2022:

So they argue that insurers still probably won’t sell en masse:

We do not necessarily think 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 the CLO equity outstanding, only around 0.5%. In a worst-case scenario where they decide to reduce exposure, we would expect minimum effect on the CLO market broadly.

Assuming adoption of the current proposal, the sector’s aggregate [risk-based capital] ratio would decline by only 80bp and still hover around 440%. Even a 100% charge would only dent the [risk-based capital] ratio by less than 4pp, given insurers’ limited holdings of these risky tranches.

There are still a couple of big ways this could matter, however.

1) A handful of insurers may be significantly affected by this rule.

In January 2023, the NAIC’s capital markets group published a stress test based on year-end 2021 CLO holdings, and found that “a few insurers” have “concentrated investments” in unrated and equity tranches of CLOs.

It was especially tough for the regulator to model worst-case scenarios for “combo notes”, which are “a repackaging of all or a portion of CLOs’ debt and equity tranches, often into a special purpose vehicle (SPV)” that is most often a principal-only security, according to the regulator’s primer.

And while these risky CLO tranches are a small part of insurers’ aggregate capital, insurers made up a good share (20 to 40 per cent) 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 markedly worse recoveries than top-tier debt.

These are often called “mezzanine” tranches because they absorb losses before the AA- and AAA-rated tranches do. And as shown in the table above, insurers own between 40 and 50 per cent of those markets.

Those markets, incidentally, were the biggest concern expressed by Barclays when regulators announced the review in July 2022. They said tougher mezzanine-tranche capital requirements could have greater impact on demand for CLOs.

But for now, at least, the “few insurers” with the biggest exposure to low-rated CLO tranches are the main point of worry. In its January report, the NAIC said the riskiest CLO holdings were concentrated among 23 insurers. Barclays’ strategists, using more recent data, made the following conclusion:

CLO equity holdings are concentrated among 22 life insurance groups. Even among these insurers, CLO equity investments make up a small percentage of their investments in the asset class held by regulated US opcos, around 9% on average. Still, there are four insurers with greater than 15% of their CLO investments in equity tranches, indicating that these investments might be more integral to their CLO investment strategy.

A decent share of those investments are held by insurers that Barclays classifies as “foreign”:

Of course, going by Figure 3, it looks like large mutual insurers face the highest risk. But their holdings are “in line with their pro rata share of industry capital,” the bank says. And Figure 4 shows that large mutual insurers are the best capitalised in the life-insurance industry. (See the leftmost “Current RBC” column).

So the foreign CLO owners are a potential source for concern.

This raises a question about what, exactly, is meant by a “foreign” US insurer. Do they mean that the ultimate parent of the insurer is based abroad? There are dozens of foreign life insurers operating in the US. Slightly dated reports from the industry show Canada, Japan and Switzerland were among the biggies. But notably, Bermuda and the Cayman Islands were near the top of the list as well.

So let’s revisit that par from before, with our emphasis:

CLO equity holdings are concentrated among 22 life insurance groups. Even among these insurers, CLO equity investments make up a small percentage of their investments in the asset class held by regulated US opcos, around 9% on average. Still, there are four insurers with greater than 15% of their CLO investments in equity tranches, indicating that these investments might be more integral to their CLO investment strategy.

Hmm. The phrase “held by regulated US opcos” sounds mighty specific, and it comes with a footnote:

We are specific in our reference to legal entities because some CLOs held by life insurers may be held by non-regulated entities or opcos domiciled outside of the US.

Well then! Offshore entities! That settles it, huh?* As always, please do provide thoughts or let us know what we’ve missed in the comments.

*That does not settle it