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Louis Pelosi, Managing Director of Client Solutions at SLC Management, discusses how recent changes to the risk-based capital charges on real estate investments could affect insurers investment portfolios.
Steve Peacher: Hello everybody thanks for dialing in to this episode of “Three in Five,” I’m this is Steve feature President of SLC Management. Today I’m with Louis Pelosi who's the Managing Director in our client solutions for our institutional business focused on insurance companies. And today, we want to talk about some changing rules in the insurance landscape that could have meaningful implications for insurance portfolio, so Louis thanks for taking a few minutes.
Louis Pelosi: Thanks Steve thanks for having me on.
Steve Peacher: So the first question, I want to ask is that in particular, it looks the regulations on the that insurance companies are under, related to investing in real estate in commercial real estate are changing and that can have significant implications. So tell our listeners about what changes are afoot.
Louis Pelosi: Sure absolutely Steve so what's going on is the American Committee of Life Insurers, the ACLI has recently proposed and the NAIC has accepted some updated real estate risk-based capital charges, now the NAIC is the governing body for life insurers, they have in place a system called risk-based capital or RBC. What that is really a solvency metric for life insurance for policyholders and regulators to understand how strong or healthy is a life insurer. That system puts in place capital charges on different asset classes to kind of assess the riskiness, you know whether that's defaults or recovery rates or market volatility and recently the ACLI has proposed that some of the data that the NAIC was using on real estate was a bit dated, you know it came from prior to 2000. So with this updated proposal they've looked at some more recent data, specifically on default and recovery statistics, as well as market implications on volatility for real estate and they've proposed – which were accepted – some significantly reduced risk-based capital charges on real estate, to the magnitude prior to the changes, those were in the 23% to 30% range down as low as 11 to 13% and for frame of reference1, a lot of people think about BBB bonds that's about a 3% capital charge2, so a meaningful reduction in overall capital required.
Steve Peacher: So, if you’re an insurance company now you've got these reduce capital charges that are coming at you, to a large asset class in the marketplace that was maybe somewhat prohibitive to invest in before. What does this mean now? If you’re in an insurance company’s shoes, how do you react to this, what do you do now?
Louis Pelosi: Absolutely, this change should add further fuel to the fire that is the growing asset allocation to alternative, or really noncore fixed income. We've been in an environment really since the global financial crisis, rather than a few blips, rates have gone down. You know life insurance, all insurers, but life insurance in particular rely on investment portfolio yield to you know maintain operations and grow profitability. With prolonged periods of low interest rates, insurers that had to look elsewhere outside of traditional core fixed income, so we've seen real estate expand on the balance sheet, depending on insurer, anywhere from five to 10%.3 Now, because of the capital implications being that an insurer has to hold so much capital and the amount of capital required to hold can vary based on investment. Traditionally insurers have gone into things like mortgage debt, which held a significantly lower capital charge, however, with this reduction specifically to real estate equity, again down from 23 to 131, we anticipate the move into real estate equity expanding, increasing at an exponential rate given real estate equity tends to offer some significantly higher yields, comparable volatility, and overall the return profile can be leveraged higher than what you would get in a traditional call it CM1, CM2 debt portfolio.
Steve Peacher: And so within any portfolio, especially with insurance companies, if you do something new, nothing's done in isolation, it has impact on the broader portfolio because you're trying, you've got broader goals. So if an insurance company does increase its allocation to commercial real estate in response to this, what are some of the implications across the remainder of the portfolio?
Louis Pelosi: You know I’ve been pretty positive on the asset class, let me, let me give some negatives, and then I’ll close out with some positives here. The NAIC doesn't do this and isolation, they've also updated risk charges specifically for core fixed income, which is you know the bulk of most life insurers assets. They’ve adopted a proposal that looks more granularly at bonds, it used to just be let's look at everything between AAA and single A is as one asset, and everything BBB plus to BBB minus as one. They've gone more granular in those assets. That overall has required life insurers to hold more capital, so in isolation, reducing real estate great but they've also been required to hold more capital elsewhere in their portfolio. Anytime you're moving into an asset class, again I said earlier 3% charge for BBB's to something like real estate equity that has 133, right you're going to be required to hold more capital. So understanding and insurers capital position, solvency, ability to hold an asset like that without severely impacting any current solvency ratios is one consideration. Another consideration are ALM concerns for a life insurer, these assets can be difficult to pinpoint on a maturity or weighted average life sometimes, particularly again real estate equity can experience some slightly more volatility than traditional debt. And last but not least, when you're looking at something like adding real estate equity onto your onto your balance sheet, you know the positive side, it does particularly well in inflationary periods, inflation seems to be a decently correlated hedge so adding real estate now can particularly benefit if we do enter a prolonged period of high inflation. Again there are certain considerations for every life insurer, they're going to have their own needs requirements. It's not a one size fits all, ‘everyone should add real estate equity,’ you should understand your ALM profile, your current capital insolvency ratios, but if all of that lines up and, hopefully it does you can create a tailored solution for yourself that has the opportunities with reduced capital penalties now to increase portfolio yield and return. The only asterisks I’ve put on all that is you know, this is a fluid environment. As more insurers look towards alternatives we've seen the NAIC put more scrutiny on these alternatives, this is where we're at in 2022 that's not saying that there's going to be changes, they're constantly updating these metrics and these risk-based capital requirements. Having someone on your team that is up to date staying up with these policies and preparing your portfolio in case of any new or updated policies, you know it's definitely something to keep an eye on.
Steve Peacher: Thanks, you know it just reinforces what my impression since I joined Sun Life over 12 years ago, is that managing money inside insurance companies like dealing with Rubik’s cube then I don't know what the analogy is on the Rubik’s cube, but it makes it just a little more complicated. Let me ask you, I like to end with a personal question. And the covid environments been crazy for everybody, but especially for you, because you've had two daughters born during the pandemic, so talk to me a little bit of what that's been like.
Louis Pelosi: Yeah, I try to look for the positives than negatives right, so never I would make light of the covid situation, but prior to covid, you know, spent a lot of time on the road visiting clients, again working on solutions for insurers. Being home for these past two years has been somewhat of a blessing, we went into the lockdown my wife was pregnant, we had two daughters during that period. Being able to spend a lot of time with them, particularly when they were young has been fantastic, I’ve gotten to see them grow up. Certainly again, can appreciate the fact that while this has been tough for a lot of people, again looking for the positive, spending more time with family is especially my young girls is has been a little hectic. On Zoom you hear a lot of yelling in the background, but the offset of being able to spend more time and see them grow up has been fantastic.
Steve Peacher: Well, everybody during this pandemic as you say has needed bright spots, and there's no brighter spot than having children so congratulations to you and your wife. Thanks Louis for taking the time to talk about these new regulations it's, this is important, it's technical but it's very important it could have implications for both insurance companies, and I suppose the real estate markets because you can have a big new buyer in there, and thanks to everyone for listening to this episode of “Three in Five.”
3 Data from SNL as of 12/31/2020
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