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A key area of interest at the NAIC's Summer National meeting was the potential changes in regulatory treatment of collateralized loan obligations (CLOs) held on insurance company balance sheets. The details regarding the recommendation will not be available until later this year, but a few key themes have emerged.
The National Association of Insurance Commissioners (NAIC) recently held its Summer National Meeting and provided updates regarding current regulatory proposals. A key area of interest was discussion of potential changes in regulatory treatment of collateralized loan obligations (CLOs) held on insurance company balance sheets. In this update, we examine some of the issues & trends driving increased scrutiny from regulators on insurance company CLO investments and we also provide detail on the proposed changes being considered.
In summary, increasing allocations in CLOs by insurance companies along with their superior capital treatment relative to the underlying loans is likely to result in the NAIC assigning higher risk-based capital (RBC) charges to the lowest rated CLOs.
What’s driving the increased scrutiny?
1. Capital Arbitrage
The NAIC compared the RBC charge of direct investments into a pool of B-rated corporate bonds to the weighted average RBC charge of same pool of bonds securitized into a CLO structure. In the former, the RBC charge incurred by these investments is 9.5% but by packaging the same assets into a CLO structure, the weighted average RBC charge is only 3.0% despite having the exact same underlying investments. The NAIC calls this difference of 6.6% the capital arbitrage benefit. The main goal for the NAIC’s CLO proposal is to minimize this capital arbitrage benefit and more closely align the risk charge assigned to the CLO with the risk charges assigned to the underlying assets.
1 NAIC Risk Assessment of Structured Securities – CLOs May 2022
2. Increasing Allocations by Insurers to Collateralized Loan Obligations
CLOs provide credit enhancement on senior secured tranches of the bank loans via collateralization and restructuring. These securities have offered higher yields than similarly rated public bonds, generating significant interest from insurers who are looking to maximize income. Insurers have been one of the largest adopters of the CLO structure, as displayed in the table below. U.S. insurers’ CLO exposure has grown significantly over the past several years as market yields on public fixed income declined and the search for yield accelerated. While the majority of CLOs are owned by life insurers, P&C insurers have begun to take notice, more than tripling their allocation in just four years. This, combined with life Insurers’ CLO allocation doubling from $48b to $148 in the same time frame, has contributed to the increased scrutiny by regulators.2
2 SNL Statutory filling
3. Reduced Average Rating Over the Years
As shown below, the majority of insurers’ CLO allocations are targeted in the highly collateralized AAA and AA tranches, whose historical default rates are close to 0%. However, recently insurers have become increasingly comfortable moving down the capital stack to lower rated CLOs, thereby increasing yield but at the cost of higher default rates and elevated volatility. This trend has unsettled regulators, as insurers continue expanding allocations to lower rated CLOs and take advantage of the capital arbitrage.
2 SNL Statutory filling
The details regarding the NAIC recommendation will not be available until later this year. However, a few consistent themes have become apparent from current published language in recent meetings.
NAIC has conducted stress testing on CLOs to understand true risk, as they are particularly concerned with the idea that the leveraged loans underlying CLOs have loosened underwriting in recent years. The NAIC believes that the relaxed underwriting may result in substantially lower recovery rates on leveraged loans than historically implied given a market decline. As indicated by the historical stress scenario below, the default rate on C-below tranches could be as high as 73.4% under base scenario and 91% under their conservative scenario (+1 standard deviation). The results from stress scenarios have pointed towards much higher default experience than what currently RBC factors of NAIC 6 would imply.
Table 2: “Historical” Default Vectors
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
|---|---|---|---|---|---|---|---|---|---|---|
Ba1 |
0.6% |
1.8% |
3.1% |
4.4% |
5.8% |
7.2% |
8.2% |
9.0% |
9.8% |
10.7% |
Ba2 |
1.0% |
2.4% |
3.9% |
5.4% |
6.8% |
8.0% |
9.1% |
10.4% |
11.8% |
13.4% |
Ba3 |
1.8% |
4.8% |
8.0% |
11.6% |
14.6% |
17.5% |
20.0% |
22.4% |
24.7% |
26.7% |
B1 |
2.7% |
6.7% |
10.9% |
14.7% |
18.5% |
21.95 |
25.3% |
28.2% |
30.8% |
32.9% |
B2 |
4.0% |
9.8% |
15.1% |
19.7% |
23.4% |
26.8% |
29.7% |
32.1% |
34.3% |
36.4% |
B3 |
6.5% |
13.6% |
20.2% |
25.7% |
30.4% |
34.4% |
37.9% |
40.9% |
43.5% |
45.5% |
Caa |
12.8% |
23.1% |
30.9% |
37.1% |
41.7% |
45.4% |
48.2% |
51.0% |
53.6% |
55.8% |
Ca-C |
49.8% |
61.5% |
67.6% |
70.8% |
71.5% |
71.5% |
72.5% |
73.4% |
73.4% |
73.4% |
3 NAIC Stress Testing
Table 3: “Historical + 1σ” Default Vectors
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
|---|---|---|---|---|---|---|---|---|---|---|
Ba1 |
1.1% |
3.4% |
5.4% |
7.4% |
9.5% |
11.3% |
12.5% |
13.3% |
14.1% |
15.0% |
Ba2 |
1.9% |
4.5% |
6.8% |
9.0% |
11.2% |
12.6% |
13.9% |
15.4% |
17.1% |
18.7% |
Ba3 |
3.5% |
9.0% |
14.0% |
19.4% |
23.8% |
27.5% |
30.6% |
33.4% |
35.6% |
37.4% |
B1 |
4.7% |
10.7% |
16.4% |
21.1% |
25.3% |
28.8% |
32.1% |
35.2% |
38.3% |
40.9% |
B2 |
7.1% |
15.6% |
22.7% |
28.3% |
32.0% |
35.2% |
37.7% |
40.0% |
42.7% |
45.3% |
B3 |
11.5% |
21.7% |
30.4% |
36.8% |
41.5% |
45.2% |
48.1% |
51.1% |
54.1% |
56.5% |
Caa |
20.1% |
32.7% |
41.7% |
47.3% |
51.3% |
53.7% |
55.7% |
58.2% |
60.2% |
62.5% |
Ca-C |
77.9% |
87.3% |
91.0% |
91.0% |
91.0% |
91.0% |
91.0% |
91.0% |
91.0% |
91.0% |
3 NAIC Stress Testing
Given the higher modeled default rates, coupled with lower recovery rates, the NAIC proposal may result in bottom tranches of CLOs being assigned significantly higher risk charges. For the lowest tranches (B, CCC, and CLO equity) the proposed risk charge may be as high as 5 times the current level. Highlighted in the table below are two current proposals from the NAIC regarding potential risk charges, neither of which have been adopted and are currently under review. A primary goal in any proposal is to minimize the capital arbitrage.
NAIC staff is moving quickly with the timeline. Based on the commentary from 2022 Summer National Meeting, the proposed NAIC Designations and associated RBC charges will come out in 2023 with implementation date setting on 12/31/2023 at earliest or 12/31/2024 more realistically. Either way, the CLO changes are imminent in next 2 years.
The increases in RBC factors will reduce the attractiveness of lower rated CLO investments for insurance companies. SLC believes that the proposed approach will have minor impact for the vast majority of insurers, who largely focus on the AAA and AA tranches. However, insurers who have added lower rated tranches may see increased capital requirements. If these insurers are capital constrained, it may lead to changes in investment strategy.
While we are a few years away from the new CLO capital framework, insurers and their asset managers should use this time to vet current and future holdings, ensuring there are no surprise capital implications.
SLC-20221012-2471773
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