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Regulatory Update - Collateralized Loan Obligations

October 19, 2022

Regulatory Update - Collateralized Loan Obligations

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.

Regulatory Update - Collateralized Loan Obligations

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

What We Know About the NAIC Proposal

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.

  1. In comment period currently, the NAIC has proposed altering the way fixed income securities appear in annual filings (Schedule D). Current proposals have CLOs appearing on their own schedule, Schedule D- Part 1B, separated from comparable corporate bonds. 

  2. NAIC ratings designations for CLOs may also change. Instead of utilizing the current approach where CLOs have the same ratings categories as comparable public bonds, the NAIC may expand the number of CLO ratings categories to more accurately assess the associated risk. Specifically, expanding the NAIC 6 designation into 6.A, 6.B, and 6.C for CLOs has been discussed, with differing risk charges for each.

  3. Finally, based on recent stress testing, BBB rated and below CLOs may see an increase in capital penalties, perhaps by a significant amount.
     

Potential Changes in Risk Charges

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.

Timeline of the project

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.

What does this mean for investment strategy?

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

 

Disclosure

This content is intended for institutional investors only. This information is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information.

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and, in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association. In the U.S., securities are offered by Sun Life Institutional Distributors (U.S.) LLC, an SEC registered broker-dealer and a member of the Financial Industry Regulatory Authority (“FINRA”).

The information presented may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility.

Efforts have been made to ensure that the information contained in this report is obtained from sources believed to be reliable and accurate at the time of publication; however, Sun Life Capital Management (Canada) Inc. and/or its affiliates (collectively “SLC Management”) do not guarantee its accuracy or completeness. Information is subject to change and SLC Management accepts no responsibility for any losses arising from any use of or reliance on the information provided SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate

© 2022, SLC Management

 

 

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About SLC Management

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate.

Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

BentallGreenOak, InfraRed Capital Partners (InfraRed) and Crescent Capital Group (Crescent)  are also part of SLC Management.

Bentall Green Oak is a global real estate investment management advisor and a provider of real estate services. In the U.S., real estate mandates are offered by BentallGreenOak (U.S.) Limited Partnership, who is registered with the SEC as an investment adviser, or Sun Life Institutional Distributors (U.S.) LLC, an SEC registered broker-dealer and a member of the Financial Industry Regulatory Authority (“FINRA”) . In Canada, real estate mandates are offered by BentallGreenOak (Canada) Limited Partnership, BGO Capital (Canada) Inc. or Sun Life Capital Management (Canada) Inc. BGO Capital (Canada) Inc. is a Canadian registered portfolio manager and exempt market dealer and is registered as an investment fund manager in British Columbia, Ontario and Quebec.

InfraRed Capital Partners is an international investment manager focused on infrastructure. Operating worldwide, InfraRed manages equity capital in multiple private and listed funds, primarily for institutional investors across the globe. InfraRed Capital Partners Ltd. is authorized and regulated in the UK by the Financial Conduct Authority.

Crescent Capital Group is a global alternative credit investment asset manager registered with the U.S. Securities and Exchange Commission as an investment adviser. Crescent provides private credit financing (including senior, unitranche and junior debt) to middle-market companies in the U.S. and Europe, and invests in high-yield bonds and broadly syndicated loans.

Securities will only be offered and sold in compliance with applicable securities laws.

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The content of this website is intended for institutional investors only. It is not for retail use or distribution to individual investors. All investments involve risk including the possible loss of capital. This website is for informational and educational purposes only. Past performance is not a guarantee of future results.

The information contained in this website is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained on this website. The assets under management (AUM) represent the combined AUM of Sun Life Capital Management (Canada) Inc., Sun Life Capital Management (U.S) LLC, BentallGreenOak and InfraRed Capital Partners.

AUM as of December 31, 2022. Total AUM includes approximately $7B in cash, other, and unfunded commitments.

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SLC Management Newsroom: SLC-20221101-2566004

UK Tax Strategy - InfraRed (UK) Holdco 2020 Limited

InfraRed (UK) Holdco 2020 Ltd is the UK holding company of InfraRed Partners LLP and a subsidiary of Sun Life (U.S.) Holdco 2020 Inc, which has its headquarters in the U.S. The company was incorporated to purchase InfraRed Partners LLP and acts solely as a passive holding company. The Tax Strategy for the InfraRed Holdco Group sets out our approach to the management of InfraRed Holdco Group UK tax affairs in supporting business activities in the UK. 

This UK tax strategy is published in accordance with the requirements set out in Schedule 19 of Finance Act 2016. The strategy, which has been approved by the Board of Directors of InfraRed (UK) Holdco 2020 Ltd, is effective for the period ending 31 December 2022. It applies to InfraRed (UK) Holdco 2020 Ltd and its dormant subsidiary Sun Life (UK) Designated Member Ltd, referred to as the “InfraRed Holdco Group”. InfraRed Holdco Group.

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