U.S. life insurers have long been among the most active investors in asset-backed securities, and collateralized loan obligations (CLOs) have taken up an ever-larger portion of their balance sheets, according to recent analysis from DBRS Morningstar.
The National Association of Insurance Commissioners (NAIC) may soon require insurers to hold more capital against those investments, a move that could hinder the CLO market.
The support for CLOs is especially strong from providers of higher-return annuities that are owned by or associated with private equity firms, the rating agency said in a recent commentary. What's more, according to DBRS, their support has so far been unwavering even as NAIC, a regulatory standard setting organization, analyzes whether to recommend that state insurance regulators impose higher risk-based capital (RBC) requirements.
The tougher requirements are likely to be imposed on the so-called "mezzanine" portion of CLOs, ranging from 'BB' tranches up to 'A'. Insurers are highly active mezzanine investors, raising concerns that higher RBC could hinder their investments in CLOs, which purchase the majority of syndicated leveraged loans.
Bonds overall represent 68% of life insurers' investments, or $3.63 trillion, according to DBRS, citing data from NAIC's Valuation of Securities Task Force. Some 23% of those bonds, or $843 million, is invested in structured credit products including asset- and mortgage-backed securities and CLOs.
Citing Federal Reserve estimates, DBRS says that U.S. life insurers own about 20% of the CLO market in the U.S., including up to half of the mezzanine tranches.
The mezzanine tranches are at the heart of the debate around the new capital requirements as the NAIC works out the details, Patrick Douville, a vice president of insurance in the global financial institutions group at DBRS Morningstar, and one of the commentary's authors, said in a recent interview.
The concern centers around the significantly lower capital charge applied to a vertical slice of a CLO compared to investing directly in the same batch of loans — about one third according to NAIC estimates. The NAIC has proposed eliminating that "arbitrage," replacing the current ratings by the Nationally Recognized Statistical Ratings Organizations (NRSROs) with its own methodology, an approach it already takes to residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). Earlier testing using its models showed losses as high as the AA CLO portion of some CLOs, bonds the market has viewed as practically untouchable.
Given that CLOs make up tiny portions of most insurers' portfolios, industry professionals see little immediate risk to the industry should the transactions prove to be riskier than current ratings indicate. Nevertheless, insurers have dramatically ramped up sales of income-producing annuities as baby boomers retire, drawing them to CLOs' higher returns and presumably lower risk.
U.S. life insurers reported a record $92.9 billion in annuity sales in the first quarter, DBRS said, citing survey data from LIMRA, another industry group. That was a 47% increase from Q1 2022, which itself set a new all-time record for annuity sales in the U.S. Fixed-income annuity sales were especially strong, growing by 98% over the same period.
The factors sustaining annuity sales growth and CLO demand are expected to remain in place, DBRS said. In addition, CLO performance has remained resilient, even after rate hikes over the last year have started to push up the default rate of the riskier loans CLOs invest in.
Returns are still higher, so [the CLO market] remains a more attractive alternative to other investment products.
Previously low interest rates drew investors to CLOs' return premiums, DBRS noted, but it doesn't expect a drastic reversal even if rates continue to rise. At this point, the Fed is not raising rates as aggressively, signaling that its campaign has reached a plateau.
"Plateauing may be the one scenario I would bet on," Douville said. "Returns are still higher, so [the CLO market] remains a more attractive alternative to other investment products."
Until recently, years of low interest rates had depressed returns on annuities, according to DBRS, policyholder enthusiasm and insurers' enthusiasm for the product. Private-equity firms and other asset managers, however, foresaw the likelihood of rate hikes and stepped up their strategic investments and acquisitions of annuity providers.
One of the most high profile of these transactions was Apollo Global Management's $11 billion merger with Athene that was announced in March 2021 and completed in 2022. Apollo is the poster child of such strategic moves, Douville said, noting that they have a large business in which they can funnel CLO capital.
Another reason that CLOs will continue to attract investments from life insurance and annuity providers is that banks, the traditional source of financing, are extending less corporate credit than before. Instead, CLOs and other private lenders are providing the loans, and insurers are eager to participate in those transactions.
"There is more of a trend toward alternative asset managers and insurers providing a greater share of corporate credit overall," Douville said.
