Potential CLO capital charges credit neutral for US life insurers - Fitch

Written by Adam Cadle

13/03/2023

Higher potential capital charges for US life insurers that invest in collateralised loan obligations (CLOs) from a recent proposal by the NAIC are not expected to meaningfully affect the investment portfolios of the aggregate US life industry, Fitch Ratings has said.

“However, the changes suggest a more conservative posture by the NAIC regarding CLOs and may lead to more conservative and impactful changes over time”, Fitch stated.

The NAIC proposal aims to close the regulatory gap in capital requirements between CLOs and underlying bond portfolios by linking CLO capital charges to yet to be determined risk-based modelling rather than CLO ratings. The higher charges target the riskier tranches of CLOs to eliminate the arbitrage of the lower risk charge for holding all of the tranches of the CLO collectively versus holding the underlying leveraged loans.

“The rule could increase capital requirements by 50% for the riskiest slices of complex corporate loan instruments to equalise the capital treatment that allows the CLO holder to pay lower blended capital charges resulting in wider spreads/higher returns,” Fitch said.

The NAIC has indicated that, based on stress test results, US insurer investments in CLOs remain an insignificant risk. For Fitch’s rated universe, CLO exposure has increased over recent years, and rose 10bps to 3.2% of invested assets as of YE 2021. Favorably, the exposure is high quality, with approximately 80% rated ‘A’ or above and 96% rated investment-grade. Therefore, Fitch does not expect the NAIC proposal in its current form to have a meaningful impact on the industry.

Certain insurers, including some alternative investment manager (alt IM)-backed and affiliated insurers have been vocal opponents of the change, positing that current CLO capital charges are appropriate and that increased investing in these instruments do not increase the risk of losses. They also point to higher corporate bond defaults and losses than those of equivalently rated structured securities as evidence that risk-based capital factors are overly conservative for comparable structured securities. Certain traditional insurers want to boost the capital charge to 45% from 30% for the riskiest equity tranche of structured securities due to their unique ‘cliff risks’ not present in most financial assets.

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