US life insurers deploying annuity capital to capture private debt illiquidity premiums

Written by Adam Cadle

20/02/2020

The largest US life insurers are entering private debt markets, as banks refocus on commercial banking against a backdrop of unconventional monetary policies and tighter bank regulations, according to a new research paper published by the Federal Reserve.

“Through complex on-and-off balance sheet arrangements, these insurers, many of whom are controlled by private equity firms, are acquiring and deploying vast amounts of annuity capital to capture the illiquidity premiums,” the paper stated. Life insurers such as AIG, Apollo-Athene and MetLife have all been named in the paper as using this strategy.

The paper added: “Within ten years, the US life insurance industry has grown into one of the largest private debt investor in the world. Life insurers that have adopted the private debt business model are originating loans to private real estate as well as originating, warehousing, and securitising loans to highly-leveraged corporations. By extending credit to these risky projects the insurers earn a spread over their stable funding.”

The Federal Reserve said life insurers with private credit investments typically target risky firms, for example, through leveraged loans. “The life insurer is potentially a relatively low-cost warehouse for the asset manager to store leveraged loans ahead of securitising them as CLOs,” it said.

“Although insurance companies do hold some leveraged loans directly on their balance sheets, their affiliate asset managers can attract more investors by pooling and tranching the debt as CLOs. After a CLO is created, the life insurer continues to finance the CLO deal risk with its annuity capital either to satisfy regulatory requirements and/or to give outside investors greater confidence in the deal. This activity requires additional complex entities within the organisational structure.”

US insurers’ total holdings of CLOs more than tripled from 2009 to 2018, reaching about $93bn in Q3 2018.

“By holding the riskiest portions of the CLOs issued by their affiliates as well as a rapidly growing portfolio of commercial real estate loans, life insurers are vulnerable to a downturn in the credit cycle,” the paper said.

“For example, a widespread decline in the value of the loans backing the CLOs could directly wipe out the equity held by the affiliated life insurers. As we learned from the 2007-09 financial crisis, even a relatively small exposure could create a vulnerability for life insurers who pledged their excess capital to the deal risk. In addition, because the vast majority of affiliated life insurers that create and hold CLO deal risk tend to rely on wholesale funding, these insurers could experience further pressure as liquidity-sensitive institutional investors -such as securities borrowers, FABS investors, or FHLBs - withdraw their funding and/or increases margins. The combination of eroding equity and rapid institutional investor withdrawals would likely create a severe liquidity crisis for the life insurance industry.”

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