#136 | Leveraged Loans & Life Insurance

2/25/19 update – Bloomberg on a Fitch report about growing life insurer exposure to CLOs

Over the past couple of years, the financial press and even some mainstream publications have begun to talk about a burgeoning “bubble” in leveraged loans, which are loans made to companies that are loaded with debt and therefore quite a bit riskier than their less-leveraged peers. They are the subprime mortgages of the corporate debt market. And like subprime mortgages, most leveraged loans are packaged into structured products (Collateralized Loan Obligations, or CLOs), with rated tranches ranging from AAA to pure equity, and sold to institutional investors. It’s no surprise that observers are starting to formally draw the connection, or at least the eerie similarity, between the pre-Crisis subprime mortgage market and the current leveraged loan market.

For us insurance folks, this raises the question of whether or not insurance companies are among the institutional investors loading up on leveraged loans and CLOs. According to a recent NAIC report, life insurers in the US held a little under $100 billion in CLOs as of the end of 2017. That’s just pure Collateralized Loan Obligations, which are reported in the statutory filings under Schedule D, Section 6.4 (Other Loan-Backed and Structured Securities). A life insurer might also have directly participated through a loan syndicate in a leveraged finance arrangement and that loan would appear elsewhere in Schedule D as a bond, even though it technically isn’t.

A hundred billion dollars is a lot of money in any context except for the total assets held by life insurers, which stands at over $6 trillion according to the ACLI 2017 factbook (although that number is a little squirrely in that it likely also includes separate account assets). It would be a real stretch for anyone to say that leveraged loans themselves pose a systemic threat to the life insurance industry. We just don’t have enough exposure to them because they aren’t a natural fit for hedging life insurance liabilities. Most leveraged loans pay a floating rate of interest based on LIBOR plus a spread. Life insurers generally like to match their liabilities, which are fixed, with similarly fixed income investments. As a result, floating rate instruments have typically garnered a small share of insurer investments and leveraged loans are no exception. In the same way that most insurers were not directly affected by writedowns in subprime mortgages, a significant correction in leveraged loans would likely bypass most life insurers as well.

But this is yet another example of where looking at average industry statistics glosses over the disparities in what specific life insurers are doing in their own investment portfolios. Low interest rates and tight credit spreads over the last 8 years have forced a lot of insurers to rework their investment playbook and each one has adopted its own strategies to get yield in a low-yield world. One of those options is CLOs specifically but, more broadly, any structured finance product (or, simply put, any non-mortgage credit risk that can be packaged, tranched, rated and sold). All of those products are reported in Schedule D, Section 6.4.

When you actually crack open Section 6.4, you’ll immediately see that it’s actually quite hard to figure out what exactly the insurer is holding. You’ll see entries for investments that look like this – VENTURE CDO LTD ABS 2017-26A C 144A. Yes, that’s an actual entry from a life insurer’s statutory filing. What is it? Well, it’s a structured product. What’s in it? No clue. Upon looking it up on Google, it appears to be some sort of a CLO, but I’m not sure because the only information I could find is locked behind the Moody’s paywall. Corporate bonds, by contrast, are very clearly described. If you pull open Schedule D, you’ll see entries that look like this – ORACLE CORPORATION SENIOR CORP BD. Pretty straightforward. But even the bond section has its wrinkles. You’ll also see entries like this one – SOCTY_CE_III DEBT TERM LOAN, presumably a leveraged loan to an unknown company that is so large that it takes up 2% of the entire bond portfolio for the insurer and is the single largest bond position. But it’s not a bond. It’s a loan.

That’s the problem with structured products and life insurers. You really don’t know what they’re holding – all you can see is that they either have a lot in Section 6.4 or not. I did a quick scan of 12 major life insurers and found that the total assets in Section 6.4 ranged from 155% to 2% of Surplus, with an average of about 50%. In short, although total CLO exposure is pretty low in terms of assets, total exposure to non-mortgage structured products is actually fairly high relative to capital. That seems like quite a bit to be invested in an asset class where regulators have literally no transparency into what life insurers are actually holding beyond the ratings given to those structured products by the same ratings agencies that got mortgage backed securities so woefully wrong.

I’m not a financial writer and don’t pretend to be, but when a finance issue touches the life insurance market then I’ll do my best to tackle it in a way that pertains to our industry. I’ll keep my eye on leveraged loan exposure at life insurers. My hunch is that for most life insurers, leveraged loan exposure will not cause any direct damage. But for a select few life insurers with large exposure to the asset class and thinner capital, it could be a real problem.

If you’re interested in learning more about leveraged loans, just Google it. Unlike our industry, which basically no one writes about, there are bountiful places to learn about and get news on the leveraged loan market. I couldn’t help but find some humor in this. CLO issuance in the US is going to break $125 billion this year, which means that it’s getting about half of the flows of the individual annuity business. And yet, judging by the attention that CLOs get in the financial press, you’d think it was the other way around and then some. We do a great job of being generally uninteresting, don’t we?