DBRS Morningstar Looks at the NAIC's Work on Collateralized Loan Obligations

What You Need to Know

CLOs are packages of secured business loans that are commonly divided into tranches that expose holders to different levels of risk.
Today, CLOs pay more and do better than comparable loans.
Some observers emphasize that the value of a riskier CLO tranche will fall to zero immediately if borrowers defaults.

Credit rating analysts at DBRS Morningstar think that the collateralized loan obligations (CLOs) in life and annuity issuers’ investment portfolios will probably continue to do well, but they’re curious to see how CLOs will perform the next time borrowers run into trouble.

Patrick Douville and other analysts at the firm talk about CLOs in a commentary, posted behind a paywall, about the possibility that the National Association of Insurance Commissioners could change the rules it uses to grade CLOs and other assets for safety.

If the economy weakens, but the higher yields on CLOs offset any increase in credit losses, CLOs will continue to be popular and issuers may simply reflect CLOs’ actual performance in annuity rates, the analysts predict.

“Data from this credit cycle will be critical in assessing the strategic merit of the CLO exposure,” the analysts add.

What It Means

Analysts aren’t sure what to think about life and annuity issuers’ use of CLOs.

CLOs

A U.S. individual life insurance policy or annuity is, in effect, a burrito filled with investment-grade corporate bonds, derivatives, mortgages, mortgage-backed securities, and a smattering of other ingredients, such as CLOs.

A CLO is a package of secured loans taken out by small businesses and businesses with relatively low credit ratings.

Investment firms often structure CLOs in such a way that part of the offering, or tranche, exposes holders to significant payment risk and pays a relatively high rate, and another tranche is much safer and pays a relatively low rate.

The NAIC’s Capital Markets Bureau reports that, at the end of 2021, U.S. life insurers had about $5.2 billion of cash and invested assets in their own general accounts, with about $164 billion of the total invested in CLOs.

The NAIC’s Project

States handle most regulation of the U.S. insurance industry, and the NAIC is a Kansas City, Missouri-based group for insurance regulators.

The NAIC’s Risk-Based Capital Investment Risk and Evaluation Working Group is now deciding how insurers should treat CLOs and other securities commonly divided into riskiness tranches when calculating risk-based capital ratios, or insurance company financial risk summary statistic.

The NAIC tries to assign each asset a risk level. It requires a life insurer with an asset at a specified risk level, or with no available risk level, to apply a “charge,” or cut in the asset’s value, when adding the asset to the total used in RBC calculations.

Concerns

Some state insurance regulators argue that the current NAIC rules for CLOs treat CLOs based on the assets’ average performance and fail to account for what could happen to a CLO in a severe downturn.

Aaron Sarfatti, the chief risk and strategy officer at Equitable Holdings, said last week in New York at an S&P Global Ratings insurance conference that a CLO tranche with a relatively low BBB- rating might continue to perform well in most scenarios.

But in a severe downturn, once business borrowers started defaulting on their loans, the value of the lower-tier tranches affected by the defaults would fall to zero immediately, Sarfatti said.

He noted that the value of the asset would fall to zero at a time when the economy was in turmoil and finding alternative sources of capital to make up for losses would be difficult.

“That’s not a good outcome,” Sarfatti said.

Sarfatti said regulators should act quickly to reflect the all-or-nothing nature of CLO asset values in insurers’ capital standards.

The DBRS Analysts’ Take

The analysts point out that some insurers like the current CLO risk-grading rules.

In the real world, supporters of the current rules say, CLOs have produced higher returns than similarly rated corporate bonds and have failed less often.

Even if the NAIC ends up increasing the capital charge for risky CLO tranches to 45%, the effect on typical annuity issuers likely will be limited, because annuity issuers usually focus on investing in the safer tranches, the analysts write.