Comments expected on NAIC proposal that could undermine insurers’ interest in CLOs
Industry comments are expected Monday, September 12 on a proposal from the National Association of Insurance Commissioners (NAIC) to model secured loan obligation (CLO) securities based on stress tests, which would increase the risk-based capital (RBC) charges of insurers for investing in them.
The comments would be the latest in discussions between the capital markets industry and the NAIC, addressing NAIC staff’s responses to an earlier round of industry comments on the proposal, which was released May 25.
The NAIC said at its August meeting that past industry comments raised concerns about the timing of the proposal, the potential impact and the historical strength of the CLO structure, BofA Securities said in a statement. its CLO Alert report published on September 7.
Final implementation of the changes would likely occur by the end of 2024, the NAIC’s Investment Analysis Office clarified at the August meeting.
In the proposal, the non-governmental organization argues that an insurer buying each tranche of a CLO holds exactly the same investment risk as buying the entire pool of loans backing the CLO. The risk-based capital for each investment must therefore be the same. He adds, however, that investing in the B-rated strip of a CLO results in risk-based capital for insurers that is about one-third of that of a direct investment in B-rated loans.
However, BofA research concludes that investing in the CLO tranche is less risky for two reasons. On the one hand, CLOs invest in diversified pools of loans in uncorrelated sectors. Moreover, they are actively managed and managers usually sell loans long before default.
Meredith Coffey, executive vice president of research and co-head of policy at the Loan Syndications Trading Association (LSTA), noted in a June 30 post “there may be good reasons to like CLO investments.” . CLO securities have seen much lower default rates than corporate bonds with equivalent ratings, Coffey said.
NAIC staff stressed that they would need more data to back up the claim that CLO pools have outperformed the lending market, according to the recent BofA report. NAIC staff also said that default rates in CLOs could be lower precisely because managers can sell distressed loans before default, and their ability to buy discounted loans to “build the pair” should not be modeled in RBC’s calculations because it “incentivizes managers to buy distressed loans.”
The bank’s report countered that the NAIC’s proposal cites a 2003 Moody’s Investors Service article that argued that buying assets at a discount in a deteriorating credit environment can lead to even greater portfolio deterioration. . The bank said this analysis was flawed because CLOs were still in their infancy and overlooked their performance over the ensuing 20 years.
“The ability to build assets at par by discounting is one of the drivers of CLO outperformance, especially during the [Great Financial Crisis) and COVID,” BofA added. “We think the NAIC should give some credence to this in their modeling approach.”
In its analysis, the LSTA calculates that CLOs’ par build resulted in CLO portfolios seeing a cumulative loss of 1% over four years, while diversified passive loan portfolios saw 4% cumulative losses over the same period.
“In addition to the benefits of diversification and active management–which provide value across the capital stack–[the] notes rated in a CLO have structural safeguards,” the LSTA said. “Finally, the highest rated ratings also benefit from subordinate ratings below them.
The LSTA noted the NAIC’s own estimates that insurers’ investments in CLOs have increased significantly in recent years and that they hold more than half of “A” and “BBB” rated CLO notes.
“Thus, if these notes – particularly BBB notes – become less attractive to insurance companies, there could be ramifications for CLO creations in general,” the LSTA says.