July 19, 2022 - Last Friday, the LSTA submitted a comment letter expressing our belief that the NAIC’s risk based capital (“RBC”) proposal has the potential of penalizing insurance company investments in CLOs and consequently impacting the CLO and loan markets. We discussed the time frame for comments (too short at 30-and-change days), the impact on the insurance industry and CLO market (potentially significant, depending on the RBC changes) and our economic arguments for why CLOs outperform and therefore currently are charged appropriate RBC (detailed in a recent LSTA post). We briefly recap our arguments below but encourage interested members to read the LSTA letter in full.
The issue: The NAIC’s Issue Paper recommends that it consider changing the RBC framework such that capital requirements for purchasing all tranches of a CLO match the capital requirements for directly holding the underlying collateral, based on the assumption that the investment strategy presents the exact same investment risk as holding the entire pool of underlying loan collateral. In addition, the paper recommends that the NAIC consider adding two new RBC factors to account for the “tail risk” in any structured finance tranche of 75% and 100%. As discussed in a Citi research report, these proposals could lead to significantly higher RBC on CLO note holdings up to – and perhaps beyond – the BBB notes.
The timeframe problem: The industry only received 30 days-and-change to comment on the issue paper. This simply isn’t sufficient time for the industry to provide constructive feedback on a proposal that requires significant review, analysis and modeling.
The potential CLO market impact: Insurance companies have more than $200 billion invested in CLO notes. While some of these investments – such as the AAA tranches – might not be impacted by the RBC change, other tranches – such as the BBB tranches – might be materially impacted by the change. Inasmuch as insurance companies hold over half of US CLO BBB notes, squeezing their demand for these assets could have a material knock-on effect on the CLO market.
The potential impact on the insurance industry: According to the NAIC, in 2020, CLO investments comprised 2.6% of insurance companies’ invested assets and cash. Life insurance companies, in particular, rely on the CLO market to invest a portion of their balance sheets in high performing reliable assets with appropriate RBC charges and attractive yield characteristics. For companies writing long-tail liabilities, CLOs represent an investment solution that helps meet their asset-liability matching goals. Quickly making such investments less attractive to insurance companies could have material unintended consequences for insurance companies and their policyholders. In particular, insufficient time to reorient their portfolios could have a dislocating impact on insurance company balance sheets and the loan market as CLO investments are sold.
The economic arguments: We recently detailed CLOs’ lower loss experience, breaking the analysis down into a better performing portfolio (thanks to an active management strategy constrained by quality-enhancing tests) and the structural protections embedded in a CLO (such as IC/OC performance tests as well as the structural subordination of lower rated notes).
The bottom line: The LSTA wished to put our preliminary arguments on the record and stand ready to help our members and the NAIC as they work through appropriate RBC for the CLO asset class.
