May 30, 2024 - Last week, the National Association of Insurance Commissioners’ (NAIC) Risk-Based Capital (RBC) Investment Risk and Evaluation Working Group (WG) held a meeting to discuss comments received on its “Memorandum on Consideration of Additional Information on Interim Factor for Residual Tranches.” The WG is tasked with performing a comprehensive review of the RBC investment framework.

The agenda focused on the proposal submitted by Everlake Life Insurance Company on the interim RBC factor for residual (i.e., equity) tranches of asset-backed securities. Everlake proposed a 45% RBC factor for BSL CLO equity and a 30% RBC factor for private credit CLO equity. The WG has put the put the proposal out for public comment and is asking for submissions by June 13th. The comment period seeks feedback on items that should be included in exempted residual tranches and an interests list that would receive a 30% factor, with all other residual tranches and interests receiving a 45% factor. The implementation date of the potential adopted solution has not yet been determined, according to a May 23 Citi research report.

The materials posted for the meeting also contained a breakdown of the allocation of residual tranche holdings by sector provided by The American Council of Life Insurers (ACLI). Of the 19 life insurers that participated in ACLI’s survey (which polled ACLI members), private credit CLOs represented 36.1% of residual holdings and BSL CLOs represented 10.9% of residual holdings. 

In a supplemental presentation, the NAIC’s Structured Securities Group (SSG) highlighted concerns with the proposal, including assigning a lower factor to private credit CLOs. To the SSG, PC CLO risk is comparable to BSL CLOs and it’s counterintuitive that assets with illiquidity risk receive a lower RBC factor.

Separately, the WG is currently developing probabilities to be used for the 10 stress testing scenarios that will support the determination of RBC factors for BSL CLO debt tranches, Citi noted in its report. As a refresher, in June 2022, the SSG recommended revising the methodology for determining RBC for CLO debt tranches. The changes contemplated transitioning from a rating-based approach to a model-based approach. The NAIC will assign a probability to each scenario to determine a probability-weighted loss metric that will be mapped and assessed capital charges. In addition to developing a means of transitioning from the practice of solely using ratings to gauge risk, the recommendation sought to eliminate a perceived RBC arbitrage between holding all tranches of a CLO’s capital structure and holding the CLO’s underlying assets directly due to the ratings process. The NAIC published an Issue Paper recommending changing the RBC framework so that the capital requirements for purchasing all tranches of a CLO and capital requirements for directly holding the underlying collateral are the same, based on the assumption that the risk is the same. (The LSTA submitted a comment letter in response to the Issue Paper outlining the impact to the insurance industry and CLO market.)

In an April 16 research report, Barclays noted that discussions at the NAIC’s April 10 meeting imply the NAIC is reviewing feedback from market participants and will have more clarity on probability weightings in mid-2024. Barclays also indicated that the NAIC stated in the meeting that implementation of model-based capital charges for CLO notes will not occur until year-end 2025. Notably, private credit CLO debt tranches are not subject to the CLO stress testing and RBC decisions.

The LSTA will continue to monitor the status of the residual tranche proposal and the stress testing scenarios and probability weightings in the CLO debt tranche proposal.

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