By the Numbers

Comments on NAIC CLO proposal suggest low risk for insurers

Caroline Chen | August 12, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The NAIC is trying to fix a loophole in its rules that allows insurers to use securitization to reduce the capital required for holding a pool of leveraged loans. But market participants are concerned the proposed work will suppress insurers’ appetite especially for speculative grade CLOs or equity. The NAIC recently published public comments on its proposal, and its responses. The comments and responses show a healthy debate. Headline risk for CLO investors may linger for a year or two based on the NAIC estimated timeline, but significant impact on most insurers’ holdings seems unlikely.

The NAIC proposal

Under NAIC’s current risk-based capital framework, insurers have to hold more capital for a pool of loans than for holding every class of a securitization of the identical loans. For example, an insurer holding a pool of ‘B’ loans is subject to a 9.54% capital charge. But an insurer holding every tranche of a securitization backed by the same pool of ‘B’ loans only needs 2.92% capital. NAIC argues both investment options involve the same economic risk, but its existing rating process and capital framework provide a significant arbitrage opportunity for insurers. To fix that loophole, NAIC staff are proposing to assess insurers’ CLO investments based on its own CLO stress test methodology with a few modifications.

A modest parade of comments

Eight institutions submitted comments to NAIC before the July 15 deadline. Respondents include TIAA, Athene, Pinebridge Investments, Egan-Jones, and trade associations from the American Investment Council (AIC), Loan Syndication and Trading Association (LSTA), Structured Finance Association (SFA), and The American Council of Life Insurers (ACLI). All respondents were concerned about stakeholders’ participation levels during the process, but public comments tended to focus on three areas and suggested mixed views among market participants and the NAIC: These topics are the

New capital charges for CLO equity,
The benefits of CLO active management, and
Use of the NAIC’s RMBS and CMBS methods for CLOs.

Mixed view on new charges for CLO equity

The NAIC proposes to add new capital charges for CLO equity, but market views are mixed. ACLI public comments indicates the group is not opposed to the new risk-based capital categories for CLO equity, and Athene thinks it may be appropriate to increase the capital charges for CLO equity to reflect the additional risk. But Pinebridge argues the current capital charges on CLO debt and equity are already quite conservative based on CLO historical performance data, and the new charges seem unjustified.

Based on an NAIC stress test analysis in 2021, the 78% of US insurers’ CLO investments are rated ‘A’ or above. Insurers at that point held more than $193 billion in CLOs. US insurers’ exposure to equity may be limited, but NAIC staff are most concerned about the tail risk as there is no principal or interest promise for the equity tranche, and cash flows may be interrupted to protect senior tranches.

The NAIC proposal did not quantify the capital impact on affected insurers, but its stress testing results on atypical CLO tranches—those having unusual payment promises and are equity or combo notes—may shed light on the potential impact. The 2021 stress testing modeled $1.3 billion in atypical CLO tranches, of which $998 million had no ratings and may include most equity tranches. The NAIC stress testing results indicate the principal loss ranging from 78% to 81% (Exhibit 1). Based on the stress testing results, new capital charges presumably would affect a large share of CLO equity.

Exhibit 1: Nearly 80% of the principal in atypical, no-rating CLO tranches were wiped out in stress testing

Notes: Scenario A, B and C are three scenarios based on NAIC stress testing methodology. The methodology is based on Moody’s annual default study published in 2021 and used 10-year cohort data for all rating cohorts from 1970-2011. Details are here.
Source: NAIC Capital Markets Special Report, Amherst Pierpont Securities

The argument for active management needs robust data support

NAIC staff agree with market participants on the strong CLO performance track record so far as well as the benefits of structural protection and trigger tests. But the regulator has not yet been convinced about the benefits of active management.

In NAIC’s view, managers’ trading choices may be a zero-sum game given CLOs’ dominant role in the leveraged loan market. If CLO managers want to trade distressed loans out of their collateral pools, it is hard to believe loan investors outside of CLOs are willing to absorb those loans at advantageous prices. NAIC staff also cast a doubt on the low loan default rates in CLOs. According to the NAIC, managers often traded loans before they default. In this case, the impact is captured in the sales price rather than default rates. Moreover, managers could make both good and poor decisions during the reinvestment period.

The NAIC’s current stress testing methodology models CLO defaults based on a historical cohort and ratings-based results without considering managers’ choices. But NAIC staff leave the door open for the proposed RBC work and urge market participants to provide robust statistical studies to support their argument for active management. The tug of war may last for a while.

The CMBS and RMBS approach for CLOs may stir up debate

The NAIC staff suggests applying to CLOs the same approach used for determining RMBS and CMBS capital. This would involve developing eight to 12 probability-weighted scenarios. The macroeconomic scenarios for RMBS and CMBS will also expand from the current four to eight to better differentiate the RBC designation. For RMBS, the macroeconomic inputs are based on the Case Shiller Home Price Index (‘HPI’) and CMBS scenarios use a similar measure called the National Price Index (“NPI”).

Most submitted comments questioned the suitability of this approach and the consistency of the model inputs:

“RMBS/CMBS approach is not a suitable model for CLO. In 2009, modeling for RMBS/CMBS was driven by negative credit rating migration. This dynamic does not exist today vis-a-vis CLOs. No such market volatility related CLOs exists which would justify the proposed RBC charge for CLOs” – AIC
“Any proposal should be consistent among asset classes at the level of stress being considered. The solution for CLOs should be a template for equivalent and transparent treatment across asset classes.” – ACLI
“Regulatory capital treatment for CLOs needs to be compared to other structured products and corporate debt.”– SFA

It is not clear which macroeconomic index will be chosen to model CLOs, but the NAIC indicates the scenarios would probably be various combinations of default rates and recovery stresses. The NAIC expects this part of the work to be most interactive with market participants and intends to keep the process completely transparent.

A long timeline

The NAIC proposed timeline seems reasonable given the complexity of the issue. The NAIC projects the work will run into late 2023 or 2024 (Exhibit 2).

Exhibit 2: NAIC estimated timeline indicates the headline risk may stay for a year or two

Source: NAIC, Amherst Pierpont Securities

With many details still fluid, it is more of a headline risk for now. The majority of US insurers’ CLO exposure is highly rated, and the impact of the proposed work may not change insurers’ appetite for those bonds dramatically. But securitization is a constantly evolving market, investors need to monitor the development closely and get ready for the potential impact.

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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