Recent proposed rule changes from the National Association of Insurance Commissioners (NAIC) could alter the regulatory treatment of securitized assets—long a staple of US insurance companies' core portfolios.
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Authors
Gary Zhu, Director—Insurance Portfolio Management; Global Head—Multi-Sector Insurance
Dmytro Mukhin, PhD, FSA, CFA, Managing Director and North America Senior Insurance Strategist—Global Business Development
It's crucial for asset allocators to understand the potential magnitude, direction and timing of the first significant changes since 2008 as they consider portfolio positioning.
While the proposed updates to risk-based capital (RBC) charges on collateralized loan obligations (CLOs) have attracted the most attention so far, they're certainly not the only changes. We review four key pillars of the potential regulatory updates and what they might mean for insurers' securitized exposure.
1. CLO Risk Assessment and the Impact on NAIC RBC Charges
The NAIC is seeking to reduce or remove the perceived risk-capital-arbitrage opportunity stemming from holding a higher-rated CLO versus the underlying loan collateral. As the Display below illustrates, the current weighted-average risk factor for an entire sample CLO structure is 3.03%, while the underlying collateral's risk factor is 9.54%—assuming B-rated loans. That's a sizable difference of about 6.5%.
A few ideas are being considered to address the discrepancy. One is to uniformly increase risk factors applied to BBB and BB rated CLO tranches (examples 1 and 2 below). Another idea is to expand NAIC category 6 into three subcategories (A, B and C), with risk factors of 30%, 75% and 100%, respectively; today, the category carries a flat 30% factor. In example 3, increasing NAIC 6 charges to 100%, while keeping charges on categories 2.C and 3.C the same, would bring average RBC charges to 8.63%, about 90% of charges under 4.B. Expanding the NAIC 6 categories and increasing RBC charges would likely be the most impactful approach.
| Tranche | Rating | Tranche Size (%) | Current Factor (%) | Ex. 1 Uniform (%) | Ex. 2 Uniform (%) | Ex. 3 Modeled (%) |
|---|---|---|---|---|---|---|
| AAA | 1.A | 63 | 0.16 | 0.16 | 0.16 | 0.16 |
| AA | 1.C | 12 | 0.42 | 0.42 | 0.42 | 0.42 |
| A | 1.F | 6 | 0.82 | 0.82 | 0.82 | 0.82 |
| BBB- | 2.C | 6 | 2.17 | 30.00 | 6.50 | 2.17 |
| BB- | 3.C | 5 | 6.02 | 30.00 | 19.00 | 6.02 |
| Equity | 6 | 8 | 30.00 | 75.00 | 100.00 | 100.00 |
| Total or Average | 100 | 3.03 | 9.5 | 9.54 | 8.63 | |
| Underlying Loan | 4.B | 9.54 | 9.54 | 9.54 | 9.54 | |
| Capital Arbitrage | 6.51 | 0.04 | 0.00 | 0.91 |
Our Assessment: This provision would likely take some time to implement. No official proposal exists yet and changing the NAIC factors would affect insurers' RBC filings, requiring updates from vendors. Adopting a modeled approach could expedite the process and enable high-quality tranches to benefit from an RBC designation upgrade. But this could also mean significant capital increases from downgrades to BBB and lower-rated tranches, including equity.
We believe that a modeled approach could benefit certain insurers, especially those preferring high-quality tranches (Display). If that approach is adopted, we would expect marginal net-positive impacts to RBC for AA and most A rated tranches, because their low expected losses would likely lead to NAIC ratings upgrades. Some BBB and BB rated tranches would face rating downgrades of an uncertain magnitude. Equity holdings would face steep risk-factor increases if the NAIC adopts the new 6.A, 6.B and 6.C categories.
2. Changes to Expected Loss Thresholds and Effect on RMBS and CMBS Ratings
Expanded NAIC categories and factors were adopted in 2021, and there's a belief that technical updates are needed to reflect consistent references to the "NAIC designation category" and the additional price points needed to determine categories. This revision would create more granular expected loss (EL) thresholds, which should translate into more granular NAIC rating categories for insurers' holdings of commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS).
Our Assessment: This revision could happen quickly. However, it might be timed to roll out in conjunction with a potential increase in the number of macroeconomic scenarios used in CMBS and RMBS modeling, which we'll examine in the next section. Expanded ratings tiers would likely increase the capital requirement for eligible CMBS and RMBS mezzanine tranches with weaker credit enhancements (Display).
For example, an eligible CMBS with an NAIC expected loss of US$1 per US$100 of par value would be designated NAIC category 1.G assets by the end of this year instead of its current 1.A. We believe that mezzanine tranches of CMBS and RMBS, as well as on-the-run (2020–2021 vintage), last-cash-flow and M1 tranches of credit risk–transfer securities (CRT), would be most vulnerable to the revisions. This is especially true in light of the possible expansion of macroeconomic modeling scenarios.