Nathan Foley-Fisher is back with another paper about what he believes to be the large, little-understood risk inside the investment operations of U.S. life insurers that issue annuities.
Foley-Fisher has teamed up with two colleagues in the Research and Statistics Division of the Federal Reserve Board, Nathan Heinrich and Stéphane Verani, to write “Capturing the Illiquidity Premium,” a look at U.S. life insurers in commercial mortgage loans, collateralized loan obligations (CLOs), and other forms of private debt.
Foley-Fisher is also the co-author of another paper about investment risk at U.S. life insurers, “Assessing the Size of the Risks Posed by Life Insurers’ Non Traditional Liabilities.”
- A copy of ”Capturing the Illiquidity Premium” is available here.
- An article about another life insurance company investment risk paper that Foley-Fisher helped write is available here.
“Liquidity risk” is that risk that an investment might be hard to sell for a good price when the investor needs cash quickly.
Because of investment principles and regulatory constraints, U.S. life insurers tend to invest a high percentage of their assets in bonds and other assets that are designed to pay a fixed rate of return.
Federal Reserve moves and general economic forces have pushed interest rates on highly rated bonds to low levels after the 2007-2009 Great Recession. Rates have crept up from the rock-bottom levels in effect then, but life insurers have been hungry for ways to increase investment yields within the guidelines set by regulators and rating agencies.
Investment bankers have been telling life insurers for years that they are in a good position to increase returns by taking on liquidity risk, because they sell products such as annuities, life insurance policies, long-term disability insurance and long-term care insurance that tend to lock the customers’ cash away for many years, or, in some cases, permanently.
Worried checking account customers may be able to withdrawl cash from their accounts immediately, but worried life insurance and annuity customers tend to have little ability to respond to panic by running to the life insurance companies to yank cash out, the investment bankers have said.
That means that life insurers can increase investment returns, without putting more assets in stocks or low-rated bonds, by investing money in financing arrangements for strong borrowers that lock money for long periods of time, the investment bankers have said.
One example is the CLO. A CLO is a vehicle for investing in a pool of loans. In 2018, U.S. life insurers had about $120 billion in investments in CLOs, and about $4 trillion invested in all types of bonds, according to the new illiquidity paper.
Foley-Fisher and colleagues say in the new paper that annuity issuers’ efforts to increase yields by investing in hard-to-sell private debt, and filling in financing gaps left by new restrictions on banks’ lending activities, may have gone too far. Many annuity issuers now appear to be part of “triangular organizational structures” that could face a severe cash crunch if the value of the loans inside the CLOs fell, or other forms of private debt ran into problems, the researchers say.
The researchers say the kind of triangular organization they’re thinking of consists of a life insurer, an offshore captive reinsurer, and an asset manager.
The triangular organizations use the offshore reinsurers to lower the capital cost of providing traditional insurance products, and to free up capital that the life insurer can use to make more investments, the researchers say.
The organizations use the asset managers to originate private debt arrangements, for use by the life insurers and, in many cases, by outside investors.
Life insurers, state insurance regulators and rating agencies contend that U.S. life insurers are tightly regulated; that their investments in illiquid assets make up a relatively small, stable portion of their investment portfolios; and that, overall, life insurers appear to be in good shape.
Rating agencies, for example, have published many reports on U.S. life insurers’ CLO holdings.
Foley-Fisher and his colleagues have provided no data on changes in defaults, default risk or value weakness in annuity issuers’ portfolios, and no data on assets that were concealed or misrepresented.
The paper includes a standard disclaimer emphasizing that the conclusions in the paper are the views of the authors, not of the Federal Reserve Board.
But, even if the researchers’ new paper is wrong, it could influence how some policymakers in Washington and elsewhere see life insurers’ investments.
Here are five things Foley-Fisher and his colleagues say about triangular annuity issuers in the new paper.
1. Asset managers may be using annuity operations to expand their private debt businesses.
The authors of the new paper contend that the private debt asset manager tail may now be wagging the life insurance company annuity issuer tail.
In some cases, the life insurers might own the asset managers, but, in other cases, an asset manager may buy a life insurer to serve as a “relatively low-cost warehouse” for the private debt arrangements the asset manager originates, the researchers say.
2. Triangular annuity issuers may be especially eager to sell the kinds of group annuities used in pension risk transfer transactions.
Most big U.S. pension risk transfer deals completed since 2012 have gone to life insurers with private debt businesses, the researchers say.
3. Analyzing U.S. life insurers’ private real estate and private credit arrangements is hard.
The researchers say they had to go through insurers’ statutory filings one schedule at a time to gather the data used in their analysis.
Residential real estate loans held by U.S. life insurers, for example, increased to about $25 billion in 2018, from only about $5 billion during the Great Recession, according to the researchers.
The amount of commercial real estate debt held has increased to more than $450 billion, from about $300 billion, the researchers say.
CLO holdings have increased to about $120 billion, from less than $15 billion.
One reason the life insurers are holding more CLO risk is that regulators now require the asset management arm CLO issuers to retain about 5% of the CLO deal risk, and, in practice, that means the life insurer tends to end up holding less attractive slices of risk, the researchers say.
4. The triangular organizers use many different types of structures to retain risk.
Only three of the 28 insurers analyzed keep CLO risk on their own balance sheets, according to the researchers.
5. The triangular organizations appear to be hard to regulate.
“Although we cannot identify a causal effect of regulation on their growth, we note that the institutional design allows these entities to operate at the precise intersection of regulatory boundaries: At the limits of oversight by the Federal Reserve, state insurance regulators, the Security and Exchange Commission, and the Financial Stability Oversight Council,” the researchers write.