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Asset Rules Pushed CLO Risk Toward Insurers: Fed Economists

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What You Need to Know

  • Insurer investments in corporate bonds rose to $1.8 trillion, from $1.1 trillion, between 2009 and 2019.
  • Insurer CLO investments increased to $125 billion, from $13 billion, over that same period.
  • Capital rules have discouraged banks from investing in CLO tranches that are not rated triple-A.

Temporary differences between how bank regulators and insurance regulators treated collateralized loan obligations caused CLO exposure to flow into U.S. insurers from 2010 through 2019, according to Fulvia Fringuellotti and João A. C. Santos.

Fringuellotti and Santos — analysts at the Federal Reserve Bank of New York — look at the impact of risk classification differences in a new paper.

Fed interest in insurance company investments could eventually lead to changes in how regulators count insurance company assets.

Any changes in how regulators count insurance company assets could affect life and annuity product features and prices.

CLO Basics

A CLO is a security backed by a group of loans. The investment bankers who create a CLO can divide the CLO into different “tranches,” or slices. The tranches determine which investors get paid first. If many borrowers default, holders of the riskiest tranches may get much less cash back than they had expected.

U.S. insurers typically emphasize that they invest only in CLOs with strong, investment-grade ratings.

CLO Numbers

The New York Fed analysts note that U.S. insurers’ CLO holdings increased to $125 billion in 2019, from $13 billion in 2009.

More on this topic

In that same period, holdings of traditional bonds increased much more slowly — to $1.8 trillion, from $1.1 trillion.

Insurance regulators’ treatment of CLOs changed in 2019.

The Analysts’ Perspective

Before 2019, banks faced rules that discouraged them from investing in any tranches of CLOs other than tranches with AAA ratings, the analysts write.

Insurers had rules that encouraged them to maximize investment yields by investing in the lowest-rated CLO tranches that were in an acceptable risk category.

The results show that insurers did work to maximize yield and that insurers have been a significant source of credit for companies, the analysts write.

The analysts say that one question about the arrangement is whether the current allocation of credit risk throughout the financial system is optimal and that another question is whether the current financing system is better than a system based solely on banks.

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