Tough critics of U.S. life and annuity issuers' investment portfolios are back with a new paper suggesting that the assets are looking worse.
"Partnerships between life insurers and asset managers have created complex and arguably opaque structures to increase investment returns," according to the new paper, which was written by four economists affiliated with the Federal Reserve Board. "These arrangements seek to shift portfolio allocations towards risky corporate debt while exploiting loopholes stemming from rating agency methodologies and accounting standards."
The economists — Sydney Carlino, Nathan Foley-Fisher, Nathan Heinrich and Stéphane Verani — conclude that life insurers' exposure to below-investment-grade firm debt has boomed.
It "now exceeds the industry's exposure to subprime residential mortgage-backed securities in late 2007," the economists write.
Meanwhile, insurers' reliance on "wholesale funding," or arrangements sold to money market funds, banks and other institutional investors, "is near its 2007 level, shortly after which life insurers experienced runs on their nontraditional funding structures," the economists write.
What it means: The new paper might not mean much. Insurance regulators and rating analysts have argued that analysts and researchers coming from the world of banking may create flawed analyses of life and annuity issuers because they focus too much on sudden, rare emergencies that lead to big calls for cash and too little on the need to meet obligations to insurance policyholders and annuity contract holders.
The Bermuda Monetary Authority recently adopted tougher capital counting rules, and the National Association of Insurance Commissioners recently started a task force that may update the NAIC's risk-based capital formulas.
But the paper shows that analysts at the Fed continue to be skeptical about life and annuity issuers' assets.
The authors: Carlino, the lead author of the new paper, is a research assistant at the Fed.
The other authors are Foley-Fisher, Borghan N. Narajabad and Verani.
Foley-Fisher and Verani published a paper on the risks associated with life insurers' investments in 2019.
In 2024, Foley-Fisher, Heinrich and Verani published a chapter on U.S. life insurers and systemic risk in the Research Handbook of Macroprudential Policy.
The analysis: The economists contend that life and annuity issuers make investments in what amount to loans to risky firms look stronger by funneling the weak loans through arrangements — such as business development companies, broadly syndicated loan pools, collateralized loan obligations, middle-market CLOs and joint venture loan funds — that qualify for higher credit ratings.
"For instance, insurers holding a portfolio of B-rated loans can cut their risk-based capital charges by two-thirds if they package those loans into a CLO and purchase the entire CLO capital stack," the economists write. "The impact is even more pronounced for middle-market loans, as their lower ratings lead to exponentially higher capital charges. An insurer in the U.S. or Bermuda that packages its [middle market] loan holdings into a CLO and invests in the entire CLO capital stack could reduce its capital charge by a factor of 10."
The share of life and annuity issuer assets allocated to corporate debt with low safety ratings fell between 2008 and 2023, but the total share of risky assets, including the share of assets wrapped into arrangements such as CLOs, increased to more than 7.5%, from about 3%, over that same period, the economists write.
Issuers get some cash from individual investors with products such as fixed annuities, who tend to be locked into their contracts, but they also get cash from companies, through arrangements such as funding agreement-backed securities, Federal Home Loan Bank advances, securities lending programs and repurchase agreements.
The institutional arrangements may be more vulnerable to "runs," or sudden spikes in demand for cash, than traditional life and annuity products, the researchers argue, citing earlier research about life insurers' use of "nontraditional funding arrangements."
The Federal Reserve Board building in Washington. Credit: Shutterstock
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