CLOs – An Interesting Insurance Investing Alternative

What is a CLO?

In a nutshell, it is a portfolio composed predominantly of senior secured loans, securitized and managed by a manager highly experienced in the CLO arena. CLOs consist of a series of floating-rate bonds with an interest rate that generally resets quarterly. The program contains what is called a first-loss equity tranche that receives all residual distributions. Supporting tranches vary in terms of priority and subordination, ranging from low to high relative to riskiness. Cash flows from the underlying collateral are used to fund interest on each layer (tranche) of the securitized debt using a “waterfall process” whereby cash flows are paid sequentially, beginning with the senior-most tranche. Each successive tranche receives its share of the waterfall until all receive their full distribution. Traditional CLOs originated around 1994 and are typically comprised of leveraged bank loans and middle-market loans.

Commercial real estate CLOs (CRE) appeared around 2012. They carry their unique characteristics by way of short-term CRE floating rate loans with a duration of three to five years.

What features do CLOs offer compared to traditional fixed-income or MBS/ABS vehicles?

CLOs have a relatively strong historical performance with built-in risk protections, beginning with the strength of the underlying collateral. Here are some of the predominant nuances of the CLO:

• The underlying leveraged loans are typically senior and secured, meaning the loan has a priority claim on all the issuer’s assets in the event of bankruptcy.
• Historical analysis reveals that no AAA or AA-rated CLO tranches have experienced losses at the senior level in the last two recessions.
• The structured subordination features of the CLO provide for the redirection of cash flows from subordinate to the senior tranches should the underlying portfolio credit quality weaken.
• CLO portfolios generally offer more diversity through leveraged loans involving 150-250 borrowers.
• Risk mitigation is further enhanced through covenant requirements requiring the CLO manager to perform consistent coverage testing of cash flows at each tranche level. This is a vital internal control process to detect collateral deterioration early. It allows for quick reaction to divert cash flows from junior tranches to senior tranches until the problem is resolved.
• The key attraction feature of the CLO instrument is its yield compared to the traditional fixed-income security. CLOs are floating-rate securities, and thereby have limited sensitivity to interest rates and provide a higher spread for a comparable credit risk. During 2023, CLO spreads to the US corporate bond index or aggregate bond index ranged from 140-200+ bp.
• CLOs are actively managed by professional CLO managers highly experienced in the distinctions of this market sector.
• Built-in risk protection of CLOs requires the CLO manager to perform stringent coverage testing monthly, which includes over-collateralization testing of each tranche, as well as interest coverage testing to ensure income generated by the asset pool is greater than the interest due on the outstanding debt.

Sounds too good to be true? What are the risks?

With all investing options, there are certainly some risks.

• There will always be a credit risk. The key is balancing that risk with mitigating factors.
• Supporting collateral in the leveraged bank loan market must be carefully managed by the CLO manager concerning potential defaults in the support collateral. As such, diversification by industry and issuer is an essential management component.
• Prepayment risk exists from the potential early payoff of leveraged bank loan refinancing should interest rates decrease.
• On the opposing spectrum, quickly rising interest rates place strain on borrowers’ funding, increasing interest expense on a variable rate loan.
• Maintaining suitable issuer diversification in the portfolio – Issuer overlap can occur, particularly when investor demand is outpacing supply or CLOs are managed by the same asset manager.
• A critical factor in this market is the investor selection of a highly qualified and experienced CLO manager with tenured experience in managing CLO structures. This is of utmost importance – the investor must be cautious of a call from a general outside investment advisor peddling a CLO product with a high yield.
• Adequate supply of quality CLO products may hinder investor demand

What’s the rub? How has the insurance industry embraced this alternative investment product?

Insurance industry exposure to CLOs amounted to $248 billion in book adjusted carrying value (BACV) for 2022, a 14.5% increase over 2021. The 2020 to 2021 pace was brisker, showing a 23% increase. In total, the CLO ownership by insurers represents a small percentage of total insurance industry cash and investments held (3%). Further, the percentage of CLOs to total insurance bond investments was 4.7% at year-end 2022. The double-digit pace of insurer CLO investment activity reflects the attractiveness of the enhanced yields without the added interest rate duration. Most CLO investing is concentrated in the life insurance arena, which would make sense considering the long-term nature of the life industry compared to its sibling. Additionally, the floating rate distinction of the CLO minimizes unrealized losses, which naturally occur in a rising interest rate environment. The vast majority of 2022 CLO bonds held by insurers fell in the NAIC 1 and NAIC 2 designations.

How does the insurance industry account for these gadgets?

Statutory accounting for CLOs categorizes them as loan-backed securities with similar characteristics to their mortgage-backed security cousins. This places the CLO under the guidance of SSAP 43R – Loan-Backed and Structured Securities. In its December 2023 NAIC National meeting, the Statutory Accounting Principles Working Group (SAPWG) removed any doubts about how CLOs should be modeled and treated in the bond category. CLOs cannot be reported as legacy securities, which has been an occasional digression in practice in the past. They are also to be financially modeled like their mortgage-backed security complements.

The CLO investment vehicle is a viable product for the insurance portfolio, particularly in a low or rising interest rate environment. If prudently screened, CLO managers carefully vetted, and securities selectively chosen, the CLO can provide an attractive investment option.