Leveraging Excess Liquidity: IG Private Assets in U.S. P&C Insurance Portfolios

A persistently low rate environment has challenged all insurers’ ability to meet their return and income objectives while also balancing the risk they take within their investment portfolios.

This dynamic has resulted in a search for yield that has pushed insurers to add credit risk and allocate to higher-yielding asset classes beyond public fixed income. In fact, U.S. P&C insurers have nearly doubled their allocation to BBB-rated public fixed income over the past decade (from 9% to 16%), and have continued to make allocations to higher-yielding assets in high yield bonds, public equities, and other alternative asset classes within their surplus portfolios.

While higher-yielding assets can achieve enhanced returns, the addition of them to insurance portfolios is constrained by a matrix of regulatory, capital, accounting, and rating agency considerations. When compared to public fixed income, most of these asset classes are subject to higher risk-based capital and rating agency risk charges – as well as the volatility of fair value accounting.

The difference private market IG can make

Rather than simply continuing to add risk through surplus portfolio allocations and dropping lower in credit quality, SLC Management believes many insurers can improve their overall investment outcomes and increase income by adding to private market investment grade strategies. Two of the options are investment grade private credit and commercial mortgage loans, both of which can be utilized in liability-backing and surplus portfolios.

By allocating to investment grade private market asset classes, insurance companies have the potential to enhance returns and income, while optimizing their asset allocation in a capital efficient way. One of the many benefits of moving to private market investment grade offerings is the ability to increase yield without significantly increasing credit risk, but rather adding liquidity risk. Significant levels of excess liquidity often become apparent when teams at SLC Management analyze portfolios, and that excess can be deployed by most companies to capture additional yield while avoiding unnecessary credit risk.

To become more comfortable about adding illiquidity to a portfolio it is important to fully understand its liquidity needs. SLC Management recommends modeling downside risk by using an in-depth, enterprise-based framework that stresses both the operational and investment sides of the business in tandem.

While insufficient liquidity is a major operational liability, excess liquidity is a missed opportunity. Based on its analysis, SLC Management believes that most insurers have excess liquidity and, subsequently, the capacity to redeploy a portion of their public fixed income holdings into higher-yielding, less liquid investment grade asset classes like investment grade private credit and commercial mortgage loans.

Industry outlook

There are a few reasons we believe that insurers can take additional liquidity risk. First, the industry has increasingly become better capitalized with improving operating metrics and risk management practices. Life, health and P&C insurers have all reduced balance-sheet leverage while growing capital positions since 2000. With stronger balance sheets, insurers have room to examine asset allocation refinements.

Many P&C insurers have recognized their strong capital positions, including the ability to take liquidity risk, and have re-deployed assets into higher-yielding strategies. One asset class that hasn’t been broadly adopted is investment grade private credit. As of year-end 2019, the P&C industry average allocation to investment grade private credit (excluding 144a securities) was just 1.4% of total assets. SLC Management believes there are significant income benefits left on the table when the asset class is excluded – the investment yield for P&C companies invested in the asset class versus those who were not was nearly 60bps higher (3.79% vs. 3.23%).

Case study: Risk management framework

SLC Management believes that an in-depth understanding of liquidity needs serves as the foundation for optimizing capital efficient asset allocation. These decisions are unique to each company’s operating profile. For example, using SLC Management’s framework, let’s look at Company ABC, a ~$6B P&C insurer which is a good representation of the industry at large.

Step 1) Modeling available capital: Identify the reserve (liability backing) and unconstrained (surplus) assets

The first step is a customized balance sheet analysis to identify assets required to support liability obligations (the reserve portfolio).

Company ABC has $3.4B of discounted liabilities, and therefore, $2.5B of non-core assets available for optimization (the surplus portfolio). This is a meaningful percentage of overall assets and is a common characteristic with many P&C insurers. As the industry has experienced a decline in balance sheet leverage, there has been a related growth in surplus portfolios.

Surplus portfolios can be used to enhance portfolio returns, while reserve portfolios should be constrained by duration volatility and asset classes. Along with public fixed income, investment grade private credit and commercial mortgage loans are commonly used in both surplus and reserve portfolios to diversify credit risk and enhance returns.

Step 2) Modeling liquidity: Stochastically forecast inflows and potential outflows to highlight stress points

Once the size and nature of the reserve and surplus portfolios are understood, stochastic cash flow modeling is used to forecast liquidity needs and highlight areas of operational stress, including reinsurance limits, CAT risk, and premium collection rates. Based on the modeling outcomes in our case study, Company ABC can meet operational liquidity needs through current portfolio maturities and income.

The modeling reveals that Company ABC can meet operating cash requirements using a portion of the reserve portfolio. Specifically, the insurer is expecting a cash outflow of $119 million in 2020, and in a value at risk (VaR) 85, would anticipate an outflow of $504 million (85th percentile VaR is defined as a worse case expected net cash outflow of $504 million in 85% of tested scenarios). Reserve portfolio maturities are projected to be $626 million.

Stress testing a range of scenarios can give insurers confidence to increase portfolio yield by reducing excess liquidity and allocating to higher-yielding assets beyond public fixed income.

Step 3) Identifying sources of liquidity: Analyze areas of available liquidity to meet potential shortfalls

Depending on liquidity forecasts, insurers should examine all sources of liquidity to mitigate the risk of forced liquidations. Typical sources of liquidity include:

• Premium collection and operational cash
• Cash and cash equivalents
• Line of credit/Federal Home Loan Bank advance
• Maturities, prepayments, coupon income
• Forced liquidation of portfolio holdings

Cash, Treasuries, and other government-backed debt are typically the only truly liquid assets during a market downturn. Therefore, we recommend that insurers’ stress test their holdings to understand their true liquid holdings and anticipate potential impairments or losses. Company ABC has $1.5B of government-backed securities and should anticipate a $400M decrease in portfolio market value in a stress scenario.

Step 4) Optimize capital efficient asset allocation. Use enterprise-based analysis to highlight portfolio constraints

Once operational, investment and liquidity constraints and objectives have been determined, we begin to examine a range of relevant asset classes based on a matrix of factors, including those below. This assessment is directly related to our downside modeling in previous steps, which indicates the capacity for higher-yielding assets.

Asset class characteristics:

• Risk and return profile
• Risk-based capital charges
• Rating agency risk charges, limits and concerns
• Valuation for statutory reporting
• SAP Schedule
• Statutory limits

It is critical for insurers to evaluate asset class alternatives using factors beyond risk/return profile to avoid the risks and potentially deteriorating economics of sub-optimal asset allocations
Step 5) Recommendations for asset allocation changes. Include impact on regulatory and solvency

By following its framework and partnering with Company ABC’s management team, SLC Management recommended that Company ABC:

• Maintain a significant allocation to public fixed income in order to meet required liquidity needs in a range of economic and operational scenarios
• Continue to fund projected cash outflows using only a portion of its reserve portfolio
• Leverage excess liquidity to increase exposure to higher yielding asset classes with close consideration to regulatory and rating agency limits to avoid deteriorating economics
• Add an allocation to investment grade private credit (from 0% to 6% of total assets) and commercial mortgage loans (from 0% to 7.6% of total assets). These shifts can provide additional spread premium and diversification to the portfolio

Key takeaways

• Insurers should optimize their capital efficient asset allocation by modeling downside risk to ensure they fully understand their liquidity needs.
• Many insurers have excess liquidity and a meaningful capacity to allocate to higher-yielding asset classes beyond public fixed income – and unused liquidity presents a missed opportunity.
• Changes to asset allocation should carefully consider the matrix of regulatory, capital, accounting and rating agency implications.

For most insurers, SLC Management sees significant benefits in re-allocating a portion of excess liquidity to investment grade private credit and commercial mortgage loans within reserve and/or surplus portfolios. Adding investment grade private credit has no regulatory, capital, accounting or credit risk implications, addresses certain risks (diversification, better recovery rates and senior debt to public bonds in default), enhances yield, and expands the portfolio’s efficient frontier.

This content is intended for institutional investors only. The information in this content is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this paper.

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management

(Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association. Registration as an investment adviser does not imply any level of skill or training.

There is no assurance that the objective of any private placement strategy can be achieved. The principal risks associated with the Advisor’s private placement strategies are described as follows. As with any strategy, the Advisor’s judgments about the relative value of securities selected for the portfolio can prove to be wrong.

(1) Interest rate risk involves the risk that interest rates will go up, or the expected spread to the benchmark will widen, causing the value of the portfolio’s fixed income securities to go down. This risk can be greater for securities with longer maturities and the widening of spreads can continue for an extended period of time. (2) Credit risk is the risk that the issuer of fixed income securities will fail to meet its payment obligations or become insolvent causing the market value of the securities to decrease. Private placements are not rated by the credit rating agencies. Any ratings assigned to this debt is the product of analysis performed by the Advisor and or Advisor’s affiliates. (3) Liquidity risk is the risk that Advisor may be unable to sell a given security at an advantageous time or price or to purchase the desired level of exposure for the portfolio. At times this market has experienced severe illiquidity and/or significant price impacts. (4) Counterparty risk involves the risk that the opposing party in a transaction does not fulfill its commitments.

Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally-purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request.

Although most U.S. dollar private placement investments have an external rating, for unrated deals, there is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.

The relative value over public benchmarks estimate is derived by comparing each loan’s spread at funding with a corresponding public corporate bond benchmark based on credit rating. Loans that are internally rated as “AA” are compared to the Bloomberg Barclays U.S. Corporate Aa Index, loans rated

“A” are compared to the Bloomberg Barclays U.S. Corporate A Index, while loans rated “BBB” are compared to the Bloomberg Barclays U.S. Corporate Baa Index. For certain power and utility project loans, a best fit approach of a variety of Bloomberg Barclays’ indices was employed prior to September 30, 2016. After this date, these types of loans were compared to Bloomberg Barclays Utilities A Index and Bloomberg Barclays Utilities Baa Index, for “A” and “BBB” internally rated loans, respectively. Relative spread values obtained through the above methodologies were then aggregated and asset weighted (by year) to obtain the overall spread value indicated in the piece.

Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of March 31, 2020. Unless otherwise noted, all references to “$” are in U.S. dollars.

Nothing in this paper should (i) be construed to cause any of the operations under SLC Management to be an investment advice fiduciary under the U.S. Employee Retirement Income Security Act of 1974, as amended, the U.S. Internal Revenue Code of 1986, as amended, or similar law, (ii) be considered individualized investment advice to plan assets based on the particular needs of a plan or (iii) serve as a primary basis for investment decisions with respect to plan assets.

This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements. As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility.

Unless otherwise stated, all figures and estimates provided have been sourced internally and are current as at the date of the paper unless separately stated. All data is subject to change.

No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

Past results are not necessarily indicative of future results.

© 2020, SLC Management

After a slowdown in issuance that mirrored public markets during the first month of the global pandemic, investment grade private credit markets sprang back to life in late April and May. Investors were able to source attractive deals at significant yield premiums to similarly rated public bonds. Additionally, active managers continue to exploit market dislocations and generate strong risk-adjusted returns for clients by adding high-quality assets at historically compelling spread levels.

SLC Management believes there is a long-term role for both public and private fixed income in investors’ portfolios. Investment grade private credit complements public credit by adding additional spread premium and diversification while retaining a high correlation to long-term financial liabilities.

What is investment grade private credit?

Investment grade private credit¹ refers to loans and debt securities issued by companies or entities outside of the public capital markets. Investors are primarily institutions such as insurance companies and pension funds.

• Investment grade private credit instruments are similar to public debt. They typically have durations that range from five to 30 years, often include collateral and financial covenants, and are available across the rating spectrum.
• Investors are paid a spread premium over comparable public bonds because these transactions are more customized and less liquid.
• The private placement issuer base includes public and private corporate issuers and spans major sectors (industrials, utilities, financials).
• Annual issuance in the investment grade private credit market is $70 to $100 billion and growing, with the U.S. representing about 60% of annual volume.

Watch now! Get an overview of the strategy from our investment team.

Why investment grade private credit?

The strength, durability, and growth of the investment grade private credit market reflects the wide range of benefits afforded to both issuers and investors.

Benefits to borrowers of investment grade private credit issuance

Flexible terms: Features and deal terms of investment grade private credit can be highly customized to meet the needs of the issuer and include non-standard maturities, delayed or multiple draw periods and custom amortization.

Confidentiality: Issuers of investment grade private credit can bypass the time and expense associated with public disclosure and registration requirements, allowing private issuers to maintain confidentiality.

Knowledgeable investor base: Most investment grade private credit investors are affiliated with larger investment management organizations with dedicated analysts capable of underwriting unique or complex transactions that would be difficult to execute in the public market. Issuers also value the ongoing relationship with private investors as a source both of capital for growth and structuring expertise.

Benefits to investors of investment grade private credit markets

Diversification: The investment grade private credit market offers investors the opportunity to invest in unique transactions and issuers not available to public bond investors.

Higher spreads: A combination of the illiquidity premium and bespoke nature of investment grade private credit placements relative to public bonds allow investors to capture a spread premium over comparable public issuers, as well as the potential for additional income associated with consents, amendments and, in some cases, coupon increases.

Better lender protections: Investment grade private credit investors benefit from deal structures that are typically more robust than public market transactions, including collateral and financial covenants that allow investors to get back to the negotiating table in the event of credit deterioration. Investors also benefit from direct access to management along with access to information not available to public investors.

Applications for insurance companies

The attractive capital efficient yields have made investment grade private credit an integral component of life insurer’s portfolios, and in recent years, there has been significant adoption within the Property and Casualty (P&C) segment as well. P&C insurers look for ways to add yield without taking on additional credit risk or exposing themselves to regulatory charges, and investment grade private credit can effectively deliver these characteristics to the portfolio.

Capital framework treatment

Investment grade private credit is typically treated like any other fixed rate corporate debt security from an accounting and capital perspective. On a capital-adjusted basis, investment grade private credit presents insurers the opportunity to add attractive yield to their portfolios at a similar capital charge to traditional public debt.

Statutory and regulatory treatment

From a statutory filing perspective, investment grade private credit is disclosed on Schedule D Part 1 (Bonds) as an Amortized instrument, in line with traditional public debt. Similarly, the Risk Based Capital charges for investment grade private credit correspond to a NAIC 1 – 2 bond, depending on the rating.

Regulatory modeling (AM Best BCAR, Moody’s, S&P)

About 80% of investment grade private credit deals have nationally recognized statistical rating organization (NRSRO) ratings, and the remaining balance is filed directly with the securities valuation office (SVO). In most cases, ratings agencies do not penalize investment grade private credit relative to traditional public fixed income. BCAR, Moody’s and S&P all treat investment grade private credit similarly to other fixed income securities that have a corresponding rating. However, Moody’s and S&P may apply a minor liquidity premium if they feel investment grade private credit allocations are excessive.

SLC Management works with clients and consultants to manage liquidity concerns around private assets. Our investment process for insurers begins with a full review by our insurance solutions team. Stochastic modeling highlights areas of operational stress (reinsurance limits, CAT risk, and premium collection rates), measures the required portfolio liquidity and then assesses a client’s ability to harvest the illiquidity premiums available in private assets within a portion of their portfolio.