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Attractive Opportunities in Investment Grade Private Credit

From the Sep 2020 Thought Leadership Insurance Special Report

It’s a changing world for insurance companies. Their reliance on fixed income is at odds with the lower for longer (and longer and longer) era, but insurers haven’t stood still. Their investment strategies are being reconsidered, and they’ve become so good at understanding their liquidity issues that they can survive and indeed thrive during economic shocks such as that brought on by the COVID-19 pandemic – assuming they were prepared for the challenge. Still, yield and income remain critical components for insurers, and a reconsideration of their core fixed income portfolio should include serious conversations about investment grade (IG) private credit, often known as private placements. In short, it’s where the yield is.

1 IG Private Credit

To get a sense of how insurers think about IG private debt, why they should be thinking about it more, and how it can fit into their portfolio, II recently sat down with Andrew Kleeman, Managing Director, Private Fixed Income, SLC Management, Louis Pelosi, Senior Director, Client Solutions, SLC Management, and Andrew Coupe, Senior Consultant, NEPC. Employee-owned NEPC is one of the industry’s largest independent, full-service investment consulting firms, serving over 350 retainer clients with total assets over $1.1 trillion. SLC Management is a global institutional asset manager with $193 billion in assets under management (as of 6/30/2020). They provide a range of alternative asset class funds and liability-driven strategies to insurers and other institutional investors.

What are you hearing from insurers these days given the economic fallout from the pandemic – specifically about their fixed income portfolios?

Andrew Coupe: The trend among many of the different types of insurers I speak to is that they are trying to be alchemists. They’re trying to create gold without adding risk to the portfolio. That’s the place we’re at now. And they’re looking at things like securitized assets, with more interest in exotic collateral types, because insurers can’t afford to take additional accounting risk because of the constraints they are under – but they are desperate for the extra return.

Andrew Kleeman: I would add that the big U.S. life insurance companies have been including investment grade private debt in their portfolios for decades – in some cases maybe a century – and they understand the asset class, the protections, and the diversification aspects of it. They like the additional yield they get from it, and there’s no wavering in their commitment to the asset class. Increasingly, asset managers at larger insurance companies are offering access to the asset class to third party clients, whether it’s insurance companies that don’t have their own private placement teams, or even companies that may find their private placement teams are unable to access the full spectrum of the market and thus looking for help supplementing internal production. But there’s certainly been a lot of attention on the asset class, driven by its performance characteristics.

Louis Pelosi: We’ve been in a declining interest rate environment for 30 years, and we have seen all insurers’ yields suffer from it. COVID-19 and its market implications really pushed a lot of insurers over the edge, with reinvestment in core fixed income, depending on maturity, under 2%. So, the pressure on yields is really much tighter this go around as we hit historic lows. The pandemic really highlighted that insurers who took the appropriate risk management steps prior to the COVID-19 outbreak were able to take advantage of huge dislocations in all the markets – equities, private markets, even core fixed income. They understood their liquidity position, and maybe took steps to have a Federal Home Loan Bank line of credit or appropriate cash reserves. They were able to hold current investments, and deploy cash to improve yields and returns.

Coupe: The very sophisticated insurance companies who were able to pivot during the dislocations are the ones who have separated themselves. All insurers, by regulation, are very conservative in their portfolios. But those who were being a bit more reactive weren’t able to buy-in to a very tight window of opportunity. Given the quick bounce-back, there hasn’t been an inordinate amount of pain felt across the industry, but the insurers who could utilize all the tools on the liability side and on the asset side during that small window are sitting a little more comfortably now.

Andrew Kleeman, you were touching on how IG private credit is something for which large insurers have long had an affinity. Why is that?

Kleeman: It’s an asset class that has performed very well over an extended period of time. You have more time to underwrite the underlying investment, and you have more access to the management team when you have questions. For a lot of life insurance companies, there’s a recognition that their buy-and-hold investments form the vast majority of their bond portfolio anyway. So, if you have a $20 billion portfolio and you’re going to hold $4 billion of that in privately placed investment grade debt, if you can earn an extra 20 to 50 basis points that’s a lot of money every year that falls to the bottom line. And you have the same capital charges that you would with public debt.

There is no insurance company that has 100% turnover in their bond portfolio in every given year – that doesn’t exist, right? So, for a lot of insurers, having anywhere from 10% to 30% or 40% in privately placed debt – the diversification, the covenants, in some cases collateral, the ability to do longer durations that might be attractive to them – say 12- or 15-year – all of that more than offsets illiquidity issues, because they’re not selling these bonds anyway.

Do all types of insurers share a similar appetite for IG private debt?

Coupe: Life insurers are very familiar with private placements, but the same is not necessarily true for P&C and health companies. There is no buy and sell of these assets – a well-performing private placement will just sit on the balance sheet and generate income – it is a beautiful thing, but that comes at the expense of liquidity. In addition, we’re really only recently starting to see the providers in this space – the asset managers – bring out some really high-quality products that have attractive fee schedules, and I think that really opens up the asset class for non-life insurers.

Kleeman: P&C insurers typically have shorter duration needs, and the life companies, which have been dominant in this space, typically have longer duration needs. That contrast has created opportunities for P&C companies because the shorter end is less competitive. There can be a lot of value in investment grade private placements in that three-, five-, seven-year kind of tenures, and that can fit the P&C companies very well, apart from all the other benefits of higher yields, covenant security, and diversification.

Coupe: I think it’s fair to say that the consulting community hasn’t necessarily embraced private placements either. Some of that is down to the challenges that it presents from an asset allocation perspective. It has very similar characteristics to public market fixed income with some additional spread. So, the incentive to add that to an asset allocation for some consultants who maybe aren’t as familiar with the insurance space, is quite challenging.

Pelosi: IG private credit is really your complement to, or replacement for U.S. public corporates. They share a lot of similar statistics and correlations. IG private placements will be a growing asset class because the alternative of a 1.5 yield, 10-year corporate is not as attractive.1 Also, P&C and health insurers are very focused on liquidity, but over the past 10 or so years all insurers – doesn’t matter which line – have become much better capitalized. They have materially improved capital positioning and generally speaking, as highlighted by COVID-19 earlier this year, a good portion of insurers were ready for a material liquidity crunch. They have access to lines of liquidity, many have modeling in place to understand their total liquidity risk. There’s no free lunch, but this is the nearest thing to it for many insurers given the increase in yield versus the trade-off for illiquidity. In short, insurers have become better at addressing liquidity issues, which gives them the flexibility to add less liquid investments that increase yield.

Where does IG private credit fit into the SLC Management playbook? And what are the traits of the businesses the strategy looks to invest in?

Pelosi: When we do modeling, regardless of insurer type, the simplest adjustment for our clients is to move out of traditional publics and into traditional privates. How we do that is two-fold. First, we get them comfortable with their liquidity positioning through operational modeling – that’s what our Client Solutions Group does. We look at your business, we understand your liabilities, liquidity position, and access to liquidity. If we and the client jointly conclude there is some excess liquidity, IG private credit is typically the first yield or return lever we pull, because it’s such a large pick up compared to other securities – and with little to no regulatory impact, as opposed to some other investments.

Kleeman: In terms of where we look to invest, we are looking broadly across a wider range of a deal structure. We manage more than $30 billion of private placements. We have a team of nearly 60 analysts, broken into several smaller teams, and we have a higher relative value focus –so that’s led to a lot more specialization in those teams. For example, we have a team, focused on private real estate deals, whether that’s credit tenant leases or ground leases or similar structures. We have a dedicated team that does a wide variety of infrastructure-backed loans, whether that’s power projects or toll roads or other social projects. And we also have a dedicated corporate finance team that has multiple areas of specialization, as well as doing more traditional broadly-syndicated private placement deals.

In general, we’re looking for stability of cash flows in the underlying credit, and to build a diversified portfolio for our clients. We’re looking for structural protections through security where it really matters, where it’s actually secured. We’re looking for covenants and we’re looking for high relative value. Our job is to find those opportunities, and this year in particular it’s been really attractive as the public bond markets – and all markets, really – have gone through quite a gyration, really stressed in March and snapping back quickly. Private market pricing responds slower than the public market, which is hard when spreads are widening in the public market, but when they’re tightening the relative value tends to sustain for quite some time. It has been a great year for us in kind of the value we’ve been able to add in private placements, despite the pandemic.

Pelosi: One differentiator at SLC Management is that due to our focus on investing for insurers all of our private credit holdings are publicly rated by the SVO. Therefore, whether our clients are focused on solvency risk based capital (RBC) or rating models (AM Best BCAR) these securities receive capital treatment the same as their public counterparts. Some private credit shops are not as focused on ratings, but we know that’s critical to insurers.

In the context of all those areas of specialization, are any areas in particular resonating with clients right now?

Kleeman: SLC Management is very focused on ESG issues and it’s something that our clients feel is important. And maybe just as important, a lot of us who work at the firm are personally passionate about those issues as well. So, we’ve found a lot of opportunities, both in the infrastructure team and corporate finance team, that blend well with our appreciation of ESG but still offering substantial relative value relative to public corporate bonds. That’s been a win-win on both the relative value front, as well as our desire to not only be good investors but to invest in opportunities that improve either the environmental impact or the social impact in our world and in our communities.

Let’s dig a little deeper into the IG private debt strategies. Investors today like flexibility – do your strategies provide that?

Pelosi: Ours is definitely not a one-size-fits-all approach. While we do offer funds in this space that are popular with other institutional investors, like pension plans, in the insurance sphere private credit funds, more often than not it’s going to be treated in a much less favorable capital fashion. Typically for insurers we’re going to tailor a separate account strategy for the type of client and their specific liability needs. Just yesterday we were having some internal conversations around specifically trying to avoid high correlation assets with current liabilities. For example, if a property and casualty underwriter in the Northeast has large exposures to the general New England area for their business, we’ll try to avoid underlying line items that also have similar exposures. If a large Hurricane Sandy type event were to have material impact to the Northeast, you’re not doubling down on both operational risk and investment risk.

Coupe: The IG private placement is likely to add between 50 and 100 basis points to BBBs. This isn’t a double-digit return type, and you really see that in the risk factor. You look at the default rate, you look at the recovery rate. It doesn’t look like what the broader investment community would consider to be private debt. We have certainly seen, across all insurers, a real run on private debt overall the last few years. The driver of this trend is the exact reason that investment grade private placements make sense; more yield per risk-based capital unit relative to similar investments. It’s really two parallel stories in private debt, but there’s not necessarily a crossover component of investors looking to move out of lower quality private debt into investment grade private debt.

Kleeman: That’s interesting, because when you talk to people from the broader investment world and say you do private debt they assume it’s below investment grade. And then as you start to describe what you actually do, they look at you like it’s something they’ve never heard of before. So, it’s definitely a market that’s less familiar to some investors. It’s hard to tell how big it is because there are a lot of direct deals or club deals that are done, but we think the investment grade private placement market is somewhere between $90 and $100 billion per year in volume.

Coupe: I actually think the nomenclature does the asset class some harm. There can be key stakeholders who don’t necessarily understand investments and hear the word “private” and just say, “Oh, I don’t want to do it, it’s private.” Or they look at the return profile and say, “Well, why are we doing this for a private asset?” That one word can do some harm to people who are looking at the asset class for the first time.

Including some of those total return investors we mentioned earlier?

Coupe: NEPC is spending a lot of time talking with insurers about that now, because in a prolonged low rate environment the total return concept is much more difficult to make work. The income focus – which will ultimately drive total return – may be more important on the bond side than capital appreciation or any sort of additive from money due on a total return basis. Going forward, P&C and health insurers could certainly look and say, “Okay, we have a lower for longer environment. Investing in income-focused assets might be a preferable way to go rather than some of the total return fixed income strategies.”

Pelosi: Some of the more sophisticated P&C and health insurers who have adapted to the market environment quickly, as Andrew just mentioned, have seen explosive growth in IG private debt space. From an asset allocation viewpoint overall, IG private debt replaces traditional IG public fixed income. With similar correlation, volatility, and capital charges, but higher yield characteristics, IG private debt tends to be the lowest hanging fruit in our asset allocation models. Across the board, the question is not “Should you use private placements?” Rather, it’s “How much can you use?” They just make so much more sense than a traditional core asset in the current market environment.

Kleeman: If you’re asking how they fit into a portfolio, we have achieved an 85-bps premium to corporates of the same rating and tenor over the last five years, and this year it has been around double that.2 I think that extra yield fits nicely into anyone’s portfolio.

We’ve mentioned larger insurers a few times in this conversation. Would smaller insurance companies have any difficulty accessing IG private debt?

Kleeman: It takes a certain scale to access the market well. There are some huge insurance companies that have big teams. There are much smaller insurance companies that have dedicated teams as well. But at some point, particularly if you want to get into the more niche sectors, it requires a level of specialization from an asset manager. A lot of the asset managers at larger insurance companies are offering third party services now. The key is making sure that whoever you sign up with, you can get a reasonable allocation. And it’s interesting that traditional life companies view this asset class as gold and they don’t want to give it up. Just understanding those allocation policies and going to a manager who’s got the ability to give their new clients reasonable allocation is a critical aspect of the client experience.

We’ve talked about a few things that differentiate SLC Management’s approach and strategies in IG private credit – what are some others?

Kleeman: One is our focus on fundamental underwriting. These are not deals announced on Tuesday and priced on Thursday. These are deals that take at least two weeks and sometimes months to underwrite and negotiate. We take a lot of pride in underwriting, so we get access to information. We use third party resources to verify our underwriting and collect more data on the underlying industries.

As I mentioned earlier, we are a team of specialists. For example, the origination capabilities required for private investment grade debt are unique. We have people that are dedicated and focused on origination. There’s a fair chunk of privately placed investment grade debt that comes from the large banks, but there’s a lot of interesting deals that come out of other sources as well, whether its boutique investment banks, a direct situation with a borrower, or other kinds of structured opportunities. Along with origination capabilities and complex fundamental underwriting, we have a dedicated legal team to get through the deal documentation – which in a lot of these situations, can be negotiated, unlike in a public deal. A robust effort is required to get each deal across the finish line – and we have all the specialists to make them happen.

Learn more about how IG private credit can potentially help address some of the investment challenges you face today.



1Investment 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.

This interview 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.

285+ basis points over relative value is the 5 year average for private fixed income USD fixed rate deals. 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. 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 corporate bonds 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 slides. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

2 Attractive Opportunities in Investment Grade Private Credit

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.

3 Leveraging Excess Liquidity

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%)1.

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.

1 S&P Market Intelligence as of 12/31/2019 and NAIC as of 12/31/2019


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

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