Insurance capital charges may force CLOs to do the splits

Charlie Dinning

Data journalist

The National Association of Insurance Commissioners’ (NAIC) long-awaited capital charges rejig is now in place, and it could result in life insurers changing their habits and CLO issuers splitting tranches.

Under the current system there are five risk categories running from NAIC 1 (covering triple A to single A-rated bonds) down to NAIC 5 (triple C-rated bonds). NAIC 2, 3 and 4 cover triple, double and single Bs. Each risk category has a flat rate charge.

However, the proposed changes in credit risk (C1) charges mean each rating band will pay a different rate and most parts of the capital structure will become more expensive.

Triple A-rated bonds and the highest rated parts of each non-investment grade rating band have a lower proposed charge than current rates. Triple As have the highest percentage decrease of 60%. They go from 0.39% to 0.16%.

But single A-rated bonds — so often the sweet spot for insurers — have the most punitive increases in charges. Previously, single A-rated bonds had the same capital charge as triple As. But the new guidelines raise the charges for A+/A1 paper by 27 basis points (an increase of 69%), A/A2 bonds increase by 43bp (110%) and A-/A3 charges are 63bp higher — a whopping 161% increase.

Change in capital charge by rating band (bp)

Insurers are the biggest buyers of single A and triple B-rated CLO tranches as they offer the greatest return on capital (ROC), but that may no longer be the case. Sources say insurance companies could move up into CLO triple and double A-rated tranches, as they offer better ROC under the proposals.

Alternatively, CLOs could come to market with more senior and junior tranches of some ratings. Every US CLO pricing in November had an A or A2-rated single A tranche. But there was some discrepancy among triple and double B-rated notes.

Seven US CLOs split their triple Bs into senior and junior tranches in November, the highest number of any month in 2021. Five had split double Bs.

BBB+/Baa1-rated bonds have the same capital charge as before, while BB+/Ba1 bonds’ charges decrease by 131bp or 29.4% under the proposals.

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Global credit funds & CLO's

January 2022 | Issue 241

Published in London & New York.

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