Equitable backs concentration charge on riskier ABS

“Ultra-high correlation of losses” between lower-rated tranches requires new regulation, insurer says

Equitable
Equitable’s headquarters at 1290 Avenue of the Americas, New York
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One of the largest US insurance companies is lobbying regulators to introduce a concentration charge for holding subordinated tranches of asset-backed securities.

Equitable is planning to propose a new concentration charge on all but the highest rated tranches in vehicles such as collateralised loan obligations (CLOs) in a public letter to the National Association of Insurance Commissioners expected in October, and is currently meeting state regulators to discuss the idea.

The charge would provide a “blunt guardrail for insurer solvency”, says a presentation given by the insurer to regulators. Equitable says details of the final submission to the NAIC are yet to be finalised.

The “ultra-high correlation of losses” between subordinated tranches of asset-backed securities (ABSs) can cause them to “default in tandem” in a downturn, Equitable’s presentation adds, potentially blowing a hole in an insurer’s capital position if it holds a high concentration of such tranches.

Equitable’s proposal comes against a backdrop of tension between traditional insurers, which have voiced concerns over the risks of structured credit, and a new breed of private-equity owned insurers including Athene and Aspida, which have invested heavily in CLOs in recent years.

The proposed concentration charge as set out in the presentation would be applied to all ABS subordinated tranches, such as CLOs, collateralised fund obligations, commercial- and residential-mortgage backed securities, and ABS collateralised with infrastructure.

Tranches of ABS tend to perform in a similar way during stress events, and current regulation fails to address this risk, says Aaron Sarfatti, Equitable’s chief risk officer.

“Once you establish that an asset class has both a very high correlation of loss and potential for near total loss, there’s no good capital charge to ensure the resilience of an insurer with a large exposure,” says Sarfatti. “The biggest benefit of a concentration charge is that it addresses the issue in a manner that is easy to implement, calibrate and understand.”

Equitable has pitched the idea to four regulators so far. “We’re getting the opportunity to socialise it more,” Sarfatti says.

Insurer exposure to CLOs has grown rapidly in recent years, though from a low base. The proportion of insurer assets invested in CLOs rose 30% between 2019 and 2021 to make up 2.6% of total assets, according to NAIC research.

A handful of insurers hold outsized allocations to CLOs. Aspida had 16% of its $11 billion assets in CLOs, June 2023 data shows. Athene held 20% of its $112 billion assets in CLOs and ABSs, according to its end-2022 filings. The firm hoovered up more than $800 million of CLOs in October last year alone, during the market volatility that followed the UK’s so-called “mini-budget”.

At least four insurers hold more than 10% of general account assets in CLOs, according to anonymised 2022 data from the American Association of Actuaries.

Blind spots

Insurers currently incur a risk-based capital (RBC) charge on their investments, which acts as a constraint on the mix of assets they can hold to cover liabilities. Riskier assets generally incur a higher capital charge.

But Equitable says subordinated ABS tranches have a risk profile that is different from conventional bonds and is insufficiently covered by RBC rules.

“Standalone capital charges, even if right-sized, are not sufficient to identify poorly capitalised insurers,” notes the presentation. “Historical insurance investment regulations did not contemplate the nuances of these assets.”

The presentation uses CLOs to illustrate how losses to ABS tranches can occur in tandem in a downturn. A CLO is a bundle of leveraged loans that is sliced into tranches of varying risk. These tranches are then sold to investors. In a downturn, as loan defaults rise, subordinated tranches are first to be wiped out. Insurers could see a number of separate subordinated tranches written down to zero at the same time.

This risk is not captured by the current RBC framework, says Sarfatti.

CLOs, for example, buy up around 75% of leveraged loans in issue, and so often hold similar underlying collateral pools. Stress-testing conducted by a subcommittee of the NAIC found that in a severe scenario, losses led to the default of single-A tranches for all CLOs tested.

CLOs are already under regulatory scrutiny, with the NAIC planning to increase capital charges on riskier tranches.

Under Equitable’s plans, a concentration risk factor would cover subordinated structured securities as a whole.

“Not all share the same degree of correlation [as CLOs],” Sarfatti says. But most have “relatively narrow collateral profiles, and they are tranched in a way that’s analogous to CLOs”.

A concentration risk charge for bond holdings already exists under NAIC regulation. But Sarfatti says it doesn’t go far enough to address the binary outcomes that subordinated tranches face in a downturn.

“Current corporate bond charges are calibrated on a pool of raw collateral whose loss correlations have not been increased by the rules of structuring,” he says.

The existing charge doubles the capital charge to a maximum of 45% for the top 10 largest bond holdings on an insurers’ balance sheet – on par with an insurer holding high-beta equities. This is a “very blunt, coarse adjustment for single name exposures” that does not capture the size of an insurers’ holdings in a security, Sarfatti says.

A concentration charge would be an addition to rather than a replacement for current capital charges. The surcharge would have to be high to make sure the capital shortfall potential of a given asset class was capped, Sarfatti says.

Sarfatti says Equitable has received pushback from other insurers on the charges for double-A tranches, which are the second-most senior in ABS structures.

Some market participants have argued a concentration charge for double-A tranches may be overly punitive. Double-A CLO tranches are typically twice the size of the single-A and triple-B tranches subordinate to them, meaning that they are less likely to take a hit in a severe downturn. In NAIC stress-testing, CLOs’ double-A tranche incurred no losses, and no double-A tranches have ever defaulted.

“There's an argument to weaken it or adjust for it,” given double-A tranches’ higher position in the capital structure, Sarfatti says.

Limits

Under Equitable’s proposal, a concentration charge would kick in only if an insurer held a pre-specified percentage of assets in subordinated ABS.

For example, an insurer holding less than 2% of its assets in subordinated tranches of structured securities backed by corporate credit would only face RBC charges; if it held more than 2%, it would face a concentration charge too.

Insurers could also be subject to an aggregate cap on subordinated ABS, meaning they could hold up to, say, 15% of general account assets in structured securities before facing concentration charges.

Sarfatti is not in favour of applying the full charge to investors’ current holdings in a single shot, but rather in a phased approach. The relatively short maturity profiles of many ABS means that, as insurers scale back their ABS holdings, insurer exposure relative to their historic liabilities would decline substantially in just three to five years, Sarfatti says, allowing the charge to be applied with minimal disruption.

Correction, October 4, 2023: The article has been changed to clarify that feedback on the treatment of double-A rated securities came from market participants, not regulators.

Editing by Rob Mannix and Alex Krohn

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