Collateralized loan obligation combination notes, which blend rated CLO tranches with riskier equity in an investment-grade note, have become a more popular way for CLO managers to sell risk to large domestic insurers in 2019. But insurance regulators suggest the notes can conceal ratings arbitrage, and they are now calling for more stringent capital weights for the instruments.

In a letter to the National Association of Insurance Commissioners’ Valuation of Securities Task Force dated July 2, the director of the NAIC’s Securities Valuation Office, or SVO, proposed rule changes that would not allow external ratings to determine statutory capital for principal-protected notes, and would require them to be evaluated in-house by regulators.

NAIC staff made clear that the desire is to ratchet up oversight, and that the NAIC wants to apply the new regime to current CLO combo note holdings.

"Our recommendation is to have the proposals adopted and in force by January 1, 2020," an NAIC staffer told LCD News. "We would not be supporting a grandfathering of the current regime."

While several variations of principal-protected notes are under scrutiny by the NAIC, CLO combination notes are listed as one type that would be brought under case-by-case analysis by the SVO, which would give the security its own NAIC designation and accompanying risk-based capital requirement.

'Significant risks'

"The SVO has become aware of a class of structured securities ... that mixes a traditional bond or bonds with additional assets that may possess any characteristic," wrote Charles Therriault, director of the Securities Valuation Office, in the July 2 letter. "Significant risks are being obscured by focusing only on risk associated with the repayment of principal."

While an asset such as CLO equity is fairly speculative, the all-encompassing combo note rating can shield large insurers from capital charges that might make the associated cost of capital to own CLO equity too high, a number of sources say. Likewise, principal-only ratings offer higher ratings for speculative-grade debt by attributing interest payments and equity distributions to principal amortization, allowing the transaction to be modeled with a simpler, easier payoff, sources add.

"I don't think that the ratings are incorrectly rating risk, per se," said one source. "The real issue is accounting. There is a given amount of money that's being paid for a form of equity, but it's being rated as a version of hybrid fixed income. If an insurance company bought equity in any other capacity, it would be charged proportionately higher for that."

Market sources say that CLO combination note issuance is up this year as challenging arbitrage has forced banks to get more creative on marketing CLO equity to investors. While the returns are lower, offering insurance companies exposure to those levels of returns with a low capital charge has obvious appeal.

However, a number of sources say that stripping away that regulatory capital sweetener might push some insurers out of the market and weigh on the capacity for CLO managers to execute deals.

"Some banks have gotten very comfortable placing CLO equity through combination notes," one CLO investor said. "Making combo notes more expensive for insurers to hold will likely make it even harder for arrangers to place CLO equity at a time when the arbitrage is especially challenged."

Regulatory workarounds

While there are no official records of combination note volume, as much of the market is privately placed, they have made a decided comeback in recent years, from the pre-crisis era, as the CLO market has regrown and insurance companies are attracted to the risk-adjusted returns that the asset class offers.

Given the popularity of the asset with some buyers, sources say that arrangers are already considering workarounds to the regulator’s proposals. Some structures are considering tweaks to the NAIC model by potentially structuring individual CLO tranches to include an equity upside, while others are considering more seriously the option of turning to foreign buyers, who could still enjoy the benefit of external ratings.
More generally, however, those who have been in contact with the NAIC say that combination notes are just the beginning of a broader review of how insurance companies hold and account for risk of more esoteric, bespoke assets on the balance sheet.

"My impression is, whatever they’re doing on the principal-protected note side is much further along than some other proposals they are considering," said one legal source. "The NAIC is looking deeper into bespoke securities that could fly under the radar, and have the SVO examine some asset classes."

An Aug. 3 meeting to discuss the issue coincides with the NAIC’s securities valuation task force annual summer conference in New York City. If the proposed amendment on principal-protected notes is accepted, it will be put up for public consultation before it is adopted.

LCD is an offering of S&P Global Market Intelligence. S&P Global Ratings is a separately managed division of S&P Global.