[T]he NAIC CMB Special Report

requires a very close reading. Financial types

pride themselves in soft-pedaling even the most

savage events and Hellbroth conditions.

Public Policy Analysis & Opinion

By Kevin P. Hennosy

EVERYTHING OLD IS NEW AGAIN?

Insurance sector loading up on high-risk bonds

At the end of 2020, the U.S. insurance sector’s holdings in high-risk bonds reached levels not recorded in more than 10 years, according to a special report published by the National Association of Insurance Commissioners Capital Markets Bureau (NAIC CMB) in August 2021.

The trend is not good.

“U.S. insurance companies reported high-yield bond exposure with a book/adjusted carrying value (BACV) of $286 billion as of year-end 2020, an increase of 25.7% compared to year-end 2019,” reported the NAIC CMB.

Keep in mind that every time the NAIC CMB uses the term “high-yield” they could have used the term “high-risk.”

The report infers that this increase in the riskiness of the insurance sector’s investment portfolio results from downgraded credit ratings of issuers, and not a strategic decision by insurance executives to load up on toxic investments.

But then again, the report never directly states that insurance executives have not taken a strategic decision to embrace high-risk investments in pursuit of higher returns—as they did in the 1980s.

Certainly, the pandemic seems to play a role in the deterioration of investment portfolios. The spread of the COVID-19 virus, coupled with the U.S. government’s botched response to it, gutted the nation’s economy in 2020. The economic downturn impacted credit markets, which prompted attention from credit rating agencies.

“As a result, the nationally recognized statistical rating organizations (NRSROs) took a record number of negative rating actions, affecting fixed income securities across many bond categories, including corporate, municipal, and structured securities,” observes the NAIC CMB report.

Near death

As someone who worked in the insurance sector in the late 1980s and early 1990s, it seems to me that the NAIC CMB report does not proffer welcomed news. We really do not know what is motivating insurers to take on more investment risk.

The topic brings back unpleasant memories. I will share them for the benefit of young agency professionals. My career in and around the insurance sector began in 1987, a time of financial crisis for insurers. The life insurance subsector was still reeling and writing assessment checks to cover the 1983 collapse of Baldwin-United Corporation—the piano maker turned financial services company. The property and casualty subsector still rocked from the 1985 failures of Transit Casualty Insurance Company and Anglo-American Insurance Company.

In September 1989, I left Nationwide Insurance Companies to accept a job as the NAIC’s media relations manager. A few weeks after that job started, I received an email from then-NAIC Executive Vice President Sandra Gilfillan, which warned me that regulators formed a secret working group to monitor First Executive Corporation and its subsidiary Executive Life Insurance Company. “You might hear about it,” said “Sandy” Gilfillan with more than a little understatement.

Up until that point, people who worked around insurance knew Executive Life Insurance Company as a purveyor of single premium deferred annuity (SPDA) products. The company ginned up an aggressive salesforce in the field, with marketing meetings storied for lavish gifts to top producers.

The Executive Life SPDA became known for ever-increasing yields that, coupled with the tax advantages of life insurance products, made the Executive Life competitive for upper-level individual investment customers. The competitive edge Executive Life wielded led other companies to offer higher yields on their products, which impacted the insurers’ investment strategies.

A few weeks after receiving Ms. Gilfillan’s email, I was setting up the press room for the 1989 NAIC Winter National Meeting in Las Vegas. The morning’s edition of The Wall Street Journal arrived carrying a front-page feature story on the looming financial problems of Executive Life Insurance Company. What happened in Vegas did not stay in Vegas.

In California, the domiciliary state of First Executive and the flagship Executive Life Insurance Company were aggressively investigating CEO Fred Carr’s operations. Soon after, it was clear that the secret NAIC working group focused on how Executive Life found it possible to offer its high-yield SPDA products.

Carr, then-CEO of both Executive Life and First Executive Corporation, forged a special relationship with the “financier” Michael Milken, the “Junk Bond King” of the soon-to-fail investment bank Drexel Burnham Lambert. Executive Life’s investment portfolio was weighted down with the un-weighed risk of “high-yield” junk bonds.

The junk bond descended from investment products formerly known as “fallen angels”—bonds issued by companies whose financial condition had worsened but still had the backing of going concerns. Fallen angels offered slightly higher yields related to the slightly higher risk of default.

Junk bonds took the next step of offering higher yields from the start, because the risk of default was much higher than fallen angels. The Milken operation used junk bonds to fund corp-orate takeovers, which generated hugefees and did not seek to improve the revenue strength of the takeover target.

In short, with his addiction to junk bonds, Fred Carr bought countless bundles of high financial risk to support his SPDA yields. Over time, Executive Life expanded its aggressive marketing beyond the speculative wealthy clients—who also deserved protection from such a pig in a poke—to include investors who did not have the assets to survive a failure.

In addition, Carr and Milken had another little-known operation, which put at risk many other people who had no idea that they were in such a speculative game. Carr used his companies to buy Milken’s junk bond issues. Milken targeted companies with pension plans set aside for their workers and retirees. With the takeover, Milken’s team would “find” that the pension plans were “overfunded” and would petition the federal Pension Benefit Guaranty Corporation (PBGC) to allow the conversion of the pension fund to an unallocated group annuity.

The PBGC provided a financial guarantee to pensions and the Reagan and first Bush Administrations wanted those financial exposures off the federal government’s books. So, the PBGC rubberstamped many conversions.

Such an annuity valued at the “right-sized” fund amount could be purchased at a percentage of the value of the existing pension fund. The difference between the annuity’s cost and the pension fund balance was pocketed by Milken’s takeover group. Where did they usually buy the annuity? Well, Executive Life was happy to sell the contract.

These machinations meant that workers and retirees no longer had a federal guarantee to their retirement income. Also, because state guarantee fund systems did not cover unallocated annuities, the workers’ and retirees’ incomes were not covered in the case of a failure of Executive Life.

Some of these conversions involved pensions that did not involve takeovers. For example, the State of Alaska converted a material portion of the Alaska state employees’ retirement fund to an Executive Life unallocated annuity. In the early months of 1990, senior Alaska officials became aware of the folly of their ways.

In the Spring of 1990, then-Alaska Director of Insurance David Walsh reported at a closed-door NAIC meeting in Charleston, West Virginia, that he made repeated calls—unreturned—to then-California Insurance Commissioner John Garamendi. When Garamendi made a smug dismissal of Walsh’s claims, the Alaska regulator began to move toward the Californian and most observers expected to see a fight—before other regulators stood between the two men. (This commentator attended the meeting as NAIC staff and witnessed the exchange.)

Months later, I was in my office at NAIC headquarters in Kansas City, Missouri, when my phone rang. The NAIC receptionist asked me if I would take a call from an upset caller. As “the PR guy” this was not an unusual request.

On the line, a man explained that he was a retired lumberjack who suffered from disabilities. The caller held his emotions together long enough to explain that he learned that his retirement payments would terminate with the failure of Executive Life. He did not even know until that point that he no longer had a pension. He did not know what an annuity was or how this happened to him. He began to cry uncontrollably. “I can’t go back to work,” he sobbed over and over.

When you hear an old lumberjack cry, you do not forget it.

The failure of Executive Life led to a series of insurance failures that the NAIC described as an “insolvency crisis.” The financial press, credit agencies, and government officials began looking into the insurance sector’s high-risk investments. The problem did not stop with junk bonds. Old established companies failed because of real estate investments, stock manipulation, and other shell-game financing.

During the insolvency crisis, customers lost trust in insurance, and insurance is a business based on trust. At one point, NAIC leaders met with the Federal Reserve to discuss an emergency infusion of capital into the life insurance sector, long before the latter did just that in 2008.

So, when today’s NAIC works up the gumption to issue a report on the growing concentration of high-risk investments of the insurance sector—I take it very seriously. Maybe this is a sign of post-traumatic stress disorder, but I believe everyone should take the report seriously.

Brimstone

Like many financial-oriented reports, the NAIC CMB Special Report requires a very close reading. Financial types pride themselves in soft-pedaling even the most savage events and Hellbroth conditions.

To interpret this report, the reader should remember that NAIC does not look for trouble. The association waits to act. Little boxes of trouble proverbially accumulate in piles in front of NAIC headquarters until passers-by, or congressional committees, begin to complain about the sound of growling and the smell of brimstone.

Only then does the NAIC start to kick around the idea of forming, say, a secret working group.

The NAIC CMB Special Report proves useful to understanding the insurance sector’s exposure to investment risk, once one translates the report writers’ use of “happy talk” phrases to describe negative conditions. For example, the report describes high-risk instruments using the term “high-yield.”

Yes, those bond issuers just increased the yield on their issues out of charity and the goodness of their heart!

Furthermore, the special report writers used the following sugar-coated jargon-laced description of credit markets: “In the corporate bond universe, high-yield companies have dominated rating actions as they generally have weaker liquidity profiles and limited financial flexibility to withstand the negative credit effects of macroeconomic shocks.”

Translation: The rating agencies sanction borrowers that do not possess enough money, revenue, or ability to increase revenue, to undoubtedly continue uninterrupted payments in a bad economy.

Just angels again?

In addition, the special report tends to bury references to high-risk instruments low in paragraphs after mentioning more benign products. For instance, the report contains a discussion of the relatively benign fallen angels, then later in the same paragraph discusses collateralized loan obligations (CLO)—which still carry the stench of the 2007-2008 financial panic.

The NAIC CMB report notes that the economy is improving. As of August 2021, the number of credit downgrades leveled by rating agencies was far below the number leveled in 2020. Therefore, the impact of fallen angels should become less of a concern, but the insurers’ craving for increased yields do not seem sated.

“Financing conditions remain favor-able for issuers—investment grade and high-yield alike—across all asset classes, with interest rates expected to remain low and investor appetite for yield strong,” observes the NAIC report.

Let us not ignore that the high-risk issuers have been able to borrow money at historically low interest rates—if we also look at the underlying default risk that made them high-risk issuers. Remember the transition from fallen angels to junk bonds.

The NAIC notes, “High-yield issuers in particular have taken advantage of the abundant credit availability to refinance existing debt at lower yields, providing them more financial flexibility at least for the near term.”

Furthermore, the special report cites other investment instruments that cannot, by definition, be dismissed as fallen angels. The NAIC observes: “High-yield corporate bonds, asset-backed securities (ABS) and other structured securities, and private-label commercial mortgage-backed securities (CMBS) were the primary contributors to the increase in high-yield exposure.”

Ten-year trend

The NAIC CMB report writers provide some calming words: “On a percentage basis, exposure to high-yield bonds began declining after year-end 2016 when the metric reached a high of 5.9%, falling to a low of 5.1% at year-end 2018.”

Yet, the report also notes, “At year-end 2020, however, the metric climbed to 6.1% of total bonds, the highest level since the 6.3% reached in 2009.

“Over the 10-year period, exposure to high-yield bonds in BACV terms has grown at a faster pace than bonds overall. High-yield exposure has grown almost 37%, despite declines in several years, while overall bonds have grown steadily throughout the period with total growth of 30%,” explains the NAIC special report.

Furthermore, the NAIC report provides the following caveat to those who would dismiss the return to high-risk investments by even a few insurers: While the U.S. insurance industry’s high-yield exposure is likely manageable given its overall capital strength, individual insurers with concentrated exposures, particularly as a percentage of capital and surplus, could be at risk of significant losses if default rates spike or rise dramatically.

One would hope that the Federal Reserve’s Systemic Financial Institutions and Markets Section would review the NAIC special report, and the underlying data used to produce it.

Because the NAIC does not have a reputation for “speaking truth to power,” the fact that one of its offices published a report on the insurance sector’s increasingly risky investment holdings should raise some eyebrows—if not activate alarm bells.

So, maybe we should all take a walk, take deep breaths, and drink lots of water—I am told it will help.

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.