Less-liquid assets play bigger role in US life insurers' search for yield

Introduction

The U.S. life insurance industry traded incremental liquidity risk, and in certain limited circumstances, credit risk for investment yield in 2021, perpetuating a trend that has run throughout much of the post-financial crisis low-interest-rate environment.

Rising interest rates in 2022 may take some pressure off the industry to deploy funds into higher-yielding investments like privately placed bonds, commercial mortgages, joint ventures, syndicated loans and collateralized loan obligations. However, we do not expect the appetite for those assets to dissipate in the near term even as new money rates on more traditional investments rise.

Some prominent life insurers recently tapped third-party alternative asset managers to handle portions of their investment portfolios. The shift of  billions of dollars  of life and annuity liabilities onto the books or under the management of private equity-linked reinsurers could accelerate in 2022, even beyond the high levels of the past two years, adding to the existing demand from within the sector for private credit instruments. Additionally, several prominent life insurers have built or already maintain core competencies within specific asset classes that will support continued allocations.

Single source for rising yields

The U.S. life insurance industry's net yield on invested assets of 4.21% in 2021 remains well below historical levels, but it marked a modest recovery from 2020's bottom. The year-over-year increase of 7 basis points is the largest recorded since 2010, and it marked only the fourth increase of any amount in the past 19 years.

Gross yields varied widely by asset category in terms of amounts and year-over-year trends, however. Yields declined for bonds, stocks and mortgages by 17 basis points, 70 basis points and 3 basis points, respectively, but surged for other long-term invested assets, commonly referred to as Schedule BA assets, and real estate equity. For those assets, yields jumped by 315 basis points and 60 basis points, respectively. The industry's overall investment yield would have continued its downward drift had it not been for the impact of sharply higher Schedule BA investment income.

Schedule BA includes a range of instruments, but interests in affiliated and unaffiliated joint ventures and limited liability companies constitute the majority of the carrying value of the industry's investments. This category would include private equity investments, and individual investments may be deemed to take on characteristics of common stock, real estate, mortgage loans and other miscellaneous types of instruments.

Among 47 individual life entities with average Schedule BA assets in excess of $1 billion, 21 reported that investment income earned on those assets more than doubled in 2021. Four produced a gross yield on those assets of more than 19%, generated year-over-year growth in that yield of more than 900 basis points and more than doubled their investment income earned:  American International Group Inc. 's  American General Life Insurance Co. ,  Voya Financial Inc. 's  Voya Retirement Insurance & Annuity Co. ,  State Farm Mutual Automobile Insurance Co. 's  State Farm Life Insurance Co.  and  Western & Southern Mutual Holding Co. 's  Western & Southern Life Insurance Co.  The highest gross yield on Schedule BA assets subject to a minimum of $1 billion in average assets in that category was  Nationwide Life Insurance Co. 's 47.5%.

Reasons for the high yields varied. AIG's American General Life recorded  $797 million  in investment income from its stake in the affiliated SunAmerica Affordable Housing LLC, which alone accounted for 31 basis points of the industry's 2021 gross yield on Schedule BA assets. AIG  sold its interests  in a U.S. affordable housing portfolio, including those held through SunAmerica Affordable Housing, to a  Blackstone Inc.  vehicle in 2021. For Western & Southern Life, its success was the result of  increased distributions  from real estate partnerships. Its affiliated W&S Real Estate Holdings LLC produced $262.1 million in investment income for the company, more than the previous two years combined.

Search for yield intensifies

Schedule BA is one of the oft-discussed categories to which insurers have been allocating more funds during the low-rate environment. Some industry participants have characterized the trade as taking incrementally more liquidity risk for greater yield potential. Gross Schedule BA investments climbed in 2021 by $55.24 billion, an increase of more than 24%, their highest growth rate since 2007. Commercial mortgage loans and unaffiliated bank loans, which include leveraged loans, grew by 5.0% and 28.9%, respectively.

Privately-placed industrial bonds, a category that includes corporate bonds and structured finance securities not issued by a government agency, also continued their upward march, rising by 9.8% to $1.38 trillion. They constituted 39.7% of total industrial bonds at year-end 2021, up from 37.6% at the end of 2020. Other loan-backed securities, a category that includes asset-backed securities, collateralized loan obligations and other structured finance securities not backed by mortgages, helped fuel the upward movement as privately placed bonds in this category rose by 11.6% to $316.70 billion. Private bonds constituted 87.5% of total holdings in this category, which reflects the nature of issuance in the applicable markets.

Massachusetts Mutual Life Insurance Co. , which has the highest concentration of private industrial bonds among individual life entities with total industrial bond holdings of at least $20 billion, said in its  2021 annual statement  that it uses investments in its privately placed portfolio to "enhance the value of the overall portfolio, increase diversification and obtain higher yields than can be earned by investing in public market securities of comparable quality." The company, which posted 10.3% year-over-year growth in privately placed industrial bonds in 2021, said it controls risk associated with those investments through stronger covenants, call protection features and collateralization than it could typically implement in the public market.

Some of the fastest year-over-year growth rates in private industrial bonds among entities with industrial bond portfolios of at least $20 billion were achieved by  Corporate Solutions Life Reinsurance Co.  and  Security Life of Denver Insurance Co. ,  each of which  came under  new ownership  in 2021.

Bond portfolios also showed evidence of migration into lower investment-grade positions. Securities with a designation of 2B under the National Association of Insurance Commissioners' expanded presentation introduced in 2020 accounted for 15.9% of long-term bonds as of Dec. 31, 2021, up 96 basis points from the same date a year earlier. The 2B designation is equivalent to S&P Global Ratings' BBB level. The highest designation, 1A, remained the second-largest designation as it contained 13.7% of life industry long-term bond holdings. The NAIC's risk-based capital framework assigns charges that vary inversely with the level of quality implied by the designation category. It is important to note that the industry's investments have increasingly focused on the lower investment-grade credits, not the below-investment-grade credits that incur the largest risk-based capital charges. Below-investment-grade securities accounted for less than 6% of long-term bonds at year-end 2021, down from 6.3% a year earlier.

Multifamily fuels mortgage expansion

Mid-single-digit growth rates in mortgage loans held by the U.S. life industry in 2021 masked a frenetic pace of loan acquisitions during the second half of 2021 and in the multifamily property type through the full calendar year.

The third and fourth quarters of 2021 ranked as the most active periods in at least the last 18 years for mortgage loan acquisitions as measured by aggregate actual cost. In fact, the industry's $79.49 billion in acquisitions during that six-month period fell just shy of its full-year 2020 total. The lower figure is a sum-of-the-parts calculation based on loans acquired between July 1, 2021, and Dec. 31, 2021. Among uninsured commercial mortgages, multifamily loans accounted for 40.2% of full-year 2021 acquisitions, with their share having peaked in the third quarter of 2021 at 44.3%. The previous multifamily high in the eight full calendar years for which data is available was 36.0% in 2019.

Life insurers allocated higher levels of their mortgage loan purchases to the retail and lodging property types, where activity had been especially depressed amid the depths of the pandemic. But their activity was unusually light in the office property type. Offices accounted for only 14.1% of uninsured commercial mortgages acquired in 2021, down from 21.6% in 2020. The office share had not previously been below 20% in a calendar year since loan-level property type disclosures first became available in 2014.

The industry's commercial mortgage positions remained well-diversified by property type and generally exhibited low loan-to-value ratios. But the asset class showed some evidence of additional risk-taking, albeit off a low base.

An analysis of supplemental investment disclosures reveals that commercial mortgages with a loan-to-value ratio of 70% or less accounted for 89.6% of total holdings at year-end 2021, down 30 basis points from 2020 and 172 basis points from five years earlier. As  The Northwestern Mutual Life Insurance Co.  pointed out in its  annual statement , a smaller loan-to-value ratio generally indicates a higher-quality loan. In its case, 96% of its $47.84 billion mortgage loans had a loan-to-value ratio of 70% or below.

NAIC CM ratings also showed some downward movement. The CM ratings, which range from CM1 to CM5 for loans in good standing, are used in a manner similar to bond designation categories for the purposes of calculating risk-based capital on a sliding scale. They include specific criteria by property type for loan-to-value ratios and debt-service coverage ratios, which compares a property's net operating income to its principal and interest obligations, with CM1 including the highest-quality loans and CM5 assigned to low-quality performing loans.

CM1 loans accounted for 52.2% of total uninsured commercial mortgages at year-end 2021, down from 54.8% a year earlier and as high as 62.3% in 2014, the first year this data was made available. CM2, or other high-quality loans, and CM3, or medium-quality loans, accounted for 40.9% and less than 6.0% of the totals, up 191 and 70 basis points, respectively, from 2020.

^{Article amended at 10:21 a.m. ET on May 5, 2022, to correct total of individual life entities with average Schedule BA assets in excess of $1 billion.}

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.}