U.S. life insurers are one of the largest group of institutional investors globally with over $4.5 trillion in invested assets. These investments, which are used primarily to support insurance liabilities, expose insurers to market risk. A constant balancing act is in play, with insurers making deliberate choices in managing their investment risks with their liability profile, capital requirements, and the need for yields.

S&P Global Ratings expects asset or investment risk to outweigh insurance risk for U.S. life insurers during this COVID-19-related economic recession. Through the first half of 2020, U.S. life insurers' investment portfolios have actually shown a low level of impairments from the market displacements. But the recession isn't over yet, and the differences in insurers' investment strategies will continue to be tested as the recession continues. Therefore we are putting the spotlight on key aspects of these portfolios, including portfolio composition, quality, performance, and noteworthy trends in investment strategies. At the same time, we are highlighting individual portfolios of U.S. publicly traded life insurers so investors and other stakeholders can see the differences in investment allocation among these insurers. It is these differences in investment allocation that will result in variances in capital requirements and investment performance, and potential impairments during an economic recession.

At an industry level, we expect the strong level of capitalization will offset some potential asset losses and continue to support our current stable outlook on the U.S. life insurance sector. However, we may lower ratings on individual insurers based on our view of potential investments losses and related capitalization impact on individual portfolios.

The Composition And Quality Of Insurers' $4.5 Trillion Investment Portfolio

Bonds remain the primary investment asset class for life insurers

Over 70% of the industry's portfolio, or $3.1 trillion, is invested in fixed-income securities. And within the fixed income portfolio, about 75% of bonds are in corporate and government securities, followed by structured finance securities, and a smaller amount in bank loans, mutual funds, and exchange-traded funds (ETFs).

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Quality of bond portfolio indicates record high of 'BBB' rated bond exposure

Over time, life insurers have increased their holding of 'BBB' rated bonds but have stayed away from increasing investments in speculative-grade (rated 'BB+' and below) securities. Heading into the last financial crisis, insurers had about 25% of their bonds in 'BBB' rated bonds, whereas today it stands closer to 35%.

The overall corporate bond market is currently heavily weighted toward 'BBB' rated bonds as well. Despite insurers' 'BBB' rated holdings somewhat reflecting the reality of the overall bond market and the thirst for investment yields, there is no denying increased "fallen angel" risk. We expect some level of downgrades and related impairments to hurt insurers' reported earnings and capital in 2020.

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With the historic level of 'BBB' rated bonds and the economic recession, it is worth looking at the number fallen angels (issuers downgraded to speculative grade from investment grade) so far this year. The count of fallen angels (through July 2020) stands at 40 issuers, representing $340 billion in rated debt. The tally of fallen angels compared with total investment-grade issuers continued to rise through July, reaching 2.5% from just 1.0% in January. This is above the 10-year average of less than 2%. While there's still considerable room for more downgrades to speculative grade this year, the pace has slowed with outlook changes prevailing over CreditWatch placements, indicating less-immediate downgrade potential (see "'BBB' Pulse: The Potential Fallen Angels Total Starts To Decline From Record Highs," Aug. 26, 2020).

How Have These Invested Assets Performed?

Declining investment yields has become a consistent feature of these portfolios

With investment portfolios heavily focused on fixed-income securities, the quality of those securities, as well as interest rates and bond market spreads, play a pivotal role in investment performance. Investment yields have been declining for over a decade, and we see no signs this reversing.

Investment yields can have an impact on product sales as well. As new money yields continue to decline, insurers will be forced to price their new products to match the market environment. A slowdown of sales is a byproduct of lower-yielding assets, and we expect some interest-sensitive retirement product to see weaker sales in 2020.

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Investment impairments have been low since 2008-2009 but will likely increase in 2020-2021

The last 10 years or so have been fairly good from an impairments standpoint. As a matter of fact, it is hard to find any meaningful net realized loss or impairments in these portfolios since the last financial crisis.

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We do expect this to change as we go through this pandemic-driven recession. We have undertaken a set of asset stress tests to assess the potential impact on rated insurers. Our analysis shows asset impairments will bend--but not break--the credit quality of this industry. This doesn't mean this recession isn't going to hurt investment portfolios, especially from "fallen angels," but that the majority of rated insurers will find it manageable given their relatively stronger levels of capitalization heading into this recession than the last one. That is a key reason we maintain a stable outlook on the U.S. life insurance sector.

Noteworthy Trends In These Portfolios

Invested-asset leverage remains high, resulting in increased focus on these investments

Insurers invest incoming funds (i.e., premiums and annuity deposits) to support the product benefits they have promised to consumers/policyholders. In doing so, they are exposed to product liability risk as well as investment risk.

Analyzing these invested assets is important not just because of the sheer size of these portfolios, but also the inherent asset-leverage they create on the balance sheet. For every dollar of capital, there is approximately $8-$9 dollars of invested assets on U.S. life insurers' balance sheets. This relatively high invested asset-to-capital leverage ratio is an inherent complexity of the life insurance business. In a benign environment, this may go unnoticed. But in a stressed environment, investment impairments create a disproportionate impact on capital.

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Structured finance securities have declined as a percentage of invested assets since the 2008-2009 financial crisis

With close to $750 billion of structured finance (SF) securities in investment portfolios, U.S. life insurers aren't shying away from this asset class. But total exposure as a proportion of the overall investment portfolio has declined since the financial crisis of 2008-2009), to 24% from almost 30% of the bonds held by these insurers being SF securities in 2008.

Specifically, commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS) holdings have declined, while other SF classes like collateralized loan obligations (CLOs) have become a large piece of the investment portfolio. S&P Global Ratings expects an increasing divergence among insurers in terms of these structured finance holdings, both in terms of quantity and quality, especially given potential asset risks during COVID-19.

CLO exposure has increased, though a majority of CLO holdings remains in higher rated tranches

CLOs have been a hot topic among insurance investors.

Contrary to the often stated perception that CLOs are a large risk exposure for the industry, our analysis indicates that U.S. life insurance industry's exposure to CLOs is actually relatively low. Although it is likely that individual insurers may see asset losses from the quality and scale of their specific CLO exposures, we don't expect the current CLO holding to disrupt the overall industry's credit quality.

Although CLOs have grown in insurers' portfolios, they remain a relatively small part of the overall industry's portfolio at this time. With about $126 billion of CLO holdings at year-end 2019, CLOs account for less than 3% of the total invested assets at an industry level. Additionally, overall quality of these investments remain in the higher rated tranches: per the National Association Of Insurance Commissioners' (NAIC) report on CLOs, 90% of the U.S. insurance industry's CLO holdings are in investment-grade, and 76% rated 'A-' or higher. Not surprisingly, individual life insurers may vary their exposure by size and quality for this asset class.

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And how will this recession impact these CLO holding? Our structured finance ratings team has published a wide range of stress scenarios on CLOs (see "How Credit Distress Due To COVID-19 Could Affect U.S. CLO Ratings," April 24, 2020). The summary of these stress tests indicate that nearly 99% of the 'AAA' CLO tranche were either affirmed or downgraded by one notch (to 'AA+') even under the most punitive hypothetical scenario. And no CLO tranche rated in the 'A' category or higher experienced a default under any of our hypothetical scenarios. Further down the capital stack, the results become more negative (as expected under stresses as significant as these), with 'B' and 'BB' rated CLO tranches showing the most adverse outcomes and 'BBB' and higher rated tranches showing successively better results.

No doubt risk exists in this asset class. But, given the overall quality (relatively small 'BB' or lower exposure) and quantity (3% of industry's invested assets) of the industry's CLO exposure, we expect a limited impact at an industry level. At a company level, some of the rated life insurers that have speculative-grade CLO exposure will likely see downgrades or defaults affecting their capital adequacy. But we expect most to have the flexibility to recover--i.e. fill any capital hole--in a short time without a major impact to overall credit quality.

There is also a regulatory change on the horizon for CLOs, which might change allocations by individual insurers. The NAIC is increasing the regulatory capital charges/requirement for principal protected securities. This would apply to a subset of CLOs known as combination notes. This change will be effective Dec. 31, 2021, but this is only a small part of the CLO industry and companies have time to unwind these securities, if needed, into more capital efficient investments.

Bank loan exposure has grown 20% year over year but remains a fairly small portion of portfolio

As the industry looks for higher-yielding non-CUSIP assets, there has been increased investment in bank loans. With almost three-fourths of these loans in speculative-grade categories, this exposure can increase riskiness of the investment portfolio. However, the exposure to this asset class remain relatively small (around 1% of industry's invested assets), thereby limiting any major impact to the overall investment portfolio.

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As insurers search for potential areas to capture yield, leveraged loans will remain a part of their portfolios. But the meaningfully higher capital requirements from speculative-grade securities will likely continue to limit their overall exposure to this asset class.

Insurers may change their allocation toward office properties in their mortgage portfolios

The vast majority of the industry's direct real estate exposure is through mortgage loans. Our research indicates that the quality of these loans are relatively good, supported by low loan-to-value ratios and good debt service coverage. As a result of its underwriting and risk tolerances, the industry's losses/impairments arising from its mortgage loan portfolio have remained fairly low.

As this recession continues, we expect to see an increase in restructured loans, but as was the case with the last financial crisis, we don't expect this asset class to cause any material impairments in the near term.

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However, changes may be coming to these mortgage loan portfolios in the longer term. With about 25% of outstanding mortgages in office properties, the question remain whether a shift in office space after the pandemic will change insurers' allocations. As a greater number of employees worked from home for several months this year, there is a possibility that corporations may look to reduce their real estate footprint and allow or require more employees to work from home permanently. If that is the case, insurers will need to evaluate their investment strategy in lending to office buildings. We don't expect insurers to reduce their overall commercial loan exposure meaningfully. Rather, we believe more new money will go toward multifamily and industrial properties compared with office space.

Increasing private bonds bring risk and reward to insurers' portfolios

About $1.1 trillion, or 36% of total bonds held by the industry, are privately placed bonds. The industry has gradually increased its private bond exposure, which was about 25% in 2010.

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Private bonds may have higher credit and liquidity risk. A greater proportion of private bonds are rated 'BBB' or below compared with public bonds (49% for private bonds versus 34% for private). And at the same time, they can be less liquid than public bonds. However, private bonds generally provide an illiquidity premium, which is extremely attractive in the current environment. Additionally, insurers can be selective regarding investing in private bonds with stronger covenant protections to somewhat reduce the related credit risk.

Despite the increased exposure to lesser liquid assets such as private bonds, mortgages, and alternatives, we view the industry to have a strong liquidity profile. Our liquidity analysis, which takes into account the liquidity or lack thereof of specific investments, shows relatively strong liquidity for most insurers. Part of this strength comes from the sector's asset-liability duration management and its lack of meaningful "run-on-the-bank"-type liabilities. However, an outsize increase in investments with less-liquid attributes, combined with higher-than-expected disintermediation risk or collateral-posting requirements could have a negative credit impact on individual insurers.

Portfolio Composition Isn't Homogenous Among U.S. Life Insurers

Common themes such as higher allocation to fixed maturities, a very low amount of public equities, and limited exposure to speculative-grade bonds are a feature of most insurers' portfolios. But strategic differences in allocation between insurers mean difference in capital needs and possible impairment results. A variety of reasons can lead to strategic investment differences, including ownership structures, relationships with external asset managers, internal risk limits, and liability profiles.

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Looking at publicly traded U.S. life insurers, which total about $2 trillion of invested assets (on U.S. generally accepted accounting principles basis), it's clear that although fixed maturities are the largest part of these portfolios, insurers take a very different stance when it comes to investing in traditional corporate bonds versus structured bonds. Allocation to structured bonds varies from less than 1% to over 40% of invested assets. We expect this difference in structured securities will remain a part of this industry for the foreseeable future.

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RMBS and CMBS account for majority of the allocation, averaging about half of the structured exposure. At the same time, CLOs have become an area of increased exposure within these structured portfolios. Once again differences remain, with some of these public traded insurers have very little to no CLO exposure at all.

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Table 1

In terms of quality, we see a common theme of higher exposure to 'BBB' rated bonds across these insurers as well. But the exact proportion differs, ranging from 20% of fixed maturities to over 50%. In our capital analysis, we have a relative higher capital charge for 'BBB' category rated securities compared with those rated 'A' or higher for fixed maturities.

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Outside of fixed maturities, the largest asset class in most of these portfolios is mortgage loans. This also is a case of differing investment strategies. Exposures range from 1% to 16% of invested assets for publicly traded insurers. Additionally, not all mortgages are related to commercial properties, as some insurers have lend to agricultural and residential properties as well.

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On average for rated U.S. life insurers, asset risk (referred to as C1) represents almost half of their available capital--and it's the same for publicly traded insurers, although investment portfolio differences mean a difference in capital requirements. For the publicly rated companies, C1 ranges from about 35% to 70%. We take into account the differences in quality and type of investments via our capital analysis of these individual insurers.

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Investment Risk Remains As The Recession Continues

The recession isn't over yet. Central banks and governments acted promptly and massively to limit the damages to the real economy and the markets, but debt levels took another step up, making the unwinding of this liquidity support difficult. Generally, markets seem to be incorporating expectations and guidance from central banks that they will do "whatever it takes" to keep capital markets functioning, liquidity flowing, and supporting investor confidence to mobilize capital to the economy. Nevertheless, markets remain fragile, with an increased focus on divergence between valuations and fundamentals and little margin for bad news, which will translate to higher volatility expectations for the remainder of the year at least.

U.S. life insurers' investment portfolios have so far shown a low level of impairments from the stress brought about by COVID-19 and the recession. The strong level of industry capitalization can cure some amount of potential asset losses and continues to support our current stable outlook on the life insurance sector. However, we may take individual rating actions based on our view of changes to capitalization levels and potential investments losses on individual portfolios.

Related Research

• Global Credit Conditions: Recovery Will Be Uneven, Unequal, And Uncharted, Report Says, July 7, 2020
• 'BBB' Pulse: The Potential Fallen Angels Total Starts To Decline From Record Highs, Aug. 26, 2020
• How Credit Distress Due To COVID-19 Could Affect U.S. CLO Ratings, April 24, 2020
• Amid Coronavirus Outbreak, S&P Global Ratings Looks At How A Hypothetical Pandemic Could Affect U.S. Life Insurers, Feb. 14, 2020
• When The Cycle Turns: Investment Impairments Will Bend But Not Break U.S. Life Insurers' Financial Strength, May 13, 2019