Recent regulatory changes for life companies benefit real estate equity and debt instruments more than other investment products, according to a new report from MetLife Investment Management (MIM).
The report, titled “A Very Long Engagement: Asset Allocation Implications of U.S. Life Insurance Risk-Based Capital Changes,” analyzed the impact of new risk-based capital rules approved in early summer by the life risk-based capital working group of the National Association of Insurance Commissioners, an organization of state insurance commissioners that sets regulatory requirements for life insurers.
Dated Aug. 5, the report calculates the long-term capital-adjusted returns of institutional investment products under the old and new risk-based capital requirements. Real estate equity, which got the lowest rating under the old regime, jumped to the highest-projected 30-year capital-adjusted yields under the new regime. Commercial mortgages and some CMBS classes jumped in the rankings of 10-year investment yields.
The new capital rules require that life companies hold 11% capital for commercial property equity investments, down from 15% before the regulations were revamped. For real estate equity investments that life companies hold in joint ventures, limited liability companies or similar structures, the amount of risk-based capital required to be held was reduced to 13%, down from 23%. The new regulations go into effect for life company 2021 year-end risk-based capital reporting.
“Life insurers’ allocation to the real estate equity asset class varies by company, but based on peer analysis is generally in the range of 0-5%,” the report said. “In light of these material favorable changes, real estate equity may become more of a consideration in life insurance strategic asset allocation frameworks going forward.”
Better Reflection of Risk
The changes are intended to update and better align risk-based capital requirements with actual market performance. To that end, the NAIC working group revised the risk-based capital requirements for all life company investment products.
The overall result, according to MIM, is that life company capital requirements will increase by 10-20%. That’s because capital set-asides will increase for some investment products, such as corporate bonds in the Aa2 to Baa3 range, the report said. All told, the report estimates that the capital requirements for corporate bond holdings will increase by 26%.
Capital reserve requirements will be reduced for investment products that include real estate equity and high-grade Aaa and Aa1 corporate bonds. Reducing capital requirements boosts the effective returns of investing in a sector.
The report ranked investment products by 10-year and 30-year capital-adjusted yields under the old and new risk-based capital requirements. Real estate debt products were the prime beneficiary of the new RBC rules in the 10-year category. Commercial mortgage loans achieved the second-highest yields under the new RBC regime, up from fourth under the old regulations. AA-rated CMBS jumped to third in the 10-year yield ranking, from 10th, while junior AAA CMBS climbed to seventh, from 14th. In the 30-year category, real estate equity went from worst (11th) to first under the new capital-adjusted yield formula.
The report, authored by Lara Devieux, Vladimir Kovalerchik and Michael Ragusa, says that life companies will slowly adjust strategies based on the new risk-based capital framework.
“(T)here could be some shifts in asset allocation preferences that occur as a result, including in certain asset classes that benefited from lower capital charges such as high-quality structured finance and municipals, as well as high-quality high yield and real estate equity,” the report said. “Our expectation is that changes in overall asset allocation will be gradual and will mainly be predicated by additional factors, including capital considerations from ratings migration.”
An NAIC committee continues to consider other regulatory changes, including one that would further reduce risk-based capital requirements for commercial properties that are valued on the books at less than market value. The proposal would enable life companies to recognize a portion of unrealized gains on properties that, for example, appreciate over time.
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