New issuance of leveraged bank loans has been increasing post-financial crisis, including among nontraditional lenders. Consequently, bank regulators are concerned over the quality of these loans due to signs of weakening standards. To the extent insurers consider investing in leveraged bank loans either directly or through collateralized loan obligations (CLOs) — particularly in this current low interest rate environment — thorough analysis, including a review of appropriate documents and models associated with the investment, will identify the risks involved and whether the proposed investment is prudent based on the insurer's strategy and investment guidelines. Having the appropriate infrastructure within an insurer's portfolio management division can help identify and monitor these risks. This includes having experienced analytical professionals within the portfolio management and credit analysis team, in addition to appropriate systems and monitoring processes in place with respect to operations and administration (as well as for business continuity plans). In addition, how the bank loans are sourced and the insurers' relationships with traders or agent banks, along with whether the bank loans are first or second lien, and how they are priced (i.e., marked-to-market, and by which vendor(s)) are also factors to be considered by insurers when investing directly in bank loans. Note that with respect to syndicated bank loans, the lead agent bank usually has (limited) authority to act on behalf of the syndicate regarding any amendments to the bank loan terms. This, therefore, emphasizes the need for insurers, and all investors for that matter, to understand the nature of their investments.

Leveraged bank loans are attractive in the current low interest rate environment because they are high-yielding with floating interest rates that increase as rates rise. Though they are typically rated below investment grade by the rating agencies, they are also senior debt within a company's capital structure, meaning that they take priority with respect to interest and principal over other classes of company debt. According to Standard & Poor's, the average yield on a leveraged loan was 5.44% in January 2013 compared to 2.75% on an investment grade corporate bond (according to Barclays U.S. Corporate Index). Leveraged loan issuance for all of 2012 was $42 billion, compared to a high of $160 billion in 2007, according to S&P Capital IQ Leveraged Commentary and Data.

In addition to a primary market for new issuance, there is an increasingly liquid secondary market for investing in leveraged bank loans, which has attracted additional institutional investors. Insurance companies invest in bank loans; however, historically, direct exposure has been minimal. Insurers are exposed to bank loans indirectly through investments in CLOs, which were approximately $22 billion as of year-end 2011. A resurgence of new issuance in CLOs post-financial crisis has played a role in the increased demand for leveraged loans.

Leveraged lending decreased during the financial crisis but has been on a rebound since 2009. Non-bank lenders, as well as non-regulated investors, entered the market and were willing to accept looser bank loan terms. Consequently, underwriting standards have deteriorated; for example, meaningful maintenance covenants were being excluded. These "covenant-lite" loans do not have the safeguards — such as limits on how much debt a company can add to its balance sheet — that traditional leveraged bank loans carry. According to S&P, for the first two months of 2013, $25 billion of covenant-lite loans were issued, which is almost the same amount that had been issued at their peak in February 2007.

On March 21, banking regulators (that is, a joint effort between the Federal Reserve Board, The Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) released updated supervisory guidance for banks regarding leveraged lending due to concerns over looser underwriting standards and banks increasing risk. The revised guidance primarily focuses on having banks establish sound risk-management practices; underwriting standards with clearly defined expectations; valuation standards that include established policies and procedures; pipeline management such that exposure can be measured timely; and reporting and analytics that include appropriate management information systems for monitoring loan characteristics and to perform stress testing.

Consequently, the Capital Markets Bureau believes it is important for state insurance regulators to be aware of the potential risks that bank loans as investments might carry, particularly if they reach high concentrations, and to be alert for significant investments by any one insurer.

In the current environment of a relatively flat yield curve and low interest rates — and with the expectation that low interest rates will persist at least through late 2014 — investors in general and insurance companies specifically may seek investing in assets that generate a higher yield than the more traditional, "plain vanilla" investments, such as corporate bonds or U.S. Treasuries. Alternatives that would add incremental yield, though sometimes only nominal, would be structured or esoteric investments. The concern with a structured or esoteric investment is not necessarily that the probability of default would be higher than that of a more traditional investment, but rather, that other key factors — such as loss given default, predictability of income streams, market value volatility, liquidity and counterparty risk — could negatively impact the investment and, therefore, the overall investment portfolio.

For example, in the case of residential mortgage-backed securities and commercial mortgage-backed securities, recent Capital Markets Special Reports have highlighted that some structures have significantly higher downside volatility in more conservative loss scenarios than the majority of the insurance industry's holdings. In addition, income streams might fluctuate dramatically for leveraged interest rate products; that is, bonds whose coupon is not only dependent on the performance of an economic or market variable such as the Consumer Price Index, the London Interbank Offered Rate (LIBOR) or the Standard & Poor's 500 Index, but which can also be leveraged to exaggerate volatility. In some structures, if the economic or market variable does not meet a specified target, no interest payment is due. So, although the repayment of principal is not directly affected, the income stream of the bond can vary dramatically from one period to another. Finally, with synthetic structured securities — which are created through a credit default swap or other derivative whereby the synthetic aspect allows the investor access to investments that might not otherwise be available — investors might incorrectly identify the investments' relevant risks, including counterparty risk, because of the complex structure of these investments. The complexity of the cash flows of some of these structures can often make it difficult for investors to fully understand the drivers behind cash flows. Synthetic structured securities, which include credit-linked and different kinds of equity-linked securities, have existed for quite some time but tend to be much more prevalent when there is limited new issuance.

Aside from the concerns discussed above, the market for highly structured and esoteric investments is not necessarily liquid. That is, they are not traded frequently, and their market prices are not always readily available. These investments, therefore, cannot be relied upon to support unexpected, short-term cash flow needs that would require the immediate sale of the securities. Although there does not appear to be significant exposure in the insurance industry of these securities, there is considerable discussion in the marketplace about developments in these areas. Therefore, the Capital Markets Bureau believes it is important for state insurance regulators to be aware of the potential risks that these types of investments might carry, particularly in high concentrations, and to be alert for significant investments by any one insurer.

Given the continued volatility in the Eurozone, European banks have been downgraded in recent months and are at risk for additional downgrades by one or more of the nationally recognized statistical rating organizations (NRSROs). U.S. bank ratings have also been lowered, or are at risk of downgrade, due in part to the impact of a weak global economy on their earnings prospects, as well as their exposure to the sovereign debt of Eurozone countries. In addition to the fundamental issues related to their core banking operations, the lower ratings could force banks to post additional collateral or possibly face the unwind of related derivatives transactions.

The latter could also impact insurers with respect to their derivatives exposure. Certain state laws require that derivative counterparties (i.e., banks) maintain a minimum credit rating. That is, insurers are not permitted to enter and have exposure to derivative transactions with counterparties that do not meet a minimum rating threshold. Upon the downgrade of a counterparty's rating below the minimum threshold, to be in compliance with applicable state laws, the insurer may be required to terminate, or unwind, any derivative transaction with the counterparty or request a waiver for the said requirement from the regulator. A forced unwind would result in the insurer having to replace the counterparty with one that is "approved" by applicable state law in terms of minimum rating requirement, among other factors, or abandon the derivative transaction altogether, either of which could be costly. Given that approximately 90% of the insurance industry's derivative transactions are used for hedging purposes, there are additional implications from a risk-management standpoint.

Therefore, the states should be cognizant of their applicable derivatives use laws and the potential impact of bank ratings downgrades. In addition, other bank-related investments that might be linked to ratings or have minimum counterparty ratings requirements, such as letters of credit, might also be impacted by the potential for lower bank ratings. The NAIC Capital Markets Bureau will continue to monitor any related trends pertaining to this topic.

Given the current environment in Europe, and as a means to ensure access to funding, some European banks have entered into "liquidity swaps." These liquidity swaps involve European banks selling (the illiquid) securities to counterparties (i.e., investment banks or insurance companies) in exchange for a discounted value of government bonds or other liquid assets. In turn, the European banks utilize these swapped liquid assets as collateral to secure loans from the European Central Bank (ECB).

Demand for liquidity swaps has increased in Europe in recent months, particularly between European banks and insurers. According to a guidance consultation paper written by the United Kingdom's Financial Services Authority (FSA) in July 2011, liquidity swaps between European banks and insurers are an increasing trend, causing the FSA to become concerned about the spread of systemic risk (that is, resulting in continued collapse of the financial system) in Europe. The suggested rationale is that liquidity swaps offer a solution to insurers' search for yield, and they also fulfill the banks' need for liquidity. For a fee, the banks can pledge illiquid structured assets (at a discount) in return for liquid collateral.

The FSA also is concerned about the interconnectedness between the insurance and banking sectors, meaning that a bank failure could also cause distress or failure among connected insurance companies. Thus far, we have not seen any evidence that insurers in the United States have engaged in this activity. However, the Capital Markets Bureau believes that liquidity swaps could present issues to be concerned about if U.S. insurers become active in this market. If U.S. insurers did become involved in this market, then they might be reported as either a repurchase agreement, which we do not view as appropriate, or as a sale and long-term purchase commitment.