While insurance companies rarely make up more than 6% of total FHLB member borrowers, historically they have had a large share of par value advances because their borrowings tend to be larger than those of other member types. It is worth noting that insurers’ move from 18% of par value of advances held in 2019 to 34% of total advances held in 2021 resulted from the combination of an increase in borrowing by insurers and a 16% drop in advances held by commercial banks year over year. The costs to an FHLBank of making a loan vary little by loan size as previously noted; the converse is true in 2023 as commercial banks have steeply increased their borrowing, so taking larger advances may help insurers obtain relatively favorable loan terms.
Putting loans to work
How are insurers using their increased FHLB borrowings? Unsurprisingly, during the financial crisis and recent pandemic, insurers’ liquidity needs drove a surge in advances. Liquidity remains a dominant motivation today, for a wide range of uses: to fund a merger or acquisition, meet regulatory requirements, and serve as a working-capital backstop. Insurers also use FHLB loans to manage and mitigate interest-rate and other risks, optimize risk-based capital (RBC), reduce cash drag, meet social goals, supplement ALM duration, and arbitrage collateral. For example, insurers may borrow funds to lock in reinvestment rates and extend the duration of existing investment portfolios, or to fill liability maturity gaps and tighten ALM duration.
An opportunity for spread enhancement
We believe insurers may find benefit from FHLB borrowings in yield arbitrage, where there is potential to earn excess spread over the cost of an FHLB advance. Portfolios structured with an objective of spread enhancement over the low rate of an FHLB advance may offer possibilities for insurers to add alpha or yield. Among the investment approaches we have seen implemented are securitized instruments, including CLOs, and corporate credit. (CLOs and short credit have even more appeal in a rising-rate environment.) Furthermore, FHLBanks can be flexible in structuring loans, offering a range of choices in addition to term and rate selection, including fixed or floating-rate pricing, prepayment, and structured options.
Floating-rate programs have been more advantageous for insurers looking to implement spread enhancement programs. Insurers have used short- to intermediate-term advancements to fund these portfolios, with the exact advance structure dependent on risk preferences and intended asset portfolio composition. Terms will vary from bank to bank but borrowers are generally provided the ability to roll advances at the end of each term. Notably, the FHLB has converted the structure of its floating-rate product from a LIBOR-based structure and now offers Discount Note, Prime, and SOFR-indexed floater structures. It would appear that these alternatives have historically provided a better rate to borrowers and we view this change as a net positive for insurance-company borrowers.
Regulatory treatment
FHLBanks do not restrict how their members use advances. However, insurers must take into account how ratings agencies assess spread-enhancement activities, how these programs affect RBC, and how state laws may impact investment parameters. Advances, including those drawn for spread enhancement, are classified as either funding agreements, which are largely specific to life insurance companies, or debt. Funding agreements (deposit-type contracts issued as general account obligations) are usually treated as operating leverage. According to a recent NAIC Capital Markets Bureau report, “approximately 75 – 80% of FHLB advances to U.S. insurers are in the form of funding agreements.” However, advances carried as debt can also qualify as operating leverage if they meet criteria of individual ratings agencies.
A.M. Best, Moody’s, S&P, and Fitch have all noted the broad benefits of the growing relationship between insurers and the FHLB. More specifically, A.M. Best and S&P have established guidelines on how each agency treats spread-enhancement activities. These guidelines cover classification of an FHLBank advance as operating or financial leverage, how the advance might affect the strength of the insurer’s balance sheet, and the resulting rating. The criteria for spread-enhancement activities to qualify as operating leverage include interest-rate duration matching between the assets purchased and the underlying debt; credit quality; liquidity risk; intent and purpose of the program; positive spread generation; risk controls; and sufficient reporting data. Further, A.M. Best notes that an investment leverage portfolio (one created with borrowed funds) cannot exceed 20% of reserves at the operating company level.
RBC impact for FHLB spread lending programs will vary by business line, size of advance, posted collateral, and investment allocation. Figure 6 summarizes potential RBC charges assuming the spread portfolio is invested with a minimum quality of NAIC 2 and an asset mix of 50% NAIC 1 bonds and 50% NAIC 2 bonds. Life insurance companies that structure a spread lending advance within a funding agreement, as illustrated, benefit from a 2018 update to the RBC framework: Capital charges are assessed only on the portion of collateral above and beyond the advance amount. Assuming an advance of US$100 million and a collateral basket receiving a 10% haircut, a life insurer would need to post US$110 million in total collateral. The US$100 million collateral amount equal to the advance does not generate a capital charge; instead, only the US$10 million of over-collateralization falls into scope for an RBC charge.
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Brij Khurana