# Insurance Float primary insurers = medical bills reinsurers = insurance for insurance companies, covid medical bills, catastrophic risk WHY REINSURANCE?\ Reduces big loss risk from catastrophies. Free up working capital. Example: Insurer can write more policies because reinsurer takes tail risk, like hurricane destroying entire city. Problem Statement\ Liquidity is the ability to meet expected and unexpected demands for cash. Liquidity risk is the \ risk that in current or possible future environments, an entity will not have enough cash or liquid \ assets to meet its cash obligations or will only be able to obtain sufficient cash at excessive cost. Invested asset- and insurance product-driven liquidity risk for insurance float. Fire sale capital gains tax implications for Solution\ Yield-bearing collateral for insurance float. Remove invested asset-driven liquidity risk so you can focus on sound underwriting. BDC for borrowing liquidity. FLOW OF FUNDS 1. Customer pays $100 premium to Insurer 2. Insurer puts $30 in reserves for future claims 3. Insurer sends $70 to Asset Manager to invest 4. Asset Manager buys bonds, sends ownership to Insurer 5. Claim happens, Insurer pays Customer $50 from reserves 6. Insurer sells bonds to Asset Manager for $20 cash if needed REINSURANCE 1. Customer pays $100 premium to Insurer 2. Insurer pays $20 premium to Reinsurer 3. Reinsurer agrees to cover losses above $75 4. $90 claim happens, Insurer pays Customer $75 5. Reinsurer pays Insurer $15 (the excess) ### Sources of Liquidity * Cash on hand * Asset sales * Secured loan from a Federal Home Loan Bank (FHLB) * Securities lending programs or repurchase agreements (repos) * Borrowing * Intercompany borrowing or dividends * Increase sales Many of these liquidity sources require some degree of planning. Securities lending and repo arrangements take time to set up and may not be available in a crisis. Getting a new loan or line of credit is neither a short-term solution nor a crisis activity, but tapping into an already established line of credit that hasn’t yet been drawn down can be done very quickly. If a company is already an FHLB member, pledging additional mortgage assets (if available) can be done fairly quickly, but it is also very feasible to pledge assets and not draw down all the cash right away, leaving immediately accessible cash for a crisis. ### Liquidity Risk 1. Invested asset-driven

2. Insurance product-driven

* Reduction in anticipated premium volume due to lower-than-expected sales or higher-thanexpected lapses. 2. Invested asset- AND insurance product-driven

3. Corporate activities

### Discussion of ALM-Driven Liquidity Risk The insurance industry, in general, is less vulnerable to liquidity risk than other financial sectors such as commercial banks. This is due to the tendency of customers to retain their insurance products even in adverse market environments and the fact that many insurance liabilities are not callable, unlike demand deposits for a bank. For long-duration liabilities, companies can invest in long-duration, high-quality assets and hold them to maturity. However, under a low interest-rate environment, companies may try to find incremental yield in alternative or illiquid assets, or may take on duration risk by investing in assets with a longer duration than the liabilities they back. Companies might also have increased their exposure to structured securities such as CLOs, CMBS, RMBS, or ABS. Such assets may have higher cash flow uncertainty or less liquidity in the event there is a cash need. {% file src="/files/AaA5SaYiYXdSydm3JqAH" %}

BDCs are tax-efficient for U.S. direct lending strategies by blocking Effectively Connected Income and Unrelated Business Taxable Income for tax-exempt investors, as they pay no entity-level tax (Horowitz & Gaines 2019). **2.1. Increasing off-balance sheet leverage**\ BDCs can significantly increase leverage without exceeding regulatory limits set by the SEC by financing loans off-balance sheet through affiliated JVLFs and CLOs. The SEC does not require BDCs to consolidate these off-balance sheet entities when calculating leverage, as the BDC shares control with other equity investors and is therefore not liable for their debts. Since 2018, the debt-to-equity ratio limit for BDCs has been 2:1, following the Small Business Credit Availability Act, which relaxed the previous 1:1 constraint. In addition to this leverage limit, BDCs must meet other requirements, including allocating at least 70 percent of their portfolio to qualifying companies and distributing at least 90 percent of their taxable income to shareholders.[⁷](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn7) Affiliated JVLFs are financed by equity from the parent BDC and other investors, including affiliated life insurers. The BDC's equity investment contributes to its 30 percent non-qualifying asset limit. The JVLF leverages this equity by issuing debt secured against its assets or cash flows, and it may obtain private credit ratings for some of its debt to attract further investment, such as from affiliated life insurers. Many BDCs have established multiple JVLFs. Similarly, affiliated CLOs are financed by equity from the parent BDC, which may receive additional support from an affiliated life insurer that invests in both the CLO's equity and debt. This structure satisfies risk retention requirements in the U.S., EU, and Japan, as the parent BDC has 'skin in the game'. [⁸](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn8) As with JVLFs, many BDCs have created multiple CLOs. While both affiliated CLOs and JVLFs hold loans originated by their parent BDCs, there are at least three key differences between these investment vehicles. First, CLOs must hold rated loans, whereas BDCs and JVLFs can also hold unrated loans. Second, CLOs typically have a first-loss ('equity') tranche equal to about 10 percent of assets, resulting in 10:1 leverage, while JVLFs generally operate with around 3:1 leverage. Third, CLOs usually have more stable liability structures and asset pools compared to JVLFs, which can relatively quickly adjust their asset portfolios and leverage. These differences give BDCs flexibility to optimize their financing strategies based on the types of loans, desired leverage levels, and origination capabilities. They can also combine CLOs and JVLFs to create multiple rounds of unconsolidated leveraged investments in risky corporate loans.[⁹](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn9) **2.2. Lowering risk-based capital requirements**\ U.S.- and Bermuda-based insurers can significantly reduce their risk-based capital requirements without changing their underlying asset exposure by swapping corporate loan holdings for CLO investments (Foley-Fisher, Heinrich & Verani 2024).[¹⁰](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn10) This loophole arises because capital charges in these jurisdictions are primarily determined by credit ratings.[¹¹](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn11) For instance, insurers holding a portfolio of B-rated loans can cut their risk-based capital charges by two-thirds if they package those loans into a CLO and purchase the entire CLO capital stack. The impact is even more pronounced for middle-market loans, as their lower ratings lead to exponentially higher capital charges. An insurer in the U.S. or Bermuda that packages its MM loan holdings into a CLO and invests in the entire CLO capital stack could reduce its capital charge by a factor of 10. Insurers in these jurisdictions can also cut their capital charges by investing in the capital stack of BDCs or JVLFs rather than directly in the underlying assets.[¹²](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn12) Unlike CLOs, these vehicles can invest in both rated and unrated loans, including highly speculative middle-market loans and relatively larger unitranche loans that substitute for bank-originated leveraged loans. We estimate that insurers could achieve a similar reduction in capital charges—by a factor of 10—by replacing their direct loan holdings with investments in BDC or JVLF vehicles containing the same loans. **2.3. Turning insurance obligations into debt**\ Larger life insurers with investment-grade credit ratings can issue institutional annuities, primarily in the form of funding agreements that transform insurance liabilities into debt.[¹³](https://www.federalreserve.gov/econres/notes/feds-notes/life-insurers-role-in-the-intermediation-chain-of-public-and-private-credit-to-risky-firms-20250321.html#fn13) Funding agreements (FAs), which have no mortality or morbidity contingencies, simply pay a fixed or floating interest rate for a specified period. FAs offer flexibility, as they can be privately placed, used as collateral for Federal Home Loan Banks (FHLBs), structured as guaranteed interest contracts, or securitized into funding agreement-backed securities (FABS). FABS effectively transform insurance liabilities into debt. Typically, an insurer issues an FA to a special purpose vehicle, which holds it as collateral and issues FABS. As the FA is backed by general account assets, FABS are senior to—and thus less costly than—debt issued directly by the insurer (Foley-Fisher, Narajabad & Verani 2020). Life insurers can customize their FABS to meet specific investor needs. For instance, they can create FA-backed commercial paper and FA-backed repos targeting institutional investors such as money market funds, banks, and private cash pools through short-term wholesale funding markets. Santos & Fringuellotti (2023) explore the motives driving life insurers' growing preference for CLOs, particularly regulatory capital incentives. While Santos & Fringuellotti (2023) provide valuable insights into life insurers' search for yield behavior, their analysis overlooks the strategic nature of insurers' affiliations with asset managers. Foley-Fisher, Heinrich & Verani (2024) emphasize how life insurers are uniquely positioned to be the ultimate bearers of CLO risk and how these relationships add a layer of complexity to insurers' risk exposure that Santos & Fringuellotti (2023) do not fully address. Our note builds on this insight by demonstrating how insurers' involvement in CLOs is not just yield-seeking behavior, but also reflects pre-existing relationships with asset managers, making investment decisions more complex than simply search for yield. ### Main risks The lack of transparency and disclosures around these investments or some of the structures can make it hard to value them or to predict their performance in a downside scenario. Also, these investments tend to be illiquid which could make them riskier in a tail scenario, if the company was forced to liquidate assets in a short period. Counterparty risk is the second key risk. As US life insurers continue to increase their partnerships and cede business offshore, they are also subject to the credit quality of third-party reinsurers, the quality of capital in affiliates, and the investment horizon of the owners, and capital standards. ### PE and Insurers

The traditional LBO transaction involves the PE company raising capital from investors in a closed-end fund and then buying control of a life insurer with a combination of debt and equity financing (Figure 3).

Higher asset allocation to private assets creates two material challenges—liquidity risk and valuation \ uncertainty.

Using ETFs to reduce tax drag in portfolio rebalancing For insurers, transition management \ is a constant source of friction as they \ fine-tune allocations. Whether it be a \ change in the investment strategy or \ moving assets to a new manager, using \ ETFs for transition management allows \ insurers to maintain market exposure \ without having to use derivatives. \ Compared to fully liquidating assets \ and redeploying that capital, ETFs can \ reduce transaction costs and cash drag \ during these transitions. \ ETFs can also be used to consolidate holdings. A \ portfolio of hundreds or even thousands of line items \ can be converted into just a few low-cost ETFs via the \ ETF creation mechanism. Using ETFs for transition \ management can also be done quietly in the market, \ as insurers can accumulate ETF shares anonymously \ rather than having to share a buy list with the \ dealer community. Examples in practice \ Consolidate holdings \ A client converted an $87M Bloomberg US \ Aggregate Index separately managed account \ (SMA) into an ETF that tracks the Bloomberg \ US Aggregate Index to take advantage of \ the efficiency of the ETF wrapper. The client \ consolidated their holdings into one line item \ versus 905 (odd-lots) with daily liquidity—while \ eliminating the need to manually rebalance. \ Quietly fund a new mandate \ A pension fund invested $800M in a high yield \ portfolio by quietly accumulating shares in the \ secondary market of a SPDR ETF that provides \ exposure to the US high yield universe an {% file src="/files/Y9uVAniFzjwzmGyzgu2e" %} es into a diversified \ portfolio of underlying bonds.

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