US life/annuity holdings of structured notes on the rise – AM Best

The US life/annuity industry increased its holdings in structured notes by one-third over a three-year period, with book adjusted/carrying value reaching $16 billion in 2018, up from $12 billion in 2015, according to an AM Best report.

The Best’s Special Report, Life/Annuity Holdings of Structured Notes on the Rise, states the number of structured notes held by life/annuity insurers rose to 1,011 from 817 between 2015-2018, with the number of those notes containing a mortgage reference increasing to 371 from 295. Despite the rise, the number of structured notes held by life/annuity writers constitute a relatively small portion of their general accounts.

Larger insurers are the primary purchasers of structured notes, as they typically have more sophisticated investment capabilities. Transamerica Life Insurance Company, CMFG Life Insurance Company and Teachers Insurance & Annuity Association of America are the top three life/annuity companies in terms of total structured notes holdings. Structured notes offer insurers the potential for an enhanced rate of return compared with traditional fixed-income products.

According to the report, a chief concern surrounding structured notes is the reliance on complicated structures whose performance is based on an underlying derivative. Derivative markets often require that investors have a sound understanding of the financial implications of their underlying assets to make sound investment decisions. This aspect, coupled with the structured notes’ fixed-income component, means that companies have to deduce the note’s payoff structure and payoff calculation prior to purchase. Not all notes have principal protection provisions, and volatility risk can cause partial or even whole losses of the principal investment.

“Another adverse feature of structured notes is their illiquidity,” said Jason Hopper, associate director, AM Best. “Structured notes are not listed on security exchanges and can thus be very difficult to buy and sell on secondary markets. As a result, holding a structured note to maturity is compulsory, which diminishes liquidity. Insurers should be aware of this at the time of purchase.”

Asset-liability management and duration-matching are key factors in AM Best’s analysis. Issues AM Best also considers in its rating analysis include trading liquidity and downward rating migration of securities during times of financial hardship. However, insurers’ propensity to invest in these notes is a reflection not only of their desire for yield but also of their understanding of the underlying exposure.

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