Utilizing FHLB for Insurance Portfolio Management to Drive Risk-Adjusted Returns

Utilizing FHLB for Insurance Portfolio Management to Drive Risk-Adjusted Returns

Jeffrey Hobbs

Jeffrey Hobbs, CFA

Head of Insurance Portfolio Management

Highlights

Adding durable, low-cost external leverage to lower-volatility assets via the FHLB system can be an attractive way to enhance risk-adjusted return potential versus owning higher-volatility assets with more embedded leverage directly on insurance company balance sheets.

  • Voya Investment Management manages over $2.5 billion of spread lending programs for its proprietary balance sheet and select third-party clients. Client net investment income from these programs exceeds $40 million annualized.
  • The insurance portfolio management team at Voya Investment Management has broad experience with spread lending programs, having managed programs through 7 of the 11 Federal Home Loan Banks over time.
  • We can help insurance companies evaluate options for sizing a program within a given risk management framework and existing collateral base, designing a liability profile that provides an appropriate match with the asset profile.

Introduction

One of the favorite pastimes of insurance company management teams is to compare their current asset allocation with those of industry participants deemed to be peer companies. Do we have more or less credit exposure? Commercial real estate related risk? Alternative asset exposure?

The problem with this type of peer analysis is that it conflates exposure with risk. Two insurance companies might have the same exposure to public credit and even a similar ratings mix but different bents towards cyclical credits or different credit concentrations that will produce different results through a credit cycle. Two commercial real estate portfolios, similarly sized, may have different loan-level leverage points. Sources of equity risk premia in alternatives books tend to offer the most varied forms of risk-taking across the industry.

More importantly, comparisons at the asset class level typically miss an even greater distinction—differences in leverage levels. Two Life companies with the same business risk profile and liability profile should probably not have the same asset allocation mix if one has a 300% risk-based capital (RBC) ratio and the other has a 400% RBC ratio. The company with the lower RBC ratio is operating with more inherent leverage and, even with an identical level of asset risk, will see more volatility through its surplus position.

For effective enterprise risk management, asset allocation decisions must be made in concert with the leverage decision. Having the leverage decision made separately from the decisions on asset risk-taking can lead to an overall risk profile that is inappropriate for the firm. In separating these decisions entirely, some companies are missing the opportunity to add low-cost, durable external leverage to their investment profile as an alternative to taking less-attractive, higher-beta unlevered asset risk.

FHLB system overview

A common source of low-cost leverage has long been the Federal Home Loan Bank (FHLB) system. This year marks the 90th anniversary of the Federal Home Loan Bank Act of 1932. For nine decades, the FHLB system has provided reliable liquidity to member institutions to support housing and mortgage markets and to foster community investment and development. As of 2021, more than 6,500 financial institutions were members of the system, including 542 insurance companies (Fig. 1). Across the entire FHLB system, there were approximately $350 billion of advances outstanding at the end of 2021, roughly one-third of which were taken by insurance companies.

Although insurance company membership remains a minority of the bank-heavy membership roll, insurance company advances as a percentage of the total have been rising steadily. This is partly due to excess deposits in the banking system from extraordinary monetary accommodation, which have led banking members to reduce advances in recent years. At year-end 2021, insurance companies had roughly the same advances outstanding as commercial banks. For the regional FHLBanks, insurance company members have never been more important to accomplishing their overall mission.

Figure 1: Insurance companies, though a minority of total members, account for a large portion of FHLB advances
FHLB membership
FHLB membership

As of 12/31/21. Source: Federal Home Loan Banks: Combined Financial Report

Through multiple business cycles and economic stress events, the FHLB system has been a steadfast and reliable source of collateralized advances to its members. Unsurprisingly, the number of insurance companies that are members of the various FHLBanks has expanded notably in recent years, reflecting the FHLB’s reliability in times of market stress (Fig. 2).

Figure 2: Insurance membership in the FHLB system has increased significantly
Figure 2: Insurance membership in the FHLB system has increased significantly

As of 12/31/2021. Source: Federal Home Loan Banks: Combined Financial Report: Years 2005–2021.

For the proprietary Voya balance sheet and for many of our third-party insurance clients, access to the FHLB system is first and foremost a source of contingent liquidity in times of market stress. This is apparently also the case for many insurance company members: of the 542 insurers in the FHLB system, only 223 (41%) had advances outstanding at year-end 2021. While contingent liquidity is a key component of managing enterprise-level risks, an appropriately constructed spread lending program can also enhance risk-adjusted returns.

Once enterprise risk management needs have been suitably addressed, a spread lending program can be conservatively sized to the amount of FHLB-eligible collateral available on balance sheet. Since lendable values are a function of market value changes and the FHLB’s prescribed collateral haircuts, the capacity for a spread lending program can fluctuate over time with market conditions. Spread lending programs need to be suitably sized to account for swings in collateral value.

Collateral

Fortunately, many of the investments that insurance companies already make in the normal course of managing their general account assets are available as potentially eligible collateral to be pledged against FHLB advances. Aligning with the FHLB system’s mission to support housing markets and community development, eligible securities include U.S. government-related securities, agency residential mortgage-backed securities (agency RMBS), select AAA-rated non-agency RMBS, select agency and AAA-rated non-agency commercial mortgage-backed securities (CMBS), residential and commercial mortgage whole loans, and certain municipal securities (Fig. 3).

Figure 3: Effective lending values for delivered collateral
Figure 3: Effective lending values for delivered collateral

As of 12/31/2021. Source: Federal Home Loan Banks: Combined Financial Report.

Investment opportunity set

Once a program is appropriately sized to on-balance-sheet collateral—leaving a cushion for contingent liquidity needs and market value fluctuations in lendable value—an insurance company is ready to build a spread lending program. Voya Investment Management runs its programs floating-to-floating, taking advances that fluctuate with the short-term financing costs of the FHLB system and buying floating-rate assets. The desire to operate in a floating-rate manner leads to a tilt towards securitized assets, which is a textbook diversifier from our corporate credit-heavy fixed-rate portfolio. Furthermore, portfolios may be constructed to meet a variety of risk appetites (Fig. 4).

Figure 4: Hypothetical floating-rate portfolios for different risk appetites
Figure 4: Hypothetical floating-rate portfolios for different risk appetites

As of 05/27/22. Source: Voya Investment Management, Bloomberg, JP Morgan, Bank of America.

Financing rates can differ slightly between FHLBanks, across tenors and based on the reference rate and reset dates. For purposes of this paper, we assume investors take advances for a three-year term (roughly the average life of the reinvestment portfolios). We also assume the advances are based on the financing cost of an FHLB discount note plus the earned spread captured by the FHLBank on average. (In the current market environment, that equates to roughly a 35-basis point (bp) spread over the reference rate.) Subtracting that spread from the total indicated above, for the AAA investment portfolio, this translates to an estimated spread pickup of roughly 150 bps over the funding cost (Fig. 5). For the NAIC 1 investment portfolio, the spread pickup is roughly 260 bps, while the pickup for the investment grade NAIC-rated portfolio is closer to 320 bps.

Insurance companies can borrow in secured form from a government sponsored entity at attractive financing rates and purchase high-quality, capital-efficient, loss-remote securities. This arrangement compares favorably versus other risks insurance companies can take to earn the same level of spread premia. For example, FHLB programs can generate sizeable spread premia compared with the incremental spreads that can be achieved by moving down in credit quality in the corporate bond market, taking on risk via inherently higher-levered companies.

Figure 5: FHLB programs can generate sizeable spread premia
Spread pickup (bps) by credit quality differential
Figure 5: FHLB programs can generate sizeable spread premia

As of 05/31/22. Source: Bloomberg Indexes, Voya Investment Management.

In addition to credit risk, part of the compensation in this floating-to-floating program comes from the fact that bondholders have sold call options to issuers. A typical collateralized loan obligation (CLO) has a two-year call option, capping some of the upside from tightening spreads. A typical floating-rate single-asset, single-borrower commercial mortgage-backed security (SASB CMBS) may have a two-year term with three to five one-year extension options. Voya Investment Management retains the option to call its FHLB advances at their monthly or quarterly reset dates with no prepayment penalties, allowing these programs to adapt their borrowing profile to changes in the average life of the asset portfolio as the moneyness of these call options changes in different market environments. While keeping a reasonable match between assets and liabilities is appropriate risk management, the FHLB system’s long-tenured history of durable financing makes rolling these advances extremely likely as long as suitable collateral is available.

In this way, by selling call options to bond issuers, FHLB programs can generate additional compensation. Though this does mean absorbing some cash flow variability, the effect can be easily offset by the liability-side flexibility provided by optionality on FHLB advances.

Avoiding mistakes

For insurance companies, the business model is predicated on using investment leverage to drive returns to the equity. The FHLB system offers an even lower-cost source of funding than the implicit or explicit crediting rate on many insurance products. Despite the funding advantage, not all insurers have been successful with their spread lending programs. Errors have been made in ascertaining the appropriate level of credit risk, managing the collateral risk and managing the mark-to-market risk on both the reinvestment portfolio and the collateral portfolio.

Credit risk: Voya Investment Management prefers to add leverage to low-volatility assets in its spread lending programs. Some investors take on too much credit risk in their programs, leading to credit losses that overwhelm the incremental spread premia of the program. Other market participants target a certain return on capital or returns in excess of the returns on existing business units. They end up solving for the “right” level of spread, which can lead to “reaching for risk.” Part of the Voya approach is adding leverage to lower-risk, loss-remote assets in lieu of owning higher-risk assets in unlevered form. The spread lending programs should be thought of as a complement to an existing investment opportunity set and designed to drive risk-adjusted returns, not simply as a means of adding risk outright.

Collateral risk: Thinking of the FHLB spread lending program as a separate business line can complicate the separation of the FHLB collateral backing the advances and the FHLB reinvestment portfolio. This can lead some market participants to use advances to further add securities that can be pledged as collateral. In times of stress, credit rating downgrades can make these securities ineligible to be pledged. A program that should be used to bolster enterprise-level liquidity may then be a drag on liquidity as money needs to be redirected to purchase additional collateral or the program needs to de-lever in a period of spread widening.

Mark-to-market risk: A well-underwritten spread lending program should allow portfolio managers to withstand market volatility. However, acute market stress (COVID shock, global financial crisis) can increase portfolio unrealized losses. Participants in spread lending programs need to have the fortitude to hold (or expand) the program during market dislocations, relying on a “through the cycle” approach to underwriting the associated fundamentals. Investors that eschew the preferred floating-to-floating program structure and buy fixed-rate assets that are swapped back to a floating rate also introduce mark-to-market volatility on the interest rate swaps. A seasoned program with laddered advances and securities of varying spread durations can limit this mark-to-market volatility.

Path forward

If you are looking to start an FHLB spread lending program, we welcome the opportunity to share our experience and take you through the process in a step-by-step manner. This would include:

  • Working together to discuss the program with the sales team at your affiliated FHLBank, potentially leveraging existing relationships of personnel at Voya Investment Management.
  • Understanding the collateral guidelines of your respective FHLBank and evaluating options for sizing a program for your existing collateral base.
  • Discussing the current market investment opportunity and the possible range of expected economics and returns on capital.
  • Understanding your overall risk management framework and relevant limits to settle on a size for the program and the risk profile of the asset portfolio.
  • With all of the above in mind, designing a liability profile that provides an appropriate match with the asset profile.

We look forward to leveraging our long history of managing FHLB reinvestment portfolios for the benefit of our insurance clients.

About the author

Jeffrey Hobbs, CFA, is head of insurance portfolio management at Voya Investment Management, responsible for developing and implementing full-service customized investment solutions across all asset classes for Voya’s proprietary general account as well as Voya’s external insurance clients. Prior at Voya, Jeffrey served as an insurance portfolio manager focused on the management of proprietary U.S. insurance assets and multi-sector insurance accounts for third party insurance clients. Prior to joining Voya, he was a portfolio manager at 40|86 Advisors, the investment management subsidiary of CNO Financial Group. Jeffrey earned an MBA from the University of Chicago with concentrations in analytic finance, corporate finance and economics, and a BBA in finance with honors from the University of Oklahoma. He is a CFA® charterholder.

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Past performance does not guarantee future results. Voya Investment Management has prepared this commentary for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest-rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.

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