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ChangeThe views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Key points
- Federal Home Loan Banks lend to insurers at very competitive rates, providing opportunities to add alpha or enhance yield by borrowing at low cost and investing in risk-appropriate markets.
- Adding to its appeal, FHLB debt may receive favorable treatment as operating leverage by ratings agencies.
- We provide examples of customized investment solutions that can enable insurers to capitalize on the advantages of FHLB borrowings, and we also note potential risks.
As of 31 March 2024, 580 insurance companies were members of the Federal Home Loan Bank (FHLBank or FHLB) system and had borrowed over US$147 billion from it year to date.1 Insurance company participation in the FHLB system directly supports FHLBanks’ ongoing mission to provide affordable lending to residential mortgage borrowers. FHLBanks lend to insurers at very competitive rates, creating potential opportunities to add income or enhance yield by borrowing at low cost and investing in risk-appropriate markets. When combined with possible favorable treatment from ratings agencies, we believe this program is worth consideration by US insurers.
Federal Home Loan Banks: Designed to support the US housing market
The FHLBanks are regional cooperatives of mortgage lenders owned and governed by their 6,502 members, which include commercial banks, savings and loan institutions/thrifts, credit unions, community development financial institutions, and insurance companies. Any entity designated as a financial institution under the Federal Home Loan Bank Act of 1932 that is in good financial standing, and that owns or issues mortgages or mortgage-backed securities, is eligible for membership.2 Insurers, more specifically, must be chartered by and regulated under the laws of a state.
Insurance companies have been eligible for FHLB membership since the FHLB system’s inception, which is evidence of their importance to the housing market and to the FHLB mission to “provide reliable liquidity to member institutions to support housing finance and community investment.”3 Today, roughly US$1.2 trillion, or 15% of insurers’ invested assets, are allocated to residential mortgage-related investments.4 Insurance companies, through these investments, are liquidity providers for the mortgage-backed securities (MBS) market, which in turn generates cost savings for individual homeowners. Not only do insurers hold mortgage-related investments, they are also largely able to hold those investments over the long term. In periods of market stress, insurers are typically not forced to be sellers, which provides support to capital markets, the home loan market, and individual homeowners. FHLBank lending amplifies insurance-company investment in the home loan market as insurers are required to overcollateralize their advances, or loans, from FHLBanks with residential mortgage-related investments. The FHLB advance program is, in our view, an important tool in service of FHLBanks’ commitment to supporting housing finance and community development.
Individually and as a whole, FHLBanks are liquidity providers; they extend attractive financing to member companies who in turn offer loans to homeowners. Government support and the fact that each bank is responsible not only for its own debt but that of every bank in the system are what enable the FHLBanks to pass on cost savings to members.
To become a member, an institution must: (1) meet a minimum holding threshold for residential MBS; (2) purchase FHLB stock; and (3) meet certain credit-rating metrics of the FHLBanks. Membership is applied for and maintained at the holding-company level. The location in which an insurer conducts its principal course of business (e.g., the location of the board or executive team) typically determines that company’s regional or “home” FHLBank. The amount of FHLB stock required to be purchased varies across FHLBanks, but typically is a small percentage of an insurer’s invested assets. FHLB stock is not publicly traded but can be redeemed for par at the issuing bank under each bank’s conditions. Once companies have met the membership requirements, they are able to apply for a secured loan, referred to as an “advance” by the FHLBanks.
Borrowing limits, loan pricing, available maturities, collateral requirements
Maximum borrowing limits for advances vary by FHLBank, but commonly fall between 20% and 60% of total assets. Member advances are priced at fixed or floating rates across a range of maturities, from overnight to 30 years. According to the most recent FHLBank Office of Finance investor presentation, floating-rate advances comprise just over 30% of total advances as of 31 March 2024, a 10% increase from year-end 2021. The maturity of advances has shortened in tandem with this trend towards a floating rate: Over 90% of advances fell within the less-than-one to five-year range by the end of 2023, a 25% increase over 2021. While rates are regularly updated and differ across banks, Figure 1 lists a sampling of rates as of 31 May 2024.
Figure 1
To capitalize advances, borrowers must purchase activity-based FHLB stock in addition to the stockholdings required for membership. The FHLBank Office of Finance cites a typical rate of 4% – 5% of principal borrowed. Both membership and activity-based stock types offer dividends. This capital is usually returned to the member via stock buyback once the advance is repaid. Advances are also required to be fully collateralized by securities or loans; specific requirements for such collateral vary by regional FHLBank and the prospective borrower’s credit status. Typically, eligible collateral must be single-A rated or above and housing-related. This may include: US Treasuries, agency debt, agency and non-agency MBS, commercial MBS, municipal bonds (with proof that these are housing-related), cash, deposits in an FHLBank, and other real-estate-related assets. Most, if not all, insurers typically already own many of these eligible collateral types. Corporate bonds, private debt, and equities are not accepted as collateral. The haircuts applied to collateral vary by bank and by member-applicant (Figure 2).
Figure 2
Securities collateral is delivered to an approved third-party custodian or to the FHLBank or is pledged by completing a form to secure the advance. Monitoring of collateral and lending capacity is ongoing and calls for additional or substitute collateral may be issued by an FHLBank to protect its credit interest. In addition, the FHLBank lender has the senior claim on pledged collateral. While the FHLBank system recorded losses from exposure to swaps issued by Lehman Brothers in the global financial crisis (at the time, all FHLB debt was swapped to 3-month LIBOR, hence the exposure), collateralization requirements have helped ensure that no FHLBank has ever incurred a credit-related loss from a member.
Strong growth in FHLB insurer membership and borrowings
FHLBanks are able to offer extremely competitive interest rates compared to commercial lenders, and recognition of this membership benefit continues to grow among insurers. Year-over-year growth of insurer membership in the FHLB system has been continually positive over the past 25 years. A total of 68 new insurers joined the FHLB in 2015, a historic high. Since then, the FHLB system has benefited from an average of 26 new insurance-company members per year.
These members are taking advantage of attractive borrowing terms: Advances to insurance-company members reached an all-time high of close to US$150 billion in the first quarter of 2024. In a survey of our insurance clients on their FHLB advances,8 respondents cited an array of uses for the funds, including untapped emergency liquidity, active liquidity spread enhancement investing, asset and liability management (ALM) needs, acquisition funding, and refinancing of 144a debt.
More broadly, membership by insurers grew at an annual pace of 7% in the period from 2013 through the first quarter of 2024. The percent of total par value of insurer advances rose 8% annually over the same period, based on data from the FHLB Office of Finance reports. As of the first quarter of 2024, insurance companies had borrowed 19% of total outstanding FHLB advances, or US$147 billion. Advances were extended to 235 distinct member borrowers out of 580 total FHLB insurance members (see Figure 3). One of the core benefits as an FHLB borrower is access to liquidity in times of market stress. The sharp drop in percent share of total par value of advances drawn by insurers reflects a 30% increase in borrowing by commercial banks year over year and in tandem with the stress felt in the banking industry in the spring of 2023 (see Figure 3). The shift in borrowing volume illustrates how the FHLB system supports not only its members’ business needs, but also those of the broader capital markets.
Figure 3
By business type, life insurers have been the biggest borrowers based on annual filings, followed by property & casualty (P&C) and health writers. The MetLife Inc. group ranked as the largest insurance-company borrower at the consolidated level, based on US$14.6 billion in advances outstanding as of the first quarter of 2024. In 2023, 37% of life, 15% of P&C, and 7% of health filers reported available FHLBank lending capacity or outstanding advances. These filers represent 93% of life, 70% of P&C, and 44% of health industry admitted cash and invested assets, respectively, as reflected in Figure 4.
Figure 4
Assuming a 5% haircut on posted collateral, we estimate outstanding borrowing capacity of US$262.3 billion across life borrowers, US$11.9 billion across P&C borrowers, and US$3.9 billion across health borrowers (Figure 5).
Figure 5
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; while the converse was true through the spring of 2023, insurance company share of advances has grown into 2024, comprising 19% as of the first quarter. The costs to an FHLBank of making a loan vary little by loan size as previously noted, 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 COVID 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 historically been more advantageous for insurers looking to implement spread enhancement programs. However, in an environment of tight spreads and rising borrowing costs, fixed-rate programs may also offer an attractive option. 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. For non-life companies, advances carried as debt can also qualify as operating leverage if they meet the 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.
Figure 6
Finally, regulatory requirements of the 50 states are too varied to address here but should be considered in the construction of the investment portfolio and viable spread targets. Investment managers and consultants are ably positioned to assist in this area.
Using FHLB advances to potentially enhance yield/generate alpha: Key considerations
Drawing on our experience in establishing these types of mandates with insurance clients, we suggest a few other points to consider:
1. Sizing of the advance and overall FHLB capacity is constrained by the amount of eligible collateral that is available to pledge. Many insurers maintain spare borrowing capacity for emergency liquidity purposes.
2. We think the pace of borrowing is essential. It is important to plan the tranches of cash flows in accordance with how quickly the cash can actually be invested into the particular asset class; we have found it is best to avoid sitting on cash while paying interest on an advance.
3. Establishing clear and comprehensive guidelines for yield-enhancement activities is also critical, in our view. Including a liquidity component and explicitly addressing other requirements for meeting regulatory and ratings-agency constraints can demonstrate intent to regulators and also create a clear framework for the investment manager.
4. From the outset, it is important to determine the metrics of success and how performance will be measured. For example, many of our insurance clients track investment income from their FHLB spread lending portfolios against an annual target. Considerations in determining an appropriate target include expected portfolio income, FHLB dividends, investment management fees, and borrowing costs.
5. Finally, a written document, of course, cannot replace the importance of ongoing communication between insurer and investment manager on pace and implementation. Frequent contact, especially in the ramp-up phase, is essential, as is the ability to generate reporting metrics that provide transparency to the insurer’s investment committee, board, and regulators.
Potential risks
It is also critical to understand the possible risks for these solutions. Insurers, as institutional investors, continually assess the available levers they can pull to potentially increase income. But each lever has potential trade-offs. By going lower in quality, insurers face credit risk. If they go private, this presents liquidity risk. By adding longer duration, insurers increase their term risk.
One way to think about FHLB spread lending mandates is that insurers are increasing potential income by adding leverage to high-quality assets using inexpensive term financing. Importantly, there are some risks to seeking to add income this way, which vary depending on the insurer’s chosen arbitrage approach.
Mark-to-market risk
These portfolios are comprised of daily-priced credit assets that will experience changes in spread. Another way to think about this could be spread-duration risk, since the liability (the FHLB loan) has no spread duration, whereas a portfolio of CLOs, as an example, typically has a spread duration of five to seven years. As spreads change, the market value of the portfolio will change accordingly. In theory, this risk can be mitigated if assets are held until the loan’s maturity, assuming no principal losses on the bonds held. However, if the asset portfolio were liquidated prior to maturity, then there could be a realized loss (gain).
Credit risk
As with any investment, the value of a fixed income security may decline. In addition, the issuer or guarantor of that security may fail to pay interest or principal when due, as a result of adverse changes to the issuer’s or guarantor’s financial status and/or business. In general, lower-rated securities carry a greater degree of credit risk than higher-rated securities.
Collateral risk
The terms of each FHLB loan will dictate the required collateral terms, but if the value of the collateral were to drop significantly, the insurance company borrower might need to post additional collateral.
Customized investment solutions that build on the FHLB lending opportunity
Working collaboratively with insurers, we have created investment solutions with custom objectives and risk profiles that seek to capitalize on the FHLB lending option. Figure 7 includes example portfolios that show how an insurer might implement this idea. The fixed-rate lending examples (shown in dark blue) of two-, five-, seven-, and ten-year terms, respectively, each comprise a hypothetical portfolio of 100% corporates matched to fixed-rate loans that have a cost of a treasury rate plus a spread. The floating-rate lending example (shown in light blue) is a 100% CLO portfolio matched against a floating-rate loan with a five-year term and has a cost of SOFR plus a spread. At times, the FHLB offers loans prepayable by the insurer, which we frequently recommend due to the minimal cost and increased flexibility.
These example portfolios consider NRSRO and rating agency guidelines with regard to liquidity and quality considerations. Historically, we have seen the most uptake in floating-rate advance options. This has been driven by the attractiveness of CLOs relative to other investment-grade asset classes, as the 100% CLO portfolio historically presents the best arbitrage opportunity. Within the CLO portfolios, we have seen a mix of credit risk ranging from 100% AAAs to a blend of A or better (as shown in Figure 8). Some clients have opted for broader securitized portfolios using other floating-rate assets like Single Asset Single Borrower commercial mortgage-backed securities (CMBS). More recently we have seen an uptick in interest in longer duration (~10 year) fixed-rate loans given their attractive spread and the opportunity to lock in low funding rates for a long period of time. The trend within fixed-rate loans has been toward 100% corporate credit given that this sector best maximizes the arbitrage, but introducing other credit sectors such as securitized or taxable municipals could further improve spread.
Figure 7
Figure 8
Conclusion
Use of FHLB lending facilities has been on the rise among insurers, promoting the FHLB mission to support mortgage lending and related community investment. Our insurance-client base has increasingly studied the borrowing options to meet a variety of needs, ranging from liquidity to spread enhancement. We believe that the FHLB advance program provides compelling potential for insurers to add alpha or increase yield by borrowing at low rates and investing in risk-appropriate markets. Combined with the favorable treatment FHLB debt may receive as operating leverage by regulators, we believe this program is worth consideration.
1Federal Home Loan Banks 1Q 2024 Combined Financial Report .| 2More background on the FHLBank system is available from its Office of Finance, www.fhlb-of.com. The FHLBank of Chicago offers further Information for insurers at https://www.fhlbc.com/solutions/details/how-insurance-companies-benefit-from-an-fhlbank-membership-q2-2019 and the National Association of Insurance Commissioners has published a Capital Markets Bureau primer on FHLBs at https://content.naic.org/sites/default/files/capital-markets-primer-federal-home-loan-banks.pdf. | 3FHLB Office of Finance website. | 4S&P Cap IQ 2023 annual filing data, including RMBS, mortgage loans, and real estate. | 5Representative lending rates courtesy of FHLB Chicago; actual rates vary by FHLBank, type of advance, and specifics of each agreement. Fixed-rate advances are based on duration-equivalent US Treasury rates plus indicative spread. Floating rates are based upon secured overnight financing rate (SOFR) plus indicative spread for a four-year term. As of 31 May 2024, SOFR was 5.33%. For illustrative purposes only. | 6Includes US government-guaranteed mortgage loans and student loans. | 7Includes Federal Housing Administration and Department of Veterans Affairs loans. | Source: Federal Home Loan Banks 2023 Combined Financial Report. | 8Source: Wellington Management. This February 2017 survey included 22 insurance client respondents. | 9Bonds – NAIC 1 – Other | 10Bonds – 50% NAIC 1/50% NAIC 2 | Sources: NAIC, FHLB, Wellington Management. Data as of 1 April 2021. | For illustrative purposes only. | 11Loan rates are as of 31 May 2024 as provided by FHLB Chicago. Funding costs are measured as spread over duration-equivalent US treasury rates for fixed-rate loans. For floating-rate loans, spread is measured as the difference between 5-year variable rates with 3-month reset frequency and overnight SOFR. SOFR measured 5.33% as of 31 May 2024. | Fixed-rate model portfolios are based on Bloomberg Corporate Index Data. | The floating-rate model portfolio data shown is of a representative account, is for informational purposes only, is subject to change, and is not indicative of future portfolio characteristics or returns. The representative account shown became effective on 1 August 2016 because it was the oldest account at the time of selection. Each client account is individually managed; individual holdings will vary for each account and there is no guarantee that a particular account will have the same characteristics as described. Actual results may vary for each client due to specific client guidelines, holdings, and other factors. In limited circumstances, the designated representative account may have changed over time, for reasons including, but not limited to, account termination, imposition of significant investment restrictions, or material asset size fluctuations. Representative account information is supplemental to the GIPS® compliant presentation for the CLO Constrained Composite which is provided in the attachment. | Data is as of 31 May 2024. | 12Quality based on middle of Fitch, Moody’s, or S&P rating (split to low). | The data shown is of a representative account, is for informational purposes only, is subject to change, and is not indicative of future portfolio characteristics or returns. The representative account shown became effective on 1 August 2016 because it was the oldest account at the time of selection. Each client account is individually managed; individual holdings will vary for each account and there is no guarantee that a particular account will have the same characteristics as described. Actual results may vary for each client due to specific client guidelines, holdings, and other factors. In limited circumstances, the designated representative account may have changed over time, for reasons including, but not limited to, account termination, imposition of significant investment restrictions, or material asset size fluctuations. Representative account information is supplemental to the GIPS®-compliant presentation for the CLO Constrained Composite which is provided in the attachment. | Model portfolio assumes a 5-year floating rate loan indexed to a 3 month spread to SOFR. | As of 31 May 2024. | Please refer to the end of the document for additional disclosures.
Additional disclosures
This material contains hypothetical analysis and results shown are for illustrative purposes and are not representative of an actual portfolio or account. Results for model portfolios are developed with the benefit of hindsight (i.e., actual knowledge of market conditions) and thus have many inherent limitations. Results of actual advisory accounts will vary, perhaps significantly, from the information shown. Since trades have not actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity, and may not reflect the impact that certain economic or market factors may have had on the decision-making process if client funds were actually managed in the manner shown. Investment guidelines or restrictions that may be imposed by a client may impact the characteristics of the investment approach. The impact of such investment guidelines and restrictions are not reflected. The material provided herein is not to be construed as investment advice or a recommendation to buy or sell any security. Please consult your own third-party advisors and consider your own circumstances and objectives prior to making any investment decisions.
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