Commercial Mortgages and Life Risk Based Capital

The U.S. insurance industry, primarily through its life insurance segment, has been a longstanding capital resource to the commercial real estate (CRE) market through its mortgage lending operations, with more than 300 billion in commercial mortgage loans outstanding as of December 31st 2019. According to the Mortgage Bankers Association (MBA), the life insurance industry owned approximately 13% of the $2.4 trillion in outstanding commercial mortgage loans, forming an important part of the life insurance industry’s invested assets and constituting 8.7% of the life industry’s cash and invested assets. The holdings of the industry are concentrated, with more than 50% of the life insurance industry’s commercial mortgage loan holdings held by 10 insurance groups. By far, the largest share of the insurance industry’s CRE exposure is held by life insurers in their direct commercial mortgage loan programs. In these programs, life insurers lend on income-producing CRE properties, taking a mortgage on the real estate that serves as the loan’s collateral. 

Life insurers have a variety of reasons for investing in commercial mortgage loans for three primary reasons: (1) to increase the level of asset type diversification in their investment portfolio; (2) to match long-term assets with long-term liabilities, because commercial mortgage loans are generally long-term with fixed interest rates and almost always include prepayment (call) protections; and (3) to minimize credit losses, because, based on historical experience, commercial mortgage loans have had modest realized credit losses. According to data published by American Council of Life Insurers (ACLI), commercial mortgage loans originated by life insurers in the first quarter of 2012 were viewed as relatively conservative investments, with an average loan-to-value (LTV) ratio on a new commitment of 60% and an average debt service coverage (DSC) ratio of 1.99 times.

Since the financial crisis erupted, life insurance companies’ ability to invest in commercial mortgage loans on their own terms has considerably improved, benefitting from lessened bank and CMBS involvement. This has enabled the insurance industry to increase its commercial mortgage loan lending volume. The industry’s commercial mortgage loan holdings’ average yield has declined in recent years due to the overall low level of interest rates. As older vintage, higher yielding commercial mortgage loans mature, they are being replaced by newly originated loans with lower interest rates. This dynamic is affecting all fixed-income segments of insurers’ investment portfolios. Average commercial mortgage loan portfolio yields are likely to continue declining in coming years, as long as interest rates remain at today’s low levels.

Due to the COVID-19 pandemic, there has been a huge impact on the commercial real estate industry. Forbearance and loan modification appear to be prevailing practice in dealing with COVID-19-related troubled loans across the CRE industry, especially for the balance sheet lenders, which have a lot more flexibility than their CMBS counterparts. These helped drive lower delinquency rates, as many borrowers are no longer behind on mortgage payments under the modified loan terms. Despite all efforts, hotel and retail sectors have experienced the largest percentage of delinquent and modified loans. Furthermore, with forbearance and modification activities underway, it is very challenging to get an accurate reading of overall CRE loan performance, so the exact severity of the hardship that borrowers currently face remains unclear. While relieving temporary pains, the longer-term question remains how many loans may still fail.

According to a recent analysis done by Moody’s Analytics, compared to the 3.0% increase in the delinquency rate of all CMBS loans, the overall modification rate is just 2.2% as of 2020Q2. Hotel loans show the highest modification rate, 7.2%, followed by 2.1% for retail loans and 1.6% for office loans. In July, the modification rates of hotel and retail loans in CMBS rose to 9% and 4%, respectively. For life insurance companies, COVID-19-related loan modifications accounted for more than 3% of the total portfolio as of April 30, 2020, compared to a 0.2% delinquency rate. Retail property type accounted for more than 50% of all COVID-19 modifications with a 9% modification rate. Hotel property type had the highest rate of modifications among all property types, at about 26%. The higher modification rates of retail and hotel loans remain consistent with their higher delinquency rates compared to other property types.

Due to high exposure of Life insurance companies to Commercial mortgages and delinquency rates spiking in the CMBS market, it becomes challenging for the life insurance company to assess the credit risk using reported delinquency statistics. Evaluating credit risk under the current environment is crucial which required continuous monitoring. As COVID-19 continues to impact commercial mortgages, the exposure of Life insurance companies to these mortgages impact their risk based capital. How will a spike in delinquencies impact Life insurance investment risk? While companies can closely monitor the delinquency rate that is released every quarter by the ACLI, companies can evaluate the impact of delinquencies on their risk based capital. The risk based capital calculations use risk factors that are assigned to different mortgages based on their CM quality. The CM quality for commercial & Farm mortgages range from CM1 to CM7. The CM quality is assigned to each mortgage based on their DSC (Debt Service coverage) and LTV (Loan to Value ratio) values.

The calculation of risk charges for Mortgages in the risk based capital calculation is complex and different for Life and P&C. The Property & Casualty Risk-Based Capital Working Group adopted a factor of 5 percent based upon the factors developed by the Life RBC formula, which ranged from 3 percent to 20 percent. The P&C RBC simply uses mortgage loans and charges them at a 5 percent risk factor included in Other Invested Assets securities lending in the R1 Asset Risk. The Life RBC has a more complex and expanded calculation for Mortgage loans and their risk. Life RBC calculations for 2013 and prior years included a Mortgage experience adjustment factor. However, with 2014 the NAIC introduced a new RBC and AVR methodology for Commercial and Farm Mortgages. Under the new RBC and AVR methodology for Commercial and Farm Mortgages the mortgage experience adjustment factor was no longer required and its determination was not necessary.

The pre-tax factors for commercial mortgages were developed based on analysis using the Commercial Mortgage Metrics model of Moody’s Analytics and documented in a report from the American Council of Life Insurers (ACLI). The factors provide for differing levels of risk, the levels determined by a contemporaneous debt service coverage ratio and the contemporaneous loan-to-value commonly known as DSC and LTV. For Mortgages in good standing, the 0.14 percent pre-tax factor on insured and guaranteed mortgages represents approximately 30-60 days’ interest lost due to possible delay in recovery on default. The pre-tax factor of 0.68 percent for residential mortgages reflects a significantly lower risk than commercial mortgages. The pre-tax factors were developed by dividing the post-tax factor by 0.7375 (0.7375 is calculated by taking 1.0 less the result of 0.75 multiplied by 0.35).

For Mortgages that were 90 days overdue but not in process of foreclosure, the category pre-tax factor for commercial and farm mortgages of 18 percent was based on data taken from the Society of Actuaries “Commercial Mortgage Credit Risk Study.” For insured and guaranteed or residential mortgages, factors are set at twice the level for those “in good standing” to reflect the increased likelihood of default losses.

Finally, for mortgages in process of foreclosure, the NAIC considered all these mortgages to be risky as NAIC 5 bonds and are assigned the same category pre-tax factor of 23 percent for commercial and farm mortgages. The final RBC requirement for commercial mortgages is calculated using a specialized mortgage worksheet that is available on the RBC filing software for each company.