THE ECONOMICS OF THE PRIVATE MARKET
Life Insurance Companies
Market participants estimate that life insurers purchase between 50 percent and 80 percent of new issue volume each year (table 7 supports estimates at the high end of that range). At year-end 1991, life insurers held $212 billion of private placements in their general accounts, representing 26 percent of their total bond holdings and 16 percent of their general account assets. 64
The twenty largest insurance companies, as measured by total assets, accounted for 68 percent of industry holdings of private placements at the end of 1992. Furthermore, for this group, private placements were 39 percent of total bond holdings and 22 percent of general account assets. The next eighty largest insurers account for most of the remaining industry holdings of private placements, and within this group, several companies have sizable portfolios.
Some idea of how the life insurance industry allocates its funds among different classes of private bonds can be obtained from the ACLI Investment Bulletin, which provides data on the composition of new commitments of funds to private placements by major insurance companies. Life insurance companies strongly prefer fixed-rate private placements: In 1992, more than 97 percent of their commitments were fixed rate. Securitized instruments, mainly mortgage-backed securities, were 13 percent of commitments although, as discussed in part 1, section 2, a much larger fraction probably carried collateral. Insurers invest primarily in medium- to long-term maturities; less than 10 percent of their 1992 commitments had an average life of three years or less, with more than half having average lives between five and ten years.
This concentration on medium- to long-term, fixed-rate debt is sensible because such securities can easily be matched with the life insurance industry's long-term, fixed-rate liabilities. Many private placements also have sinking fund provisions that further enable insurers to match the cash flow of their investments with that of their liabilities. The strong call protection that is typical of private placements also facilitates matching. 65 Life insurance companies buy private placements from firms in all sectors of the economy. Most tend to diversify across a broad range of industries, although many have favorite industries in which they have a particular expertise. In 1992, 78 percent of their total commitments went to the nonfinancial sector, with just over 30 percent going to manufacEagleTraders.comg, 8 percent to the oil, gas, and mining industries, and another 20 percent to the utilities, communication, and transportation sectors. Life insurance companies have sharply increased their purchases of securities issued by foreign companies, or U.S. subsidiaries of foreign companies, to over 7 percent in 1992 from less than 3 percent of total commitments in 1990.
The large insurers' investment in risk-control technology is extensive. 66 Most of these insurers have large staffs of credit analysts, who evaluate the credit quality of potential issuers and monitor the health of firms to which credit has been extended. Most conduct a quarterly review of each private bond held in their portfolios, with a more formal annual or semiannual review. Violations of covenants or requests for waivers of covenants generate further reviews. The costs of risk-control operations are covered by the higher risk-adjusted yield of private placements relative to public bonds, which require little or no active monitoring by security holders. 67 The private market provides borrowers willing to compensate the lender for these risk-control services.
The large investment in credit evaluation and monitoring leads most large insurance companies to concentrate on more complex credits; however, strategies vary even among these companies. Besides dominating the straight debt sector of the market, life insurers buy other types of private securities, such as convertible debt or asset-backed bonds, though their share of these sectors is somewhat lower. In terms of credit quality, insurers focus primarily on securities rated A and BBB (chart 15). At the end of 1992, around 17 percent of total private bonds held by the twenty largest companies were rated below investment grade; however, substantial variation exists, with some companies having up to 38 percent of their private portfolio in below-investmentgrade bonds and others having almost none at all. 68 Securities in this credit range, particularly those rated just below investment grade (which insurers often refer to as Baa4 securities), are favored by those insurance companies attempting to gain maximum advantage from their credit analysis and monitoring skills. These insurance companies like to take advantage of the large difference in yields between investment-grade and below-investment-grade credits by lending to strong BB-rated companies. However, others are more conservative and focus solely on issues rated A or higher. 69
According to market participants, smaller insurers typically have much less extensive risk-control technology at their disposal. They therefore tend to concentrate on higher-quality, less-complex credits. They also may participate in deals that larger insurance companies have already committed to, using the presence of these larger insurers as a signal that the deal is a favorable one.
Most insurance companies rely heavily on agents for prospective transactions, although some direct lending occurs between an insurer and its existing borrowers. Only the very largest insurance companies originate new transactions on a regular basis, and only one insurer syndicates private bonds. The largest insurers generally prefer to be the sole source of funds for an issuer. However, many issues are larger than the maximum amount that individual insurers permit to be lent to one borrower; a typical issue may have up to a half dozen insurance companies funding it. Insurers typically fund between 5 and 20 percent of the deals that are marketed to them.
Most large insurers invest in both public and private bonds, and they have allocation mechanisms to alter the flow of money into these markets as spreads change in the two markets. Until recently, the groups within large insurance companies responsible for purchasing private and public bonds were usually separated; however, some companies have recently combined the groups. Market participants report that many medium-sized insurers have for some time used a single group to make all investments in bonds.
Source: National Association of Insurance Commissioners.