OLDWICK: According to insurance sector rating agency AM Best, the U.S. life/annuity (L/A) insurance companies continued to increase their exposures to commercial mortgage loans in 2019 and now hold more than $522 billion, up significantly from $382 billion in 2015.

The Best’s Special Report, titled, “Commercial Mortgage Loans Increasing, Credit Quality Decreasing,” notes that U.S. economic fundamentals were mostly favorable throughout 2019, with continued GDP growth, low unemployment and rising retail sales.

All these factors led to stable commercial real estate rents and stable vacancy rates. However, more-recent trends for commercial mortgage loans (CML) properties show decreases in office and retail properties and increases in apartment properties. COVID-19-related developments may lead to further percentage declines in these holdings. Holdings in hotel and motel properties, which make up roughly 4% of L/A insurers’ CML investments, also likely will come under pressure until economies reopen more fully.

Despite the increased holdings, including an 8% year-over-year increase in 2019, the percentage of investment-grade loans with the highest rating, designated as CM-1, has declined steadily, while the percentage of loans designated as CM-2 has grown. The shift to CM-2 loans appears to be due to insurers’ efforts to increase yield, rather than to deteriorating conditions leading to downgrades.

AM Best’s recent COVID-19 stress testing on its rated companies assumed declines in several asset categories, including a 10% drop in the statement values of CMLs, with such declines reducing surplus, adjusted for taxes. CML valuation declines will impact Best’s Capital Adequacy Ratio (BCAR) results, particularly for property types affected the most by the COVID-19 shutdowns.

Hotel properties in particular are experiencing unprecedented vacancy rates. Retail and office property also are experiencing significant drops in revenue, which can lead to deterioration in quality and declines in valuations. This will also affect the performance of other mortgage-backed assets, such as commercial mortgage-backed securities. A prolonged impact of COVID-19 could have a significant effect on the loan values and operating income of most property types as well.

As the pandemic leads to loan forbearance, along with remote work forces and travel restrictions, the potential for deterioration in credit quality grows. However, L/A insurers’ low exposure to hotels will help minimize the impact. Instead, insurers will feel the impact of longer-term pandemic conditions through accelerated loss recognition, leading to pressure on GAAP earnings. AM Best will closely monitor insurers with higher CML exposures relative to total statutory surplus.