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A Note on Spread Risk and Capital Requirements for Insurers

Western Asset

Executive Summary

  • Insurance portfolios with similar levels of spread risk can have significantly different levels of regulatory and rating agency spread-related capital requirements.
  • Careful portfolio construction may allow an insurer to manage to a desired economic spread risk and yield profile1 with significantly lower required capital consumption than alternative portfolios with similar risk.

Spread Risk and Capital Requirements

A key component of an insurance company’s business is the management of spread risk in its general account investment portfolio. For bearing this risk, rating agencies and regulators establish capital requirements that vary with the level of risk, as measured by credit ratings. For example, in the US, all BBB rated bonds have an NAIC regulatory capital factor of 1.0%. Bonds rated A and better have a 0.3% factor. In Europe, Solvency II QIS5 uses a factor of 2.5% for all BBB rated bonds (multiplied by spread duration), while A rated bonds have a 1.4% factor. These capital requirements serve as benchmarks for the ratings assigned to a company’s claims-paying ability and the assessment of a company’s solvency position. Consequently, they are critical business considerations. Insurance companies continuously balance their preferred economic risk/reward profile with other goals, such as desired regulatory capital ratios.

Rating agency and regulatory capital factors clearly over-simplify; they are calibrated to approximate the average risk of bonds within a rating category. Capital market spreads within a single rating category have a wide range, reflecting the reality that risk is more nuanced than a handful of rating categories suggest. At the end of the second quarter of 2012, for example, within the BBB rated bonds in the Barclays U.S. Corporate Bond Index, the fifth percentile spread was 96 basis points (bps) while the 95th percentile spread was 410 bps. Spreads on A rated bonds ranged from 44 bps (fifth percentile) to 323 bps (95th percentile)2. Presuming that bonds trade at spread levels that reflect risk relative to their peers, it is clear that there is significant variation in the market’s perception of risk within each rating category. Exhibit 1 illustrates the range of spreads between the fifth percentile and the 95th percentile within each investment-grade rating category of the Barclays U.S. Corporate Bond Index. Exhibit 2 plots each AA to BBB rated bond index member by spread and duration.

Exhibit 1
Barclays U.S. Corporate Bond Index, Spread Range by Rating Category 2Q12
Source: Barclays, Western Asset. As of 30 June 12.


The market spread overlap between different bond rating categories gives insurance companies the opportunity to build portfolios with a targeted spread risk exposure and a prudent economic capital position, while minimizing rating agency and regulatory capital consumption. Solid and thorough fundamental analysis is a key credential in this process. Assuming that a manager’s fundamental analysis is indifferent between BBB rated and A rated bonds with the same spread and spread duration, selecting the A rated alternative will improve the capital ratios used by rating agencies and regulators.

Western Asset works with insurance clients to build portfolios that are appropriate for a company’s liabilities and risk tolerance. Capital efficiency, as described in this note, is a key consideration in the management of insurance portfolios at Western Asset.

Exhibit 2
Option-Adjusted Spread and Duration, Barclays Corporate Bond Index Issues 2Q12
Source: Barclays, Western Asset. As of 30 June 12.


  1. Please see “A Note on the Use of High-Yielding Fixed Income Sectors,” Western Asset, 2012
  2. Using the fifth and 95th percentiles illustrates the spread range while avoiding outlying spread observations
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