As commercial real estate lenders, life insurance companies have a unique approach on dealing with potential losses or loan loss reserves in their mortgage loans holdings. Unlike bank mortgage lenders, who apply their risk based capital requirements on a loan level basis, life insurance companies use an approach that applies at the portfolio level (called the “mortgage experience adjustment factor” or “MEAF”). In 2013, this probably will change – and life insurance companies will use a “loan level” approach. This should give more liquidity to the commercial real estate market. MEAF takes a mind-bending approach in determining the amount of capital that must be set aside (as a loan loss reserve) for a bad commercial real estate loan. Under MEAF, loss reserves are based on a formula that “includes a moving eight month moving ratio of company to industry experience with minimum to maximum limits.” (Instructions for Life Risk Based Capital Formula (MEAF) risk based capital). This comparison of company losses to the industry means that a few of bad loans could generate (via the formula) a total loss reserve well in excess of the actual losses from those few bad loans. This plays out as follows (and has been the story for life company holdings of commercial mortgages over the past few years):
- they avoid recognizing defaulted commercial real estate loans
- they hyper monitor loans in tough markets and over the last couple of years prior to maturity
- for loans that could go into default, or be tough to refinance at maturity, life companies will sell the loan PRIOR to either event – even if the sale is at a loss (i.e., not at par)
- recognizing that the MEAF approach has a draconian effect, the NAIC set floors and ceilings on the MEAF formula during 2009-2012
Why the incredible low number of defaulted loans on the part of life insurance companies in recent years? MEAF is part of the answer. The suggested approach will be similar to the process used to assign capital charges to corporate bonds. With cost of funds for banks at an all-time low (i.e., zero and almost zero), it will be interesting to see whether this change (if it is passed by the NAIC and adopted by the states) will at least partially level the playing field for life insurance companies, as they compete with banks for the best commercial loans. At the very least, it could level the playing field at the investment committee in a life insurance company (as mortgage lending competes with corporate bonds for investment allocations). And it could mean more liquidity for the commercial real estate market. It also will mean the “end” of the “deals” for those who have been buying these loans from life insurance companies. Please share your comments and perspective below.