AM Best flags Level 3 bond growth in life/annuity books

AM Best has put a name to the risk building inside life/annuity balance sheets, with a new Best's Special Report arguing that the segment is driving the industry's Level 3 bond holdings higher and that the growth is a valuation risk. Kaitlin Piasecki, an industry research analyst at AM Best, discussed the findings.

The warning lands a day after PWD's tracking showed life/health net yield up 10 basis points to 4.6%, the income statement's first visible payment on a private-allocation decision, and it follows AM Best's separate flag of a collateral gap in offshore annuity reinsurance and an A+ rating for Athene with the asset test still looming. Together, the three items describe a segment earning its yield now and defending its marks later.

Level 3 bonds are the model-dependent corner of the fair-value scale, and for a segment whose liabilities are fixed and long-dated, an asset whose value is set by model rather than by a traded price is a strange thing to build a yield program on. The marks may be right; they have simply not been tested. That untested quality is what AM Best means by valuation risk: the bond can pay off in full and still create a balance-sheet problem if the model's assumption is wrong when a sale forces the price.

That the report arrives just after the net-yield step tied to earlier private-allocation decisions, and after AM Best's warnings on collateral and on Athene have already framed the general account as the segment's open question, makes it harder to wave off. The Level 3 note completes the picture: the yield is coming from assets that cannot be independently corroborated by a market.

The concern centers on the difference between default and price discovery. With no liquid market for these bonds, a sell-off is unlikely; the more likely adjustment is a higher capital charge for an asset whose price cannot be corroborated, and for a segment that sells guarantees, that is a margin squeeze.

The income statement gets the yield today; the balance sheet carries the price-discovery obligation. A 10-basis-point gain is real money, but paying for it with Level 3 bonds only postpones the valuation event. The general account is becoming an underwriter of supply constraints, not just a lender, and Level 3 bonds are the logical endpoint: an asset whose price is a negotiated judgment.