The life insurance and annuity industry went through dynamic changes especially to carrier ownership and structures since the early 1990s that helped shape the industry that we see today. Massive balance sheet restructurings, “demutualization” of several carriers, dramatic increases in foreign ownership, acquisitions of large asset managers and consolidation through mergers and acquisitions. However, it is notable that private equity (PE) firms did not necessarily enter the fray as owners of either carriers nor reinsurance companies until much more recently. Certainly, where there is industry disruption or a major dislocation capital, PE firms can be found making substantial investments in to what appears at the time to be a chaotic market. But PE firms making large investments across multiple companies is neither an indicator of success nor a harbinger of doom. That is no different with PE’s recent push in to the life insurance and annuity industry. And, after some 30-plus years in the life insurance and annuity industry, I have never seen this amount of outside capital flowing into the industry as we see today. It is safe to say that industry is going through a period of dramatic change with PE playing a sizable role.
Why PE is Investing Now
PE has invested in the life and annuity industry in the past. However, those investments were often in “closed blocks” of business, outsourcing service providers and the occasional insurance company-owned asset manager. It rarely involved direct ownership of a life insurance or annuity carrier. Successful investments have been made in outsourcing partners, technology vendors and even more recently reinsurers.
What changed to make investing the carriers more attractive for PE firms? First and foremost, it is the widespread impact from a prolonged period of low interest rates. The slow and steady decline of interest rates has done material damage to the balance sheets, pricing capabilities and earnings of life and annuity carriers. Carriers’ inability to reinvest fixed income assets at comparable or improved yields is very similar to the widely discussed problems faced by yield-hungry institutional investors all over the globe. Since a life or annuity carrier’s operating earnings are historically based upon an investment portfolio mix that includes a sizable percentage from income, pressure has steadily increased on management teams to find other performance drivers as well as the need to rely more on external financing for growth.
In part to address the pressure on life and annuity carriers caused by the Global Financial Crisis, regulators made changes to the rules governing how carriers managed their general account assets. These changes made PE investment and ownership of life or annuity carriers a far more attractive investment opportunity. (More on this in a moment.) It may not be accurate to describe investing in a life or annuity carrier as “distressed investing.” However, carrier valuations have been trending downward for the past twenty years.
While no PE firm is investing solely on the industry-wide life that a rise in interest rates will provide in the foreseeable future, it is another part of the rationale for investing in life insurance carriers, annuity carriers or reinsurers. PE investors are also seeking to take advantage of any tax arbitrage that may exist for both parent and subsidiary operations of a life or annuity carrier. Some of these tax arbitration strategies are now widely accepted practices. Lastly, the use of reinsurance both for carriers and reinsurers themselves is on the rise across the industry.
Another factor that helps make this a more attractive environment for PE investors is the demographic conditions in the market for risk management and investing. The combination of Baby Boomers nearing and entering retirement coupled with the Millennials starting their earning years is creating a strong environment for present and future growth in the insurance and annuity industry. Simultaneously, the industry is primed to make major investments in technology, both to lift operating efficiencies and drive top-line growth.
While regulatory requirements and oversight have always represented a challenge for investors in the life and annuity industry, the current climate for either increased oversight or regulatory requirements is somewhat predictable. Aside from the aforementioned accommodations on general account investing, new regulations on distribution add near term costs. However, they are also forcing the industry to be more transparent. Since increased transparency is something that both distribution partners and consumers alike have cited as a major complaint against the insurance industry, these changes are another factor that could contribute to a lift for the industry overall.
Lastly, there is the “Buffet Effect.” Berkshire Hathaway has been an investor in the P&C and health segments of the insurance industry for over 50 years. Berkshire’s ability to take advantage of the float – money owed to policyholders but not yet paid – has allowed the company to make countless successful investments to the benefit of Berkshire shareholders.
There are also concerns by stakeholders across the life and annuity industry about PE’s role and influence going forward. We have all heard some of the concerns such as:
· PE owners will prioritize short-term profitability above the long-term stability of contracts purchased.
· PE will only make money if they can merge large companies and then “right-size” the combined company for cost savings.
· PE will introduce tech-based platforms that eliminate the need for advisors and agents.
If we set aside fear of what “may happen”, it is easier to forecast where PE ownership may have an impact and the potential for positive change.
General Account Performance or General Accounting Investing Performance
While there are many factors contributing to PE’s historical lack of interest in investing in carriers, perhaps the greatest contributor are the rules surrounding investments made by an insurance carrier’s general account. For those of you unfamiliar with life and annuity companies, the general account is the investment account that supports many of the products sold to consumers and institutions. These products are often referred to as “fixed” life insurance and annuity products. One rule that affected PE firms’ decisions to invest in life and annuity carriers are those for reserving according to investment type known as risk-based capital (RBC) requirements. RBC requirements call for an insurance company to set aside in reserve a percentage of the capital allocated to any specific investment made within the insurance company’s general account. RBC requirements – sometimes referred to as RBC “charges” – will increase according to the risk classification of the assets. These reserving requirements ultimately involve a trade-off between increasing carrier solvency while lowering net returns from general account investments. The National Association of Insurance Commissioners (NAIC) changed the RBC rules sufficiently that it makes it easier for the insurance carrier to invest across a broader array of asset classes. Some of these changes were put in place immediately following the Global Financial Crisis. This will most likely have the greatest impact on an insurance carrier’s ability to increase its investments in asset-backed securities and private credit.
Investment Analysis and Selection
Pension funds and insurance company have always enjoyed success in recruiting and developing talented investment professionals. However, beginning in the early 1990s and continuing through today, these companies underwent a long, steady transformation of outsourcing many of their investment management functions. The logic stood that the companies were having a harder time competing for talent with Wall Street while many of those same Wall Street firms were offering to handle more and more of the investment management functions for the insurance companies. This trend was also aided by life and annuity carriers acquiring their own investment management firms which, in turn served as one of the outsourcing partners for the parent insurance company’s investing operations. It is not surprising that most investment management functions at life and annuity carriers today are lean and efficient. Conversely, PE firms have grown substantially both in number and in scale over the past 30 years and especially in the past 10 years. The largest of these firms have proprietary investment operations across a myriad of investment strategies. These firms are highly successful in attracting some of the best talent on Wall Street to put this capital to work across some of the most promising investment strategies.
Let’s consider the pressure on insurance companies to improve yields – especially on their large fixed income holdings. We have to accept that much of that pressure falls on the ability of the carriers to a) increase risk to improve yield while b) maintaining even higher standards of credit analysis to help mitigate those risks and c) optimizing their deal flow so that the company does not miss out on the highest quality assets available. Insurance companies are moving in aggregate away from corporate bonds towards more asset backed securities (ABS) and private credit to find these risk-adjusted yields.
In general, ABS quality has greater variability than investment grade and even junk corporate debt; therefore, the opportunity to improve yields by greater levels of investing in ABS carries with it an increased demand on underwriting and deal flow. PE firms are some of the largest originators of ABS brought to market.
However, just because a PE firm is originating a given ABS issue, that doesn’t automatically imbue the offering with higher credit quality. Along with PE firms and the broader market for ABS, life and annuity carriers are scouring the markets for more ABS opportunities.
PE firms acquiring life and annuity carriers make the argument that they are in a better position to source and analyze credit products across a wide spectrum of industries and type than many other financial institutions. They may be right. Can the PE firms as owners of life and annuity carriers leverage their unique position in the capital markets to realize better investment returns than previous ownership? Possibly.
Reinsurance has always represented a double-edged sword to life and annuity carriers. It is used by carriers as an effective way to manage overall risk. The carriers use reinsurance both when they issue new products as well as later in a product’s life cycle. Reinsurance can also be a mechanism that allows a life or annuity carrier to restructure the company’s balance sheet by moving earnings from products sold to a reinsurance company in exchange for that reinsurer assuming the liabilities tied to those products. While annuities have less mortality risk than life insurance, they do have risks associated with various account crediting as well as income and other benefit guarantees created to make the products more attractive to consumers. Reinsurance is actively being used to improve the health of insurance carriers’ balance sheets.
Another tactic using reinsurance is one commonly employed by PE-backed carriers – to hold less of the overall risk tied to a block of life or annuity products from the time of product launch and going forward. This “capital light” approach to product development is designed to allow the carrier the ability to focus more of its capital on other critical competitive business areas such as customer experience, product innovation, distribution and service. While we cannot predict industry-wide changes in the use of reinsurance either for new products or closed blocks, we can identify that PE-owned life and annuity carriers are more likely to increase their use of reinsurance enough that its influence will be felt industry-wide.
Permanent Capital for PE
Large PE firms have sought “permanent capital” for many years now. The idea is that PE firms could further leverage their investment management and investment origination capabilities if they could spend more time on investing and less time raising money. This is at least somewhat ironic since the largest PE firms are incredibly prolific in their capital raising capabilities. Furthermore, as long as the insurance company can generate capital flows at a rate well-below what the company can generate through its investment activities, then owners of the insurance company will be pleased. PE ownership of life and annuity carriers is certainly influenced by the desire by PE firms to have a permanent source of capital.
A Rising Tide
PE interest in life and annuity carriers is not solely driven by investment management opportunities. As is often the case with PE firms (and their investing ‘cousins’ in venture capital), they have a history of investing in industries that are positioned to experience sustained increases in demand. As I mentioned earlier, the combination of Baby Boomers entering retirement and the Millennials entering the start of their earning years means that demand for life and annuity products should increase steadily for some time. When we also consider a) rising interest rates, b) increased demand for guarantees and c) the potential inclusion of guaranteed income products in defined contribution plans then the life and annuity industry should see substantial and sustainable increases in demand for several years.
PE Ownership is a Catalyst for Change
The bottom line is the presence of PE is a catalyst for change in an industry that was poised for substantial changes before PE become such significant investors. What will be PE’s contribution and role moving forward? We shall see.