#71 | The New PE Gamble – Part 1

I remember well when so-called PE firms started getting into the life insurance and annuity business en masse back in 2012 and 2013. The narrative among the skeptics was that these firms were only in it for the money and would fleece policyholders at first opportunity in order to make a buck. The irony, of course, is that the traditional insurers have been far more active in fleecing policyholders than their PE counterparts. Over the last 5 years, these firms have transformed into major players and the fact that their growth capital came from something other than public shareholders or policyholders is an afterthought. Athene Holding is now publicly traded at a valuation bigger than firms like Brighthouse and Voya. Global Atlantic is a major player in the annuity space via its acquisition of ForeThought and continues to invest in its life business at Accordia, much to my surprise. Guggenheim has proved to be an adroit operator of its businesses, notably Security Benefit, EquiTrust and Delaware Life, in addition to its tie-up with Sammons. I could go on. The fact is that firms funded by investor capital have proven to be more like their stock, mutual and private peers than not. So for the purposes of this conversation, I’ll just refer to them as “nontraditional carriers.”

Their path into the insurance business, up until this point, has been a rather particular one, with the exception of Guggenheim’s purchase of Delaware Life in 2012. The general playbook was to buy a company with a significant stockpile of general account assets tied to products where profitability hinged on spread rather than underwriting or financial guarantees. Nontraditional carriers could easily employ investment tactics that took advantage of either their appetite for more risk, disregard for ratings or supposed investment prowess to generate a bit more spread and, thanks to the magic of leverage, a lot more profit.

But another way to increase spread was to move the economics of the domestic insurers they purchased via reinsurance to a (usually) Bermuda-based reinsurer also owned by the (usually) Bermuda-based holding company to take advantage of a host of clear tax advantages and some often-downplayed reserving advantages. You can see this tangled web in Schedule S Part 3 of the statutory filings for the writing entities owned by Athene and Global Atlantic. Almost all of their domestic entities dump massive amounts of liabilities over to a Bermuda reinsurer. All of that makes sense. These nontraditional firms are doing what they do best – playing the spread and conducting a bit of regulatory and tax arbitrage to magnify gains on a leveraged position. It’s not quite as easy as picking up money on the street, but in the insurance world, it’s just about the closest thing.

Before I move into the recent interest of nontraditional firms in VA with LB business, I think it’s worth taking a few minutes to talk about Bermuda reinsurance or, as a friend of mine in this business likes to say, the “Bermuda advantage.” I recommended that he make golf shirts with the slogan on the sleeve because it’s so damn marketable. It’s also materially distorting the market. Both Global Atlantic and Athene, but particularly Athene, are making a killing providing reinsurance deals to US domestic insurers and kicking back some of the Bermuda economics via a ceding commission. The way it works is pretty simple and is, for all practical purposes, like any other reinsurance deal except with a twist. A domestic direct writer reinsures some amount (50-90%) of its flows in a certain product to Hamilton Re (made up name) under a modified coinsurance and/or funds withheld arrangement. In other words, the liabilities and economics are shifted to Hamilton Re, but the domestic company retains control of the assets and usually places them in a trust, which is standard fare when dealing with an unauthorized reinsurer. But because Hamilton Re is based in Bermuda and therefore has a different tax and reserving regime than the domestic writer, Hamilton Re can kick back some of those benefits to the domestic direct writer via a ceding commission. Voila. It’s like being able to financially spend half the year on the pink beaches of Bermuda and the rest in the Iowa cornfields you call home. If you’re a real dork and want to see one of these transactions in action, pull American Equity Life’s 2016 statutory filing and look at pages 43, 44 and 77. You can also see similar transactions in the books of Athene’s domestic direct writing subsidiaries.

The impact on the economics of the direct writer from one of these transactions can be massive. Let’s just say that your up-front capital cost in year 1 for writing an FIA is 7% and your annual estimated profit spread is 1.15% (round numbers and rough math, here). Your IRR is somewhere around 12%. If you split the economics with a reinsurer 50/50, the IRR stays the same. But if that reinsurer spots you an extra 1.5% in ceding commission just in the first year, your IRR goes to 25%. So let’s say you’re a midsized, capital constrained company owned by people who like high rates of return. This seems to be the biggest no-brainer of all time. No surprise, then, that some of these firms are going whole-hog into the deal. You’ll notice that American Equity is reinsuring, I kid you not, more than 80% of its flows to Athene on some of its products, particularly MYGAs. They’re basically a glorified distributor for those products because the economics are dependent on the ceding commission, which looks a lot like a distributor override. Lots of grey lines, these days.

Now, of course, the direct writer can decide what it does with the ceding commission. It can keep it as profit. It can run a rate special on a MYGA. It can sell an FIA with higher caps. It can offset better living benefit riders on an FIA. And this is the problem – these products are all commodities. Sooner or later, the profit from the reinsurance deal stops going to the bottom line and starts going to maintaining your competitive positioning. Increasingly, a Bermuda reinsurance deal is a requirement for having a competitive MYGA and FIA offering and even the big companies are starting to get into the game. Lincoln just sent out a press release heralding their new reinsurance deal with Athene a few weeks ago. What does that portend? You guessed it, follow up comments from Lincoln talking about how they’re going to make a big play in the FIA space. This type of publicity and competitive pressure is going to mean nothing short of a bonanza for Bermuda firms facilitating these types of “flow” reinsurance deals. In the announcement, Athene noted that it has 18 such arrangements in place, which would account for a significant number of major players in the MYGA and FIA space.

It looks like nontraditional firms have a good thing going. They’re making spreads. They’re building businesses. They’re growing quickly. So why, then, are some of these firms suddenly clamoring to buy VA with Living Benefit blocks? Again, with the exception of Delaware Life, VALB has not been part of the playbook. So I’m going to speculate – a lot – in the next post about what they’re up to. Regardless of whether agree with my opinions or not, the fact that any VALB block is changing hands these days is a notable event and worthy of some discussion.