#72 | The New PE Gamble – Part 2

Over the past few weeks, there has been a fair bit of press over two acquisitions of VA with Living Benefit blocks. Hartford has confirmed that it is selling its operating unit Talcott Resolution to an investor syndicate anchored by Global Atlantic. Talcott holds mostly VAs with Living Benefits and a reasonably large Private Placement Life Insurance block. It also has the reinsured shells of businesses that it has previously sold, most notably Hartford’s Individual Life business that has gone to Prudential. Recall that Hartford was an early innovator in the VALB space and, for a time, one of its dominant players before Hartford got its clock cleaned in the crisis and had to take TARP. The WSJ broke a story that Voya is in talks with Apollo (which owns Athene) to sell $50B of assets under management, apparently mostly VALB. Voya is operating its old VALB block as a runoff segment called CBVA. I pulled the filings for Voya and it looks like CBVA is only about $20B of assets, so there are likely other things in the mix. More on this later. But, the shocking thing is this – like I said in the last post, Global Atlantic, Athene and their ilk have mostly stuck to financial engineering behind simple products to make money. Now, they’re tackling the most complex of all products with these acquisitions. So what are they up to? Again, allow me some room to speculate.

First, and foremost, these VALB businesses are being sold at a discount to book value. This is not surprising given that the general narrative is that VALB blocks are the stone around the neck of the firms that have a lot of it on the books. Dumping a VALB business at half of book value might actually boost the stock of the company unloading it. For the acquiring company, they are getting something that’s technically half off. That’s why the stock prices of both Voya and Athene popped after the news came out in the WSJ last Friday.  The market obviously thinks that Athene can do more with Voya’s run-off VA business than Voya can.

Which leads me to my second point – Bermuda. It will be immensely interesting to see the structure of these two deals. Acquisitions in the insurance business tend to take two forms. They’re either reinsurance or they’re an actual acquisition of the writing entity. For example, Prudential’s purchase of Hartford’s life business was actually a reinsurance deal. But it looks like the Talcott Resolution deal will actually move the subsidiaries to new ownership. The press release says that the investor syndicate led by Global Atlantic is buying Hartford Life, Inc, which is the holding company of the subsidiaries that make up Talcott Resolution. In order to complete the trade, they’re actually moving functions out of those entities, which implies that the rest of the entity is being sold. Why is that important? Because that means that the acquirer will have quite a bit more latitude over the liabilities. I’m going to grab two disparate things together and make a completely unsubstantiated guess. There’s a lot of change to VA reserving in the cards. Doing offshore reinsurance deals, if you’re a domestic insurer, to offload your VA liabilities will be harder. So why not sell your runoff VA liabilities to an offshore reinsurer before the rules change? Seems like a smart move.

The proof will be in the pudding if Voya and Athene do an entity acquisition rather than a reinsurance deal for a specific block. The details on Voya’s transaction with Athene are still confidential, but it looks like something like $50B of assets are in play, most of which is VA with LB. If it’s a full entity sale, then my bet is that the entity will be Voya Insurance and Annuity Company, which is where the individual CBVA business sits and is currently being reinsured to some Arizona captives. Voya wrote in its 2016 annual report that it fears that the AZ captives will no longer provide relief for its VALB business after the reserving changes take place. Sounds like a great time to sell it to a company domiciled in Bermuda. Hence, the reason why both stocks have appreciated since the word got out. Not because Athene will know better what to do with Voya’s runoff business, but because Athene is in Bermuda.

The last piece is, I think, the most important and the least clear. A key part of the winning formula for these nontraditional firms has been making their nut on the asset side of the business rather than the liabilities side. In other words, all of these companies hide extremely complex financial games behind pretty benign and simplistic products like MYGAs and most FIAs. In their world, the product is simply a means to gather the assets so that they can do more of the sexy stuff to make more spread. End of story – right? Well, apparently not, because now they’re making a play to buy VA with Living Benefits blocks. VALB is about as complex of a liability as you can imagine, even if the product itself is not that complicated. Profitability hinges on a host of factors spanning interest rates, fund performance, fund restrictions, managed volatility structures, sequence of returns, volatility regimes, hedging, policyholder behavior and longevity, just to hit the big ones. And, of course, all of these things have interrelating qualities that spawn new variables of their own, driven just by the covariance of one or more factors. Ah and, of course, you have constant regulatory, competitive and demographic pressures as inputs. To use an analogy, nontraditional firms have been drawing stick figures and now they’re thinking about building fully immersive virtual reality worlds. The skills in one do not translate to the other.

But, if you ask any individual actuary (especially consulting actuaries), you will probably get the impression that VALB is not actually that complicated because, see, we have this wicked good model over here that will show you all of the cash flows so you can know the value of the block and the pressure points. The problem is that the model that actuary is using is not the same as the model the actuary across the river is using. I’ve seen full-on VA models and I certifiably guarantee you that every model has errors in it, some of which are trivial and some of which are, let’s just say, not so trivial. That’s inevitable when you have a model built on hundreds of thousands if not millions of lines of code cobbled together over many years and by many people. Even if you can get your model pinned down, good luck in trying to document and standardize all of the embedded assumptions buried deep, deep in the mechanics of the model. Pricing a VALB is kind of like looking at a map and saying “see, all you have to do is walk from here to there” without actually being able to see the terrain. Every year, you trudge a few miles and you start to see all sorts of things that don’t appear on your map. Don’t believe me? Just look at all of the carriers taking huge losses (and sometimes gains) from actuarial updates to their VA assumptions. There’s no such thing as a sure thing when it comes to VALB.

So, admittedly, I still haven’t said why I think they’re interested in these blocks because I think there are a range of answers. Maybe they feel like they’re just getting a steal on the price. Maybe they have a strategy to move this stuff over to Bermuda to get regulatory and tax relief. Maybe they think they can manage these blocks better than the insurers that currently own them. And maybe, just maybe, they’ve seen the bet that any VALB represents – massive upside potential, massive downside risk – and they like it. If you’re a moderately capitalized investor syndicate with no real ambitions to maintain sterling credit ratings, taking on a polarized risk profile might be a pretty smart bet. If things go well, you make a killing. If things go badly, well, you just dump the entity onto whoever might step into the gap. That’s why I’ll be quite interested to see what the regulator reaction to these deals will be and the appetite of regulators to allow risky blocks to float from well-rated companies to not-so-well-rated companies. But they’ve let that happen before, so they’ll let it happen again. Maybe, surely, these companies know something I don’t. However it pans out, these VALB acquisitions represent a sea-change in thinking about those blocks and could portend a dramatic shift in the VA landscape, especially if Global Atlantic follows through on its insinuations that it will run Talcott Resolution as a new business franchise.

Final word. If these companies experience any measure of success, others will follow. More importantly, other liabilities will follow. There are plenty of asset-heavy liabilities with huge risks attached to them that traditional insurers would like to dump, not the least of which is Guaranteed UL. There’s not much of a market for acquiring in-force GUL blocks because of the reserving issues, but deals like what might happen with VALB could pave the way for GUL acquisitions as well. And that’s when things will get really interesting.