#289 | The Private Equity Playbook

train in railway

For two weeks in a row, I’ve put my normal article on ice to write something that specifically addresses articles released by other publications that are, you know, a smidge more prominent and have a slightly larger readership than The Life Product Review – such as Bloomberg and the Wall Street Journal. Last week, the topic was Private Placement Life Insurance. This week, the topic is private equity firms snapping up life insurance and annuity blocks and companies. This is not normal. For the most part, life insurance never hits the press radar except once in a blue moon. But two weeks in a row? Unfathomable. I’m not quite sure what to make of it.

Regardless, here we are. The Wall Street Journal’s article on September 21st addresses the recent spate of M&E in the life insurance and annuity space, tracing it back to 15 years ago Jim Belardi and Chip Gillis pitching Marc Rowan of Apollo on the concept of a Bermuda-domesticated insurer that would buy blocks and write new business. The new firm would be called Athene and it would go on to be a juggernaut by scooping up blocks and reinsurance deals across the industry. Its success has spawned a whole crop of companies using a similar strategy, all hoping to become “the next Athene.”

I wrote about Athene and these new crop of insurers in late 2017 in two articles – The New PE Gamble Part 1 and Part 2. The articles describe, in detail, the basic PE-backed insurer model and how these firms were beginning to transition the model to buy more exotic and risky insurance liabilities. The closing paragraph of Part 2 reads “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 [Variable Annuities with Living Benefits, VALB] could pave the way for GUL acquisitions as well. And that’s when things will get really interesting.”

Well, those VALB transactions did happen and things have gotten very interesting. But before I get to that, I think it’s important to lay some basic groundwork about the nature of these “new” insurers. In general, life insurance companies can have two types of ownership structures – stock and mutual*. If you look at an org chart (Schedule Y of the statutory filing) for New York Life, MassMutual, Northwestern Mutual, Guardian or PennMutual, you will see that the very tip-top of the chart is a mutual life insurance company. Everything that happens at these insurers happens within the walls of the mutual company and structure.

If you look at the org chart of a stock life insurer, you will often find a non-insurance corporate entity – a holding company – at the very top. For “stock” companies, the holding company has shareholders and is publicly traded, such as Prudential Financial, Lincoln Financial or American Financial Group. At mutual holding companies, the holding company is structured as a mutual company with shares owned by the subset of participating policyholders at the stock life insurer subsidiaries. The only time you won’t find a holding company above a stock company is if the stock company is privately owned or has shares that are directly traded, as American National was until a couple of years ago when it reorganized and put American National Life Insurance Company under a publicly traded holding company, American National Group, Inc.

The distinction between a life insurance company and an insurance holding company is not just a technicality. It’s the key to understanding what’s been happening with all of these new insurers – excuse me, new insurance holding companies (IHCs) – that have burst on the scene since Apollo backed Athene. For IHCs, life insurance companies are assets. They have value in either the in-force block that comes with the life insurer or they have value in being able to facilitate new retail sales or reinsurance transactions. Life insurers are the vehicle that allows insurance holding companies to deploy capital. The story of M&A in today’s life insurance industry isn’t about life insurers – it’s about holding companies.

And where does that holding company capital come from? If you wanted to blurt out “private equity!” then hold your horses for a minute. It’s more complicated than that. Private equity is traditionally built around limited partnership funds where the capital is supplied by the PE firm and by limited partners, the investors in the funds. These funds have mandates. They have timelines. They have liquidity provisions. When a company is bought by a private equity fund, the assumption is that the PE firm is going to do its thing to “add value” and will sell the company later, hopefully at a profit that is shared by the rest of the fund.

That model strikes fear in the heart of people in the life insurance business because the perception is that these staid life insurance companies are being bought by PE funds and then flipped for a short-term profit after the firm has “added value” in the form of stripping capital from the insurer via complex reinsurance transactions and screwing customers by changing non-guaranteed policy elements. To be clear, that can happen and has happened. It undoubtedly will keep happening. But my view is that situations like that are going to be the exception, not the rule.

Why? Because the reality is that what we call a private equity company – even an exceedingly well known private equity firm like Blackstone – does much more than what I described above. These firms have morphed into full-fledged asset managers, usually through being opportunistic or by acquiring firms along the way that became integral to the functioning of the enterprise, not a business to be fixed and flipped. These firms are managing investments for other institutional investors and leveraging their considerable expertise in sourcing non-traditional investment opportunities for their institutional clients, usually in a size that’s just small enough or in markets that are just exotic enough to not catch the interest of larger asset managers catering to retail investors.

Furthermore, these firms are becoming so large that they have significant amounts – sometimes tens of billions of dollars – in firm capital to deploy that is unrelated to a specific fund. That capital isn’t bound by mandate. It doesn’t have a timeline. It doesn’t have liquidity issues. That capital is meant to be deployed to deliver the right return over a wide range of time horizons and conditions. It is opportunistic capital meant to grow the firm itself, not just earn fees managing assets for other institutional investors or get a spiff on a limited partnership fund.

In other words, these private equity firms are probably better described as institutional investors with services to offer. That’s the pitch that got Apollo excited about Athene. The insurance business itself could generate significant long-term profits and Apollo could earn a fee managing Athene’s assets by leveraging its considerable skill in sourcing specialty investments, particularly in credit, which is what fuels all insurer balance sheets. The other service they can offer, of course, is reinsurance through other owned insurers – particularly reinsurance in tax and capital friendly jurisdictions like Bermuda, which can wring profits out of an otherwise moribund block of business.

This view of private equity is not nearly as terrifying. At their best, these firms are long-term buyers of life insurance companies with the intent of making money by writing profitable business and managing the assets for decades, perhaps with a bit of tax and capital relief through reinsurance as well. Their goals are not so different than the goals of stock life insurers. And it’s really not a complex model, nor is it difficult to figure out why institutional investment firms – including those that have no affiliation with private equity – are so attracted to our space. They think they can source high quality, high yield assets in bulk. Selling annuities is a way to make money at both ends of the trade. And if they really do their job well, they’re going to sell a lot of annuities and make a lot of money both by running the business and managing the assets.

It’s hard to fault this model. In fact, as the WSJ article noted, AM Best’s analysis of these firms notes that they tend to hold more cash and capital than their traditional counterparts, which partially offsets their higher asset yields. This is the Risk Based Capital formula at work. If you’re a life insurer and you want to invest aggressively, you have to hold more capital against the investment. That protects the solvency of the company and creates a more level playing field for asset investments. The new breed of insurers simply think that yield from the riskier assets is worth the extra capital.

However, the more you dig, the more you see some wrinkles to this story. The NAIC’s RBC framework isn’t foolproof. The holy grail for assets is to find a low risk, high return asset with an NAIC 1 designation, which means the life insurer needs to hold very little capital against the asset. Some institutional investment managers feel like they’ve found certain corners of the credit market than can deliver those sorts of assets. More common, though, are assets that are moderately risky in some very peculiar ways so that they can still get rated as low-risk and, therefore, have above-market yields with very little RBC capital strain.

The easiest way to make that happen is to use securitized debt, particularly Collateralized Loan Obligations, which I wrote about in #138 – Leveraged Loans & Life Insurance. In the models, these types of securitized debt structures are bulletproof. In the real world, they blow up. Some life insurers are stuffed to the gills with CLOs and other risky credit instruments that pass the NAIC RBC smell test but have real-world risk. Make no mistake about it – life insurers are taking a lot of credit risk. The question is whether or not their capital stocks will be enough when the credit markets hit a rough patch.

If you’ve made it this far, you may be wondering why I’ve been writing about annuities and not life insurance (this is The Life Product Review, after all). The reason is because Athene’s strategy and its many copycats have traditionally not been interested in life insurance. Unlike annuities, life insurance assets are encumbered by actual risk, whether in the form of mortality, morbidity or interest rate risk. And life insurance assets are relatively small compared to annuities. If you’re in the asset-gathering business, selling life insurance is just about the slowest and messiest way to do it. Annuities are much, much faster. Hence, the attraction for these firms to annuities. It’s all about spread.

But it’s increasingly looking like there’s a new playbook for institutional investors in our space – insurance risk management. This is an entirely different strategy that relies on an entirely different set of skills and assumptions. At its core, the idea is that an institutional investor-backed insurer can take on certain risks that traditional life insurers don’t want on their books, even if those risks are backed by nearly dollar-for-dollar capital, as in the case of Prudential and Equitable’s VALB blocks. If the old strategy might be called an “asset-side” strategy, these new entrants are playing a “liability-side” strategy.

In the asset-side strategy, the secret sauce is the ability to source high yield credit and earn an outsized spread. But what’s the secret sauce for a liability-side strategy? Sourcing high yield credit to offset high risk liabilities is like shooting a bullet at a freight train in an attempt to slow it down. It’s a game of basis points. But the liability-side strategy is a game of percentage points, not basis points. Either interest rates go up and you get bailed out or not. No amount of strategic investing on the margins is going to make up for an ultra-low interest rate environment when these toxic liabilities were priced for mean-reversion interest rates.

That leads us to take one of two conclusions – either the firms buying these toxic blocks don’t understand what they’re doing or, even more troubling, they understand exactly what they’re doing. More than a few people who have worked on transactions where toxic blocks are reinsured to institutional investor-backed insurers have told me that the deal was predicated and priced by the acquirer as if interest rates are going to increase, equity markets are going to boom and policyholders are going to do what they’re supposed to do, which is not use the benefits they’re paying for. In other words, these are all the same assumptions that got the life insurers in trouble in the first place. The only difference between the life insurers that wrote the business and the firms buying the blocks is that the life insurers actually understand the risks and the buyers don’t. Yikes.

Even more troubling, though, is the hypothesis that these firms understand exactly what they’re doing and are doing it anyway. They know that these blocks have to be extremely well capitalized because they’re risky. They also know that by massaging some of the assumptions, the “economic” capital of the block can be reduced, allowing that capital to flow back upstream to the investors. They know that it’s easy to find an amenable jurisdiction to host a captive that will give them the flexibility to do it. The whole point of the transaction isn’t to take the risk to do right by policyholders – it’s to strip capital out of the block while retaining the veneer of solvency, all while recognizing that, at the end of the day, someone else is going to be left holding the bag.

Any deal involving life insurance is almost inevitably a liability-side play. The asset base is too small and too encumbered to get asset-side interest. That’s not good news for policyholders. I would have zero qualms buying an accumulation annuity from an institutional investor-backed life insurer actively employing an asset-side strategy. Annuities are short term investments backed by 100% reserves plus capital. Things can go south, but it’s going to take a lot to cause a real problem.

But life insurance policies are meant to be held for decades. If my life insurance policy was transferred to some new insurer playing the liability-side strategy, I would start sweating. The entire goal of that company is to reduce capital held against my policy and pull out dividends. With the asset-side strategy, policyholder and corporate interests are mostly aligned – I want them to earn high yields without blowing themselves up, which is what they want to do too. With the liability-side strategy, the policyholder and insurer are fundamentally at odds. That’s not a great place to be.

The fact is that a raft of new players are getting into the life insurance and annuity business by buying companies or blocks. The names seem to run together – Apollo (Athene), Blackstone (Allstate), Constellation (Ohio National), Venerable (Equitable VA), Brookfield (American National), Resolution (SLD), Fortitude (Prudential VA), Guggenheim (Several), KKR (Global Atlantic), Altamont (Kuvare). But the group should be divided between those primarily focused on asset-side and liability-side strategies. For the asset-siders, their strategy is straightforward and, as far as we can tell, it works. But for the liability-siders, time will tell. And my hunch is that time will not be friendly to them.

Just this morning, Lincoln announced that it is doing a “flow” coinsurance arrangement with Talcott Re, a private-equity backed reinsurance company that was created out of the ashes of the Hartford VA block. The deal is a “first-of-its-kind” in that Lincoln is actively reinsuring the living benefit risk on its Variable Annuities with a third-party reinsurer. It may be the first of its kind, but hardly the last. The arrangement undoubtedly provides capital relief to Lincoln while shunting much of the VALB risk off to a third party. Again, there’s a pertinent question to be asked – is Talcott taking this business because they understand it better than Lincoln? Probably not. But they are very likely willing to make assumptions about future interest rates and equity returns that even Lincoln is not willing to make. And my hunch is that those assumptions are very aggressive indeed.

*This isn’t quite the full story. My understanding is that fraternal organizations are technically different than mutual companies, although they operate nearly identically. It’s also possible to have an employee-owned firm, such as Sammons Financial, which owns Midland National and North American.