Recent comments from Benjamin Lawsky, New York Superintendent of Financial Services, shined a spotlight on concerns about private equity firms investing in the life insurance industry, particularly the annuity business. “Private equity firms follow a model of aggressive risk taking, high leverage, typically making high-risk investments,” Lawsky noted during remarks at the recent 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in New York City. “This type of business model isn’t necessarily a natural fit for the insurance business, where a failure can put policyholders at significant risk.”
The issue of private equity investment into insurance has spurred a healthy debate. Many financial professionals have voiced concerns about the commitment of private equity owners to the business and whether they can meet their long-term commitment to the contract holder. Will they, at some point, pare back operations and product benefits in order to generate a higher return on investment? For their part, private equity firms claim that their asset management expertise will benefit the industry.
So what’s the truth behind all of the activity?
At this point, it is impossible to say with certainty. But contract holders and the producers who sell annuities from these companies have reasons to be concerned and need to watch future developments closely. The choice they are making has long-term consequences that can affect the contract holder’s pocketbook and the producer’s reputation.
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One way to better understand this choice is to compare the historical risk profile of both private equity firms and insurers to gain a better understanding of what their goals have been in the past, and how that may inform decisions they choose to make in the future. After all, those goals – whether they are to meet profit targets for shareholders or establish stable performance for the benefit of contract holders – are strongly connected to the assets they hold, where they make their investments, how much risk they are willing to take, and ultimately, what contract holders can expect.
A private equity primer
A key aspect of a private equity fund is the investment structure used to raise the capital necessary for large investments. The vast majority of this capital doesn’t come from the private equity firm running the fund, but rather from outside investors who buy in, looking for healthy returns on their investment. The typical private equity firm contributes 1 percent to 5 percent of the cash for a private equity fund, so the bulk of the investment comes from outside investors.
The lifecycle of a typical private equity fund has several distinct periods that inform the end goal of creating returns for outside investors. After funds are raised from outside investors, investments made during the early years of the fund’s life, referred to as the investment period, are typically held between three and six years. After the investment period, where the investments are closely monitored, an exit strategy is executed, often in the form of an IPO or strategic sale.
Private equity funds usually have several revenue streams. The most prominent are performance fees, which are generally structured at 20 percent of the gains of the fund, once a specified hurdle return rate (internal rate of return, or IRR) is met, which is generally 7 percent to 9 percent per annum. But there are also management fees, typically fixed at 1 percent to 2 percent on committed capital for the duration of the investment period as well as any investment returns from capital invested directly by alternative asset managers.
The high-risk private equity model
Under this fee structure, the private equity firms running the funds have a lot to gain if their investments perform better than the previous asset manager was able to achieve – whether that asset was a block of annuities or a sports franchise. For example, if a private equity fund made an investment of $1 billion, and that investment earned an additional $1 billion, the fund would stand to earn $200 million in performance fees and up to $20 million in annual management fees. This is typically referred to as the 2/20 rule in the asset management world.