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A risk worth taking?

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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.

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.

In this scenario, significant profits can be made by both the private equity firm – based on an initial investment of only $50 million (5 percent) – and the outside investors. However, the profits don’t tell the whole story of a private equity fund. Taking more market risk is often necessary to achieve the robust returns expected by investors (generally 15 percent to 20 percent after expenses). To meet these high return hurdles, firms are constantly challenged to look for investment yield, and they often find it by taking greater risk.

For private equity funds buying into the annuity business, the annuity products offered by the insurers they own tend to have rich product benefits designed to attract new customers. These customer dollars can be used to invest in higher-risk investments, including other affiliated investment vehicles, which in turn help generate greater returns to the fund investors. The concern from many financial professionals is that these high-risk investments ultimately support the product guarantees. This higher risk profile speaks to a larger strategy and ultimate goal of generating returns for the fund’s investors.

To summarize, the typical private equity firm generally takes on very little risk itself, based on its initial cash contribution, but might incorporate a higher level of risk within its investments (a part of which may be annuity assets from its insurance holdings) in order to generate larger returns for the fund and its outside investors. At the end of the day, the normal incentives of a private equity firm are to maximize the value of its investment over the short-term so that it can realize its investment and any associated gains. The long-term stability or backing of an annuity contract may not fit well with this risk profile.

The insurance company model

The typical insurance company, on the other hand, strives to deliver strength and stability to both shareholders and contract holders via a consistent and dependable return. This philosophy has an impact on its risk profile and how an insurance company makes decisions.

Managing risk is essential for insurers and contributes to their overall financial strength. Attributes such as strong ratings, efficient asset-liability matching, strong risk modeling and extensive risk management capabilities help insurers maintain stable, high-quality returns to both shareholders and contract holders. Because they aren’t as concerned with short-term gains or meeting investor demands, insurers focus on long-term investments that help protect policies against extreme market events for the duration of the contract. In fact, a conservative investment strategy that seeks steady, reliable performance is the preferred model within the industry. Some may argue this is old-fashioned, but insurers believe this model is an integral aspect to fulfilling their long-term promises.

What does it mean for you?

Financial professionals should consider many factors when choosing the products they offer clients to help meet financial and retirement goals. If a client is seeking the guarantees available via an annuity, the risk profile and approach of the backing company should certainly be part of the evaluation. Independent rating agencies regularly analyze carriers’ financial results and evaluate management’s objectives and strategies. We believe the best insurers work diligently to earn and maintain consistently high ratings, which speak volumes about their ability to deliver on their promises.

Hopefully, your client will be able to enjoy a long retirement where they can utilize the results of the careful planning and sound strategy that you helped to execute. Clients rely on financial professionals to guide them through the complex retirement landscape and provide solutions that can offer a level of retirement security. Annuities can deliver that benefit, but not all annuities are created equal and some may be vulnerable due to the amount of risk the carrier has in their investment portfolio. Keep in mind, your personal reputation is tied to the annuities you offer to your clients. So when selecting the appropriate product for your client, you have to ask yourself, how much risk are you willing to take?

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