S&P Global Ratings believes that the involvement of alternative capital in the U.S. life insurance sector could double over the next two to years.
The most recent merger and acquisition (M&A) announcements in the U.S. life insurance sector has seen increased involvement of alternative capital investors. This is not the first time we have seen interested acquirers who aren’t traditional insurers (i.e., alternative capital), nor do we believe it will be the last. All major stakeholders, including insurers, insurance agents, brokers and regulators will have to adapt to this new paradigm.
At the end of 2017, we estimate over $100 billion in insurance liabilities were held by insurers where alternative capital owned a majority equity stake. This is slightly less than 5% of the total life insurance liabilities in the U.S. We believe this level could grow meaningfully, mostly due to the seeming increase in the alternative investors’ risk appetite and the available supply of relatively riskier, longer-tailed liabilities.
Alternative capital is usually attracted to insurance products or liabilities that accumulate assets. In the past, most of the acquisitions have involved liabilities such as fixed annuities. But, the two recently announced acquisitions by investor consortiums—Voya Financial Inc. ‘s closed block of variable annuities (VA) and Hartford Financial Services Group’s run-off life and annuity block—demonstrate that outside money is now willing to take on more-complex legacy liabilities.
Both Voya’s and Hartford’s blocks contain VAs with guaranteed living benefit. Such VAs are generally more complex, more difficult to hedge, and have more potential for capital and earnings volatility than its fixed annuity cousin. This very riskiness perhaps makes pricing more favorable for the alternative investors. We also believe the prospect for inorganic growth is much greater, since the industry definitely has plenty of such complex legacy blocks that they would be happy to divest.
But, the question is, does the increased involvement of alternative capital help or hurt the credit quality of the U.S. life insurance sector?
We view alternative capital as providing much-needed breathing room, at least in the short-term, for a sector where certain legacy risks are coming home to roost. Many years of historically low interest rates, coupled with policyholder behavior not being in-synch with pricing assumptions, haven’t made things any easier. Even when managed well, such risks can exacerbate capital strain and increase volatility in earnings. Our ratings are generally constrained on insurers that have meaningful exposure to such legacy risks. Shedding these risks can help insurers focus their capital and resources on their core businesses. Additionally, equity valuations for publicly traded insurers could also see an uptick, since public markets generally discount for these kinds of legacy risks. This derisking path, which is likely credit positive for these insurers, has been made possible to a great extent by alternative capital.
Such near-term breathing room is a boon for the sector. But, what about longer-term credit implications? Just because the liabilities have changed hands, doesn’t mean that they have left the insurance industry. Policyholders still expect to receive their guaranteed benefits no matter which insurance entity is holding their policies.
The longer-term credit quality question is a bit more complicated. It involves market conditions, knowing both the investment strategy and exit strategy of each alternative capital investor, and appreciating the contagion effect of an insurance entity’s failure.
Depending on the level of market stress, the strength of reserves at the point of sale, and ongoing hedging strategy, we think the new owners will likely be able to manage these legacy risks successfully. Of course, the return timeframe for the investors will have to be longer, and a well-planned exit strategy or a patient dividend plan is needed to support any return expectations. In a benign-to-moderately stressed environment, we believe the illiquidity premiums for taking on these complex risks should be available to the alternative investors.
But, then there is always the low-probability, but high-severity “fat-tail” scenario. These legacy risks are sensitive to tail risks and are exposed to policyholder behavior assumptions that can’t be hedged. If not appropriately hedged and adequately reserved, such tail events will likely require an infusion of additional capital. Under this scenario, not only do alternative investors not get their expected returns, they now need to put up additional capital. If they are unwilling or unable to make the additional commitment, their fast—perhaps damaging—exit could leave the industry vulnerable to contagion risk. Unlike corporate entities that are able to file for bankruptcy, a failing insurance company is taken over by the state regulator. This is followed by a long process that results in healthy insurers having to pitch in to pay the failed insurers’ policyholder liabilities.
As alternative capital spends more capital and time in this sector, learnings from their longer-term involvement will have a meaningful impact on analyzing sector credit risk, regulatory oversight of such transactions, and ongoing interactions between insurance agents, brokers and policyholders. Armed with these learnings, their interest in complex risks will evolve. For now, without any fat-tails wagging, we believe alternative capital is set to double down on the life insurance sector.
— Read Analyst Sees ‘Great Restructuring’ of Life Industry, on ThinkAdvisor.
Deep Banerjee is a director and sector lead with S&P Global’s Financial Services Ratings Group.