Life insurance companies do not always make a profit from the insurance underwriting portion of the business. Most of the profit comes from investing the policyholders’ premiums and realizing the financial returns. In a way this amounts to a double-edged sword of risk taking—first in the underwriting of insurance policies, and secondly in the management of investments. The trend as of late has been for the insurance companies to hand over the second part of the risk taking to private-market firms, who manage the assets for a fee. But is it a wise idea for those responsible for payment performance on insurance policies to leave the profitable part of the business to an outside firm?
Regulation is Managed at the State Level: In the U.S. the insurance industry is regulated at the state level and not the federal level. Various regulatory standards can be different from state to state, and most policy holders that move from one state to the next would do so without a clear understanding of those differences. State insurance regulators often move at a slower pace than private-market firms, who are quicker to take advantage of loopholes or lapses in industry regulation. The National Association of Insurance Commissioners (NAIC) is the regulatory body that sets generally accepted standards for the industry as a whole including maintenance of capital reserves. The NAIC has also taken the mantle to research and investigate aspects of how assets are managed with respect to industry standards. In that the NAIC is a nationwide organization that is not a part of the federal government, it is subject to differences of opinion on policy by constituent members from the various states.
Annuities: In the U.S. the fixed annuity industry is now at $1.1 trillion. The purchaser sends a certain amount of money on a one-time basis to the life insurance company that provides the annuity, and then receives a regular payout for the remainder of his/her life. Life insurance companies traditionally invest these one-time payments into the bond market at higher rates of return earning the spread. However, much of this investment activity has moved to private-market firms. As a precaution, annuities typically have “surrender fees” to retard the early withdrawal of funds by the annuity holder. This has led the private-market managers to invest the funds into higher-yielding, lower-liquidity assets such as structured securities that are backed up by pools of loans, shifting away from the easily tradable bonds. The NAIC reports that about 29% of the bonds under management by private-market firms are structured securities versus 11% for the industry as a whole. This asset class has had problems dating back to the Financial Crisis of 2007/8 with collateralized debt obligations (now called collateralized loan obligations) being sold as class AAA securities when in fact the loan pools backing them up contained shaky, risky, loans. Some of the problems still exist in the form of valuations of structured securities that are categorized as “level 3”, or without clear market values.
Reinsurance: There are several different methods of reinsurance that generally serve one particular purpose—to pass a certain amount of insurance risk from the underwriting life insurance company to the reinsuring company for a fee. Often this is performed via treaty reinsurance contracts that are not done for one specific risk, but instead for a bundle of various risks. Some of the larger private-market firms own reinsurance companies located off shore in places such as Bermuda where regulators are more accommodable. They will then direct the assets backing huge amounts of life insurance to be ceded to the offshore reinsurance company to collect the fees. This of course is in addition to the fees they collect from managing the life insurance company’s assets in the first place. Moody’s Investors Service points out that at the end of 2022 the amount of offshore reinsurance from life insurance companies was about $800 billion.
The Case for Risk: Many of larger private-market firms invest the client’s premium monies into structured securities that are represented by tranches (segments of the total loan pool). Tranches can be segregated in several different ways, but in any case, the client life insurance company’s own management may not be completely aware of what their money is ultimately being invested in. Securitization often pertains to real estate loans, but also can include corporate loans bundled together. The bigger the bundle, the more difficult it is for the life insurance company to understand the underlying risks. The bigger the private-market firm, the more likely the firm would be to own some of its reinsurance companies. The bigger the size of the reinsurance deal—Lincoln National’s $28 billion deal with Fortitude Re, MetLife’s $19 billion deal with KKR’s Global Atlantic—the greater the risk of losses that the client’s management could not see beforehand as their investments were no longer under their control, and transparency did not exist. It may reach the point where the capital strength of the entire industry is impaired. The Federal Reserve’s research has shown that the life insurance—private-market management connection leaves the insurance industry more vulnerable to such shocks as another pandemic might bring. All of these creative methods designed by private-market management to ameliorate risk have yet to be stress tested in a manner similar to what banks face over their loan books on a periodic basis.
Conclusions: The trend of outsourcing their investments to private-market firms does not eliminate risk for the insurance companies—it only passes it down to different management. But the watchdogs for private-market firms are having a more difficult and uncertain time monitoring their activities. This adds up to amounts of risk that are difficult to evaluate for insurance companies and their policy-holding customers.
Sources: The Economist, In for a Trillion, January 27th, 2024.
Investopedia.com.