Too Boring to Fail? Insurer Investment Strategies Yield Higher Returns but Pose Greater Risks

Big and boring.? Those two words have traditionally described the use of annuities as investment vehicles.? Annuities remain “Big” – US issuance is expected to top $360 billion this year, breaking a record set last year and adding to the whopping $3 trillion of annuities currently in force in the US.? But the old, boring business model for companies selling life insurance and annuities has largely been replaced by one that assumes greater risk in search of higher returns on equity.? As risk increases in this enormous market, some observers have sounded alarms about the potential for systemic disruption.

The investment strategies of life and annuity insurers remained straightforward and similar for many years. Using actuarial estimates backed by reams of data, insurers could calculate with precision when they would be required to pay the obligations created by their policies.? They would use this information to invest in assets whose maturities largely matched the payout dates.? Their investment portfolios tended to be dominated by long-term, fixed-income investments.? Insurers’ earnings were a function of the spread between returns on those investments and their policy obligations.

Two factors have changed this picture. First, life and annuity insurers replaced banks as purchasers of higher risk assets.? After the 2008 financial crisis led regulators to impose more restrictive capital regimes on banks, they abandoned investment models that used short-term credit to fund long-term, higher risk assets (including the residential mortgage backed securities (RMBS) that were at the center of the crisis).? Banks returned to using deposits to fund commercial and retail loans and other, much safer assets.

Financial engineers saw opportunities in this transition, however, and ramped up the creation of Collateralized Loan Obligations (CLOs) that bore many similarities to the RMBS securities that led to the financial crisis. These vehicles aggregate commercial loans in a pool and then slice them into tranches, with some being rated Triple A and some — so-called “mezzanine” tranches — bearing a lower rating.? The issuer retains ?a residual risk component, often the lowest rated piece.? CLOs became extremely attractive to life insurance and annuity insurers.? Mezzanine tranches generated much higher yields than comparably rated corporate bonds.? Different regulatory regimes resulted in much lower capital charges for CLO investments held by insurers than the same investments would require if held by banks.

These factors created a market that bears an unsettling resemblance to the RMBS market prior to the financial crisis. Securitization sponsors – many of them affiliates of life and annuity insurers — bundle and slice loans to create CLOs.? Insurers, using the strong cash flows generated by policy premiums, finance purchase of mezzanine tranches through short-term funding, including private funding agreements and Federal Home Loan Bank advances.? Insurers then hold the CLOs against the long-term liabilities created by their policies, yielding a spread much higher than that generated by traditional corporate bonds.?

As a result, insurers have come to dominate the CLO market.? A Federal Reserve study reported that life and annuity insurers held $115 billion in CLO tranches rated lower than AAA in 2022, and held just over 25% of all leveraged loans in CLO vehicles.? The Fed study noted that life and annuity insurers have effectively replaced banks in the role of maturity and liquidity transformation in this market, but without the same level of regulation or supervision – becoming part of the shadow banking system.

The attractiveness of this investment strategy also led to the second factor transforming life and annuity insurer investment strategies – the entrance of private equity.? Private investors can acquire existing insurers or books of business and significantly increase their rate of return by adopting a CLO-heavy investment strategy. Buyers can further improve returns by offloading life insurance liabilities to Bermuda reinsurers, which have significant tax and regulatory advantages over US-domiciled companies (Insurers tend to retain annuity liabilities, which have low mortality risk, and thus allow insurers to operate with a smaller capital cushion). Private equity companies have found that they can participate in the CLO market through investments by life and annuity insurers at a much lower cost of capital than if they raised and invested funds directly in the CLOs.

All five major private equity firms have made recent acquisitions of life and annuity insurer assets, totaling 15 to 50% of their assets under management, according to a study by McKinsey.? The same study found that by the end of 2022, private equity owned $900 billion of life and annuity assets in Western Europe and North America.? That amounts to 12% of all such assets in the US, including one-third of all net written premium for indexed annuities. Many legacy life and annuity providers have either exited the business or sold closed blocks of old policies to private equity investors.

These two factors have combined to greatly increase both the returns of investors in life and annuity insurers as well as the credit and liquidity risk of their investment portfolios.? This higher risk profile makes them more vulnerable ?to external events.? As the failure of Silicon Valley Bank demonstrated, rising interest rates can create volatile and unpredictable financial conditions. Annuity holders who wish to exit their contracts may be more willing to pay surrender charges if they can reinvest their principal in higher yielding products.? Early surrenders can create maturity mismatches in investment portfolios, creating a liquidity crunch. Insurers may be forced to sell assets at unattractive prices to fund redemptions.? An Italian life insurer, Eurovita, failed in 2008 after a wave of early annuity surrenders. State guaranty associations protect annuity holders in the event of insurer failures in the US, but would have difficulty withstanding a default by a major insurer.

The size of these investment portfolios not only makes them more vulnerable to systemic financial risk, but could create risks to the system itself.? Higher interest rates, if combined with unfavorable economic conditions, could lead to a rise in corporate bankruptcies.? Insurers holding mezzanine positions would be forced to assume a larger share of these losses than holders of Triple A tranches, as well as the residual risk share held by their issuing affiliates. A 2019 Federal Reserve study noted that even relatively small losses in CLOs and other non-traditional investments could have a major impact if institutional investors get cold feet and are reluctant to continue to advance short-term funding to insurers.? Two large insurers, AIG and The Hartford, were required to seek government assistance in 2008 when they were unable to roll over the short term funding that supported their RMBS portfolios.

As annuity sales continue to rise and insurer investment portfolios of long term assets funded by short term debt continue to grow, so does the risk of an event or a failure that would spread throughout the financial system.? Regulators have taken note.? The National Association of Insurance Commissioners (NAIC) recently developed stress tests for regulators evaluating insurer liquidity needs and CLO holdings.? But insurance regulation in the US is a patchwork, spread among 50 states and the District of Columbia, and these additional precautions cannot be universally applied.? On the federal level, the Financial Stability Oversight Council (FSOC), a creation of Dodd-Frank, has issued updated guidance on its process for designating nonbank financial companies that pose a potential threat to the viability of the financial system.? A company that receives this designation would be subject to prudential and capital supervision by the Federal Reserve, similar to a bank holding company.? But all four of the nonbank companies that previously received this designation (including three large life insurers) ultimately escaped Fed supervision.

?Annuity investors seek security and predictability.? The investment strategy pursued by life and annuity companies fulfilled these goals for many years.? Recent developments have made these companies more profitable for their shareholders, but have created new risks for their policyholders and for the overall financial system.? While no large insurers are in acute financial distress today, annuity purchasers will need to more closely examine the financial viability of their provider.? Regulators must begin to view these companies for what they have become – another extension of the shadow banking system.

?The Fed studies of insurer reliance on CLO issuance and insurers as shadow banks are available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr975.pdf?sc_lang=en

and https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3534847

The updated FSOC guidance on designation of nonfinancial companies as systemic risks is available at https://home.treasury.gov/news/press-releases/jy1876

?My podcast, “Risk Management for Financial Institutions - How Banks Stay Safe and Sound,” is available at https://youtu.be/2kNWCLQp678.

?Fred Egler is an independent consultant who advises on operational risk issues at financial institutions, including banking, securities and insurance. He is also a member of the National Roster of Arbitrators of the American Arbitration Association.? He can be reached at [email protected].

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