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Library: McKinsey – Why private equity sees life and annuities as an enticing form of permanent capital

July 2022 featured report:

This report by McKinsey looks at the growth of private acquisitions of in-force life and annuity books and offers some ideas for those who are thinking about coming into the market.

 The Digital Insurer reviews McKinsey’s Report on Why private equity sees life and annuities as an enticing form of permanent capital

private acquisitions of in-force life

The idea of permanent capital that such books present is, according to the authors, “holy grail” of private investment.

In 2021 private investors announced deals to acquire or reinsure more than $200 billion of liabilities in the United States. And investors such as these now own more than $900 billion of life and annuity assets in Western Europe and North America.

In time, this may mean private investors hold 12% of life and annuity assets in the United States, to the tune of $620 billion. To put that into perspective, that is more than a third of US net written premiums of indexed annuities. That’s big money.

An attractive asset class

The top five private equity firms all have life holdings of between 15% and 50% of their total assets under management. Meanwhile, 15 alternative asset managers have been encouraged to enter – or commit to entering – the market.

This attention has been beneficial to some insurers. By flogging off old legacy books, insurers have been able to improve return on equity and free up capital for reinvestment.

But there isn’t anything new in this. Warren Buffett knows a good deal when he sees one and his at Berkshire Hathaway Group acquired National Indemnity as far back as 1967. That example shows that it doesn’t need to be life and annuities that can serve as a source of permanent capital – speciality and property and casualty will also suffice.

However, most annuities balance sheets offer a straightforward point of entry. These assets need to be invested to generate returns and the cost of servicing those assets should be lower than the returns creating the attractive margin. After all, that was the original premise the insurance companies based their business models on. Private equity firms may acquire a range of books from other insurance, then run the assets to squeeze some outperformance.

The authors identify three benefits for this:

  1. internal rates of return can be as high as 10% to 14% or even higher if the managers can tilt towards higher risk – and therefore potentially return – assets where appropriate or possible under regulatory guidelines. Disciplined owners will also be able to operate a business more efficiently and effectively, but they must manage the risks from volatility and opacity of the underlying investments.
  2. These assets provide a stable base for private equity firms to rapidly build their alternative credit capabilities. This is important, as private equity markets have become highly competitive and there’s already an awful lot of dry powder hanging around. The acquisition of a legacy book provides long term assets for credit investment and depending on how the debt is structured, it could actually generate fee income through instruments such as collateralised loan obligations (CLOs), which is currently a $760 billion market.
  3. Life insurance offers the potential for scale. Life liabilities in Europe stand at €4.5 trillion, while the US life carries $4.5 trillion of assets on the general account. There is an additional $1.5 trillion in separate variable annuity liabilities. And, not to be forgotten, is $3 trillion private sector defined benefit liabilities. Even if PE picks off some large acquisitions, there is a huge amount of liability left in the market, providing opportunities for scale in this area.

Willing victims of acquisition

Potential purchasers are like to be welcomed with open arms, as many sellers want to make a shift out of their legacy books into a capital light, regulation lighter, feed based model, similar to those in the asset management and record keeping sectors, say the authors.

Defined contribution pensions are also growing at 6% to 8% annually across Europe and the United States.

If insurers can generate high levels of fee earnings, they will trade at higher valuations, often nine to 12 times P/E ratio, or 1.1 to 1.7 times their book value than capital intensive businesses. That’s one way of pivoting into a new area, leaving behind the old millstones holding you back and with capital to invest in a new, digital, business model.

While there are opportunities for private equity companies, there are wrong ways to go about doing it. PE firms must be clear on strategy to determine the kind of insurance book they’re looking at. Is it an opportunistic play to be sold off like a normal PE investment, or are they looking to build a future platform. There are huge implications, because the latter will require considerable investment in technology, administration and all aspects of operations if the business is to be brought up to date. After all, that’s probably the main reason the insurer was prepared to sell it in the first place.

It also has implications, as it may fundamentally alter the structure of the existing business. This may have more than operational impact, as it could have an influence over funding requirement and regulatory oversight, too. That may require a rethink about strategy across all business areas.

Not all plain sailing

While the most common approach is to acquire a closed book, with opportunity comes risk. Illiquidity and credit risk must be managed. And while the opportunity to tilt into higher risk credits may be attractive, volatility or a shift in fundamentals could lead to stress on the balance sheet.

Regulators have appeared unconcerned at private equity firms taking over insurance books, but If this trend continues, regulators may want to have commitments from PEs that they are in it for the long term. That means building relationships with the regulator if they are to succeed.

Public opinion can also scupper deals and the views of limited partners should be sought if governance challenges are to be overcome.

The authors have identified six levers that can improve return on equity by between 4% and 7%. Yes, really. They are:

  1. investment performance optimisation of the strategic asset allocation;
  2. capital efficiency optimisation of balance sheet exposures, for instance active management of duration gaps;
  3. operations and IT improvement to reduce operational costs through simplification and modernisation;
  4. technical excellence leading to improvement in profitability through price adjustments such as reduced surplus sharing;
  5. commercial uplift cross selling and upselling higher margin products; and
  6. franchise growth acquiring new blocks or new distribution channels.

Getting ahead of the game

Some insurers are already doing what McKinsey is advising PE firms to do in this report. Arguably, those insurers will be in a better position for leveraging operational, technical and commercial positions. They could also learn something from private equity.

Insurers are building investment skills “with an eye on their strategic asset allocation and looking for new secure ways to generate alpha from higher yielding capital efficient asset classes provided they can fit effectively manage the risk”.

If selling off or reinsuring capital intensive books will free up significant capital, particularly if an insurer can’t see a way of building that business into something more.

This provides an out for an insurer, something that many have been resistant to, but realise they must either swim with the current and modernise or do something very specialist.

Even then, they will have to determine a fair price, but the authors offer another idea. Cold insurers pool their challenged assets and build sufficient scale to offer “a compelling proposition to another insurer either as a purchase or a joint venture”?

If they are going to stay in, they’re going to need a much broader strategy in order to deal with the ever increasingly challenging environment.

For more, see the full report.

Link to Full Article:: click here

Link to Source:: click here

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