Key Points
- Global demand for insurance continues to grow, driving an increase in both insurance assets and capital requirements.
- Private capital managers are attracted by the investment opportunities in insurance and believe that insurer returns can be improved by repositioning asset portfolios toward alternatives.
- For private capital firms, insurers offer “sticky” long-term assets under management.
- While this trend can provide better returns and prices for policyholders and appears likely to continue, some critics worry that it introduces systemic risk.
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Although the capitalization and prudential regulation of insurers is complex, the economic essence of an insurance company is simple.
A company is established with capital and regulatory licenses. It agrees to make future benefit payments and/or cover the economic cost of certain risks in return for receiving premiums. Because of the time lag between the receipt of premiums and ultimately having to pay out — which can be decades — if the company is well run, it will enjoy an ever-increasing “float” of money.
If that float is well invested and the underlying insurance risks are underwritten and managed correctly, there is the opportunity to profit not only from the underlying insurance business (taking in more premiums than you pay out) but also from the return on the float.
For private capital firms eyeing the sector, there is another factor: the opportunity to earn attractive fee income on the float and the capital that backs it.
Worldwide, more risk is being insured, creating greater premiums (so, increased float) and capital requirements to back those risks. Likewise, for savings-related insurance products such as annuities, an aging global population is creating compounding demand for greater insured savings.
Traditionally, the float and capital in insurance companies have been conservatively invested, often weighted heavily toward a mix of money market cash, national and local government bonds and bills, and high-grade listed corporate credit.
Private capital managers have realized that repositioning those asset portfolios into a strategic asset allocation more heavily orientated to alternative assets — such as private credit, real estate and infrastructure — can increase the returns of the insurance business and also provide the private capital firms with long-term captive assets under management, which offer attractive fees.
How Is This Being Done?
There are a number of models in the sector:
- The private capital manager buys or establishes an insurer or reinsurer (together, (re)insurer) using its own capital (rather than its investors’), wholly owning it, and manages the assets.
- The private capital manager buys or establishes an insurer or reinsurer using its funds and/or co-investor money, on a wholly owned basis, and manages the assets.
- The private capital manager buys into a (re)insurer using its own money but seeks to buy the smallest stake necessary to secure an asset management mandate.
- A private capital manager or private capital money directly buys into a “sidecar,” which is a special purpose vehicle set up to take particular risks from an insurance business, usually on a limited duration basis. The manager then runs those assets.
Perceived Benefits and Concerns
The economic benefits seem clear: The insurance sector needs a lot more capital as it grows, and private capital provides a solution. More sophisticated asset management should offer higher returns (provided that liquidity requirements are addressed, assets are duration-matched with liabilities, volatility is managed and sufficient capital is held).
Higher returns should mean more competitive pricing of products and, when policyholders participate in returns, better returns for policyholders.
Nonetheless, regulators and traditional participants in the market have expressed concerns.
Some believe that private capital is an inappropriate owner of financial institutions because it is “short term.” Such critics often cite the traditional 10-to-12-year duration of private equity funds, although the majority of insurer acquisitions have not been made by funds structured that way.
Concerns have also been raised over the so called “trader’s option” creating systemic risk: The manager benefits from greater fee revenues but is not at risk of capital loss, so the manager (to win fees) is incentivized to “gamble” by investing in higher risk/higher return assets. However, this criticism doesn’t take into account the disastrous reputational impact for the manager that would ensue from such a strategy, or the fact that often the house owns (or partially owns) the insurer, so it is typically at first risk of loss.
Looking Ahead
The general consensus is that, notwithstanding these concerns, private capital and its managers are now here to stay and will play an ever-increasing role.
Success for private capital, its managers, states, regulators and policyholders — and ultimately the economy — is only possible if all stakeholders seek to understand each other, are in active dialogue and reach dynamic compromise that balances the opportunities and risks associated with these sector developments.
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.