Private equity investment in life and annuity insurance companies has created a shotgun marriage of the damned and the desperate.
Life insurance and annuity companies have an insatiable need for capital. Without a steady, reliable stream of new capital, it is impossible for a life and annuity insurance company to function, let alone grow. Insurance companies are dependent on a flow of new capital because, unlike other types of companies that report a profit once the product is manufactured and sold, insurance companies book an initial loss every time a new policy is sold.
Once expenses and commissions are paid and the necessary reserves are set up for future liabilities, the insurance company has paid out more than the initial premium collected for a new policy. Most life and annuity policies do not begin to generate profits for the insurance company until three to five years after it has been issued. And that creates a rather unique financial drama: The more new policies sold, the larger the losses reported and the greater the need for additional capital. And if the policyholder cancels during the first few years, the company loses most of the capital it has invested. In fact, it can take 20 years or longer for a life insurance company to make the anticipated profits on the policy. (Property and casualty insurance companies do not have the same type of capital issues, because the product cycle is much shorter – usually one year – while life insurance companies deal with product cycles that can extend over decades.)
For more than a century life insurance companies were able to access two sources of capital to meet their needs: As profits emerged from a growing block of existing policies, this “new capital” was reinvested back into the company to cover the cost of issuing new policies. The second supply of capital traditionally came from reinsurance companies. These are insurance companies with a large pool of capital, but without the wherewithal to market and issue policies directly to the consumer. As a result, in exchange for participating in the future profits of the policy, reinsurance companies offer their capital to cover the losses on new policies issued by “direct writers.”
But the world has changed. In recent years, a maelstrom of financial events – low interest rates, economic decline and stagnation, real estate depression and the toxic nature of collateralized mortgage bonds – all conspired to cause the well of capital for life and annuity companies to all but run dry. Although the cost to write a new policy remained fairly static, profits have nevertheless been squeezed. The culprits? Regulators have increased the amount required for reserves while the Fed’s low-interest-rate environment continues. The resulting reduction in anticipated profits from new policies triggered a substantial reduction in the valuation of insurance companies. That made it difficult, if not impossible, to go to the market for fresh capital. At the same time, cash infustion from reinsurance companies evaporated as they too had to shore up their own reserves and losses; reducing their appetite to invest in new life and annuity policies that may or may not produce a profit. (What capital was available from reinsurance companies shifted away from life and annuity to short-term casualty policies.)
Looking for an Answer
Starved for capital, life and annuity companies were faced with distasteful alternatives: They could either cut back on the amount of new business they were willing (able) to write, withdraw from the market altogether, put themselves up for sale (with few takers) or in a number of cases, they could turn to the only group with excess investment capital – private equity investment firms. For a variety of reasons, private equity firms never had much interest or motivation to invest in the life and annuity business; the low investment rate of return on insurance policies and the long-term emergence of profits and return of capital did not fit well with the private equity business model.
However, private equity firms also faced their own challenges. These firms had accumulated large amounts of capital from investors, but with economic and business uncertainty, they were challenged to find appropriate investments. The confluence of insurance companies need for capital and the necessity for private equity firms to invest its capital, set the stage for what seems like a shotgun marriage of the damned and the desperate.
The fundamental business models for private equity firms and life and annuity companies are so diametrically disparate that putting them together is like trying to mate a tortoise with a hare. Private equity firms attract investors based on the premise of higher (much higher) than normal market return on invested capital and a fairly short – five to seven years – return of both capital and profits. The incongruity implicit with investing private equity funds in insurance companies is the relatively low rate of return on investment (even in the best of times it may be no more than 12 percent – less than half of what equity firms seek) and the long-term emergence of profits and return of capital that is central to the life and annuity insurance business model. Despite this, private equity firms are diving head first into the shallow waters of the life insurance industry; and insurance companies, thirsty for capital, are drinking in as much as they can. This activity is the incarnation of the idea that desperate times call for desperate measures taken by desperate people.
Are Private Equity Firms the Answer?
Private equity firms have adopted two approaches when it comes to insurance investments: One strategy is to purchase an “existing block” of policies. The second, more troubling, stratagem is for private equity firms to purchase actual control of the insurance company.
Purchasing an “existing block” of insurance policies is a fairly mundane transaction. The business has an established track record of performance that can be measured; the insurance company has made the initial capital investment in the business and has absorbed the early losses. In effect, the investment firm is simply buying the discounted present value of future profits. In times of relatively low investment returns, this established and steady flow of profits can be attractive. The only investment risk for the private equity firm is that the policies will continue to perform as they have in the past. By selling the future stream of profits on its existing business, the insurance company receives a shot of needed capital to continue its operations, but at the price of reducing future profits and long-term value of the company.
The more problematic transaction – for all parties concerned – is when the private equity firm purchases control of the insurance company. Private equity firms have little, if any, expertise in the insurance industry or at running an insurance company. Those hired with experience to manage an insurance company have little, if any, experience understanding the mentality of private equity. This presents an immediate potential conflict. What private equity firms will soon learn is that purchasing an insurance company is unlike buying any other company. The investment needed to purchase the insurance company is just the down payment. For the company to grow – if that is their plan – an ever increasing stream of capital must be fed into the company. Capital that creates an immediate loss and does not return profits for decades is not something likely to please private equity investors.
For their part, insurance executives will find themselves dealing with investors who have a much higher investment risk tolerance than insurance companies can safely take; or that regulators will allow. They will be accountable to investors who view all actions from a “financial-engineering” perspective – squeeze out every penny you can as soon as you can – as opposed to long-term value-added strategies. So that they can begin to recover their investment, the private equity business model also calls for mining dividends as soon as possible from their investment in a company. Taking all this into account, insurance companies could be forced into a new paradigm of seeking short term gains and profits to facilitate the private equity dividend and “exit” strategy of five to seven years, which is their ultimate end game; as opposed to a long term, stable investment that is traditional in the insurance industry.
The inherent risk of all this for those in the insurance industry – executives, employees, agents and even policyholders – is that when private equity firms discover – if they haven’t already – the long term nature, complexities, regulatory environment and relatively low rate of investment return, they will come to view the acquisition of a life and annuity company as simply the purchase of the existing business. If this is the case, the strategy will be to allow the existing business to throw off profits in a run-off mode; cutting costs and benefits as much as possible and be unwilling to invest in the future growth and development of the company.
Private equity firms could be tempted to take advantage of a quirk in the profit flows of an insurance company. With most non-insurance companies, growth means increased profits. In the insurance industry, once a company reduces growth – writes fewer new policies – profits spike up; at least in the short term. This phenomenon fits perfectly with the mentality and time-horizon of the private equity investment model; which could motivate them to actually reduce the size of the company and stifle the growth of new business.
Certainly, at least to consummate the marriage, the private equity groups have offered encouraging if obfuscating comments as to their commitment to the long-term nature of the insurance business and their desire to build the company. That may be the case, but it is not the genetics of these companies or how they have operated in the past. It is taken as a compliment when private equity firms are accused of being more interested in profits than people – or policyholders.
If this should happen, it will lead to reduced employment opportunities, less competition within the industry, less support and fewer product options for the agent distribution system; along with less value and lower benefits for policyholders. Of course, this may not happen. After all, if you do mate a tortoise with a hare you might end up with something that is strong and fast, that can run for a long time. Then again, you might end up with a tortoise like animal that runs fast till it dies.
And the moral of the story . . .
Insurance companies need fresh capital; and they need it now. Private equity firms have excess capital they need to invest; and they need to invest it now. It may be tempting to match these two needs together, but the mating of two needs does not necessarily make for a happy solution. In fact, the business model for insurance companies and private equity firms are so diametrically at odds with each other, it is hard to imagine how such a marriage could be happy much beyond the honeymoon period. When private equity firms get beyond their short-term needs to put investment capital at work and discover the difficulty of extracting short-term gains from a low-return, long term business and insurance companies get beyond their immediate need for long term capital and discover the pressures and risks of performing in a short term environment, the only result that seems likely for both parties is short-term frustration and long term-failure.