Life insurance becomes less boring with creative financial engineering

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Are we back to “normal”? That’s a question many investors may be asking now that the Federal Reserve cut interest rates by 50 basis points this week.

After all, ever since the 2008 crisis, finance has been in a deeply abnormal state: first, central banks cut interest rates to stave off depression, then they doubled when the pandemic hit—before raising in the latter panicked when inflation exploded. But now the Fed is cutting rates in response to slower growth. This is more like the financial cycles before 2008. No wonder the markets are recovering in relief.

But before anyone gets too giddy, they should remember a crucial point: We still don’t fully understand the long-term consequences of those anomalous quantitative easing experiments. Because cheap money has distorted finance in numerous half-hidden ways – and created some startling future risks.

Consider, for example, life insurance. This sector was usually ignored by the media because its business model was seen as boring: companies collected commissions from clients, invested them in safe assets such as bonds and used the proceeds to pay annuities.

But as sociologist Viviana Zelizer has observed, life insurance has always provided an intriguing window into society’s attitudes toward risk. And during the era of cheap money, there have been changes that are not boring.

Most notably, as a new essay from the Bank for International Settlements describes, during QE insurance companies’ investment income shrank, making it harder for them to pay annuities. So those companies – like many other asset owners – shifted from bonds to riskier, illiquid assets in a desperate search for yield. They also adopted balance sheet “efficiency” (aka financial engineering) through reinsurance transactions to offload assets and liabilities to other entities, making it easier to meet capital standards.

Most surprising of all, cheap money has made the sector a target for private equity groups. Entities such as Blackstone, KKR and Apollo have taken minority or controlling stakes in insurance companies, particularly in the US. Indeed, by the end of 2021, PE-influenced companies controlled 10% of all insurance sector assets – up from less than 2% a decade earlier, according to an IMF study.

In theory, this PE invasion made perfect sense: insurance companies needed capital, and private equity groups needed somewhere to deploy their funds, which tripled between 2016 and 2022. (Which, of course, was another consequence of QE as investors moved into PE to seek yield.)

Moreover, PE players seemed better equipped than heavy-handed insurance officials to unleash creative “financial efficiency.” In particular, PE-influenced companies were much more active than others in using reinsurance transactions to flatter insurance companies’ balance sheets and shifting investments to riskier assets to increase returns.

In some ways, this has worked well because it has kept insurance companies profitable enough to continue paying those annuities despite pressure on earnings from low rates. Therefore, policyholders have no reason to complain.

But what worries the BIS and the IMF is that this dramatic – but largely unseen – change has also created long-term risks. One problem is that the private equity assets now sitting on life insurance balance sheets are not only illiquid and opaque, but sometimes tied to the same PE firms that own those life insurance groups.

The IMF report highlights a deal in which KKR bought Global Atlantic insurance and then announced an expected increase in “fee income of $200 million a year or more. . . probably . . through Global Atlantic, allocating a portion of its investment portfolio to KKR’s managed assets.” This could create conflicts of interest.

Another problem is that reinsurance transactions appear to involve interrelated firms. Thus, the BIS notes that “PE-linked life insurance in the United States has ceded risk to affiliated insurers equivalent to nearly half of their total assets (or nearly $400 billion) by the end of 2023” and “about two-thirds of risks ceded by PE-linked life insurers were assumed by PE-linked affiliated reinsurers located in offshore centres’. Yes.

This means that flows are highly opaque, both to regulators and investors. What worries the BIS and the IMF is that if – or when – interest rates rise in the future, or there is a slowdown in the private equity world, there could be unexpected losses that would create a domino effect.

Some signs of investor unease have emerged. As the New York Federal Reserve pointed out, when Silicon Valley Bank failed last year, the share price of life insurance companies fluctuated, apparently as investors began to ask questions about the long-term costs of cheap money.

So far, however, most of the dangers now lurking in the world of life insurance continue to be hidden in plain sight — and are likely to remain so as the rate cycle changes. It may not matter in the short term. But the risks could bite in the long run, as the BIS and IMF fear.

So, if nothing else, the saga should remind us all that it is premature to celebrate the end of the QE experiment. Even amid the new “normal,” some deep anomalies in finance remain. We forget this at our peril.

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