An Alternative to Banking-as-Usual
As more and more investors seek the elusive twin goals of safety and guaranteed returns, a strengthening alignment between insurance companies and alternative asset managers is producing what many market veterans view to be an alternative model for long-term performance.
Most of this has occurred in the insurance annuity market, in which individual policy owners make payments to insurance companies in return for either guaranteed growth of their investment or a future income stream.
These annuity guarantees require insurers to generate rates of return in excess of the liabilities owed. In partnership with appropriately resourced alternative asset managers, insurers are not only meeting these obligations, but achieving a profitable “spread,” thanks to expertly sourced and managed portfolios of long-tenured credit assets that increasingly are migrating away from the balance sheets of banks.
To be sure, the insurance industry has long been a major component of the broader financial market. But over the past decade, the role played by the annuity insurance market, in particular, has evolved to take on greater prominence as a protector of savings and guarantor of competitive returns.
This evolution has given a competitive edge to organizations that combine industry-leading asset management with insurance experience, joint capabilities necessary to deliver the protections and returns required by customers and regulators alike.
A Matter of Time
The core business of annuity providers is easier to describe than to deliver. Payments made by policyholders are put to work in diversified investment portfolios custom-built to match assets with liabilities. In order to make a profit, the annuity providers must generate a “spread” above and beyond the base-level guarantees, without taking on undue risks that would imperil the contractual returns.
For asset managers suited to the risk-management imperative, the long-term nature of annuity policies allows time and optionality to generate the returns needed. In particular, asset managers able to successfully access and navigate the complex world of high-quality, illiquid assets enjoy advantages over competitors who must take on interest-rate or credit risk in pursuit of returns.
Legacy managers of insurance products have traditionally matched annuity liabilities with liquid corporate bonds, according to David Ells, a Partner and Portfolio Manager in Ares Alternative Credit, who also advises insurance company Aspida, a strategic partner to Ares. Outside a core portfolio of corporate bonds, these managers often set aside a smaller allocation to higher-risk investments, in the hopes of generating outperformance necessary for a spread. But over the past decade, some asset managers have innovated a superior approach to generating spread that doesn’t rely on riskier credits or interest rate bets, Ells notes.
“With a little bit more thought given to liquidity and credit, asset managers can substitute a diversified pool of structured assets for corporate bonds and earn a significant, incremental premium, while at the same time reducing credit risk,” Ells says. “We think this portfolio is higher quality, and has better downside protection, than what you would typically find in the liquid corporate bond portfolio of an insurance underwriter.”
* Yield is an attribute of underlying investments and does not represent a return to investors.
The higher-quality portfolios play to advantages that annuity providers have over deposit-taking savings banks. While individual bank savings accounts can be closed on any given business day, annuity contracts come with long-term lock-ups, bolstered by surrender penalties for early liquidity. That typically gives annuity providers an enhanced ability to match relatively illiquid annuity policies with illiquid, long-term assets.
Indeed, the specter of asset-liability mismatch was put on display in a 2023 financial crisis that took down Silicon Valley Bank (see “Long-Term Lessons from a Banking Crisis,” below). The crisis highlighted the business-model contrast between banks, which need to manage their portfolios to daily customer liquidity, and annuity providers, which do not.
In keeping policyholder capital locked up over the long term, annuity providers can better align with asset managers to create what insurers call a “well matched book,” defined as a portfolio of long-term investment assets that match long-term liabilities, able to withstand many different market and liquidity scenarios that may happen along the way to maturity.
Regulatory Scrutiny
The success of private-capital backed annuity companies in forming well matched books has evolved under heavy scrutiny from regulators and ratings agencies, who require extensive transparency and evidence of sound practices. Alternative asset managers entering the insurance business must demonstrate not only that they operate at the highest level of risk-return management, but have insurance experience embedded in their operations.
“What investors need to understand about running an insurance company is that you are incentivized to improve your credit rating,” says Raj Krishnan, a Partner and Chief Investment Officer of Ares Insurance Solutions and Aspida. “There’s a little bit of a misconception that the new breed of partners in the insurance industry are risk-takers. In fact, the exact opposite is true. Alternative investment managers have a demonstrated ability to be thoughtful stewards. There are many eyes on them, from on-shore and off-shore regulators. These sponsors know that sourcing high quality assets with appropriate downside protection is the right thing to do for any investment portfolio, particularly insurance company portfolios.”
As the annuities market has evolved, so too has the sophistication of regulators and ratings agencies, who are today more focused on understanding how, exactly, portfolios of assets are matched with portfolios of liabilities. In the past, regulators were more likely to scrutinize an insurer’s investment portfolio in isolation, says Krishnan.
The heightened scrutiny has revealed that insurers are “trying to do the right thing” by embracing diversified, illiquid pools of assets backing annuities, argues Krishnan. “They are thinking about differentiated sources of asset yield to make good on the policies that they’ve written.”
While alternative asset managers strive to correctly assess the risks against which they lend, evidence is mounting that long-tenured, structured credit products are a mismatch for traditional deposit-taking banks. “More and more, I think you’re going to find that insurance companies are a better home for a lot of these assets,” notes Ells. “They have a much better ability to hold them than banks.”
A few of the largest alternative investment managers have decades of experience sourcing and managing long-term credit assets, making them sought-after partners to a next generation of annuity providers. “Insurance underwriters can now go directly to direct lenders and capture some of the underwriting premium that a bank would have kept. At the same time, people that were holding bank deposits are saying, there’s a safer place.”
The Insurance ‘Menu’ Expands
Long-Term Lessons from a Banking Crisis
A CONVERSATION WITH RAJ KRISHNAN AND DAVID ELLS
DAVID ELLS,
Raj Krishnan: How do bank and insurance company risks differ?
David Ells: The difference in risk profile between the two business models is largely defined by a difference in the liquidity needs of the underlying customers. Traditional banks must manage assets against assumptions of both long-term and short-term behaviors, from holders of 30-year mortgages to savings-account customers who can take out all their money without warning, and thereby potentially strain the bank’s ability to service the withdrawals. By contrast, insurers structure their annuity products exclusively as long-term contracts, reinforced by early liquidity penalties, giving them greater ability to manage portfolios of long-duration, illiquid assets, which, if properly sourced and managed, can offer higher yields, greater flexibility and superior credit quality.
RK: What are the risks of asset-liability mismatches?
DE: The most prominent recent example of an asset-liability mismatch was seen in the 2023 decline of Silicon Valley Bank. SVB had among its savings-account customers many venture capital-backed startups who lost confidence in the bank’s health, and began shutting down their accounts en masse. Although SVB largely held zero-risk bundles of government-guaranteed mortgages, a mismatch emerged in the long duration of these assets. Held to maturity, the Fannie Mae and Freddie Mac securities would have maintained enough value to cover the withdrawals. But in the midst of an unexpected bank run, SVB faced steep discounts on the sale of these less-liquid assets, throwing the presumed asset-liability match off kilter and forcing the bank into receivership. The demise of SVB is a textbook example of an asset-liability mismatch with no corresponding credit risk.
RK: What lessons did insurance companies and asset managers learn from the demise of Silicon Valley Bank?
DE: The SVB crisis produced a ripple effect throughout the financial market, especially among regional US banks. But even at the national level, market participants are rethinking the traditional banking model, in which long-tenured assets are matched against deposits demonstrated to be shorter-tenured than preferred. More and more, market participants are coming to believe that illiquid, long-tenured credit assets should be held on longer-tenured balance sheets. This thought-shift is driving a migration of assets from bank balance sheets to the insurance space.
RK: How can the participation of alternative asset managers in the insurance market enhance risk management and asset origination practices?
DE: Among other benefits, the participation of alternative investment managers in the insurance space oftentimes enhances the asset-origination capability of insurers. The evolution of the annuity model in particular has improved the ability of the insurance industry to meet a rapidly rising volume of premiums and still be able to generate attractive yields required for benefit payments. This performance enhancement is due to a material increase in the diversification of insurers’ asset portfolios. Where partnerships between insurance and alternative investment managers succeed, portfolios are better able to hold high-quality, all-weather assets.
RK: What does the future look like for the evolved insurance annuity market?
DE: Insurance annuity remains a competitive market. Of the businesses to date aligned with alternative asset managers, no single participant has a dominant market share. The ultimate beneficiaries of the innovation taking place in annuities are policy owners, who today are better able to achieve safer, higher yields. The performance improvements come at a time when a huge cohort of Baby Boomers are entering their retirement years in need of income. As such, we are seeing savings in bank-sponsored accounts increasingly migrating to the annuity space.