The Evolution of Insurance in the Age of PRT

The insurance industry is evolving rapidly and not everyone is on board. Before the pandemic, interest rates were at historic lows and insurers moved into higher-risk investments, including private credit, to help shore up returns and ensure that they would be able to meet their long-term liabilities. Alongside this trend, private equity firms have increased their presence in the insurance industry—especially in the annuity space—to cash in on lucrative spread trades and get a piece of the rapidly growing pension risk transfer market. Now, regulators, lawmakers and some annuities customers are wondering if insurers have taken on too much risk.

Pension Risk Transfer Under the Microscope

Pension risk transfer is a process whereby fully funded pensions can move all or part of their long-term liabilities over to insurers through, among other things, the bulk purchase of annuities for pension participants. This practice can remove long-term liabilities from employer balance sheets and, in the best case, continue to provide a fixed income for plan participants throughout retirement. However, doing this is not cheap and plaintiffs’ attorneys are raising new questions about the fiduciary suitability of some annuities compared to traditional pension distributions.

To put into context how fast the pension risk transfer market is growing, according to the latest data from LIMRA, an industry group that tracks life insurance data, PRT sales topped $45.8 billion in 2023, the second-highest year since LIMRA began its benchmark study of such deals. According to LIMRA data, there were 296 PRT contracts sold in the fourth quarter of 2023, a 26% jump year over year. There were 850 contracts completed in total for 2023, a 25% increase from 2022. Both figures mark the highest number of contracts sold in a quarter and annually.

As CIO  recently reported, in the first quarter of this year, PRT sales reached $14.6 billion across 146 contracts. The value of first quarter transactions exceeded those in Q1 of 2023 by 130%, and the number of contracts sold rose 26%. Analysts note that higher interest rates are helping some pension funds meet their funding status goals faster, which could put them on a path toward risk transfers sooner. Higher PBGC premiums are also likely incentivizing some plan sponsors to at least consider if a portion of their liabilities could qualify for a pension risk transfer.

However, a group of lawsuits could slow down the pace of these transactions. In March, plan participants brought a case against AT&T over an $8.05 billion risk transfer deal that they say put them in risky annuities backed by Athene Annuity and Life Company – an insurer and wholly owned subsidiary of Apollo Global Management. The AT&T case was the first in a handful of complaints challenging transfers to Athene that now include plan participants from Lockheed Martin and Alcoa. All of the complaints allege that the investments Athene makes to fund its long-term liabilities are too risky and, if they were to fail, participants in these vehicles will not have the same protections that they would in an ERISA pension plan which would be covered by PBGC insurance.

“When it comes to pension risk transfer, DOL guidance requires employers to pick the safest possible alternative. But we’re not seeing that. If you look at the data that we have on Athene and risk there are a lot of questions being raised by respected voices and organizations,” explains Jerome Schlichter, founder and managing partner of Schlichter Bogard. “We allege that the annuities received have a lesser value than the pensions they replaced and a lesser value than other annuities from respected insurers because the market places a lower value on them because of risk. Greater risk means lesser value.” Schlichter Bogard is among the law firms involved in the complaints.

John Golden, global head of insurance regulation at Apollo and Athene pushes back on these claims. “Insurers have a big role to play because of our ability to finance long-term credit,” he says. “We’re financing the real economy and insurers often have a better credit profile than banks. Our bond portfolio is 97% investment grade and banks tend to be somewhere around 65%. And, we have seen liquidity increasing in certain areas of private credit – and we do think some of the dialogue of liquidity risk misunderstands that and doesn’t align with what we’re seeing and investing in.”

Liquidity Risk

Questions about risk and value are not just coming from the plaintiffs’ bar. At the end of May, Morningstar DBRS examined the potential for growing liquidity risk within the insurance market.

Analysts note, “typically, insurers allocate only a small portion of their portfolio to alternative strategies, including private equity, real estate, or infrastructure, because of the nonguaranteed and higher-risk profile of the return of these asset classes. However, with private credit, insurers can potentially build a larger allocation to private assets while continuing to achieve their asset liability matching and investment risk goals. This could lead to significantly higher liquidity risk, especially if certain products become viable only when supported by private credit assets. Notably, the U.S. annuity market is experiencing fast growth driven by higher-yielding structured finance and private credit strategies.”

Report data further shows that the private credit market has grown so large that in theory, insurers could have the most of their fixed income exposure coming from this asset class. Morningstar analysts add that when these investments are combined with offshore reinsurance, risk profiles could increase and be more opaque due to their offshore components. There are also questions about the concentration of these portfolios, if they are over reliant on a single asset class. Private equity has long been a participant in the reinsurance market and state insurance commissioners in the U.S. have cited concerns about the lack of transparency in offshore jurisdictions like Bermuda—where most of the reinsurance market is located.

Golden argues that Morningstar’s analysis and concerns about private credit broadly leave out core components of how insurers view private credit and how they invest. “The focus on private credit tends to be on the private direct lending market which is somewhere between $1.5-$3 trillion in market size. If you look at the private credit market as a whole, it’s much larger, close to $40 trillion, and principally investment grade. I think that gets at some of the mismatch when we hear about concerns over the private credit market,” he says. “That $40 trillion includes mortgages—residential and commercial, CLO tranches, leasing, supply chain and infrastructure finance, and so on. There needs to be an understanding of what insurance companies are investing in and why this much larger market is safe.”

These concerns may be coming to a head. In April and May, the Risk-Based Capital Investment Risk and Evaluation Group of the National Association of Insurance Commissioners held discussions about increasing the capital charges insurers would face for holding certain risk assets. The working group is also looking at ways to modernize how it examines some credit investments to make sure that insurers are still meeting their liability needs.

The proposal on the table increases the capital charge for residual tranches within credit portfolios to 45% from 30% and would take effect in 2025. The increase is significant and has prompted consternation among some insurers that feel the increase is too big. A comment period was opened, and those comments are being reviewed. Another meeting is slated for this month to discuss the comments submitted and see if any changes are warranted before the increase goes into effect in January. The NAIC is also looking at a process that would support internal reviews of certain products, including collateral loan obligations, rather than relying purely on outside ratings to make sure that they meet suitability requirements for insurers.

Nathan Houdek, insurance commissioner for the State of Wisconsin and chairperson of the Financial Condition (E) Committee at the NAIC, says these efforts are part of a years-long process within the NAIC to deal with growing complexity within the insurance industry.

“Since the great financial crisis, we have seen a material shift in the complexity of insurance company investment strategies,” he explains. “We’ve seen a move towards more private assets, more structured assets, and more complex assets overall. As a result, the NAIC has been spending the past few years looking at this shift and analyzing the regulatory framework for insurance investments that we rely on to determine risk, ensure insurer solvency, and protect consumers.”

Houdek says the NAIC recognizes that the industry is evolving and the demands on insurance companies have made it necessary for insurers to consider all of their investment options. The goal for the NAIC, he says, is to ensure that as portfolios evolve, they remain solvent.

“As we’ve seen private equity move into the insurance space, we’ve started looking more closely at the risks associated with the activities of these new ownership structures,” Houdek says. “But it’s not about the ownership, it’s about making sure that our regulatory framework doesn’t have any gaps in it and is adequate to address evolutions in the industry with regard to changing investment strategies, affiliated asset management agreements, offshore reinsurance—all of those different but related activities.”

Zach Goodman, a partner in the financial services group at EY, who works closely with insurers on their investments and operations noted that while the increases in capital charges would likely change the economics of some investment choices for insurers, insurers should be able to afford the cost without significant changes. He adds that the regulatory framework has not been updated in many years and the changes the NAIC is pursuing would ultimately ensure that the framework is responsive to current investment products and portfolio constructions.

“I think we’re going to continue to see complexity in the investment space in particular. I think that is exactly why this new guidance has come out. We continue to get questions pretty much on a daily basis from different companies looking at very unique investment structures,” Goodman says. “Insurers are looking at what the investment opportunities are today and also what happens when the new guidance becomes effective on [January 1, 2025].   They’re also looking at their capital positions over a very long horizon.”

Shifting Landscape

As the court cases and proposals work their way through the American system, the Bermuda Monetary Authority, the financial regulator overseeing insurance and reinsurance in Bermuda released a discussion paper that seems at least in part to address some of the concerns about the lack of transparency in the territory’s insurance market.

The discussion paper outlines the position of the BMA, which is that long-term block reinsurance transactions—the kinds of deals favored by private-equity-backed insurers—have to have prior approval and could be subject to capital charges or other measures if there are concerns about risk.

The European Insurance and Occupational Pensions Authority also highlighted its plan to closely monitor risk within the insurance system as part of its 2024 priorities.

There is also some indication that private equity may be cooling on the insurance sector. Spreads were a lucrative trade in 2023 that would have made insurers look like a desirable target, but capital costs remained elevated throughout the year and interest rates are likely to remain higher than previously anticipated this year. The first quarter saw a number of broken deals involving private equity and insurance—firms, including Cinven, were reported to have lost out on planned transactions as a result of questions about the private equity ownership structure from regulators. Increased corporate taxes in Bermuda and the U.S. may also be having an impact.

Still, there are indications that the relationship between insurers and alternative asset managers may continue to deepen. This month, private credit shop Golub Capital announced that it was joining forces with annuities provider Nassau Financial Group through a $200 million equity investment. Nassau has reported plans to use the investment to grow operations and make acquisitions.  

EY’s Goodman says he anticipates private equity will also widen the scope of its investment interest in insurance as diversification could mitigate the impact of new capital charges or other limits on investments: “Private equity was initially interested in gathering up annuities for spread. That’s getting harder to do as the market evolves. So private equity firms are looking at other products—longer life products, universal life, reinsurance and pension risk transfer.”