Note: This post is general commentary, there’s no moneymaker stock pick in here. I just like thinking about life insurance / annuities. I also did not spell check this.
About 10 years ago, I remember being in a smelly conference room full of MBB consultants and PE clients discussing the output to the question posed to us – what is Apollo up to with Athene? While there was not much else insightful about that moment to mention today, I do distinctly remember the point person of the PE client’s response when the partner on our team described the 5 years Apollo had been at this as a potential barrier to entry. The guy was rather apoplectic and growled, “Are you fucking telling me you don’t think we can do this? Do you think we’re fucking incapable of executing something like this?”
All told, the guy was probably just having a bad day, but they did go on to try, and by most measures, did not succeed given their head start. If you asked me then, 10 years ago, if the project that we worked on (life insurance) would be perhaps one of the hottest things in asset management 10 years later (perhaps second only to private credit) – I simply wouldn’t have been able to conceive how that would come to be. Yet here we are.
If you’re unfamiliar with the space, Life Insurance, or more specifically the Annuities part of “Life and Annuities,” has undergone an evolution in which the collision of Dodd-Frank fueled separation of myriad lending activities paired with both the previously sleepy long-duration reserves of an annuity contract and the need by legacy annuity writers to unload unhealthy blocks. You see, the legacy players wrote annuities during a time of normal interest rates pre-2008. As rates pressed down to zero, the underwriting assumptions floated farther away from the reality on the ground. Annuitants didn’t let go of their annuities because what were they to do, roll them into new near zero yield new contracts? The asset-liability mismatch ensued, and these blocks were stuck with stubborn liabilities paired with near-zero yields in the assets they were allowed to invest in by law.
Apollo was not the only one active, but perhaps the only one doing size in relieving these legacy players of these capital-intensive and unprofitable books of business. Sellers were able to release capital to reinvest in more profitable business, and the buyer got a block of annuity liabilities cheap. Pair that with a generally fearful credit environment, and strong profits ensued for Apollo.
Fast forward to 2019, people in the KKR and Ares lab must have had a similar “what is up with Athene?” moment, as Apollo had quietly scaled Athene up to well over $100B in AUM at the time and had gotten traction selling annuities to retail via its acquisition of Aviva’s US annuity business. The conclusion of their hypothetical lab moments was an exhausting diligence between KKR and Global Atlantic, an annuity writer incubated and owned by GSAM clients, during the outbreak of Covid. The result was an announcement of majority ownership by KKR. Ares followed with the purchase of a tiny outfit to be used as the chassis for a de-novo effort. I believe this was when the rest of the “pack” took notice and the stampede to establish a beachhead in life insurance started in earnest.
Today, Brookfield has acquired its way to $100B in various diverse liabilities extending beyond annuities. Blackstone has taken an “open architecture” approach by partnering as a 3rd party manager to other insurers’ balance sheets without permanent stock ownership of an insurer. Mutuals are establishing beachheads to reinsure the tidal wave of annuities from other mutuals. Sidecar funding to fuel the capital requirements of steep annuity writing growth is gushing in.
So where do we go from here? This open-ended question can take various different pathways, but I’m personally interested in the following question. While “insurance” is mentioned ad-nauseam in all external-facing press across asset managers, who has the best setup?
First, it’s helpful to understand where each player is playing, roughly speaking. I don’t include all players because (1) I don’t know all well enough and (2) some are just less relevant.
Profitability on the “complex” side of liabilities is more dependent, on a relative basis, on underwriting based profit versus the “simple” side. Said differently, investment results matter more for simple liabilities versus complex liabilities. This is why asset managers tend to focus on the simple liabilities in their hunt for more assets to manage. Thus if you have the means to do so, you likely push from the bottom right to the top right if you can, as the bottom right (acquisition of simple blocks) is very crowded today.
Athene has all but vacated the inorganic field and focused on scaling simple liabilities up and above the pack while KKR has pushed into a niche of very large but complex reinsurance deals (e.g., Long term care with all non-spread risks reinsured to 3rd parties). Ares is ramping up its issuance of organic business and Blue Owl has acquired the old Allstate life business (most recently owned by RenRe) which has an organic pipe.
Brookfield has acquired American National, Argo, and American Equity Life in a very short period of time (in insurance years). My take on their approach is they got in a room one day and had a decision to make. Should we start this from scratch and be a cautious and slow late mover (Ares approach)? We’ll have the benefit of a unified technology and support stack, have no dirty back-book of liabilities, and build our IG private credit business in tandem. Or should we put this together inorganically, thereby prioritizing getting to scale quickly while sacrificing the above benefits and short / medium term returns (if all goes to plan). My guess is the thesis that life insurance as an industry may grow well in excess of what people believe held the day, so getting to scale to capture a greater share of the future growth is more important than having the cleanest base or great day 1 returns to start with. While I’m quick to clown Brookfield as the difficulty of dealing with all sorts of legacy liabilities, 3 different platforms, and doing the same on the private IG asset sourcing side of things, I have to be open to the fact that they have considered this and feel good about the work ahead. Time will tell.
Fortitude (Carlyle) has taken an opposite approach by consuming large inorganic blocks of complex liabilities. It likely believes that in this less competitive market (likely by a wide margin), they can get pricing that more than compensates for the thorny and terrifying nature of the liabilities. Actuarial risks aside, many of the liabilities that they are purchasing are very long duration and provide for a long runway of investment on the asset side. But the attraction of long duration liabilities and the ability to invest them to earn fees is a side show to the main event of pricing the insurance risks correctly. Time will tell whether this very insurance risk centric approach is fruitful and synergistic to Carlyle’s asset management business.
The Big Picture
Major point one of this missive: (A) revenue derived from managing 3rd party insurers’ assets is a low quality revenue stream. Consider 2/20 over an 8% pref, or 1.25/12.5 over a 5% pref. How much AUM do you need to manage to be a legitimate growth engine versus your higher margin fee cards at 40bps and no carry? A ton. And you only manage the private IG part of the insurer’s balance sheet, not the whole thing. So you need a lot of very large clients who are growing nicely. And the list of potential US clients isn’t that long:
If…you want to manage a metric f*ckton of insurance assets, (B) you need a gigantic amount of flow. Private IG credit is relatively short duration, say 4 years. So a huge portion of your client’s assets are rolling off each year and need to be replaced. And if you have growth ambition, well you need even more flow.
Asset Manager Approaches to Flow
Asset managers have taken differing approaches on how to deploy their insurance strategy. Namely, some firms have essentially vertically integrated insurers into their business. Others just serve insurers as clients like they do clients in other asset classes. Each argues their model is superior yet it’s unclear whether there’s truly a right or wrong.
Few Large Trades and Flow Deals
Let’s say you want to source some multi billion dollar amount of private investment grade assets every year. How do you do this?
There are two pathways. One is to underwrite a small volume of very large transactions, which can be parceled out to insurance clients. In contrast, the opposite approach is to underwrite an immense amount of small(er) ticket loans and aggregate them.
In the first pathway one may get two Patagonia vests and a Bloomberg and have them buy BSLs, package and tranche them up, have your banker sell the AAA/AA pieces to Japan, parcel the A/BBB tranches to your insurance clients, and stuff the mezzanine tranches in a captive vehicle with 3rd party capital / sell it off. That works to some extent, but insurers need diversification, so you need more than just structured corporate loans.
Maybe you lift out a team from a bank consisting of 30 vests and 30 Bloombergs and you’re in business making commercial mortgage loans. Pretty good! But in each of these oversimplified examples, there is high competition given the lower barriers to entry and what you effectively get is beta plus an illiquidity premium.
But corporates and mortgage loans don’t provide your insurance clients with enough diversification, so you have to figure out how to get access to various other specialty finance end markets – such as consumer, equipment leasing, railcar leasing, etc.
The Flow Purchase Approach
One can choose to build specialty finance vehicles to diversify their flows, or they can buy the flow from others and place it with their insurance clients. Like Costco but for IG private assets, “we buy in bulk for all of our clients and get deals you can get due to the size we’re buying.” They look at the bank and non-bank specialty finance landscape from large cap to regional and say to themselves, these people have all the technology, systems, and relationships in place already. Why build something that dilutes my core business when not only do they have everything in place, but they need capital to relieve their balance sheets – perhaps forever given the trajectory of regulations. Blackstone has done forward flow agreements with Barclays and Keycorp, who are likely more than happy to preserve the front end relationships and collect fees while relieving their balance sheets of tied up capital. Synthetic risk transfers of bank assets have also come en vogue to further lighten up bank balance sheets. Ares has been aggressive here. Before, these wouldn’t be as interesting to asset managers given the low absolute returns but their insurance clients provide a newfound thirst for IG returns.
Overall, I believe that the flow purchase approach is generally a decent one but cedes control to the flow partner on the credit pen, volume, and technology / support standards backing the business. Moreover it can be somewhat pro cyclical as independent speciality finance businesses are generally writing more business during good times and hunkering down during bad times.
Last, if we consider episodic purchasing of assets from banks, there are limits on future visibility of what the asset managers can feed their insurance CIO clients. There is a material advantage to be able to forward plan what is going onto an insurance balance sheet as the insurer can be sure not to over / under produce liabilities, take on other assets at the right time, and ensure diversification.
Aggregation of Small Loans
Consider Ricoh Imaging, an office printing equipment lessor and servicer. They supply offices with various imaging devices and handle resupply / maintenance so that corporations don’t have to dedicate headcount to such activities (sidetone: one of my high school jobs was refilling paper and ink at a HP office). In this case, GE Capital was the longtime financing partner in this space to Ricoh, providing the financing for printers, imaging devices, etc. The ticket size was undoubtedly small. It required a technology and support build that takes time, money, and brain damage. 10+ years ago GE Capital had well north of 200 people exclusively selling, underwriting, and servicing Ricoh vendor finance. This is not a screen based effort, nor a call around effort, it often requires an on the ground, high headcount sales presence that is pressing flesh. And those relationships matter. GE Capital’s relationship with the maker of Yale forklifts was north of 20 years, its relationship with Bobcat mini-dozers was over 40 years. And Ricoh, Yale, and Bobcat are just a few of the countless GE Capital clients that followed the mold of aggregating medium / small sized tickets. But perhaps most important, these businesses are not easy to scale. You could very reasonably have the 10 vests originating CLOs, 50 vests doing CMLs and 250 person specialty finance company, all originating $1B in credit annually. As a more tangible example, OneMain Financial has near 10k employees to originate about $10B / year in small ticket personal loans. Then there’s a wholly separate piece to consider standing up a specialty finance operation.
So you wanna to finance Yale forklifts? You invest in building the tech and support necessary to underwrite / ingest small ticket loans and somehow you start stealing business from an incumbent and start piling up loans that may be interesting to your insurer clients. But wait, not so fast, they don’t want first loss risk. First, you need enough scale to be able to securitize the loans and create a large IG tranche. It doesn’t work at small size. And you need someone else who will take the first loss layer. Are there natural buyers of specialty finance equity layers? Probably some. Clearly markets exist for corporate / real estate junior tranches but for your niche printer leasing equity layer? Maybe not. Moreover, you want to have a dependable buyer for that risky slice of paper that’s there for you during both exuberance and desperation. Realistically you need to have a vehicle that warehouses those equity or junior debt slices to always have a buyer of last resort. So not only do you need to build the systems and human capital to sell, underwrite, service small ticket loans, but you need to put up reserves against your equity layers (or at least whatever portion of those layers the banks won’t finance). Congrats, you have effectively created a full blown corporation called a specialty finance company.
How to Pay for Specialty Finance Companies
If you’re standing up your little CLO squad, you probably don’t need much capital (ignoring risk retention regs for now). Especially if you’re able to sell off your equity layers. You just need to hire a few people and pay their salary until the fees start rolling in. Effectively you’re standing up a capital markets effort, something notoriously asset light.
If you’re standing up a bonafide specialty finance company, it costs dramatically more. Both KKR and Apollo have either bought or built a specialty finance portfolio that have required somewhere between $5-10B in equity capital to date to fund. Within these platforms Apollo has roughly 4k employees, KKR has 6k employees, and as a reference point, GE Capital had well north of 22k employees executing their commercial loans and leases segment (equipment leases, ABL / factoring, leveraged loans, franchise loans, inventory finance).
The issue with sinking all of this capital and complexity into specialty finance shops to fund your private IG asset flow for insurance clients is it probably doesn’t pencil if you’re just clipping 40bps as a manager of 3rd party assets. (C) There’s a reason only the asset managers who brought the insurance earnings on balance sheet are pursuing this strategy, as the insurer provides the capital required. Said more directly, you need to own an insurer to the strategy of directly running a speciality finance portfolio to feed your flow needs. And accordingly, you need to accept that you are forced to (1) compete with your insurance clients as well as (2) take on insurance risks, however large or small.
Which Model Is Best Positioned?
Separate from which asset manager will either grow fastest overall or have the best stock performance, I’m interested in thinking about which asset manager is most successful in the insurance space.
To summarize the vectors discussed:
- Given the low fee rate, the amount of insurance AUM you need to manage is massive versus legacy alternatives products (that have higher fee and include carry)
- To manage a massive amount of insurance AUM, you need massive flow, which you can either gather via fewer large trades and flow agreements or the aggregation of countless small loans
- Fewer large trades require less capital and complexity whereas small ticket aggregation requires a lot more capital and complexity / execution
- Fewer large trades / flow agreements involve better line of sight by virtue of smaller operations, access to flow partners that are at scale
- Small ticket aggregation is a supposed pathway to higher returns by virtue of diversification, lower fee drag, less competition, control of credit pen, and less cyclicality
- The cost of full corporate infrastructure and equity capitalization for small ticket aggregation versus the thin fee rate of insurance AUM only makes this possible for those that have the insurance earnings or balance sheet to shoulder the cost of this
The other vector I’ll introduce, albeit near the end of this note, is given the above graphic of how concentration of annuity assets exists (top 20 players are roughly 75% of annuity origination), and that concentration is increasing quickly, the competitive positioning of your insurance partners will matter more going forward than it did in the past. In the past, it was really a race to see who could pair up with whom (or merge) and AUM allocated to alts grew quickly.
So which model on the back of this does the best?
Frankly I’m a bit tired of writing this piece, have re-written the end many times, and find it not hitting the spot. So I’ll leave this note with the following, which is what I believe to be true, and you can draw your own conclusions.
Kings don’t buy flow.