Trading Complexity for Capital Intensity in Life Insurance

Consider this part 2, with part 1 being a prior post titled “Kings Don’t Buy Flow.” If you have not read that, it is likely worthwhile to do so for this as this picks up where the prior article left off.

If insurance asset management at its core is indeed a low quality revenue stream due to low fees and little / no carry, requires multiples of traditional fee + carry AUM to make meaningful fees, and is potentially is best served by vertically integrating credit origination across both large credits and myriad smaller credits – one naturally would want to know if there are ways to upgrade that quality of revenue and reduce the capital intensity, at the expense of further complexity.

Like most things in investing, one can take a high-octane approach or a conservative, measured approach. In a simple applied example, to achieve certain investment outcomes, one can utilize leverage to turbocharge returns at the risk of ruin or use no leverage and take longer to reach the destination with lower risk of ruin. 

Leverage truly is a double-edged sword. But sometimes leverage can be a bit of a gift, with the right terms. Margin lending is a widely available form of leverage and easy to access, but subject to public market sentiment. Leverage in the form of corporate bank loans and bonds is frequently used by corporations but subject to covenants based on fundamental performance metrics. A US home mortgage is an example of a truly special kind of leverage, with no recourse to the borrower, an astounding 30-year term, and no mark to market margin calls nor any real covenants. 

But there is one form of leverage that is truly special. And that is the leverage provided to an asset manager by limited partners. Only in this truly special relationship does one party effectively get massive leverage, with no immediate recourse or financial penalty, and that same party gets paid fees to take on the leverage. Now I know I am slightly misrepresenting the asset manager / investor relationship in relation to the word “leverage” – the investor has equity upside, not a debt-like upside which is capped in theory. But the management fee + carry business model is a true thing of beauty for its ability to rake mountains of cash to the asset manager if investment performance activates dramatic amounts of carry, with low capital intensity.

Now back to the prior topic: you are an asset manager trying to win in insurance. The fees that the pure play private investment grade asset management business generate are low. So, what can you do? You may ask yourself whether there are pockets of equity that exist in your structure in which a fee + carry approach may be able to slot in. In this case, a winning strategy is the shaking your box of insurance asset management so vigorously such that any part of the structure that qualifies as equity falls out the bottom. And for every crumb that falls out, you whack a management fee + carry model on it to drive higher leverage in the system, and upgrade the quality of the consolidated revenue stream within insurance asset management.

Remember, if you want to be a king by not buying your flow, this monarchial effort is an equity intensive endeavor. I established in the prior post that to fund the vertical integration of your insurer, capitalize specialty finance companies, and provide capital for their growth – a substantial initial and material ongoing equity commitment are required. But on the bright side, the sleeves of equity that fall out when that when the proverbial box is shaken, can each provide opportunity to apply a fee + carry model on top.

Equity Sleeve #1: Insurance first-loss capital 

All that have taken insurance liabilities on balance sheet are either considering or have already taken on positive leverage in the form of other people’s money to fund growth in their liabilities / annuity book. Every annuity policy requires some reserves placed against the policy to make whole the annuitant against guarantees issued. For the privilege of providing the first loss capital, the person that puts up the reserves receives the spread that the portfolio generates in excess to what the insurer guaranteed the annuitant. Given the cash generative nature of the annuity, co-investing in this sleeve was an especially interesting product for limited partners in a zero-interest rate environment. However, “sidecar” capital to fund liabilities has continue to proliferate in a higher for longer environment. These sidecars pay fees to the asset manager in the form of both asset management fees and the almighty carry, as the return is an equity return and can bear high quality, equity-level fees. 

Equity Sleeve #2: Specialty Finance Companies 

Another place asset managers can introduce carry and reduce capital intensity is in their specialty credit origination machines. They can bring in other people’s money to participate in the equity layer, and again given equity-like returns, accrue both fees and carry. This can reduce the burden of the capital outlay required to build your flow in exchange for increasing complexity to investors in the top Holdco. People that make such equity investments often also want access to the flow that the specialty finance machine creates, so it is a bit like a “pay to get access to your pro-rata share of flow” arrangement. 

Asset managers will utilize positive leverage in both of those pathways (insurance liability sidecars and specialty finance equity) to help lighten the capital burden to be successful in insurance.  

Equity Sleeve #3: Insurance Balance Sheet Equity 

There is one more pocket within the supply chain in which more leverage can be added, though this is more akin to traditional leverage versus the positive leverage offered via the fee + carry model. What if you could take equity capital, leverage it 10x, and then use 5% of the total leveraged capital to fund your specialty finance commitments. Said differently, if you vertically integrate your insurer using $10 of equity capital, and that allows you to manage $100 of assets, and you could take $5 of those assets to invest in building your credit flow pipeline (if you choose to invest all of it in specialty finance companies). The alternative is funding those specialty finance equity commitments from your Holdco balance sheet. 

Effectively, if this pathway is chosen, one is funding the capex necessary to build their own flow by using other people’s money in the form of the annuitants’ reserves. And while, as mentioned, this is more akin to traditional leverage in a sense, it enables further fee + carry applications.

Equity Sleeve #4: Insurance Equity Portfolio Co-Invest 

Specifically, utilizing the equity sleeve of the insurer’s balance sheet to fund specialty finance equity investments enables a co-invest opportunity with a fee + carry model. Remember, we now considered that the specialty finance portfolio can be funded by 5% of the insurance portfolio. That is to say, the 5% insurance balance sheet driven investment is paired with positive leverage, say 70% insurance company money and 30% other people’s money. 

In summary with this model, you have the following: $5 in insurance company equity paired with $5 in sidecar equity supports $5 in insurance company equity assets. $5 in insurance company equity assets supports a ~$7 evergreen fund (70/30 split). A $7 evergreen fund supports $14 in specialty finance company equity (50/50). So, $5 in equity drove $14 in equity investments. Last, consider if inflows from new insurance liabilities grow the business 10%, requiring $0.5 in incremental statutory insurance capital. If all OPM commitments grow in line, $1.7 in additional specialty finance equity capacity is created. Keep in mind that the specialty finance companies if performing well (not to mention the insurer), generate material amounts of cash to support equity growth. 

The overall point here is that the ownership of an insurance company can enable an asset manager to reduce the capex commitment required to generate one’s own flow. Moreover, the leverage in the insurance company makes every dollar of growth in the insurer generate a multiple of equity capital to invest, further multiplied by introduction of incremental OPM at every stop in the value chain. This leveraged approach makes it incredibly hard for players not pursuing this model to simply keep pace with the quantum of capital being sunk into building flow. 

Back in the real world, those numbers I walked through were taken to the extreme for illustrative purposes as the insurance company will not allocate the full $5 in balance sheet equity to specialty finance. Moreover, insurance liabilities in the ground today are not split 50/50 between asset manager equity and sidecar equity, as sidecars are newer to market and fund recent and future growth. But hopefully this helps illustrate the idea that this model is akin to 8 person shell rowing versus a 1-2 person shell (I never rowed, pardon the lack of correct rowing verbiage).

Equity Sleeve #5: Up The Value Chain (Warehouse Lending) 

What if, to further increase the aperture of where one can generate flow, the asset manager goes up the value chain in specialty finance? It not only builds its flow by owning and running specialty finance companies but starts to play bank by financing 3rd party specialty finance companies, thereby generating high quality credit via warehouse facilities and gaining access to the desirable IG tranches of the ultimate securitized product. And again, funding this from the insurance balance sheet / evergreen fund.

This strategy of using OPM in every part of the system multiplies the capex availability to form credit, enabling it to extend its reach substantially deeper into the broad industry of investment grade lending than a strategy using greater own capital. It is extracting flow from places that a capital light approach likely cannot begin to touch. Its reach up the value chain also places it at the forefront of specialty finance M&A (though in theory there is a firewall between a warehouse lending group and the broader asset management and insurance practice).

The opposite approach of originating solely within corporate and real estate debt and buying flow in other large sub-sectors of credit (e.g., consumer, student loan, credit card) and depending on the business quality of insurance clients to drive growth in their liabilities to grow one’s own AUM, obviously seems like a less committed or a more hedged approach. Simply focus on capturing some of the retirement tailwinds, driving greater scale in corporate and real estate lending, and innovating more capital light ways to expand. And most important, avoid incorporating insurance liabilities and ALM management, maintaining simplicity in the business model.

Moreover, adding the higher octane gas to a business model in the form of taking the insurer on balance sheet and stuffing any existing equity sleeve with OPM creates a daisy chain of interdependencies. Leverage in the form of equity capital from others, even from sovereigns, may be finicky during the worst of times. And a model that incorporates OPM across one value chain versus a model in which OPM is deployed mostly in unrelated silos is likely more fragile.

Only time will tell which model(s) within the “build flow” approach will win, or whether the “buy flow” approach has winning legs under it. However when within asset management, the term “insurance” as a growth vector is thrown around as if all approaches are relatively analogous with respect to the model employed, addressable size, quality of revenue, capital employed, and investment pace – it is worthwhile to explore just how different they are.