Alternative Asset Managers’ Double-Edged Sword: Transforming Insurance Balance Sheets and Unveiling Hidden Risks

As discussed in my previous article, “The Intersection of Insurance Capital and Asset-Based Finance” [click for article], the involvement of private equity and alternative asset managers in the insurance sector has surged over the past decade, driven not only by M&A activity but also by outsourced investment management. Insurers are increasingly drawn to the investment opportunities offered by alternative asset managers for several reasons: they provide access to assets that generate enhanced yield compared to traditional investments, especially during the sustained low interest rate periods; they provide more efficient asset-liability management given their long-term nature; and, finally, they offer diversification away from public markets. In light of these market dynamics, how are these trends manifesting on insurers’ balance sheets, and what hidden risks are exposed?

Bonds (64%) comprise the greatest part of insurers’ assets[1] due to their predictable cashflows and downside protection. Common stock (15%) includes publicly-traded stocks while Mortgages (9%) are predominantly comprised of residential mortgages held in whole-loan format. Schedule BA Assets (7%) do not qualify for inclusion in other schedules and typically include a large concentration of alternative assets.

Within the Bond bucket, Corporate Bonds have consistently comprised over half of the insurance sector’s portfolios. However their share, along with Municipal Bonds, has declined over the last six years, while the concentration of ABS has increased from 8.5% to 12.1% over the same period. While insurers have historically favored ABS bonds for their enhanced yield and favorable regulatory capital treatment, the increasing involvement of alternative asset managers in insurance investments is accelerating this shift toward ABS, now evident at the portfolio level. One popular product included in this category and likely contributing to this increase are collateralized fund obligations (CFOs), which are tranched securities backed by LP interests in private equity funds.

The concentration of mortgages within insurers’ total assets has also experienced rapid growth, increasing by 38% between 2018 and 2023, with 15% of that growth occurring in the last two years despite a 50% decline in residential mortgage originations. Residential mortgages, in particular, benefit from unique risk-based capital treatment for insurers which makes them highly capital efficient given their yield. However, given alternative asset manager’s expertise in trading mortgage whole loans – especially in the private label mortgage market – their involvement in the insurance market is likely influencing this growth.

Schedule BA Assets (BA Assets) represent long-term assets that do not qualify for other schedules and include private equity, fund investments, ABS residuals and real estate, among other asset classes. BA Assets increased rapidly between 2018-2021 with double-digit YoY growth rates but their increase has slowed down in the last two years.

While the slowing growth of BA Assets on insurance balance sheets may seem to contradict the theory that alternative asset managers are fueling the growth of insurance companies, the composition of BA Assets over time tells a different story.

The most notable shift is the increasing exposure to private equity which grew from 26% to 35% in five years while Hedge Fund exposure declined from its peak of 30% in 2019 to 26% in 2022. While it appears that the “Other”[2] category also declined, this reduction in 2022 is due to ABS residual holdings, which was previously captured in “Other”, now being reported separately. This change will provide some transparency into insurers’ activity with ABS bonds and possibly provide insight into their involvement with PE-owned specialty finance companies that are active ABS issuers.

Is this growth in insurers’ private equity assets, as well as ABS securities and residential mortgages just a coincidence? It’s hard to prove either way without more granular data, and NAIC has yet to release its 2023 BA Asset breakdown. However, NAIC published a study in 2022 [click for report] that presented data on PE-owned insurance companies supporting the theory behind these recent portfolio shifts. A few interesting observations from NAIC’s 2022 report (note all data in the report is from 2020 and 2021:

• PE-owned insurance balance sheets are materially different from the rest of the industry. Seventy percent (70%) of their assets were invested in bonds (vs 61% for the industry in 2021) and 13% in mortgage loans (vs 8% for all insurers). Only 3% of PE-owned insurance companies’ portfolios were invested in common stock (compared to 15% for the sector).

• The composition of the bond portfolios was materially different. PE-insurers had materially more exposure to ABS markets in 2021 (28% vs 10%) and their holdings of private-label RMBS were double the industry (4% vs 2%). Conversely, their exposure was materially less than the market to municipal bonds (5% vs 10%) and AAA-rated US Treasuries and agency-backed RMBS (3% for these two categories vs 11%).

• Credit risk (measured as NAIC designations) skewed downward for PE-owned insurance companies but remained mostly investment grade (NAIC-1 designations are AAA-A and NAIC-2 is equivalent to BBB).

The 2022 report clearly shows a difference in asset composition for PE-owned insurers that is likely even more apparent today if the data was available. With these shifts into alternative assets, three key risks for insurers are emerging that were less critical in the past but must now be considered: liquidity, valuations and enterprise management.

Liquidity

A shift toward alternative investments, such as private equity and ABS residuals, can reduce portfolio liquidity. Insurers with a higher concentration of alternative assets must carefully plan their future liquidity needs to meet policyholders’ obligations, regulatory requirements and solvency needs. And while the diversification offered by alternative assets can provide some protection against public markets shocks, if such shocks occur, illiquid alternative investments may need to be monetized to fulfill cash requirements. Selling illiquid assets during periods of volatility rarely yields positive outcomes.  

Asset Valuations

Given the absence of an actively traded market for alternative assets, managers must develop proxy valuation methods for these investments, which introduces the risk of potential overvaluation. With no consistent valuation methodology for these assets, investors must rely on managers’ judgement to accurately identify, assess and price a fair value for these portfolios. While alignment between manager, investor and policyholder can reduce the likelihood of significant overvaluations, the possibility of mis-valuation should still be considered when reviewing these portfolios.   

Enterprise Risk

Finally these less liquid, complex assets require a robust infrastructure for underwriting, managing and reporting. Identifying and implementing the appropriate operations to support these complex investments requires not only a deep understanding of all aspects of the business but also an ability to enhance systems efficiently before any operational shortcomings materially impact performance. Getting the pipes perfectly aligned and properly flowing is a challenge for any organization, especially when managing complex investments.      

Given PE-owned insurers’ $800bn share of the $8 trillion insurance market, their differentiated investment strategies result in only small shifts in the overall risk profile of insurance companies’ investment portfolios. Consequently, their involvement – at least for now – is unlikely to have a systematic impact on the sector. Additionally, alternative asset managers are likely best equipped to manage these risks, given their successful track record of navigating through multiple cycles and robust operations. However, alignment among all parties is essential to keep these risks in check and ensure managers remain accountable. Finally, regulators are becoming increasingly aware of these shifts, and their actions may help – or hinder – efforts to monitor these unveiled risks.

[1]   Insurers include all sectors such as life (64%), property & casualty (P&C) (31%), health and title insurers (5%); percentages based on book/adjusted carrying value (BACV)

[2] “Other” includes housing tax credits, fixed income investments that don’t qualify for Schedule D (Bonds), surplus debentures, among other categories with small percentages.