Author: Brian Lo
The influx of significant new private equity (PE) capital into the insurance industry over the past decade has provoked some spirited debate.
Some contend the investment expertise of PE-backed reinsurers improves the economics of asset-intensive insurance products, which in turn increase ceding commissions paid to direct writers. The resulting financial enhancement allows insurers to price more attractive products, benefiting consumers and driving industry growth.
But critics claim that such reinsurers must achieve short-term returns by any means possible — high leverage, big bets, and potentially bad behavior. This is anathema to an industry that relies on a perception of stability and good faith.
Gallagher Re believes that a more nuanced view is required. Some PE-backed reinsurers may have concerning characteristics, but not due to their ownership — they may simply face the same challenges that startups often face. Meanwhile, other PE-backed firms can provide long-term partnerships as effectively as any traditional reinsurer.
PE-backed reinsurance is here to stay; its place in the value chain for asset-intensive products is too compelling to forego. Their investment skill can make both flow and inforce transactions into profitable propositions. But there is no free lunch; these firms have particular risks that need to be taken into account by anyone considering a transaction with them.
At its core, an asset-intensive transaction is effectively a loan made to the reinsurer, who must invest premiums to earn a sufficient return to cover benefits with an embedded rate of interest. So, it's useful to look at these deals like a bank evaluating a borrower and consider the "Five Cs of credit" (modified to fit the insurance context).
Collateral
Because reinsurance premiums are used to support future benefits, the transferred funds are typically collateralized in trusts. The biggest concern of critics is that PE-backed reinsurers use collateralized assets that are too risky. Different firms have different specialties — private loans, structured products, real estate, and so on — but the common goal is to obtain a higher yield than traditional fixed income investments. This results in a riskier, less liquid portfolio.
By itself, a more aggressive investment strategy should not be a reason to avoid PE-backed reinsurers. It does, however, require cedants to have confidence in the reinsurer's investment capabilities.
Gallagher Re has evaluated numerous investment platforms of PE-backed reinsurers; some have capabilities that rival or exceed even the best direct writers. But we believe the governance of portfolio management is arguably more important to clients than the ability to pick high-yielding assets. The choice of sub-advisors, asset/liability matching, credit monitoring, liquidity risk management, and back-office capabilities all limit the potential downside risk.
Gallagher Re works with clients to not only determine their minimum tolerance for riskier collateral, but also to quantify their willingness to give more investment freedom if it will improve the quote.
Capital
Critics believe that the tendency of PE-backed reinsurers to domicile in offshore jurisdictions such as Bermuda signals their intention to minimize regulatory capital requirements. Gallagher Re pushes back on this notion.
Recent changes from the Bermuda Monetary Authority have resulted in capital requirements that in many respects are more conservative than in the US. There are also other good reasons to domicile offshore — for example, the flexibility to provide international reinsurance.
That said, financial disclosure from offshore entities still lacks the detail of US statutory accounting (although all accounting systems can be distorted). When drafting the reinsurance treaty, there must be features that define capital robustly and provide protection against potential erosion.
Given the importance of capital adequacy to regulators, rating agencies, and counterparties, PE firms are very aware of the need to maintain financial strength in their carriers.
Conditions
Whatever the reinsurer's apparent strengths when the deal is closed, the cedant must also have confidence that the agreement will remain on the intended path in the future.
Protection from portfolio deterioration can include minimum allocations to low-risk assets; prohibition of certain asset classes; concentration limits; asset/liability matching requirements; and regular assessments of the fair values of illiquid assets. Provisions can also be set to cover breaches of the investment management agreement or guidelines.
Cedants must also look carefully at capital requirements. There is no "one size fits all" approach, as PE-backed reinsurers may be based in different jurisdictions. Structuring a treaty may require adjustments to the reinsurer's capital metrics, as well as consideration of ratings actions, regulatory changes and any parental guarantees.
There are also non-guaranteed elements to address for inforce business, and provisions for how flow business is supported. The indefinite duration of the treaty makes it all the more crucial that PE-backed reinsurers demonstrate their long-term commitment.
We have found most PE-backed reinsurers to be skilled negotiators, well-versed on key provisions and adept at focusing on "win-win" outcomes for both parties. When this is not the case, ceding companies are well-advised to seek alternative partners.
Capability
Private equity has the reputation of employing workers who are bright, ambitious, and extremely hard-working. In our experience, these traits are also present at the reinsurance level. We do highlight two concerns:
External focus
Newly formed companies are understandably focused on putting investor capital to work and allocate resources accordingly. However, the importance of strong internal operations, supported by a robust governance framework, cannot be overstated.
The need to resource financial, actuarial, legal and administrative functions is often underestimated — and the scalability of treaty management overestimated. If internal resources are thin, an issue with one transaction can hobble the reinsurer's ability to properly administer its other treaties.
Talent acquisition
The staffing needs of new PE-backed reinsurers dilute the availability of experienced talent — recall the consequences of the hiring frenzy during the "dotcom" boom of the late 90s and the financial bubble of the mid-2000s. As new entrants hire top performers from competitors, staff quality is not necessarily related to a reinsurer's size or maturity. These strains will continue if the PE-based industry grows faster than the talent pool, and are particularly notable at senior, high-impact positions.
Gallagher Re believes that PE-backed startups can be susceptible to both risks. We advise clients to ensure comfort with their reinsurer's operating framework and that they are adequately staffed with seasoned (re)insurance professionals.
Character
Of course, the most careful evaluation of the above factors can be thwarted if the reinsurer engages in intentional deception. For example, companies can characterize assets as high-quality even if they at best evade the spirit of the rules, and at worst are fraudulent.
We urge our clients to meet with prospective partners face-to-face, whether the reinsurer is PE-backed or not. The ideal situation is where the parties have prior experience of each other, based on years of interaction. When that's not the case, then reputation and industry profile are also important forms of diligence. And while market chatter is just that — chatter — it should not be completely ignored. All information is useful to some extent.
Does a reinsurer backed by private equity indicate a greater likelihood of bad actors? Our answer is a resounding "No." While the culture of a PE-backed reinsurer may differ, Gallagher Re does not have that sentiment about their moral compass. But as in all walks of life, you have to know the person you are dealing with.
Conclusion
While not all carriers are created equal, a PE-backed reinsurer is not automatically one to treat with more skepticism. But cedants do need to do their homework, especially given the more limited public information available on privately held companies. The support of an advisor with deep experience navigating these waters is an indispensable tool to add to the bottom line — while also helping you sleep at night.
