Private capital and insurance: two way traffic

Consolidation in private capital markets is accelerating due to fierce competition in the private capital space and the pursuit of economies of scale in order to have the ability to distribute increasing technology and compliance costs over a larger asset (AUM) base. In addition, fundraising has become more challenging over the last few years as higher interest rates have reduced investors' appetite for committing new capital. Investors are furthermore increasingly favoring established financial sponsors with broader AUM due to the stability and diversified investment opportunities such sponsors offer.

There are a variety of different ways in which private capital can be deployed in the insurance sector, each with different sets of benefits.

Investment in a risk carrier (insurer or reinsurer) means the acquisition of a company on an own account basis which has a large pot of premium income built up over time, which can be put to work to generate investment returns, in particular in the areas of the financial sponsor’s expertise. This can be particularly appealing when other sources of funding have become harder to source or more expensive (e.g. debt funding and fund raising during the recent period of higher interest rates).

Investment in distributors (broker or agent) or service providers (e.g. claims manager) provides the opportunity to roll up multiple smaller players into one larger one through a buy-and-build strategy, with synergies and economies of scale providing the desired return.

All of the above investments provide the opportunity for financial sponsors to charge fees for investment management or other services.

A financial sponsor wishing to build a diversified book will find in insurance, particularly non-life, a sector that is not correlated with the debt and equity markets.

The traditional challenge for private equity investors has been the requirement of their funds to achieve an exit within a duration between five and ten years. Insurance is inherently unpredictable, and being forced to exit at the wrong point in an insurance market cycle is not good for the return. This can be overcome through evergreen fund structures that mean that the investment can be patient, but can nonetheless create a tension when the cycle has a deeper or longer trough than expected. A further challenge is that a fund is intended to be finite – whereas an insurer can be in need of recapitalization.

Risk carriers are subject to significant regulation: both in order to obtain authorization in the first place, and to maintain that authorization, without the potential imposition of restrictions or other remedial capital requirements that hamper their profitability. The regulation is focused on minimizing the risk that the risk carrier will be unable to pay claims as they fall due, and tends to be supported by governance requirements that are likewise aimed at minimizing this risk. This builds quite a lot of frictional cost into their operations, which can go against the structural efficiency that private capital would generally be seeking. Others in the insurance sector (distributors and service providers) are less encumbered by these requirements (although not entirely free from them), which has meant that they have lent themselves more naturally to private capital ownership.

In relation to risk carriers, the regulation means that owners face greater limits on shareholder autonomy than they would be used to in other sectors. Regulators expect an insurance company to be run on a standalone basis by its board, and for that board to have a substantial independent non-executive director component. While the shareholder has the power under corporate law to appoint and remove directors, its power to determine what happens day-to-day is in practice constrained by the need to demonstrate it is a fit and proper owner of an insurance company, by allowing the company to be run by its board on a standalone basis.

Private capital has a long history in the insurance world. Lloyd’s owes its four hundred year existence to individuals exposing their capital to insurance risk, and many of its corporate members and managing agents are backed by private capital. In recent times there has been an increasing sophistication of participation, with financial sponsors taking ownership over multiple facets of insurance, covering life, non-life, and distribution.

There has been some regulatory deliberation over the desirability of private equity ownership, in Bermuda, by the US National Association of Insurance Commissioners (NAIC) and even at the level of the IMF. The main concerns have been: whether there is an issue created by the traditional term for a financial sponsor to realize its investment and the longer term over which an insured (in particular on the life side) needs their insurer to be viable to meet its claim; and the desirability of private capital shifting an insurer’s investments into assets that are less liquid and more volatile than the insurer would otherwise have had within its risk appetite. While some headwinds in this area have been noted, our view is that this should not hamper the continued and increasing involvement of such an important source of capital. We would expect the penetration that private capital has achieved in the U.S. to be mirrored over time in the UK, Japan, and Continental Europe.