Life insurer valuations continue to languish to the point where one wonders if the market doubts these are going concerns. At a minimum, it reflects a belief that interest rates will never go up and earnings are severely overstated.

This view is at odds with the prices paid for blocks of business in private transactions. Private equity firms find great value in fixed annuity and basic mortality products. Retirement and group assets trade to strategic buyers at high multiples.

Even variable annuity blocks transact for positive prices in contrast to the negative value implied by sum of the parts calculations on the public companies.

Why do the public life insurers trade at such a discount to private valuations? The obvious reason is the lack of information public investors have vs. a private buyer who can do due diligence.

However, I think this only explains a small portion of the difference. Investors can certainly see the private valuations and there are enough savvy investors who can estimate what “mark to market” earnings would look like.

I think the bigger reason is that the public companies continue to commit capital to underperforming businesses. You know what they say about the first thing to do when you’re in a hole is stop digging? Yeah, life insurers haven’t learned that lesson yet.

A life insurance CEO hard at work!

The Life Insurance Value Chain

Sure, the immediate reaction to that comment will be “what, you want us to stop writing business?” No, not really. I want companies to stop putting business on their own balance sheet.

Life insurers need to learn the lesson P&C insurers have begun to learn and that banks earned before them…the franchise value is in originating not holding risk.

Most of the public life insurers have origination franchises that can not be replicated. However, holding risk is not a competitive advantage as demonstrated by the number of companies that specialize in buying and managing blocks.

If the market has spoken that it hates when life insurers add risk to the balance sheet and there is a market of private companies willing to hold that risk, why do the public companies still manufacture risk???

Because there is a lack of creativity and willingness to change in the life insurance industry so these companies keep digging bigger holes.

Demand For Third Party Risk

There are really two questions to answer before a life insurer could evolve its model: one, is there enough demand by other parties to take the risk and two, is there an effective structure to pass along the risk without creating undue counterparty risk.

Regarding the former, we know there is plenty of demand for block transactions by private equity firms. That’s a given. The only real change here is asking them to take new business production.

We’ve already seen some attempts to do this such as the Lincoln-Athene fixed annuity transaction where Athene took on part of Lincoln’s production and was able to offer better crediting rates by passing along some of its higher assumed investment returns to customers.

This is actually a perfect example of why traditional insurers shouldn’t be holding risk. Other entities, mainly private equity firms, value it more because they believe they can make higher investment returns.

What the investment firms lack is big enough origination engines to feed their appetite. This is why a partnership makes sense for them as well. There is a very compelling rationale for both sides. The main hurdle is the reluctance of legacy firms to admit they need to change their business model.

If we look further down the road, once this new model is validated by big balance sheet investors, it would only be a matter of time before capital markets would want a piece of the action too.

Securitizations could be created that give institutional investors access to the liability cash stream and the investment return of the security would be managed by the large asset managers or investment banks.

The Right Structure

So how would we structure these transactions to reduce counterparty risk to the originator? The normal way might be to structure it as reinsurance. That is certainly an approach with which life insurers are comfortable.

However, over time, they would build very significant reinsurance recoverables and there is also continuity risk if at some point the partner decides they don’t want to trade forward and now the originator has to scramble for new capacity or keep everything net.

The more efficient way to do this is likely to act as an agent and let the partners assume risk directly. Obviously, this requires well rated partners but the life entities owned by PE all have solid ratings and could probably create separate vehicles for this business that they overcapitalize to reach the same rating as the legacy carrier if needed.

Since it is unlikely originators would want to completely exit manufacturing (and to align incentives), the partner carrier could reinsure part of the business back to the originator.

If this sounds similar to an MGA arrangement where the MGA takes part of the risk back through a captive, bingo, you got it. The only real difference is the large life insurers already have in place statutory entities that can take their portion of the risk.

Is there still the potential for the new manufacturer to walk away and leave the originator holding the bag? Sure, but if they follow the path I suggested above where there are multiple partners including securitizations, then this risk is diminished.

The other big advantage is having some reliance on third parties to fund your business creates discipline as it becomes much harder to get into “feature wars” when you have to convince someone else to carry the risk of that feature.

It makes it a lot easier for wholesalers to say no when the brokers are asking for something new to make next quarter’s sales’ target. This alone is reason enough to adopt this new model. It makes it much harder to create the next LTC or next VA!

The Path to Fat Multiples

Origination franchises get valued much higher than balance sheet businesses across financials. Life insurers have been very slow to recognize this. Even private equity is focused on the balance sheet side of the business.

While the large public lifecos won’t be able to achieve a balance sheet free model, they can change the mix and become more reliant on origination fees than spread income. In addition to reducing their retention of new business, they can sell off blocks of in force a little at a time with a goal of say reducing in force by half over five to ten years.

And what if inflation comes back, rates shoot up, and the market loves spread income again? You can always cut back the amount you send to third parties and retain some more for yourself.

This is no different from what P&C companies do in a hard market. Retain more in good times, reinsure more in tough times. The problem with life insurers is they don’t have this tool. Well, actually, they do have it, but they don’t think to use it. That needs to change.