With the KKR acquisition of Global Atlantic, it has now become table stakes for the large private equity firms to own an annuity platform. Apollo, Blackstone, Carlyle, KKR are all in the game now. The question at hand is how will this change the annuity business?

There is the old saw about how when you observe a behavior it changes. I suspect something similar will happen with annuity returns, which is to say net returns will not be sustainable. More on that below, but let’s set the table first.

The History of Float

These savvy investors were attracted to the annuity space for the same reason the hedge fund titans were attracted to reinsurers…cheap float. Let’s review the modern history (I’m sure cash flow underwriting goes back hundreds of years) of what happens when smart people decide to take advantage of cheap float.

1970: Buffett buys National Indemnity

This is obviously the foundation story of cash flow underwriting. Buffett made it work so we should copy him!!! Let’s think about that for a second. It’s analogous to saying if I read all of Buffett’s annual letters I can invest like him. How many people have tried and failed at that??? Yet, much smarter people think they can copy float investing with the same success.

1970s: Cash Flow Underwriting Blows Up

Yes, the often forgotten part of the story is the big P&C insurers had figured out float at the same time Buffett did. They levered up their balance sheets and started plowing into equities. They started writing comp well above 100 CR because they would “make it up on the asset side”.

When the Nifty Fifty (for those too young, look it up and it will sound scarily like today) market ended with stocks getting cut in half, insurers were bludgeoned (not finding the charts at the moment but equity holdings were > capital at many carriers). This was a big catalyst for the mid 70s hard market as pricing needed to rise to account for lower forward investment returns.

1990s: General American

General American is a good reminder of what happens when life insurers get too aggressive in their investment portfolios. They got into the spread lending game (that also burned life insurers, though to a lesser degree in 2008) of borrowing institutional money to chase higher yields elsewhere.

They collapsed when the asset prices declined and the lenders decided not to roll over their capital commitments. This was before the days of ERM models when insurers didn’t think they had bank run risk and ignored how quickly liabilities could be redeemed in a confidence crisis.

2000s: Max Re

Remember Max Re? They were the progenitor of the hedge fund reinsurers of the next decade. Max was the first to do the Bermuda based long tail liability invested into a levered hedge fund strategy. It didn’t work so well. The investment returns lagged (sound familiar) and Max eventually had to transform into a traditional reinsurer.

2010s: Hedge Fund Re

Ignoring the history of Max, a new class of hedge fund heroes came along and figured they could emulate Buffett. Or at least that’s what they told people. The truth is hedge fund re was largely about generating investment management fees for the sponsors.

As most of you are aware, they have run into the same problem as Max. Their investment returns have underperformed expectations and the underwriting has been subpar at best as they have no franchise and are at the mercy of the brokers.

2020s: Private Equity Fixed Annuities

And now we reach the present. Some of these investment firms have been in the annuity space for a decade, but certainly the new flavor of the moment is for PE to buy into the annuity market.

The premise is very familiar. They can take more investment risk than the traditional insurers and they also can earn above market returns for that risk (aka alpha) because they have superior investment acumen and origination skills. (While we can debate the former, there is some merit to the latter.)

Once again, the real motive is the allure of guaranteed fees off of permanent capital. It’s hedge fund re on a larger scale!

The question is why do they think this will end with any fewer tears than all those who have gone before them? And also, why fixed annuities? In a zero yield world?

The Future of Float

So we return to the original question: how will returns changes in the annuity business?

Increased Crediting Rates

It seems obvious, no? When there was just one participant with a total return strategy, they could be a price taker on the funding side (i.e. they could pay market yield to savers on the annuity).

As more and more of the market share gravitates toward total return players, then they will begin to set the market price and customers will get higher yields.

A simple example to help make it more clear. If a traditional life insurer might credit 1% today on a new annuity sale and invest at 3% for a 2% spread, then a private equity backed one might invest at 4.5% for a 3.5% spread.

Inevitably, the newer entrants will push the 1% crediting rate to 2% narrowing their spread to 2.5%. How do I know this? Because it’s what always happens!

The only difference between the annuity market and the GIC or funding agreement market is one is retail and the other institutional. Otherwise, they behave the same. When yield opportunities are good, crediting rates go up. This happens in every bull market.

For the P&C readers, the more relevant analogy may be to cat pricing after ILS. ILS originally priced in line with traditional cat and earned fatter spreads. Over time, they cut prices to drive growth and let margins come down which squeezed the traditional cat underwriters.

Yield Chasing

The other thing that happens in bull markets when competition heats up is the investing decisions get more aggressive. Riskier credits start getting bought to keep up with the demand for yield to offset the pressure from higher crediting rates. Inevitably, these credits go bad and we get our aforementioned tears.

Potential Negative Spreads

The final thing worth mentioning is the “Japan risk” with annuities. Let’s say the Fed eventually goes to negative rates. What happens to annuities? Unlike bonds or CDs, life insurers at any time can lower the crediting rate on your annuity…subject to a minimum crediting rate in the contract. Minimum rates have come down over the last 10 years but can’t go below 0.

If bond yields go negative, customers will have no other option to invest above 0 and will retain their annuity for as long as rates remain negative. Meanwhile, even with positive credit spreads, insurers may not be able to buy assets with positive yields. They end up in the dreaded negative spread trap that killed so many Japanese insurers in the 90s.

If private equity used institutional funding rather than annuities, they would have the potential to borrow at negative rates (though with the bank run risk General American experienced). That seems less likely in a consumer product where people have the option to put the money under the mattress. This tail risk has been seemingly ignored by all these new entrants.

Destined to Repeat the Past

It’s pretty obvious how the story ends. What we don’t know is when. Or how much the PE sponsors will make in fees along the way before it goes south.

The model is highly dependent on a benign, Goldilocks Fed. If rates go too low, as mentioned, we end up in Japan with negative spreads. If rates go too high, there will be mass surrenders as customers cash out to reinvest elsewhere, as well as large credit losses. This is not the simple, boring product that it is often presented as.

With most of these PE firms now public, the investors are left holding the bag on the tail while the managers pay themselves giant bonuses each year along the way before the music stops. If this sounds an awful lot like running a cat book without any retro, yes, that is an apt way to look at it.