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To the extent that we think about insurance, we would like the experience to be imbued with a sense of comfort and security. Yet warnings are mounting about the risks hanging over the sector.
Climate disasters are hard to insure. Rising bond yields lower the market value of the assets insurers hold to match their liabilities. Veteran investor J Christopher Flowers reckons that insurers “will get whacked” on the private credit that they have bought — and that this may pose a systemic risk.
He is referring to the practice of investing policyholders’ cash, traditionally placed in government or corporate bonds, in private credit — loans extended privately to companies by institutions other than banks.
This practice has been spearheaded by the US, where private equity groups such as Apollo, Blackstone, Carlyle and KKR have pushed into insurance, furnishing themselves with a source of long-term capital. The National Association of Insurance Commissioners reckons private-equity owned insurers had $534bn of investments in total at the end of 2022.
The same approach is spreading to the UK, with reports that Canadian investment firm Brookfield is casting around for a UK insurer to snap up.
In theory, there is nothing wrong with private credit, or with insurers investing in it. It fills a market niche. Banks, keen to conserve capital, have pulled back from some corporate lending. Private credit funds have mushroomed in their place, with total assets of $1.5tn according to Morgan Stanley.
Insurers buy such debt, which offers higher yields than publicly traded bonds because it is not easy to buy or sell. The fact that it is illiquid suits the insurers. They will need the cash back only when policyholders die or redeem their policies. Insurers controlled by private equity groups gain access to private debt through financing for leveraged buyouts. Others invest in private debt funds.
The situation should only be concerning if private debt looks riskier than the corporate loans or bonds that it is replacing. That it does, makes intuitive sense.
For one, private credit is usually extended to smaller or more leveraged companies. Blue-chip AAA-rated giants generally opt for bonds or bank loans. Morgan Stanley reckons that 80 per cent of leveraged buyouts in the first quarter of 2023 were financed by private debt, up from around 60 per cent in 2021. Refinancing maturing LBO debt is another factor in the growth of private credit, as suggested by news that KKR is looking to replace $3bn of expiring loans at its PetVet vet hospital business.
Secondly, booming markets are not usually known for their discipline. The fear is that as demand for private credit rises, the quality of the assets may deteriorate.
Another issue is that investment expertise is not infinite. The sector’s pioneers — such as Apollo — have had time to build the knowledge and experience that are crucial to navigate this inherently riskier section of the corporate debt market. Later arrivals may struggle, just as they are desperately trying to grab a slice of this market.
That explains concerns that, when the economic cycle next turns, some parts of the private debt market may start to creak. This would hurt private debt funds, insurers and other investors.
One reason why insurers are attracting a lot of focus is that their liabilities may not be quite as long-term as they suppose.
Earlier this year, regulators were forced to freeze early redemptions at troubled insurer Eurovita, backed by private equity firm Cinven, before it was placed under administration. That experience has given rise to fears that, if the market were to lose confidence in the value of private debt assets, it could spark a run on an insurer.
But that seems rather a remote risk. Insurance policies are not bank deposits that might be used for day-to day spending, and insurers are not banks. Pulling money out of an insurance product is much harder than out of a bank account, not least because there can be a sizeable upfront penalty. In the UK, individual annuity holders cannot withdraw from the products, and taking money out of pension savings can result in a tax charge.
But while systemic risk looks unlikely, losing a chunk of money on these assets would be painful nonetheless.
While UK insurers have not piled in to private credit to anything like the extent of their US counterparts, the Bank of England should be vigilant.
That’s especially true given proposed regulatory changes that will make it easier for insurers to invest in a wider range of assets to match their liabilities. This approach is meant to help unlock long-term investments in UK assets, but it will also make evaluating the risks lurking in insurance balance sheets that much harder.