High inflation, the spectre of a recession and an increase in the cost of borrowing could put pressure on many SMEs that have taken out floating rate loans from private debt shops or that are looking to restructure existing debt or take out additional loans in the coming twelve to 24 months. It’s an industry wide challenge that the private debt sector – by far the largest subset of the alternative credit market – will face in the short term.
Some of the nuances of the life insurance industry may provide some kind of insulation from the coming storm. Life insurance companies tend to make more money in a rising interest rate environment because the premiums received from any new business they underwrite can be allocated to higher yielding investments; ergo, they are healthier counterparties for investors and lenders.
Despite this benefit, however, this subset of the direct lending market remains an under resourced one. Dan Knipe, Founder and CIO of speciality lender and KKR portfolio company Kilter Finance, says that there is a perception issue amongst investors that is a touch misguided.
“Investors tend to only see a handful of household names. This larger end of the insurance lending market is very efficient from a capital markets perspective as the issuers are generally listed and can tap the debt capital markets when they need to,” he said. “But below that, it’s super inefficient because private lending is out of scope for the investors in the large public bonds and traditional private lenders don’t have the familiarity with the balance sheet side of the insurance sector. When you look at the amount of capital across European and US life insurers, there’s in excess of $1.5trn worth of capital and surplus. The tail of potential borrowers for private debt solutions is really long.”
Part of the reason that the insurance sector is less well served by private debt than, say, the manufacturing industry might be is because of the comparatively higher level of complication of the respective companies. Lenders to manufacturing or retail businesses, for example, understand where the revenue comes from, and they have a good sense of what needs to be done to engineer a recovery, if necessary. But life insurance companies are complicated businesses with additional layers of complexity.
“A life insurer’s balance sheet is very large and materially different to businesses whose revenues are derived from the provision of services for a fee. It’s a heavily regulated sector, so debt underwriting, debt management and any debt workout requires specific and specialised experience and skills,” said Knipe. “Private debt markets are available to insurance services businesses that don’t need large balance sheets. For life insurers who have a material balance sheet the presence of complex regulatory, rating and accounting interactions opens up an interesting opportunity to earn excess returns as compared to lending to simpler businesses.”
Investors looking at the life insurance sector as an alpha generator should also need to drill down on the differences in exposure to life and non-life carriers as Luca Tres, Head of EMEA Strategic Risk and Capital Life Solutions at Guy Carpenter, explains.
“On the life side, catastrophe risk tends to be fairly limited (we witnessed this during the Covid-19 pandemic), but the asset risk component is usually more prominent than for property and casualty carriers because of the longer duration of the life insurance liabilities and the savings components that many life insurance policies have. Also, it’s very different to lend to a life insurance company with a traditional risk product mix and a conservative investment portfolio. And the jurisdiction of the borrower can have an important role itself, since capital requirements, investment and risk guidelines can be different.”
Additionally, the wide range of debt financing opportunities in the life insurance market – reinsurance-based financing, senior bonds/loans, Tier 2 financing, RT1 financing, etc. – need to have the risk exposure analysed and understood.
“These are all insurance lending structures, but the risk can differ materially depending on the type of financing. Also, insurance holding company financing versus financing a transaction at the operating company again has a different risk profile,” said Tres. “Insurance lending provides different risk/reward profiles suited to different investors’ needs in different parts of the credit cycle, so every situation needs to be analysed on a case-by-case basis.”
Investors look to credit investing as a lower volatility yield generator that serves as a diversifier to public and private equity exposure. Tres says that in times of economic uncertainty, life insurance companies can provide a defensive element, too.
“Lending to highly regulated businesses like life insurance companies can make a material difference compared to non-regulated businesses. While one could argue that asset risk is one of the largest risks (especially in a volatile macroeconomic context) for insurance companies, in a stressed context, the regulation that insurers are forced to comply with by definition puts lenders in a better position compared to many other industries. In Europe for example, Solvency II forces insurance companies to have capital covering the 99.5% worst case scenario; if you exclude insurance and banking activities – where do you see anything that’s comparable?”
For Knipe, those potentially interested in accessing the life insurance space for fixed income returns need to get comfortable with the potential correlation of returns in the space to the broader fixed income and equity markets, but he agrees that the regulatory situation can act as a defensive support and urges investors to take more notice.
“You can’t say that there is a zero correlation between life insurance companies and financial markets – there is always some level of correlation,” said Knipe. “But the regulatory framework tends to isolate an investment in a life insurer from many of the cyclical impacts you might see in other sectors. We’d encourage investors to take some time to understand the large opportunity set in the space. It’s an opportunity to access a diversifying return stream to complement a broader private credit portfolio.”