There has been extensive coverage in the trade media in the past 12 months relating to the use of private assets by US life insurers to back pension liabilities they onboarded through bulk purchase annuity transactions; the coverage has largely been driven by lawsuits being filed against certain plan sponsors where the plaintiffs suggested that the plan sponsor did not use the ‘safest available annuity provider’, a requirement, as laid out in the Department of Labor (DOL) Interpretive Bulletin 95-1 of the Employee Retirement Income Security Act of 1974 (ERISA).
Certain cases are still working their way through the US courts. But surely, life insurers stateside have been loading up on liquid fixed income in recent years, because higher interest rates make US treasuries more attractive when compared to their illiquid counterparts – which would make the private assets criticism less relevant – at least, for now?
It is likely that it is not that clear cut. Despite the recent higher interest rate environment, the risk-free curve has been fairly flat. The back end has not been high enough, so investors have not been paid enough to go long duration, which life insurers need to some extent for liability matching purposes.
Hence the increased interest in private assets, which began in the aftermath of the Global Financial Crisis and now comprise 44% of the bonds used in life insurer portfolios stateside.
But it is not as if plan sponsors are unaware of how the life insurer invests and the pension scheme committee tends to have representation from the workforce itself, something seen less commonly in the UK, for example, where external trustee service providers are used. The process from when the conversation opens through to closing is lengthy, and detailed.
“Firms appointed to perform insurance company due diligence typically make a presentation to the plan sponsor which covers a range of sub-topics, from administration-related issues through to insurer investment approaches, capital and other financial metrics. When acting in this role, we will also often conduct interviews with insurers as part of the process. The resulting deck has considerable detail on insurers. The analysis may conclude that more than one insurer can offer the safest annuity available. The plan sponsor’s fiduciary committee will then choose the insurance company or, in larger cases, delegate that decision to an Independent Fiduciary.” said James Walton, Senior Vice President at Gallagher.
When a deal is completed, and the plan sponsor pays the premium to the life insurer, the job of deploying that premium begins but even still, guardrails exist to protect the members of the pension plan.
One of these is that the insurer may operate a separate account, to which the assets and liabilities associated with the transaction sit. While the plan sponsor does not have a say in the asset allocation, the use of a separate account could provide a level of protection should the worst come to the worst.
“If the insurer fails, assets in the Guaranteed Separate Account may only be used to meet the liabilities in that account. If the assets there are insufficient, any shortfall still has a claim against the insurer’s general account. In the event of failure, it is like having two bites of the cherry compared to if the annuity contract is backed by the general account only,” said Walton.
“Some security aspects of the pension risk transfer market are often overlooked. If you compare total losses on annuities in the pension plan system and in the insurance regime over the last 30 years, they have been a lot lower in the insurance regime. This is primarily because the likelihood of a well-rated insurer failing has been lower than a typical corporate with a pension plan. In addition, an insurer that fails may still deliver 90-95 cents on the dollar in recoveries, if not 100 cents. When plan sponsors have failed historically, their pension plans have not been as well funded as that.”
That is not all. Life insurers stateside are subject to a range of actuarial requirements that are designed to account for the unique risk characteristics of private credit.
First, VM-30’s required asset adequacy testing (AAT)is a primary way that actuaries project asset and liability cashflows under a broad range of scenarios to help ensure assets backing reserves are adequate under different economic conditions.
Second, VM-22, a new requirement that will become effective in January 2026, is a regulatory framework developed by the National Association of Insurance Commissioners (NAIC) to standardise reserves requirements for non-variable individual and group annuity contracts, including those used in PRT deals with a principles-based approach that also considers asset cashflows rather than the previous formulaic approach that did not. It is designed to ensure that insurers hold adequate reserves by prescribing valuation methods that reflect asset-liability matching, interest rate risk, and contract-specific features.
“Principles-based statutory reserving methodologies such as VM-22 quantify risks with an element of conservatism, including prescribed conservative default costs, prudent estimate assumptions with margins, stochastic modelling to capture moderate tail risks, an alternative investment strategy with a credit guardrail, and rigorous documentation and governance,” said Jason Kehrberg, President, Vice President, Life at the American Academy of Actuaries.
“One of the ways that the American Academy of Actuaries helps inform the discourse is by bringing a clearer understanding of actuarial work and standards related to private assets in PRTs. Without that background, which can involve technical and complex aspects that those outside the profession may not normally be aware of, it can be easy to miss the critical role of extensive stress testing and governance by actuaries. Numerous actuarial standards and regulations help ensure portfolios are resilient.”
Third and finally, the Academy is also working at the NAIC’s request to help the NAIC staff develop a framework for setting risk-based capital (RBC) requirements on structured securities. While the focus of the current work with NAIC is on assigning risk designations to Broadly Syndicated Loan CLOs, the Academy’s own broader project on CLOs models complex securities to help ensure insurers hold sufficient RBC on assets backing PRT liabilities, and in time will include other CLOs, including non-public middle markets.
Another piece of the risk mitigation pie relates to the evolution of the US life insurance industry in the past few years, particularly with regards to human capital capabilities. The life insurance industry in the US built their own investment franchises by lifting teams out of banks, which were de-risking due to their own regulatory environment. The industry has built capabilities in asset-backed finance, for example, which again provides downside risk protection. They’re originating assets and achieving good ratings from the agencies, which supports the asset portfolios used in the market.
So, what is the bottom line here?
“As a thought experiment, you can think of a typical US life insurer as like a pension plan that is 108% funded, and the regulatory regime is designed to wind them up at around 102%. Losing that 6% is very unlikely with assets predominantly in investment grade bonds whether they are public or private. To lose more than a couple of percent of an investment grade portfolio in a year historically you would have had a very severe recession – if not great depression levels of defaults,” said Walton.
“There is a lot of focus on private assets, but we should not lose focus that it is the underlying credit quality that is the most important thing. Average credit quality of private asset portfolios is often similar to the public assets in life insurer portfolios.”