The rising interest rate environment of the past two and a half years has had the impact of reining in deal activity in some life ILS trades, such as commission financing or value-in-force (VIF) deals, because rising rates make these transactions more expensive for life insurers, thus dampening demand, as well as being challenged by rate-driven lapsation.
That is not the case in the asset-intensive corner of the life ILS market, however. These deals – whereby the investor(s) assume both the liability and asset risk associated with a block of insurance-linked policies, like annuities, for example – benefit from a rising interest rate environment.
“In asset-intensive deals, you are primarily investing in the spread between asset and liability performance. On the liabilities side of the trade, your cost of funding is largely fixed at the time of pricing. But on the asset side, as rates rise, you’re earning more as you reinvest cash flows, thus benefiting from a wider spread,” says Gokul Sudarsana, Chief Investment Officer – Life Insurance at Hudson Structured Capital Management Ltd. (d/b/a HSCM Bermuda).
“While some liabilities may experience higher lapses as rates rise, this is offset by the asset side,” Sudarsana added.
The outlook for interest rates in the short term is uncertain. If rates start coming down again, it follows, other things being equal, that commission financing and VIF transactions would become more interesting to life insurers, given both the cost of capital and the stability of collateral.
But falling rates doesn’t mean that asset-intensive trades would see a reduction in the spread. Similar to how many defined-benefit pension plans are buying interest rate hedges to maintain their newly fully-funded status, insurers take steps to create and preserve value through the economic cycle.
“Unlike some trades in the life space, asset-intensive deals give you more flexibility in managing both sides of the balance sheet. Generally, the capital markets risk is muted to begin with as you are matching stable, predictable liabilities with all-weather, investment grade assets. But it is important to have a good feel for where we are in the prevailing interest rate cycle, which will inform pricing, hedging, and rebalancing decisions to tactically optimize the business,” said Sudarsana.
In March, industry group LIMRA published data suggesting that annuity sales in the US in 2023 came in at their highest ever total, $385.4bn. Then in April, it followed that up with a press release stating that the first quarter of this year was the best ever quarter at $113.5bn.
Annuities are a good example of products that work well as the basis for an asset-intensive life ILS trade as many of them have a specific term, meaning that the liabilities are fixed and known. And while the apparent boom in annuity sales has motivated a large number of asset managers to rush in and try to take a slice of this growing pie, the moats in the space are formidable.
First and foremost, certain expertise is required to execute these deals effectively.
“The actual underwriting of the risk requires significant actuarial, investment, and regulatory expertise. The assets and liabilities are not necessarily going to run off the way you model them, and the ongoing operational and governance requirements are complex, so insurers need a partner that has the requisite expertise and credibility,” said Sudarsana.
Additionally, what also impedes the ability of others to enter the space is the good, old-fashioned network.
“These deals are often bilateral, and you need relationships at the executive level at life insurance companies, which take years to develop,” Sudarsana added.
“Asset-intensive trades are as much strategic partnerships as they are transactions. The whole project, from the ideation stage through to completion, regularly takes well over a year.”
Finally, asset-intensive trades are often hundreds of millions of dollars – sometimes, billions of dollars – in size, which requires access to large pools of long-term capital. That requires thoughtful structuring to fit fund mandates and robust institutional distribution capabilities.
Asset-intensive deals aren’t all about annuity-backed business. In a low-rate environment, annuity-backed trades work well because buyers need cheaper liabilities because their asset returns are lower. But in a higher rate regime, buyers can pay more because their returns will be higher, which brings into play liabilities that are higher cost and more complex, like certain life insurance products. The pension risk transfer market, for example, has, in the past couple of years, seen significant growth in activity as defined benefit pension schemes generally have become fully funded; both the UK and the US market delivered approximately £50bn and $50bn of transactions value in 2023.
Good news for those in the space, indeed. And more is on the way – at current interest rate levels, activity in the asset intensive space should keep growing.
“There is a need for capital for life insurers globally to support the strong demand for savings, retirement, and life insurance products. It’s a virtuous cycle; the growth exists because rising rates make annuities more attractive to consumers, and so more capital is needed to support this demand,” said Sudarsana.
“We participate in in-force block transactions that provide capital relief to insurers so they can redeploy into new business, as well as supporting new business flows.
“The growth at the front end is driving the demand for capital which is driving the opportunity for the capital markets to participate in the risk. These transactions are actually well insulated from capital markets risk because of strong credit quality and tight asset-liability management. Consequently, there is growing interest from long term institutional capital, like pension plans, sovereign wealth funds, etc. that value the stable, uncorrelated cash flow profile that asset-intensive life ILS transactions can provide,” he added.
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