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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Are we back to “normal”? That is a question many investors might now ask, after the Federal Reserve cut interest rates by a whopping 50 basis points this week.
After all, ever since the 2008 crisis, finance has been in a deeply abnormal state: first, central banks slashed rates to stave off depression, then they doubled down when the pandemic hit — before finally raising in panic when inflation exploded. But now the Fed is cutting rates in response to slower growth. This looks more like the pre-2008 financial cycles. No wonder markets are rallying in relief.
But before anyone feels too giddy, they should remember one crucial point: we do not yet fully understand the long-term consequences of those abnormal quantitative easing experiments. For cheap money has distorted finance in numerous half-hidden ways — and created some striking future risks.
Consider, for example, life insurance. This sector has usually been ignored by the media, since its business model was seen as boring: companies collected fees from clients, invested those in safe assets such as bonds and used the returns to pay annuities.
But, as the sociologist Viviana Zelizer has noted, life insurance has always offered an intriguing window into societal attitudes to risk. And during the cheap money era, shifts occurred that are anything but boring.
Most notably, as a new essay from the Bank for International Settlements describes, during QE insurance companies’ investment income shrivelled, making it harder for them to pay annuities. So those companies — like many other asset owners — shifted from bonds into more risky and illiquid assets, in a desperate search for yield. They also embraced balance sheet “efficiency” (aka financial engineering) through reinsurance deals to offload assets and liabilities on to other entities, making it easier to meet capital standards.
Most startling of all, cheap money made the sector a target for private equity groups. Entities such as Blackstone, KKR and Apollo have taken minority or controlling stakes in insurance companies, particularly in the US. Indeed, by the end of 2021, PE-influenced companies controlled 10 per cent of all assets in the insurance sector — up from less than 2 per cent a decade earlier, according to a study by the IMF.
In theory, this PE invasion made perfect sense: insurance companies needed capital, and private equity groups needed somewhere to deploy their funds, which tripled in scale between 2016 and 2022. (Which, of course, was another consequence of QE, because investors moved into PE to seek yield.)
Moreover, PE players seemed better equipped than stodgy insurance officials to unleash creative financial “efficiency”. Most notably, PE-influenced companies have been far more active than others in terms of using reinsurance deals to flatter the insurance companies’ balance sheets, and shifting investment into riskier assets to raise returns.
In some senses, this worked well since it has kept the insurance companies profitable enough to keep paying out those annuities, despite the pressure on earnings from low rates. Policyholders have thus no reason to complain.
But what worries the BIS and IMF is that this dramatic — but largely unseen — shift has also created long-term risks. One issue is that the private capital assets that are now sitting on life insurance balance sheets are not just illiquid and opaque, but sometimes linked to the same PE firms that own those life insurance groups.
The IMF report highlights one deal where KKR bought Global Atlantic insurance, and then announced an expected increase in its “fee income by $200mn per year or more . . . presumably . . . through Global Atlantic allocating some of its investment portfolio to KKR managed assets”. This could create conflicts of interest.
Another problem is that the reinsurance deals appear to involve interrelated firms. Thus, the BIS notes that “PE-linked life insurers in the United States had ceded risk to affiliated insurers equivalent to almost half of their total assets (or nearly $400bn) by the end of 2023” and “about two-thirds of the risks ceded by PE-linked life insurers were assumed by affiliate reinsurers with links to PE located in offshore centres”. Yikes.
This means that the flows are extremely opaque, to regulators and investors alike. What worries the BIS and IMF is that if — or when — interest rates rise in the future, or a slowdown occurs in the private capital world, unexpected losses could emerge that would create a domino effect.
Some hints of investor unease have emerged. As the New York Federal Reserve has pointed out, when Silicon Valley Bank failed last year the share price of life insurance companies swung, seemingly because investors started asking questions about the long-term costs of cheap money.
However, thus far most of the dangers now lurking in the life insurance world continue to be hidden in plain sight — and are likely to stay that way as the rate cycle turns. That might not matter in the short term. But the risks could bite in the long term, as the BIS and IMF fear.
So, if nothing else, the saga should remind us all that it is premature to celebrate the end of the QE experiment. Even amid the new “normal”, some profound abnormalities in finance remain. We forget this at our peril.
