Insurance regulators scrutinize new owners
August 10, 2013 by Victor Epstein
Insurance regulators have launched an inquiry into the potential threat posed by the entry of hedge funds and private equity funds into their industry.
The worry? The funds make riskier investments, which, if they go sour, could leave the troubled insurance companies they’re buying without enough money to pay benefits promised to policyholders, industry experts say. That could mean annuity buyers would receive only a portion of each dollar they’re expecting in their retirement. The funds also have a reputation for being quick to lay off workers as they reorganize companies for resale.
Such a scenario is of particular concern in Iowa, where 212 insurance companies were headquartered last year. The industry accounts for 20 percent of the Des Moines area’s $221 billion economy and employs 24,100 workers in the city, which is a hotbed for insurers who specialize in selling annuities.
The insurers include West Des Moines-based Aviva USA, which private equity firm Apollo Global Management is buying. State regulators are reviewing Apollo’s $1.8 billion bid for Aviva USA.
If approved, the sale would be the second major deal this year involving a private equity firm and an Iowa insurer. In January, Guggenheim Partners paid $471 million to FBL Financial Group Inc. of West Des Moines for its EquiTrust annuities business.
“There’s a lot of concern within the industry and among regulators about the influx of private equity into the insurance sector,” said Terri Vaughan, former Iowa insurance commissioner and former head of the National Association of Insurance Commissioners. “Some people are worried that their business model is to invest in a variety of high-risk opportunities, knowing that some won’t turn out. And in our industry, that means policyholders wouldn’t get the benefits they’ve been promised, and the rest of the industry would have to share in the losses.”
In a move it did not publicize, the National Association of Insurance Commissioners, the industry’s rule-making body, decided last month to create a working group to examine the risks when hedge funds and private equity funds buy insurers.
Hedge funds pool money from wealthy individual and institutional investors and invest in such things as stocks, oil or gold. Private equity funds specialize in purchasing companies or buying enough of a share of them so they can influence how they’re run, streamline their operations and resell them.
Both hedge funds and private equity funds possess a high appetite for risk and are willing to use borrowed money to maximize their return.
The association’s Financial Analysis Working Group (FAWG), which is charged with handling insurance solvency issues, suggested the new working group, said Julie Mix McPeak, chairwoman of the association’s Life Insurance and Annuities Committee. The group also will consider creating new guidelines for state regulators such as Iowa Insurance Commissioner Nick Gerhart to use when reviewing purchases of insurers by hedge funds or private equity funds.
“FAWG and other regulators are already discussing that we have to have life insurance owners that are fit for that purpose,” said McPeak, who also is the Tennessee insurance commissioner. “FAWG has already noticed that there could be inconsistent promises between a private equity firm and beneficiaries of a life insurance or annuity company. … There could be some firms that think this is a nice big pool of assets that they could invest more aggressively than we would be comfortable with.”
Aviva USA had $56 billion in assets in December, when Apollo’s winning offer to buy it was announced. Apollo has about $113 billion in assets.
Insurers are more vulnerable to takeover now, after being battered by a prolonged stretch of low interest rates and bond yields. As their profitability has narrowed, the cost of acquiring them has plummeted. Aviva USA was originally purchased for $2.9 billion in 2006, when it was known as the AmerUs Group.
Key is determining a fund’s motives
The challenge for insurance industry regulators is to determine when a fund is purchasing a struggling insurer to secure profit growth by any means necessary, or is making a sincere attempt to rebuild it with an eye toward profiting from a future sale.
“Insurance regulators are alarmed, and they should be alarmed,” said Eric Lohmeier, managing director of the NCP investment banking boutique in Des Moines. “Traditional insurers plan for the worst with surplus capital, but the hedge funds and the private equity funds that are buying these insurance companies want to put more of that capital to work. … (They’re) not planning for these insurance companies to blow up, but if they do, the risk gets shifted to policyholders, other insurers and taxpayers.”
Taxpayers could be stuck if multiple failures trigger a federal bailout.
“Regulators are trying to provide oversight on overall risk,” said Matt Hutton, an insurance industry analyst at Deloitte, “and they’re worried that the private equity firms are going to make riskier investment decisions to drive their overall returns to the detriment of policyholders.”
Hutton estimates that hedge funds and private equity funds like Apollo control about 1 percent of the $5 trillion to $6 trillion in assets in the global life insurance industry, which includes annuities. He said that amount will increase to 3 percent if two pending deals, including Aviva, are approved.
Apollo seeks to buy Aviva through its insurance arm, known as Athene. Aviva employed 1,400 people in the Des Moines metro area at the end of last year and ranked eighth among the nation’s fixed annuity sellers in the first quarter. Athene CEO Jim Belardi has already announced at least 50 job cuts in Aviva’s investment management arm and the planned sale of its life insurance arm.
Wariness is rooted in clash of cultures
Some of the alarm raised by the insurance industry can be attributed to a clash of cultures, experts say. Insurance has historically been a staid sector, making conservative “buy and hold” investments in vehicles like bonds to meet the burden of keeping long-term promises to policyholders. Insurers are also governed by state regulation as a safety net to protect policyholders.
Hedge funds and private equity funds, in contrast, are a more swashbuckling industry. They’re led by a generation of financial professionals that author Tom Wolfe called self-appointed “Masters of the Universe” in his novel “Bonfire of the Vanities.”
Private equity firms’ appetite for risk was noted in an article in the July newsletter of the National Association of Insurance Commissioners’ Center for Insurance Policy and Research. “Although private equity firms are well-known for their investment expertise, they generally have a higher risk tolerance and invest more aggressively than a typical (insurer),” the center’s Michelle Lee Wong and Ryan Couch wrote.
In the eyes of many insurers, hedge funds and private equity firms are the financial equivalent of an invasive species. Besides their risk tolerance, they are less regulated, quicker to lay off workers and fond of basing their ventures in hard-to-monitor offshore tax havens.
Walter White, chief executive officer of Minneapolis-based Allianz Life Insurance Co. of North America, is among the skeptics.
“The insurance business is a long-term business,” White said. “For any player to be successful, you have to take that long-term view. The traditional view of private equity is more short term.”
Allianz was the No. 1 seller of fixed annuities in the first quarter.
White views private equity firms’ entry into the insurance industry as one of the most significant developments of his career.
Insurers have another reason to be wary of risky investments by hedge or private equity funds that enter the insurance industry: When an insurance company fails, state guaranty organizations require other insurers to share the cost of compensating policyholders.
That clubby arrangement means that if the new owners of Aviva USA invest more aggressively than traditional insurers, the higher risk of a failure could be parceled out to their competitors.
Gerhart is reviewing the Apollo-Aviva USA deal, which also requires approval by New York state, because a small piece of its business is located there. Gerhart’s New York counterpart already has threatened to scotch the sale unless Apollo accepts conditions that would better protect policyholders.
Ben Lawsky, superintendent of New York state’s Department of Financial Services, pursued a similar strategy before approving the $1.35 billion sale of a Sun Life Financial annuity unit to Guggenheim last month.
Iowa firms already paying for bailouts
Bailing out other insurers is already costing Iowa insurers millions.
Guaranty fund assessment payments cost Des Moines-based EMC Insurance Group $1.02 million in 2012 and $1.4 million in 2011. American Equity Investment Life of West Des Moines paid $8.5 million in the second quarter just to help compensate policyholders of the insolvent Executive Life Insurance Co. of New York.
That company is a former piece of First Executive Corp., a California-based insurer that imploded in 1991 in the biggest insurance failure in U.S. history at the time. First Executive had invested billions in junk bonds purchased through the now-defunct Drexel Burnham investment bank, run by disgraced financier Michael Milken.
Billionaire Leon Black and other Drexel employees founded Apollo in 1990, and he continues to lead it as chairman and chief executive officer. The New York financier spent 14 years at Drexel, serving as head of its mergers and acquisitions group and co-head of its corporate finance department. Black did not respond to a request for comment.
An Apollo Global Management spokesman released this statement Saturday: “Neither Apollo, Leon Black nor any other Apollo principal had any significant business relationship with Executive Life Insurance Company or any of its principals prior to the commencement of its court-supervised rehabilitation proceeding in California. Any statement or inference to the contrary would not be accurate. In 1991, after Executive Life went into rehabilitation, Apollo led a process that resulted in the rehabilitation of Executive Life.”
Fred Hubbell, a former board member of Dutch financial services giant ING and part of the family that helped found the insurance industry in Iowa, said Aviva policyholders should be nervous about Apollo’s connections with Drexel.
“I believe that a good businessperson can make a profit without hurting their customers or their society, but everyone doesn’t operate that way,” Hubbell said. “If the system works, everything should be fine, but the system has to work properly between the rating agencies and the insurance regulators. The downside if they don’t is that insurance companies will either be going bankrupt or having to be bailed out by the state guaranty associations.”
What’s a private equity firm?
TERMINOLOGY DISPUTE: Is Apollo Global Management a private equity firm, as the Register has described it? Apollo’s public relations representatives routinely argue with reporters about terminology.
HEDGE FUNDS: They object to describing the company as a hedge fund, although it was once proud of those operations. Hedge funds are pooled investment vehicles that typically cater to wealthy individuals and institutional investors, according to the NCP investment banking boutique in Des Moines. They often use leverage, or borrowed money, to maximize the return from a winning investment. They’re lightly regulated, generously compensate their managers, and can rapidly move in and out of investment positions. They have a higher appetite for risk than insurance companies, banks and mutual funds and require a lockup period when investors cannot withdraw their funds.
PRIVATE EQUITY FUNDS: Apollo’s representatives also regularly object to the term “private equity fund,” even though its private equity operations accounted for 89 percent of the $198 million in economic net income it reported in the second quarter. Private equity funds specialize in acquiring and investing in companies that are poorly run, are in troubled industries or have the potential for rapid growth, according to NCP. Private equity funds often reorganize the companies and then sell them. The funds typically have a higher appetite for risk than insurance companies, mutual funds and banks. Like hedge funds, private equity funds commonly use borrowed money to maximize profits. They tend to take a longer outlook on their investments than hedge funds.
APOLLO’S PREFERENCE: Apollo prefers to describe itself as a “leading global alternative investment manager,” financial lingo for a firm that invests in complex instruments like derivatives, whose implosion played a key role in the global financial crisis. Derivatives are derived from other investment vehicles, like energy prices, stocks and bonds.
“INSURANCE GUY”: Jim Belardi is the chief executive officer of Athene, which is seeking to buy West Des Moines-based Aviva USA. He described himself to the Register as “an insurance guy,” rather than a “private equity guy.” However, on his watch, Apollo’s insurance arm has invested in everything from a casino to subprime mortgages and a railroad in Kazakhstan. Likewise, the insurance arm of private equity firm Guggenheim Partners invested $100 million in the Los Angeles Dodgers professional baseball team last year, according to Bloomberg LP. Those kinds of investments are a far cry from the low-risk government bonds that insurers favor.
TOUTING BENEFITS: Still, Belardi insists that Aviva USA will benefit from the Apollo deal. “We believe strongly that Aviva will be a stronger company because of Athene and Apollo’s ownership,” he said in a July 11 interview with the Register. “That’s been the case in every acquisition we’ve made.”
The Apollo-Aviva deal
THE PRICE: The insurance arm of Apollo Global Management, known as Athene, is seeking to purchase Aviva USA from its London-based parent company for $1.55 billion and the retirement of a $257 million external loan financing agreement.
TAX HAVENS: Athene is headquartered in Bermuda, a tax haven. Apollo controls Athene though a third company called AP Alternative Assets. It’s headquartered in Guernsey, a tax haven in the Channel Islands, between France and England.
UNDER REVIEW: Iowa Insurance Commissioner Nick Gerhart is reviewing the deal.
OTHER BIDDERS: Two other finalists in the bidding war were also private equity firms: Guggenheim Partners, a private equity firm that in January paid $471 million to FBL Financial Group Inc. of West Des Moines for its EquiTrust annuities business; and Harbinger Capital, run by hedge fund maven Philip Falcone. They and Apollo are based in New York City.
