Until April 2011, Patrick “Pete” Dodd, a former money manager at Liberty Life Insurance Co. in Greenville, South Carolina, invested customer premiums in what he calls a “squeaky clean” portfolio: bonds backed by state governments and blue chip corporations.
Then a company funded by private equity firm Apollo Global Management LLC (APO) acquired Liberty and inherited its clientele, mostly people approaching retirement who had bought annuities from the company to supplement their Social Security. Now the unit's holdings include securities backed by subprime mortgages, time-share vacation homes and a railroad in Kazakhstan.
“When you look at the business model these guys use, where they're substantially increasing the risk in the bond portfolio, sooner or later, in my opinion, that has to come home to roost,” said Dodd, 55, who helped manage $4 billion before the sale to New York-based Apollo's Athene Holding Ltd. “All the upside would go to Athene if it worked out. And the downside would go to the annuity holders if it didn't.”
Wall Street firms such as Apollo, Goldman Sachs Group Inc. (GS), Harbinger Group Inc. and Guggenheim Partners LLC are acquiring life insurance companies and shaking up a staid industry with investments in everything from the Los Angeles Dodgers baseball team to mortgage-backed securities that cratered during the financial crisis. The newcomers are meeting resistance from some state insurance regulators accustomed to vanilla portfolios, who have warned about exposing policyholders to greater risk.
New York State may need to modernize its regulations to deal with the increased presence and “troubling role” of private-equity firms in selling annuities, which promise regular payments to policyholders, Benjamin Lawsky, New York state superintendent of financial services, said in a speech last week.
“The risk we're concerned about at DFS is whether these private-equity firms are more short-term focused, when this is a business that's all about the long haul,” Lawsky said. “Their focus is on maximizing their immediate financial returns, rather than ensuring that promised retirement benefits are there at the end of the day for policyholders.”
Private-equity firms can be very successful even if some of their ventures fail, he said. “This type of business model isn't necessarily a natural fit for the insurance business, where a failure can put policyholders at very significant risk.”
Apollo and Goldman Sachs both shifted the legal addresses of their South Carolina insurers out of state after its regulators limited their investing strategies. For New York- based Goldman Sachs, the move came after it hired the state's former insurance director as a lobbyist and appealed for help to the South Carolina governor's office.
“Companies want to do things, and then when a regulator tries to do their job, then they go find a domicile that will let them do what they want,” said Scott H. Richardson, who was the South Carolina insurance director when Goldman Sachs left the state for the nation's capital in 2009. “We weren't being friendly enough to them, so they went to D.C.”
The money managers say their investments are no more dangerous than those of traditional insurers, and that they're managing them with a long-term view. In a key measure of financial health known as the risk-based capital ratio, the units far surpass the minimums required by state regulators.
While some of its investments are unorthodox, “our portfolio is less risky than traditional life-insurance companies,” said James R. Belardi, chief executive officer of Apollo's Bermuda-based Athene unit. It is “a reason why people should invest in our company, as opposed to the unsuccessful strategies of traditional life insurance companies, which has been an underperforming sector in the economy for many, many years.”
Guggenheim's insurance units bought part of the Los Angeles Dodgers last year, when Guggenheim CEO Mark Walter led a $2 billion purchase of the baseball team. Its insurance arms invested about $100 million, according to a person close to the company who spoke on condition of anonymity because of Major League Baseball confidentiality rules.
Guggenheim's insurance arms invest conservatively, and it plans to own them for a long time, said Michael Sitrick, a spokesman. A money manager based in New York and Chicago, Guggenheim also advises traditional insurers about their investments.
Investing premiums in a baseball team is “a little odd,” said Nick Gerhart, the insurance commissioner for Iowa, one of five states that oversee Guggenheim insurers.
Later this year, Gerhart is expected to review Apollo's biggest insurance takeover yet -- its $1.8 billion agreement to buy the West Des Moines-based U.S. operation of London-based Aviva Plc.
“This move from private equity into insurance is relatively a new phenomenon, and I don't know how many regulators have even spent time thinking about it,” said Gerhart.
Athene's plans to acquire Aviva's U.S. operation disturbed Michael Garcia, a retired phone company salesman in the Los Angeles suburbs. Garcia, 61, spent most of his life savings on an Aviva annuity last year, he said.
“The new owners, Apollo, are not an insurance company. They're a private-equity company. That's a big difference,” he said. “So obviously my concern is: Are these people going to keep enough reserves? Are they going to play by the rules that insurance companies have to play by?”
“Don't play poker with our money,” Garcia said.
By routing at least some of their insurance units' investments to funds managed by the parent company, the Wall Street firms can generate fee revenue. Athene, for instance, put about a third of its $15.8 billion of assets into Apollo funds, including collateralized loan obligations and private equity, generating fees for Apollo.
Harbinger Group tried the same tactic. Controlled by Philip Falcone's Harbinger Capital Partners LLC hedge-fund firm, Harbinger Group entered the insurance business in 2011 when it bought an annuity provider in Maryland from London-based Old Mutual Plc.
Harbinger soon sought to transfer $3 billion of the Maryland firm's business to an insurance company it owns in Bermuda, according to Securities and Exchange Commission filings. About $1 billion would be managed by Falcone's hedge fund firm and invested in assets rated non-investment grade, or junk, below Baa3 by Moody's Investors Service and less than BBB- by Standard & Poor's.
Maryland regulators rejected the proposal last year. The deal may “adversely affect interests of policyholders,” wrote Neil Miller, an associate Maryland insurance commissioner. “There is no assurance that the investment manager will successfully mitigate the risks.”
Harbinger later won approval for a smaller deal involving more traditional assets, which the hedge fund wouldn't manage.
Since it made the original proposal to Maryland, Harbinger Group has changed its strategy, said Phil Gass, a managing director, adding that it owns fewer junk-rated securities than most insurers. Unlike private-equity funds, Harbinger, a publicly traded company, can hold onto acquisitions indefinitely and takes a long-term view, he said.
The Wall Street-backed insurers primarily sell retirement- savings products known as fixed annuities. Wall Street firms account for 15 percent of the fixed annuity market, up from 4 percent a year ago, Lawsky said in his speech. The planned Aviva acquisition by Apollo, one of the world's largest private-equity firms, would make Athene the second-largest U.S. seller of fixed annuities. Athene targets return on equity of 16 percent to 20 percent, according to an Apollo presentation in February.
Lawrence J. Rybka, chief executive officer of ValMark Securities Inc., said his firm won't sell the new insurers' annuities, in part because their financial-strength ratings from A.M. Best Co. aren't high enough. His Akron, Ohio-based company's liability insurance won't pay for his defense if he's sued by a client who buys an annuity from a company with less than an A rating that later fails, he said. Unlike the Wall Street-backed firms, most of the country's largest insurers, such as MetLife Inc. (MET) and New York Life Insurance Co., have ratings of A or better.
Annuities can tempt insurers to boost profits by investing aggressively, Rybka said. In a typical transaction, a customer hands over her retirement nest egg to an insurance company in exchange for a promised future stream of payments.
The insurer gets to invest the money and keep any earnings beyond what's guaranteed to the policyholder. If the bets backfire and the insurance company fails, some losses may be borne by customers and state guarantee funds, Rybka said.
“The long-term interests of policyholders are not in alignment with the short-term interests of private equity,” Rybka said. “It's a heads I win, tails you lose game.”
While the U.S. bank regulatory system is predominantly federal, insurance is regulated by state insurance officials, who play dual and sometimes conflicting roles as economic boosters and consumer watchdogs.
South Carolina is “among the most business friendly” states, according to its commerce department website. Still, it balked when Goldman Sachs wanted to dip into policyholders' premiums for funding in the financial crisis.
One of the largest U.S. securities firms, Goldman Sachs set up an insurance unit in Charleston in 2004. It joined dozens of companies recruited by Insurance Director Ernst N. Csiszar to establish subsidiaries known as “captives” in the state. Some of them were used to experiment with brand-new types of financial transactions.
“Bermuda was advertising itself as the offshore laboratory of insurance,” Csiszar said in a recent interview. “I said O.K., why don't we become the onshore laboratory?”
Csiszar resigned later that year, replaced by Eleanor Kitzman, founder of an auto insurance company in the state. After then Governor Mark Sanford forced Kitzman out of office in 2007, she took a job in government relations with Goldman Sachs, and became president of the investment bank's South Carolina subsidiary.
In 2008, Goldman Sachs sought South Carolina's permission to tap the Charleston subsidiary, which had taken on more than $600 million of assets backing customers' life insurance policies that year, for deals akin to “reverse repurchases” -- short-term influxes of cash to fund Goldman Sachs' trading, according to a person with knowledge of the matter who requested anonymity because the unit's investments are confidential.
The evaporation of such funding, in the midst of a financial panic that year, would contribute to the collapse of Lehman Brothers Holdings Inc. and the forced sale of Bear Stearns Cos.
South Carolina rejected Goldman's proposal, and also rescinded an earlier approval for a similar plan, said the person with knowledge of the matter.
Richardson, South Carolina's insurance commissioner at the time, confirmed he rejected a Goldman Sachs proposal. The department had grown stricter since Csiszar's tenure, especially after a few of the newly established companies ran into trouble, he said.
“When Ernie first started it, of course, it was new. We were sort of the new kid on the block,” he said. “We went out and did some things we probably shouldn't have done.”
Move to D.C.
Around that time, Goldman Sachs sought help on an insurance matter from the governor's office, which refused to intervene, said Scott English, then Sanford's chief of staff. A person close to the company said no one in its insurance group recalls the conversation.
Goldman Sachs soon found another way around the South Carolina roadblock: moving to the District of Columbia. “It is not surprising we would choose to relocate to the District of Columbia once South Carolina reversed itself,” Goldman Sachs said in a statement.
Like South Carolina, the district was advertising itself as a haven for captive insurers such as Goldman Sachs's. Thomas Hampton, the Washington commissioner at the time, said Kitzman led talks with him. Hampton said he agreed to allow the investments that South Carolina prohibited, after reviewing them with his staff.
Goldman Sachs's arrival “was great,” he said. “It not only brought revenue here, but payroll taxes and everything else.”
Kitzman, now Texas insurance commissioner, declined to comment.
In D.C., Goldman Sachs borrowed a small amount of money from its insurance unit through the same strategy that South Carolina rejected, the firm said in the statement. It said two such trades were secured by assets and never amounted to more than 2 percent of its overall insurance portfolio.
Goldman Sachs is now shutting down its D.C. insurance operation. The unit is a small part of the firm's insurance group, known as Global Atlantic. Apart from the D.C. trades, Global Atlantic has always had a “traditional” investing strategy, the company said.
Two years after Goldman Sachs exited South Carolina, Apollo's insurance unit, Athene, arrived.
Founded by billionaires Leon Black, Josh Harris, and Marc Rowan, Apollo decided after the credit crisis in 2008 to buy beaten-down bonds and illiquid mortgage-backed securities at distressed prices through an insurance company, Rowan said on a conference call last year. Investing policyholders' money alongside its own would magnify returns, employing “a significant amount of leverage,” he said.
Run by Belardi, a Californian who twice competed in Olympic swim trials and had been a top executive at SunAmerica Financial Group Inc., Athene took on its first major deal in October 2010, agreeing to acquire Liberty from Royal Bank of Canada for about $600 million. Founded in 1919 by a salesman named Frank Hipp, Liberty had its roots selling policies to workers in Greenville's textile mills. Hipp's heirs sold the company to RBC in 2000.
The Athene agreement was the start of “rather extensive negotiations” with South Carolina insurance regulators, according to Thomas W. Cooper, a retired judge who oversaw the months-long approval process. Apollo resubmitted its proposal four times.
“Most of the time was spent trying to get the buyer to satisfy the department that there were sufficient safeguards,” Cooper said.
Athene eventually agreed in April 2011 to limit Liberty's investments in junk-rated securities; to maintain Liberty's capital levels, including by contributing more capital if necessary; to submit a quarterly liquidity report; to pay for the department to hire an actuary to monitor the company's health; and to appoint three independent directors to the board.
Athene also said Liberty would “continue operations in South Carolina.”
Less than five months later, Athene switched Liberty's legal address to Delaware. Liberty's headquarters remains in Greenville, South Carolina, and it does less than 1 percent of its business in Delaware.
Athene was in the process of buying a smaller insurer in Delaware, and state officials “did the right things, we thought, as far as encouraging businesses to be there,” Belardi said. “We wanted one regulator. We liked them better.”
As a condition of the transfer, South Carolina officials insisted that Delaware keep all the conditions that had just been negotiated as part of the Liberty takeover unless it hired an outside expert to affirm they weren't necessary.
Subsequently, Delaware did so and dropped some of the conditions, said Nicole Brittingham, an insurance department official.
Athene's own internal guidelines are “stricter than any regulator was talking about with us,” Belardi said.
After Athene took over Liberty Life, Dodd and the rest of the company's investment team were replaced by a group overseen by Belardi in Manhattan Beach, California.
The new group replaced Liberty's conservative portfolio with more exotic -- though still mostly highly-rated -- securities. Out went most of Liberty's state and municipal bonds, and its mortgage securities backed by government- sponsored firms like Fannie Mae. In came mortgage securities without a guarantee. Because they had declined in value when the U.S. housing boom ended, Liberty could buy them at a discount.
Liberty, which changed its name last year to Athene Annuity & Life Assurance Co., also embraced collateralized debt obligations, complicated products backed by pools of assets like mortgages or high-yield loans. In commercial real estate, it added mezzanine loans from Tucson, Arizona, to Tampa, Florida, which are the first to default if property owners can't pay their debts.
Lower-yielding bonds from the biggest U.S. companies were deemphasized. The new additions included $9 million in securities backed by Wyndham Worldwide Corp. timeshare vacation homes in resorts. Plus: $1.2 million in bonds to modernize a Soviet-era railroad owned by the Kazakhstan government.