Risk altered as private equity moves into insurance

Until April 2011, Patrick “Pete” Dodd, a former money manager at Liberty Life Insurance Co. in Greenville, S.C., 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 giant private-equity firm Apollo Global Management LLC 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 Mr. Dodd, who helped manage $4 billion before the sale to 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, Guggenheim Partners LLC, Harbinger Group Inc. and The Goldman Sachs Group Inc. 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.

‘TROUBLING ROLE’

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 recent speech.

“The risk we’re concerned about at [the Department of Financial -Services] is whether these private-equity firms are more short-term-focused, when this is a business that’s all about the long haul,” he 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.”

Money managers contend that their investments are no more dangerous than those of traditional insurers and that they are 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.

UNORTHODOX

Although some of its investments are unorthodox, “our portfolio is less risky than traditional life insurance companies’,” said James R. Belardi, chief executive of the Athene unit.

Athene’s plans to acquire Aviva PLC’s U.S. insurance operation in a $1.8 billion transaction disturb Michael Garcia, a retired phone company salesman.

The 61-year-old 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,” Mr. Garcia 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?” Mr. Garcia said.

“Don’t play poker with our money,” he said.

The Wall Street-backed insurers sell primarily retirement savings products known as fixed annuities.

Wall Street firms account for 15% of the fixed-annuity market, up from 4% a year ago, Mr. Lawsky said in his speech.

The planned Aviva acquisition by Apollo would make Athene the second-largest U.S. seller of fixed annuities.

Athene targets return on equity of 16% to 20%, according to an Apollo presentation in February.

Annuities can tempt insurers to boost profits by investing aggressively, said Lawrence J. Rybka, chief executive of ValMark Securities Inc.

“The long-term interests of policyholders are not in alignment with the short-term interests of private equity,” he said. “It’s a “heads, I win, tails, you lose’ game.”

STATES’ CONFLICTING ROLES

Although the U.S. bank regulatory system is predominantly federal, insurance is regulated by state 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 during the financial crisis.

The Wall Street giant sought permission to tap its Charleston, S.C., subsidiary, which had taken in more than $600 million in 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 the financial panic that year would contribute to the collapse of Lehman Brothers Holdings Inc. and the forced sale of The Bear Stearns Cos. Inc.

South Carolina rejected Goldman Sachs’ proposal and also rescinded an earlier approval for a similar plan, said the person with knowledge of the matter.

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.

Goldman Sachs is now shutting down its D.C. insurance operation. Two years after Goldman Sachs exited South Carolina, Apollo’s insurance unit, Athene, arrived to take over Liberty Life.

DISTRESSED PRICES

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, Mr. Rowan said during a conference call last year.

Investing policyholders’ money alongside its own would magnify returns, employing “a significant amount of leverage,” he said.

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.

Athene said that Liberty would “continue operations in South Carolina.”

Less than five months later, Athene switched Liberty’s legal address to Delaware, where state regulators were willing to loosen some restrictions. Liberty’s headquarters remains in Greenville and it does less than 1% of its business in Delaware.

After Athene took over Liberty Life, Mr. Dodd and the rest of the company’s investment team were replaced by a group overseen by Mr. Belardi in 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 such as 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 such as mortgages and high-yield loans. In commercial real estate, it added mezzanine loans, which are the first to default if property owners can’t pay their debts.

Lower-yielding bonds from the biggest U.S. companies were de-emphasized.

The new additions included $9 million in securities backed by Wyndham Worldwide Corp. time share vacation homes in resorts. Plus: $1.2 million in bonds to modernize a Soviet-era railroad owned by the Kazakhstan government.

Related Topics: Goldman Sachs & Co.