#403 | The Double Edged Sword – Assets

closeup photo of black hilt and brown sword

Writing insurance is a double-edged sword. One side of the blade are the risks covered by the insurance policies themselves – the liability structure. The other side of the blade are the assets that support those liabilities. Successfully managing an insurance company means wielding the sword without being cut by either side of the blade. Confederation Life, Executive Life and Mutual Benefit Life were largely cut by the asset side. They each made aggressive investments that ultimately led to a swift collapse. Many insurers from Lincoln to General American to Ohio National have been cut by the liability side, taking massive write downs on in-force blocks of business or collapsing into the arms of a buyer. Wielding the double-edged sword is not for the faint of heart.

Right now, we are witnessing two historic situations that represent the worst of what happens when either side of the blade cuts deep. A few weeks ago, AM Best was sued by two insurers, Sentinel Security Life and Atlantic Coast Life, in order to stop an impending downgrade from B++ to B-. The two insurers have combined individual annuity reserves of over $9 billion. The cause for the downgrade was asset quality deterioration. And just last week, the Connecticut Insurance Department placed PHL Variable Life into rehabilitation, locking down over $4 billion in policyholder assets in the process. The reason? Losses from life insurance policies written in the mid-2000s, the liability side of the ledger.

It’s tempting to thematically tie these two situations together. Both involve private, institutional investors that might label themselves or be labeled as private equity. Sentinel Security Life and Atlantic Coast Life are owned by A Cap and PHL Variable Life is ultimately owned by Golden Gate Capital. Both situations involve reinsurance transactions that have gone sour. But reality is much more nuanced – in one case, private equity and reinsurance were at the heart of the problem. In the other case, private equity and reinsurance were arguably the only thing that kept a dead heart beating.

Every situation like these involves multiple points of failure. I read a book recently about the history of Concorde and was struck by the way that the author, who was the chief pilot for the British Airways Concorde fleet, wove the narrative of the development of the plane into the story of the fatal crash of a Concorde in 2000 as it took off from Paris. Concorde was an incredibly complex airplane that had to be operated within very, very tight parameters. The crash resulted from a confluence of factors – overfull fuel tanks, an unrepaired bump in the runway, worn bushings on the landing gear, unrecorded extra baggage, a growing tailwind, miscommunication in the cockpit and even the presence of the President of France’s plane waiting to taxi across the end of the runway. The irony was that the original explanation, a piece of metal debris left behind by another jet, was not actually a factor. Things are never quite as simple as they seem.

I say all of that to set up this article because I think the job at hand is to understand each situation individually and to determine whether or not those situations apply elsewhere. When one Boeing 737 Max crashed, it was an outlier. When a second Boeing 737 Max crashed, it was a pattern. The situations with SSL/ACL and PHL Variable are not the same airplane. And SSL/ACL isn’t yet a crash – it’s simply an impending significant downgrade. The degree to which these situations portend problems at other insurers is a question of how closely their fact patterns generalize elsewhere.

The Asset Side – Sentinel Security Life and Atlantic Coast Life

To understand what is going on with SSL/ACL, you have to ask a fundamental question – what is a life insurance company? At its core, a life insurer takes in premiums, holds investible reserves, covers mortality/longevity risk and maintains enough capital to cover all but catastrophic unexpected asset and liability losses. So what, then, do we call a company that takes in premiums, offloads virtually all of its reserves to other entities and maintains capital only sufficient to cover the sliver of reserves that it actually retains? Technically, it is a life insurance company. But practically, it’s a distribution and marketing company – a fronting company for other companies that are actually in the business of investing reserves, covering risk and posting capital.

Of SSL/ACL’s total annuity reserves of $9.5B (2022), $8.3B of those reserves are reinsured. SSL/ACL holds a total of $185M in capital against those $9.5B of reserves, which is a capital ratio of just under 2%. By contrast, most major life insurers have capital ratios at least three times that. But because the reserves are all shunted to reinsurers, the total risk-based capital requirement for the actual writing entities (SSL/ACL) remains low at just $34 million. Against $9 billion in total reserves. So who is posting all of the capital to cover those reserves? The reinsurers.

And that, of course, begs the question of who is reinsuring all of SSL/ACL’s business. The answer is tricky. There is a smattering of third-party reinsurers that tally up to around $1B of SSL/ACL’s reinsured reserves. A few of the names are familiar, such as Munich, Swiss and Hannover Re, and those firms seem to be on the hook for legacy life insurance business. The vast majority of the business is with three captive reinsurers – Haymarket ($2.95B), Jazz Re ($2.2B) and Southern Atlantic Re ($2.1B). Because the firms are captives, we can’t see their capital structure, investments, reinsurance deals. We can’t really see anything.

And that’s the point. Folks who are familiar with the legacy of captives in the life insurance business tend to assume that all captives are designed to manage liabilities that have “redundant” reserves because that’s what life insurers did for their Term and Guaranteed UL blocks. These captives, however, are designed as a waypoint in order to shield the investment strategy and reinsurance transactions from prying eyes.

Haymarket is owned directly by the parent holding company so we can’t see any details about the company. Jazz Re and Southern Atlantic, however, are owned by SSL and ACL (respectively) and domiciled in the same state as the parent company, which means they have the same regulator oversight. SSL and ACL hold their respective captive reinsurer’s capital on their balance sheet just like any other equity investment. So for Jazz Re and its $2.2 billion in reserves, how much capital does the company have? $3 million. The comparable figure for Southern Atlantic is just under $5 million. These reinsurers aren’t reinsurers. They are simply conduits to other reinsurers that we can’t see ­– and it seems reasonable to assume that Haymarket is the same deal.

Now, here’s where things get interesting. One of those reinsurers is 777 Re. We know that not because it’s in a regulatory filing that we can access but because of some astute investigative journalism from some Norwegian soccer fans and subsequent acknowledgements of the relationship by A Cap. Why do a bunch of Norwegian soccer fans care about 777 Re? Because, according to the reports, some of 777 Re’s investments are being funneled towards buying soccer clubs (including Everton, an EPL team) on behalf of 777 Re’s parent, 777 Partners. And to make matters more complex, the reports claim that A Cap is the puppeteer behind 777 Partners, supplying capital and loans to 777 to make investments on its behalf. The story makes for salacious reading.

Elements of it also happen to be broadly verifiable simply by looking at SSL and ACL’s statutory statements. Scattered amongst the two company’s roughly $1.5B (YE 2022) are investments linked to 777 Re – as verified by looking at 777 Re’s disclosure of affiliated investments, searching corporate records or simply looking at the name – that add up to over $160 million. For example, the largest investment is $55 million to JARM Capital LLC, a Florida entity with no discernible business purpose and is personally owned by one of the principals of 777 Partners. And that $160M is just what’s at the direct writing entities. It doesn’t include the more than $1 billion of 777-related assets at 777 Re that are backing SSL/ACL’s business through its reinsurers. The fate of SSL/ACL seems to be inextricably intertwined with that of 777 Re.

A few months ago, AM Best took the unprecedent step of dropping 777 Re’s rating from a solid A- to B and then again to C-, essentially sounding the death knell for the reinsurer. The cause was simple. 777 Re had invested roughly half of its assets in debt related to 777 Partners, which was becoming embroiled in scandals, lawsuits, a DOJ investigation, asset repossessions and good ‘ol fashioned money hemorrhaging. AM Best has expressed real concern over the quality of the affiliated assets and whether they’re worth anything at all. 777 Re’s capital isn’t sufficient to cover the losses and much of it, from what I can tell from reading the Bermuda filings, is in the form of promissory notes from the parent anyway. The Bermuda Monetary Authority has placed the reinsurer under administration and essentially frozen the assets until it can figure out what to do.

This places SSL/ACL in a very tough situation. Purely recapturing the reinsurance is out of the question. The companies don’t have enough capital to do it. Transferring the assets to a new reinsurer will also be difficult because the assets are frozen and don’t have a market value. The new reinsurer could be staring down a billion-dollar hole. Raising money to support recapturing the business at ACL/SSL will be extremely difficult because the extent of the losses is unknown. If the assets turn out to be good, then there will be no problem. If the assets turn out to be bad, then the losses will overwhelm the capital at SSL/ACL many times over.

That question is at the heart of SSL and ACL’s lawsuit against AM Best to stop an impending downgrade to B-. According to the life insurers, the assets – virtually all of which are held at 100 cents on the dollar on their balance sheets – are still high quality regardless of the challenges at 777 Partners. According to AM Best, the assets are essentially worthless. If the life insurers are right, then they’re also right to fight the downgrade. But if they’re wrong, then AM Best is being very, very optimistic by assigning them a B- rating.

What is terrifying, if you’re a participant in this industry, is the swiftness and severity with which this situation unfolded. A year ago, SSL/ACL were B++ rated carriers eyeing an A- rating and 777 Re was a solid A-. No concerns anywhere. No indication that things were about to start to fall apart. If you’d looked at SSL/ACL’s financials and 777 Re’s, you wouldn’t even have known there was a relationship between the companies. And yet 777 Re is on the verge of insolvency and SSL/ACL is buying time with a lawsuit against a ratings agency. How could we have known?

We couldn’t have. All we can see are the factors that led to the problem – lack of transparency, reliance on small third-party reinsurers, some funky investments and a thin layer of capital. That’s the smoke. The fire was lit by the problems at 777 Re, but the reality is that A Cap was playing a similar game with affiliated investments itself. Stuffed inside the balance sheets of SSL/ACL are affiliated debt and equity investments in A Cap companies that, as with many of the 777 Re-related investments, have no internet presence or discernible business activity. Affiliated investments aren’t necessarily a problem. Sometimes they can be fantastic. But they can also be fatal if the same rigor that would be applied by a third-party manager to a third-party investment isn’t applied to an affiliated investment. And who checks to make sure? Effectively no one, which is why most jurisdictions have tight requirements around allocations to affiliated investments.

We can see the problems at 777 Re precisely because it is rated by AM Best and because of the press around its parent entity. But what about other reinsurers that aren’t rated? We can’t even see where SSL/ACL reinsurers its business because it’s shielded by the captives. How do we know there aren’t more 777 Re-like problems lurking elsewhere? We wouldn’t know. There is no way to check. And that’s kind of the point.

However, we can get a window of insight by looking at SILAC. In many ways, SILAC looks a lot like SSL/ACL. It is a life insurance company that offloads the vast majority of its reserves to third-party reinsurers. Of its $10.5 billion in total reserves, roughly $8.3 billion is reinsured. SILAC holds substantially more capital (around $450 million) but much of that capital entered the system over the past few years courtesy of a $120 million surplus note offering and a capital infusion from the parent. Only $120 million is unassigned surplus, which constitutes the vast majority of surplus at typical insurers. SILAC is better capitalized than SSL and ACL, but it is by no metric well capitalized. Hence, its B+ rating from AM Best, lower than SSL and ACL prior to the recent issues with 777 Re.

Because SILAC uses third party reinsurers directly and doesn’t run the deals through a captive, we can actually see where it is offloading its business. One of its reinsurers was, until the first quarter of this year, 777 Re. Total reinsured reserves to 777 Re tallied up to just under $1.4 billion at the end of 2023. However, SILAC had enough capital to recapture all of that business – but it also had a trick up its sleeve.

As of Q1 of 2024, there were around $300 million of 777 Partners-affiliated investments on SILAC’s balance sheet, many of which are the same companies that are on the balance sheets of SSL/ACL. SILAC sold all of those assets (at par, mind you) to the Dacian Feeder Fund and then immediately repurchased debt in the feeder fund, essentially converting high-capital, high-risk assets into a stable NAIC 2 categorized bond. Voila. Little wonder that the NAIC is discussing cracking down on rated feeder funds. But for the time being, SILAC got a reprieve, although its RBC ratio undoubtedly still took a beating that we’ll see at the end of this year in the filing.

But the real story for SILAC isn’t 777 Re, it’s the other reinsurers who take its business. One is a very reputable, well-capitalized and well-rated firm called Knighthead out of Grand Cayman. Knighthead also runs a successful offshore business that is used by large banks and independent broker-dealers. It’s the real deal. But the rest? Not so much. Converge Re II is an unrated reinsurer out of Puerto Rico that, coincidentally, is also used by ACL. Ludlow Re is an unrated Cayman reinsurer backed by a US credit manager, Hildene, that also owns a part of SILAC. Weddell Re is unrated, domiciled in Barbados and backed by Antarctica Capital, a tiny asset manager in the US. Weddell lists no staff on its website. And, finally, SILAC reinsures nearly $3 billion to Heritage Re, which is an unrated reinsurer out of Arizona ultimately owned by oil baron Bobby Patton. Quite a lineup.

As more and more life insurers push business off to reinsurers, we have to go back to the basic question – what is a life insurer? One of the best lines I’ve heard on this topic is from an agent who said that life insurers used to be in the business of making and keeping promises, but now they only seem like they’re in the business of making promises and finding other people to keep them. Well said. In annuities, you simply can’t assume that just because you wrote a policy from XYZ insurer means that XYZ insurer is actually keeping the business. We’ve long ignored financial reinsurance because of the strength of the writing entity. But if a life insurer can’t handle a problem at any one of its numerous insurers, then how strong is that life insurer, regardless of what the AM Best rating says? You have to do your due diligence and, even then, you may not really know where the buck stops.

In life insurance, the buck still mostly stops at the company that wrote the policy. There is far less coinsurance in life insurance than in annuities, to be sure. If you bought a policy from a Big 4 mutual company, you can be almost completely sure that the company who sold you the policy is also keeping the risk. It’s core to their business. They’re actually, you know, life insurers. That’s also true for virtually all Indexed UL policies as well. The reality is that life insurance is too complex and the blocks are too small to get the same sort of attention as annuities. If you’re an asset manager and you want to raise a billion dollars to manage, life insurance is probably one of the hardest ways to do it. Even if life insurers wanted to use reinsurance leverage in the same way as annuity writers, they wouldn’t find very many willing counterparties.

The lesson, in my mind, is pretty simple – if you’re going to write annuities, make sure you understand the business model of the insurers you’re selling. If the model is to originate annuities and then reinsure the liabilities, make sure you know who the reinsurers are. There is nothing inherently wrong or problematic with a life insurer using reinsurance for annuity liabilities. Major, high-quality, well-capitalized life insurers including MassMutual and Guardian do it. But if the carrier itself has only a thin layer of capital, make sure you know where the buck ultimately stops.

If you’re writing life insurance at one of those carriers, then you should care a lot about how they manage their annuity block. As covered in previous articles, Brookfield reinsured American National’s annuity reserves to their own affiliated reinsurer and immediately started investing in affiliated assets. What happens to that reinsurer and those assets matters to the life insurance policyholders. With offshore reinsurance and affiliated assets, the concern is that a problem from the annuity side comes to haunt the life side. But as we’ll see next week, PHL Variable Life is the other cut of the sword – a liability problem on the life insurance side that has come to haunt its annuity policyholders.