#420 | A Question of Value

12/16/24 Update – The South Carolina Department of Insurance has also mandated that A-CAP’s South Carolina entities, Atlantic Coast Life and Southern Atlantic Re, stop writing new business as of 12/31. This decision was inevitable and probably unavoidable because Atlantic Coast Life uses Haymarket as a reinsurer.

12/23/24 Update – The South Carolina order was made public and there are a few revelations in it that are worth noting. South Carolina has been a party of the Utah examination of A-CAP’s companies since January of 2024. The two A-CAP companies domiciled in SC were placed under administrative supervision in April of this year and were told on 10/21 to stop writing new business immediately. However, they were then given an extension to 12/31 despite the fact that “the insurers exhibit negative surplus.” In response to a letter from A-CAP stating that its “financials are strong” and “is closing out a profitable” year, which South Carolina calls “consistent with the circumstances justifying ongoing regulatory action and are otherwise confusing, inaccurate and misleading,” South Carolina decided to make the notice public. South Carolina also notes that [A-CAP] has made “misleading assertions regarding the directive to cease writing new business.” I’ve read the notes from A-CAP and they strike a surprisingly optimistic tone, but the letters regarding both Sentinel Security Life and Atlantic Coast Life basically say the issue at hand is the valuation of certain invested assets and that A-CAP is holding the assets at proper value based on third-party appraisals.

There basically are three causes of failure at a life insurer – operations, liabilities and assets. Columbian Mutual is what happens when a life insurer simply can’t operate with sufficient margin. PHL Variable is what happens when a life insurer writes unprofitable policies. But what happens when a life insurer just flat out invests in the wrong stuff? We have Executive Life, Mutual Benefit and Confederation Life, all of which were highly rated until they blew up seemingly overnight because of bad investments.

And now we may be adding one more to the list – Sentinel Security Life. Last week, the Utah Department of Insurance filed an Emergency Order declaring that Sentinel Security and two of affiliated Utah-domiciled captive reinsurers, Jazz Re and Haymarket Insurance, are in a “Hazardous Financial Condition” due to an aggregate surplus hole of over $500 million and demanding that Sentinel Security stop writing new business by the end of the month. Take a look at the swing in surplus by entity using the “updated” numbers from Utah’s examination:

If these names sound familiar, it may be because I covered Sentinel Security, its sister company Atlantic Coast Life and its parent A-CAP back in June in #403 | The Double Edged Sword. Over the summer, Bermuda-based, formerly A- rated 777 Re imploded due to mounting losses in assets affiliated with its owner 777 Partners, which famously failed to buy Everton FC. The vast majority of the assets in 777 Re were actually invested on behalf of A-CAP through reinsurance arrangements. These investments are anything but standard corporate grade debt. The assets at 777 Re are a web of interparty transactions. They’re extremely difficult to value without insider information. AM Best was set to downgrade A-CAP from B++ to B- but was stopped when A-CAP sued AM Best. At the center of that lawsuit was a core question – what are those complex, illiquid, obscure and privately traded assets actually worth?

A-CAP is far from the only insurer with a lot of complex, illiquid, obscure and privately traded assets. The entire financial services complex is starting to move more towards private equity and credit investments, as has been well documented in the financial press. Life insurers are no exception. Small insurers still have stereotypical portfolios comprised primarily of investment grade corporate bonds, but any insurer with more than a billion dollars in reserves is undoubtedly investing in more complex asset classes that are difficult to value.

These assets earn higher risk-adjusted yields in large part due to what investment folks refer to as liquidity premium and “complexity” premium – basically, if an asset has a smaller natural market and is more arcane, then it generates a higher risk-adjusted yield because there are fewer people who understand it and will step up to buy it in a pinch. Those sorts of assets theoretically make sense for life insurers because life insurers hold generally hold assets to maturity and mark them at book value for statutory accounting. Complex and illiquid assets are a natural fit for insurance.

This revelation is the reason why “private equity” firms have been entering into our space in the past few years. One of the impediments to really understanding their model is pure terminology. Let’s take Apollo, for example. Apollo has three primary lines of business. The first has $502B in AUM, the second has $105B in AUM and the third has $88B in AUM. Second place is private equity and third place is real estate. Apollo’s largest business by both assets under management and investment employee headcount is private credit. So what is Apollo? It’s not a private equity firm – it’s “an alternative asset management and retirement services leader.”

If you’re trying to understand what they’re doing in the life insurance business, then viewing firms like Apollo through the lens of asset management is more accurate and more insightful than viewing them through the lens of traditional private equity. An oversimplification of the traditional private equity model is that it’s about buying, rehabbing and flipping companies. The opposite is happening in our industry. Apollo founded Athene, which is the industry’s largest fixed annuity writer, and then merged the two companies together.

Asset managers generally don’t view insurers as businesses to be built and sold. Instead, they view insurance as a means to an end. What are these asset managers trying to do? Manage more assets. The traditional route is to raise money to manage from endowments, pension plans, high net worth individuals, and other institutional investors, including life insurers. It’s a world with relatively few large and very demanding customers. Competing for allocations from those sources is bloodsport with the countless other alternative asset managers vying for the same slice of the pie. It’s a very tough market.

Insurance represents a different path for growing assets under management. If the asset manager is willing to take some of its own capital to fund an insurer and/or a reinsurer, then they can generate assets to manage by selling or reinsuring annuities. They are not insurance experts. They don’t want to take complex longevity, mortality or morbidity risks, which is why they’ve generally eschewed life insurance and even annuities with living benefits*. They just want to manage money. The catch is that if you’re going to raise money with insurance, then you have to play by the rules of insurance.

Writing insurance requires capital. For every $100 of annuity deposits, the insurer has to put up between $10 and $20 to cover commissions, expenses, reserve strain and RBC capital. Commissions and expenses are simply the cost of doing business. Reserve strain for products with guarantees, such as MYGAs, is usually handled by reinsuring the business to a jurisdiction that allows for GAAP reserve accounting. The variable in RBC is C-1, which is meant to reflect the inherent default risk of the investment portfolio supporting the product.

The goal of any insurer writing annuities is pretty simple – earn enough investment spread to more than cover the all-in cost of the annuity liability, which is usually referred to as the cost of funds. Writing annuities is a transactional way to generate more assets to manage. The goal is to clear the hurdle rate and whatever is left over is profit for the insurer. That dynamic is one of the reasons why insurance is so appealing to alternative asset managers. With traditional fundraising, the maximum upside for the manager is the management fee. But with insurance, the asset manager is posting the capital and gets a shot at a lot more upside through retained spread.

The incentive, therefore, is to push the limit as much as possible while still complying with the letter of the RBC formula. If a traditional A-rated investment grade corporate bond is yielding 5% but an A-rated Collateralized Loan Obligation that is more complex and less liquid is yielding 6%, then the CLO represents an opportunity to pick up spread without posting more capital. These sorts of opportunities abound in the private markets. And who is creating them? The same asset managers who are buying life insurers.

The net result of all of these new entrants is that annuity rates are more competitive than ever. Policyholders have their choice of annuities from an enormous range of companies, everything from unimpeachable A++ rated firms like New York Life to never-heard-of-‘em B+ firms like Wichita National Life which, ironically, is only licensed in a handful of states. The current spread between the offered 5 year MYGA rates for these two firms is 1.5%. Like the bond market, lower rated companies tend to offer higher rates because they’re pushing the limit on investments and capitalization.

Increasingly, the way that traditional insurers compete in this market is by using reinsurers owned by asset managers for their annuity flows. Global Atlantic, which is owned by KKR, runs some of its reinsurance treaties through Commonwealth Life, a US-domiciled insurer. As a result, we can see who is using Global Atlantic for annuity reinsurance and it’s a stacked list – Guardian, MassMutual, OneAmerica, USAA, Lincoln, Brighthouse, TruStage, MetLife, PacLife, Riversource, Transamerica and Mutual of Omaha, to name a few. All told, these companies reinsured $54.5 billion in reserves and $13.5 billion in annual premium in 2023 through Global Atlantic. And that’s just one asset manager-backed reinsurer and not even the largest one.

The appeal of the strategy is built on the idea that an asset manager who understands complex, illiquid and usually private assets can generate higher returns on capital and attract more assets to manage by offering better rates to customers. So far, that’s exactly what has happened. But the flip side to the strategy is that if some of those complex, illiquid and privately traded assets end up being problematic, then it can cause chaos.

This brings us back to Sentinel Security Life and the question of asset valuation at the heart of the Utah Emergency Order. As a part of the evaluation process, Utah hired a third-party firm called Harvest Investments to dig through the books at Sentinel Security, Haymarket and Jazz Re to identify potentially problematic investments and to assign a reasonable recovery value.

Harvest only made it through three investments before Utah issued its Emergency Order. Those three investments are JARM LLC, PAC Wagon and Flair Airlines. Between Haymarket Re and Sentinel Security, those three investments account for a whopping $450 million of exposure that is on the books at 100 cents on the dollar. Harvest, however, set the values at between 0.0 (Flair) and 27.14 (PAC Wagon) cents on the dollar. The valuation applied to any single one of those investments would likely have put the entire company into rehabilitation.

The Emergency Order states that “Harvest continues its valuation of the Companies’ high-risk assets/investments” and that “the examination is ongoing.” There’s a lot more to sort through, particularly at Haymarket Re. Of the roughly $3.5 billion in assets at Haymarket, more than $750 million is related to 777 (based on public records) and has not been yet evaluated by Harvest, including a $200 million bridge loan to 777 Partners itself and a $275 million loan to Nutmeg, the entity that holds 777’s soccer clubs. Sentinel has smaller slices of many of the same assets. If Harvest assigns valuations of anything less than 100 cents on the dollar for any of those assets, which is currently where all of them are valued on the books, then the surplus hole is only going to get bigger.

Comb through the books at Haymarket and Sentinel and you’ll see a lot of other obscure investments. There is a $17 million VIP Term Loan, for example, at Haymarket. The two insurers have aggregate exposure of $135 million to Pistosi and Libresine, both of which are affiliated with A-CAP. There are a bunch of ambiguously named loans that only show up in A-CAP filings and not at other insurers – Claughton Island Holdings, 1974 Senior/Junior, Aircraft Subordinate Debt, Hafen, a series of companies named after trees, Phipps Litigation, entities related to SQN and a slew of exposure to Freedom 3 funds. Virtually all of them are held at 100 cents on the dollar.

A-CAP’s response to Utah was the same as its response to AM Best. It hired Houlihan Lokey, a well-known investment bank, to assign valuations to the assets and not surprisingly came up with very different valuations. Notably, A-CAP didn’t contest Utah’s 11-cent valuation of JARM LLC, which is registered personally to Josh Wander of 777 Partners. The Emergency Order states that the “[A-CAP] criticized Harvest’s work and submitted alternative valuations of the Flair and PAC Wagon loans. After considering the Companies’ input, the [Examiner-in-Charge] did not alter the adjustments [to the valuation].”

The thing about valuations is that, eventually, they get sorted out. The loans either default or they don’t. If the owner wants to sell, then the loans either sell at the book price or they don’t. We will see over the coming months whether the assets at A-CAP are worth what Harvest says or what Houlihan Lokey says – and the viability of the company hangs in the balance. As an outsider, it’s impossible to know.

The broader question is why the situation at A-CAP wasn’t evaluated long ago. Statutory accounting recognizes default primarily risk through NAIC ratings, with 1 and 2 being investment grade debt and 3-6 below investment grade. Carriers have to hold capital and Asset Valuation Reserve based on the classification of their assets. Based on NAIC ratings, there was nothing weird about A-CAP’s portfolio. The vast majority of it was classified as NAIC 1 and 2. It looked pretty normal and generally pretty high quality.

This sort of ratings-based approach makes sense if a company has a highly diversified portfolio of credit issuers, which is usually the case for insurers. Look through any company’s Schedule D and you’ll see hundreds of issuers that are usually names you know, each with a little slice of the overall portfolio. Using historical default rates to calibrate capital and AVR for this sort of portfolio makes sense. You know the average default and you also know that any single default won’t blow up the insurer. It’s the law of large numbers working for investments the same way that it works for mortality.

However, that is not the situation at A-CAP. Consider the fact that Haymarket has statutory surplus plus AVR of a little over $100 million and it has several single-issuer investments that are larger than $100 million** each. A-CAP books all of those investments at 100 cents on the dollar. JARM LLC, which both Utah and A-CAP appear agree is essentially worthless, is held on Haymarket’s books at par with an NAIC 1 rating. PAC Wagon is categorized as investment grade debt under NAIC 2. Flair Airlines is one of the few holdings at NAIC 3.

The fact that this concentration risk was not caught earlier by Utah, which is the domestic regulator for all three entities under the Emergency Order, is mind blowing. Equally mind blowing is that AM Best didn’t catch it either until 777 Re started to implode. Something is clearly amiss with the regulatory regime if a group of companies can make a $700 million surplus swing from positive to negative simply from the valuation of three investments.

If these investments prove to be as bad as Utah says they are and Sentinel Security loses its appeal to stay the Emergency Order, then there is no doubt that A-CAP will be held out as the worst of what happens when asset managers get involved in the life insurance business. I think that would be a mistake. A-CAP’s level of concentration risk was far beyond what I’ve seen in any other insurance company. It was a huge bet on 777 Partners that they should have never been allowed to make, even if the bet had turned out to be a good one.

Still, there’s a lesson to be learned. As life insurers – all life insurers, not just insurers owned by asset managers – move into more complex, less liquid and more privately traded investments, the question of asset valuation will move to the forefront. There is no doubt in my mind that this transition is ultimately good for policyholders, insurers and for capital markets at large. Insurance represents a unique liability that demands unique assets. Life insurers finally have a way to get an edge on the asset side.

But these assets open up a whole suite of new challenges for valuation. Is the traditional statutory accounting regime ready for it? Based on what’s happening at A-CAP, the answer seems to be that it’s not. Until there is a way to gauge concentration risk and put realistic and real-time valuations on tough-to-value assets, there will remain the possibility of dead insurers walking in the flesh – and they themselves may not even know it.

*The more experience that an asset manager has with insurance, the more willing they are to write mortality and longevity risk. Sometimes that experience is acquired with an in-force book, sometimes it’s built up over years of being in the business and hiring experienced insurance folks. But out of the gate, most asset managers want nothing to do with actual insurance risks.

**Single issuer is in contrast to a position in a diversified underlying portfolio such as a Collateralized Loan Obligation.