Warnings of Mounting Risk.
XOL assets.
The following piece was written by Mary Williams Walsh, an exceptionally talented former New York Times reporter and News Items contributing editor. She’s written a number of pieces for us on how “private-equity firms have muscled their way into the life-and-annuity business, by buying U.S. life insurers or otherwise controlling them.” This one will make your head hurt.
By Mary Williams Walsh
We keep seeing warnings of mounting risks in the life-and-annuity business. The latest report, issued this week by Moody’s Ratings, found that some carriers were loading up on “private debt” – paper that doesn’t trade much and could pose problems if insurers had to sell it to pay claims “during market stress.”
That followed last month’s report by the Bank for International Settlements, which noted that private-equity firms have muscled their way into the life-and-annuity business, by buying U.S. life insurers or otherwise controlling them. As a result, the life insurers were relying on “riskier and opaque assets,” derivatives, and reinsurance deals, “often through offshore jurisdictions.” Offshore jurisdictions regulate insurance differently, resulting in more leverage, and more profit for the private equity firms to reap.
Like previous reports from the Federal Reserve and the International Monetary Fund, the BIS paper dwelt mainly on the dangers facing the financial system – the possibility that if a big life insurer got into trouble it might bring havoc to other financial institutions. They’re supposed to worry about that.
They didn’t really get into the risks for consumers who buy life policies and annuities. Protecting U.S. policyholders is the job of state insurance commissioners, and their National Association of Insurance Commissioners fights to keep interlopers off its turf. The Moody’s report did rank the ten U.S. insurers with the biggest holdings of illiquid debt – Security Benefit Life and Delaware Life were tied for first place – but it warned that a fire sale in a down market could cause “realized losses and earnings volatility.” Those are concerns for insurers’ shareholders, not for policyholders.
It’s odd to leave policyholders out of the discussion. The boomers are aging, and the ones with money have been pouring it into annuities, even as sweeping changes are exposing them to risks they can’t see. In September the Life Insurance Marketing and Research Association reported annuity sales of $226 billion in the first six months of this year – 4 percent more than in the same period last year, which itself broke the previous record. Annuity records are being broken all the time these days.
The complex contracts allow boomers to pay life insurers now to send them a stream of monthly payments in the future – coveted retirement income. Annuities come in all shapes, sizes and structures, but the basic idea is that if you annuitize, say, your 401(k) balance, you won’t risk outliving your assets. The insurer will keep sending you money like clockwork until you die.
Annuity buyers were apparently not scared off by the disaster last year at 777 Re, a private-equity-owned reinsurer in Bermuda that was supposedly reinsuring the obligations of a group of annuity writers in the United States. 777 Re was abruptly shut down by the British territory’s regulators, who had learned it was being used as a cash cow by its Miami parent, 777 Partners. The American annuitants were dutifully sending their premiums, unaware that the money was being sunk into pro soccer teams, unprofitable budget airlines, streaming platforms, and other investments wholly unsuited to the securing of annuity obligations. In October, 777’s chief executive Joshua Wander was indicted by the U.S. attorney for the Southern District of New York, on charges of stealing more than $500 million from his company’s lenders and investors.
The collapse of 777 Re came close to toppling a handful of U.S. insurers that had been using it as their reinsurer, a family known as Advantage Capital, or A-Cap. The A-Cap insurers’ lead regulator, the Utah Insurance Department, said the companies were “insolvent, impaired, in a financially hazardous condition, [and] in flagrant violation of multiple provisions of the Utah Insurance Code,” and petitioned a court to take them over. Utah’s commissioner, Jon Pike, is also chair of the N.A.I.C.’s Market Regulation and Consumer Affairs Committee.
But before the state takeover could take place, Utah went into confidential mediation with the A-Cap companies. Then Pike withdrew the petition without explanation. A Utah judge dismissed the case last May. On the surface, everything looks fine. No one’s talking about “flagrant violations” any more. Annuitants are still sending in their premiums. Claims can apparently be paid out of cash flow, at least for now. (Annuity claims are often paid out slowly, over many years.)
Was 777 Re just a bad apple? Or did it exemplify the kind of “riskier and opaque assets” that the BIS and other analysts see in “offshore jurisdictions”?
I decided to ask Tom Gober, a forensic accountant for clients ranging from hedge funds to trial lawyers to financial advisers with very risk-averse customers. He’s had a particular interest in reinsurance misconduct since 2003, when he helped to untangle Reciprocal of America, a medical-malpractice insurer that went broke, leaving thousands of doctors stranded. Reciprocal had used reinsurance to trick its Virginia regulators into thinking it was solvent. Gober found that the reinsurance was fake, and Reciprocal in fact had a $490 million hole in its balance sheet.
So, I asked him, what was he seeing these days?
As it turned out, I caught him at a propitious time. He had just written to the N.A.I.C., warning of a purported type of asset – an “XOL Asset” – that he’d found reinsurers using to secure their annuity promises. Some were claiming that their XOL Assets were worth billions of dollars. Gober thought they were worthless.
(In insurance lingo, by the way, XOL stands for “excess of loss,” a type of reinsurance that’s commonly used to protect against black-swan events. But knowing that doesn’t shed any light on what an XOL Asset is.)
Gober wrote to the N.A.I.C. because it’s the body that defines “asset” for insurance purposes. And it has high standards. An asset has to be “readily marketable.” It must have “economic value” that “can be used to fulfill policyholder obligations.” It’s all there in black and white, in the N.A.I.C.’s Statutory Accounting Principles.
Gober thought XOL Assets were making a mockery of that. He gave me a copy of his letter, which used snippets from the financial statements of American Equity Investment Life to explain why.
American Equity is part of the Brookfield Corporation, a Canadian conglomerate that recently bought some life insurers, including American Equity, and joined the annuity stampede. It is now the 14th-largest provider of fixed annuities, having sold $3.9 billion worth in the first half of this year. (The top provider was Athene Annuity and Life, a unit of Apollo Global Management, with $16 billion sold. Years ago, Apollo was the first to see the advantages of reinsuring annuities in Bermuda. It made a killing, and soon other private equity firms were rushing to get in on the act. The annuities are sold in the United States, then reinsured offshore, often with assets supplied by the controlling private-equity firm to secure the obligations.)
American Equity is regulated by the Iowa Insurance Division. Its financial statements show that it “ceded” about $7 billion of annuity obligations to three wholly owned subsidiaries in Vermont. When an insurer “cedes” obligations, that means it reinsured them. It can then remove them from its own balance sheet, because the reinsurer is taking them on.
Gober was skeptical: In general, he didn’t think it made a lot of sense to use a wholly-owned subsidiary as a reinsurer. Reinsurance is supposed to involve “risk transfer,” and American Equity hadn’t really transferred its annuity obligations anywhere, since it owned the three Vermont companies that now held them.
Then he saw that the three Vermont subsidiaries were classified as “captives,” and his heart sank. Captives are legal structures permitted by some states, which let insurance companies do their confidential reinsurance deals right on the U.S. mainland – no trip to Bermuda needed. State-based insurance captives enjoy Bermuda-like secrecy rules.
With captives involved, Gober could see $7 billion in annuity promises leaving American Equity in Iowa, but he couldn’t see how they were handled once they landed in Vermont. Were there enough reserves? Were the assets any good? Each captive was a black box. Gober had been trying for 15 years to see a captive reinsurer’s financial statements, without success.
But then – surprise! While looking at American Equity’s website, Gober found that someone had posted the three Vermont captives’ financial statements there, presumably by mistake. By the time the company pulled them down, Gober had made copies and saved them.
At last, he could see how some captives were securing their annuity obligations: The mysterious XOL Assets were far and away the biggest item on the “Assets” side of each captive’s balance sheet, eclipsing the bonds, stocks, cash and everything else.
Gober wanted to know what the XOL Assets consisted of, so he delved into the captives’ footnotes. Each one had a footnote acknowledging that the Vermont Insurance Division normally required insurers to use the N.A.I.C.’s accounting standards – but each then went on to say that Vermont had also enacted a law giving certain companies a break.
The law “deemed it allowable” for the captives to include their XOL Assets as claims-paying investments, even though doing so “is otherwise disallowed by the N.A.I.C. Statutory Accounting Principles.”
Then came a chart, showing that each captive had a positive balance sheet when it included its XOL Asset, and a massively negative balance sheet when it followed the N.A.I.C.’s rules. An insurance company with a negative balance sheet is supposed to be taken over by its state regulator, to protect its policyholders.
American Equity’s Vermont captives were being truthful about their financial condition – just not in a place where anyone would be expected to see it.
“These are prohibited deals,” said Gober. “So why is Vermont letting them do it? They are permitting companies to do prohibited transactions in their state, transactions that are prohibited by their own state laws.”
He still wanted to know exactly what the XOL Assets consisted of. He found the answer in another set of footnotes, where each captive described its reinsurance activity. Those footnotes said that each captive’s XOL Asset reflected the value of payments it would receive under an excess-of-loss contract with Hannover Life Reassurance Company of America. Altogether the three XOL Assets were valued at $5.2 billion.
Or were they? The footnotes went on to say that each captive had run N.A.I.C.-mandated tests, to make sure risks were really transferred to Hannover Re. The tests had come back negative. No risk had really been transferred, and Hannover Re would not be paying any claims. The assets that had been worth $5.2 billion a moment ago were now worthless. All in the same footnote. In a financial report that no one was supposed to see.
Gober double-checked the numbers by studying Hannover Re’s financial statements, which are public. They listed hundreds of reinsurance contracts, each listing how much Hannover Re expected to pay. Sure enough, there were three contracts for which Hannover Re expected to pay zero. They were contracts with American Equity’s Vermont captives.
In his letter to the N.A.I.C., Gober noted that insurance executives are required to swear that the information in their financial statements is “full and true.”
“Brookfield took a reinsurance mechanism widely and prudently used by property and casualty insurers” – excess-of-loss coverage – “and twisted it into a pretend reinsurance recoverable ‘asset,’” he wrote. “The reported values should be written down to zero.” That would leave the captives insolvent, which meant, in turn, that American Equity would have to take back its $7 billion of annuity obli“Once done,” Gober wrote, American Equity “will have a substantially negative surplus, prompting a regulatory event.”
Like what was supposed to happen to the A-Cap insurers but did not.
“Please reach out to me at your first convenience,” he wrote. “I am available at any time to discuss my research in greater detail.”
Maybe someday the N.A.I.C. will answer him.
Seems the textbook definition of fraud on an epic scale. 2008 redux.