The comment period closed yesterday on an eyebrow-raising memo about private equity deals with annuity and life insurance companies—an issue of growing concern for producers who represent insurers with ties to private equity and/or who compete with such insurers.
The 1,600-word document has been circulating for the past several weeks among state regulators who serve on the Financial Condition (E) Committee of National Association of Insurance Commissioners (NAIC). It was the handiwork of the Financial Analysis (E) Working Group, a subgroup of the E-Committee.
Among other things, the memo calls for creation of a new NAIC working group to develop procedures that regulators can use when reviewing deals and monitoring post-acquisition activities. If that happens, it would put a bigger spotlight on private equity deals involving insurance.
The lengthy memo also proposes numerous best practices for state insurance regulators to follow when reviewing and monitoring private equity deals with insurance entities, plus “new or enhanced regulatory authority for regulators” in certain areas.
Special purpose working group
NAIC’s E-Committee already has scheduled a public conference for July 17, at which time regulators will consider establishing the new working group, according to NAIC.
Larry Hamilton, a partner at Mayer Brown who has been following the developments closely, thinks the regulators will go ahead and vote to move forward on that proposal.
“The chair of the working group and the chair of the E-Committee are both strong leaders who view this as an important issue,” Hamilton explained. He was referring to Steve Johnson, deputy insurance commissioner in Pennsylvania, and Joseph Torti III, deputy director and superintendent of banking and insurance in Rhode Island, respectively.
In addition, many regulators believe “that financial engineering may be putting policyholders at risk,” Hamilton said. That concern will help motivate a go-forward decision, he predicted.
Even if regulators do form a new working group around this issue, “the proposed changes won’t happen quickly,” he predicted. That’s because some of the proposals are extensive, requiring assessment of impact on insurance regulations overseen by different units of NAIC.
Still, he added, some states already may be doing some of these things. And others might use the memo as an informal checklist or best-practices list to consult when reviewing any private equity/insurance deals or issues that come their way.
In its memo, the E-Working Group members lay out their primary concern plus five “possible best practices” and three “possible new procedures.”
The primary issue is the “increased interest in the insurance industry by private equity interest and hedge fund managers,” they wrote, noting that this appears to be directed at life insurers, especially those engaged in annuities.
This interest is not limited to the acquisition of control of life insurers, the regulators continued. “In some cases, the firms utilize a reinsurance agreement in order to increase their control over such business and related assets. Control over annuities, either through acquisition or through a reinsurance agreement, provides the firms the opportunity to manage the assets of the insurer.”
The regulators acknowledged that the current low interest rate environment creates risk for life insurers, to the point that some carriers may want to limit the risk by reinsuring the business or by selling such operations.
In those cases, it is “critical” that investor interests be aligned with the interests of annuitants and beneficiaries, they wrote, pointing specifically to the need for firms to take “a long-term view when investing these individuals’ funds to meet the future policy benefits.”
The problem? Some regulators believe that such prudence is “inconsistent with the business model of private equity firms and therefore creates inherent risks.”
Some of those points, particularly the concern about inconsistency in business models between private equity firms and insurance companies, resonated with concerns raised in April by Benjamin M. Lawsky , superintendent of the New York State Department of Financial Services (DFS). That department is investigating the same topic, with an eye toward developing new regulations on private equity/insurance liaisons.
Last month, Sun Life Financial announced that its December agreement to sell its U.S. annuities business to private equity firm Delaware Life Holdings, has been delayed, pending outcome of New York’s review of private investor groups as owners of annuity businesses.
As Mayer Brown’s Hamilton sees it, New York is fast-tracking the issues. But any regulations that result from that effort will be focused on New York, he said. By comparison, NAIC is taking a more deliberative approach and looking at the issue from the perspective of regulatory needs in all states.
Could the fact that inquiry is underway have a chilling effect on deals going forward? “It’s too early to tell,” Hamilton said, reiterating that “we’re a long way from [seeing] any restrictions put in place.”
The suggestions in the memo are more extensive than a simple tweak here and there, and some may involve changes to existing NAIC documents.
For example, the proposed best practices call for: changes in Control Form A (used in acquisitions, mergers, etc.); annual targeted examinations to ensure use of prudent investment strategy; targeted examination procedures on non-affiliated insurers where the direct writer has ceded a material portion of its annuity risk to the private equity-controlled insurer; coordination with international regulators or others when a non U.S. insurer is involved , etc., and continued monitoring of macro-level events through the NAIC Capital Markets Bureau.
Several of the proposals have specific subsections, calling for specific regulatory activities.
As for proposed new procedures, they include:
· Changing the Credit for Reinsurance Model Law to provide regulators with additional authority to require approval of transactions with non-affiliates
· Changing state investment laws to provide regulators with additional authority in limiting risks
· Changing the risk-based capital formula to capture any risk not otherwise already addressed
As for the proposal to create a new NAIC working group, the memo said its purpose would be to develop best practices and possible changes in policy positions that “regulators can use when considering ways to mitigate or monitor these inherent risks [in private equity/insurance business structures], most of which are currently not codified to address this specific risk.”
Hedge funds and private equity?
Insurance people do not typically mention the term hedge funds in the same breath as private equity firms. Insurance scrutiny tends to focus on private equity firms buying into annuity companies, since most of the recent buyers have been private equity-related firms with a yen for annuities.
For that reason, the mention of both terms in the working group memo may be puzzling.
A possible explanation is that private equity firms and hedge funds share a similar business model, to the point that many people use the terms synonymously. The regulators may have addressed that issue by including both terms.
Both types of businesses have pools of money that they invest with the intention of making significant gains and selling in the foreseeable future.
In addition, neither of those business categories is subject to regulation under the Investment Company Act, Hamilton said. “That is because their investments are limited to high net worth or institutional investors.”
The businesses do have certain differences, however. For instance, private equity tends to invest in or buy companies that they help manage (or do manage)—their so-called “portfolio companies.” These firms tend to sell their acquisitions within three to seven years or so. Hedge funds tend to (though not always) seek out liquid investments—such as stock in public companies and other securities—that they can hold or sell quickly. As a result, hedge funds do not typically have a hand in managing their holdings, though some do occasionally try to influence outcomes.
There is a lot more to this, and the differences cited here are not universal. But for everyday purposes, many people view private equity and hedge funds as more alike than different.
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