One Way Life Insurance Customers Can Protect Themselves

In February, Option ARMageddon published thoughts regarding the troubled state of the insurance industry. First we noted that insurers were seeking to change their regulatory capital requirements in order to avoid harming shareholders—say by cutting dividends or raising incremental capital. We also wrote that, at the corporate level, many companies are ridiculously over-leveraged. Finally we noted how state insurance guarantee funds aren’t actually funds: there’s no money in them and they would most likely be unable to withstand a systemic event.

All of this raises tricky questions for policy-holders. Your policy is only as good as the company that stands behind it. What happens if the company disappears? How can you protect yourself, especially if existing safety nets—the guarantee funds—look so unsafe? These are scary questions, which is probably why few people are asking them.

I have been in contact with a financial planner, we’ll call him John Doe, who has been working on this issue on behalf of his client. Below I’ve published the full text of an e-mail exchange we had recently. My hope is that it gets a discussion going about ways for life insurance and annuity customers to protect themselves. Life settlements may be a good option…

Before getting to that, a quick review of why the insurance industry looks so troubled. With toxic assets on one side of their balance sheets, and huge liabilities relative to equity on the other side, the insurance industry looks just as insolvent as the bank industry. And their real financial condition is likely far worse than their published financial statements indicate. This is because “insurance accounting around the world is broken.”

This is not news to the market of course. Insurance company stocks have been hammered over the last year.

The insurers themselves know how bad things are, which is why they’ve taken a more aggressive capital raising stance since OA first reported on the issue. Many have since cut dividends. Already they had cut staff and turned to the government for help: to the Fed for subsidized lending via the Commercial Paper Funding Facility, to Treasury for bailout cash via TARP, and to FDIC for still more subsidized lending via the Temporary Liquidity Guarantee Program.

On Monday, insurance stocks dropped precipitously because one in particular, Lincoln National, withdrew its application to the TLGP, saying it didn’t meet the qualifications. According to Bloomberg, its TARP application is still being considered, so the government hasn’t turned its back on the company.

With that as prologue, here’s the exchange with the financial planner:

John Doe, March 25th, 2008:

I’ve been looking over the 2008 statements for Lincoln National Life, the subsidiary inside of LNC that my clients have a policy with. I’ve attached the statements I pulled from the NAIC website, including a break-out of the separate accounts.

I’ll mention the facts that jumped out at me that may pertain to your interest in the insurers:

1. In the separate accounts, which account for about half of the balance sheet and primarily consists of annuities, asset values declined by about a third. But then again, so did liabilities. I don’t know if this is actuarial legerdemain or is legitimately based on some reference rate such as AA corporate bonds. I am doubting the latter.

2. In the other part of the balance sheet – the one the this pie chart references – there were practically no unrealized capital losses. I don’t know why this is, but hypothesize that it is related to an accounting or actuarial rule despite being labeled “fair value”. It sure doesn’t jibe with reality.

3. There were actually fewer surrendered or withdrawn policies than in 2007. I am not seeing evidence of a run on the insurers. However, business is down, as considerably fewer premiums were collected.

4. The subsidiary improved its cash position and took a small operating loss, with the surplus mostly unchanged - but it also borrowed money and paid a $400M dividend to its “shareholders”, which I believe is the parent holding company. This is about half of the dividends paid in the previous year, but still seems excessive, given the subsidiary’s less than stellar surplus position.

That is it for the balance sheet. Not being able to trust the accounting has made me more risk averse towards this counter-party. I don’t know if my comfort level has increased now that the administration seems to have signaled its general determination to prevent secured creditors from taking a loss. While it might reduce the credit risk in the portfolio, it certainly is inflationary and consequently lowers the [net present value] of the contract, which I model like a 27 year maturity zero coupon muni.

You might remember that in the previous analysis I sent you I did not include an estimate of recovery value in the event that the insurer had to be put into administration. This depends on the state of residence of the policy holder, whether the insurer gets taken over by another insurer, whether the state guarantee fund makes good, and whether the policy holder decides to get cash value or maintain the policy. But in my client’s specific case, I found that they had a guarantee only up to its approximate current surrender value, so paying future premiums would represent a potential loss. Indeed, they are a bit like paying premiums for call options on the insurer.

The reason I mention this is because I have been exploring the “life settlement” business. Essentially, you can sell your life insurance contract to a third party. These contracts are even sold on to hedge funds. It’s currently a small and illiquid market ($18B?) but is expect to mushroom over the next 5-10 years. I didn’t know this market was so small when I first started looking into it, and was essentially searching for a source of market based pricing of insurer risk to confirm my own assessment. At any rate, what I found changed my view on the current value of my client’s contract.

Life settlements can pay out much more than surrender value, especially if the covered policy holder has aged or developed an illness, or if future premium payment obligations are small. The idea is that some contracts are expected to make a large lump sum payments in the not too distant future(upon death), so they have a higher NPV than the surrender value. Not many policyholders know about this, which is why 35% or more of “in the money” policies are allowed to lapse – a nice little freebie for the life insurers. Currently, I am calling around for quotes on my client’s contract, and expect them to be able to obtain a quote higher than the surrender value of the policy.

Looping this back in to a theme with broader application – given the devastation of portfolios, it is going to make sense for a lot of policy holders to take life settlements, because by doing so they can increase the security of their retirement years. This will reduce the number of lapses for insurers and will hurt their bottom line. Not a big finding, but a trend to watch.

OA, March 30th:

Doesn’t counter-party risk destroy the life settlement business? You may want to sell your client’s policy for greater than its cash surrender value but who would purchase it if there’s a threat that the insurer won’t be around to pay out at death?

John Doe, March 30th:

I’m with you on the counter-party risk. This is why I am soliciting quotes aggressively and researching how to speed any deal we may decide to enter. Right now the market for life settlement seems to continue to exist, but I am not counting on this lasting. However, if we somehow pull out of this economic and market nosedive, the life settlement business will continue to thrive and will thus cut into insurer profitability in the future.

Comments

[michael55555:]

I think "John Doe" should be reported to the NAIC, because he clearly doesn't know what he's talking about and I have very serious doubts that he's licensed to sell life insurance. The separate account assets and liabilities are *always* at fair value. If a policyholder owns a separate account product then they have the only claim on the assets backing it. The term "variable" might it away, as in "variable universal life" or "variable annuity". In those cases there is *NO* counter-party risk to the cash surrender value. I'll repeat: NO COUNTER-PARTY RISK to the cash value. Guaranteed death benefits or guaranteed living benefits do have counter-party risk and are backed by the guarantee funds, within limits. The time to look at life settlements was a few months ago before they began pricing with an updated mortality table. The table reflects much longer life expectancy than they were pricing with before, so the payouts have dropped significantly. see: www.bloomberg.com/apps...

Apr 01 07:48 AM

[abcde_98:]

Rolfe, good to explain this to build awareness. I've been mentioining such things on the Yahoo msg boards for quite some time. A few other things:
- consumer has a contract with the insurer; insurers often transfer a portion of the risk to another company/pool (called reinsurance); some reinsurance contracts may participate in loans, etc but this would need to be investigated further to determine what the %
- reinsurers were the 'gateway' to capital for insurers needing capital; reinsurers got capital from the investment banks (traditionally)
- so, the food chain goes up to investment banks. At an industry meeting 4 or 5 years ago, as the reinsurance market had consolidated substantially from the 1990's to mid 2000's (the top 5 Life/Annuity reinsurers account for 70%+ of the market ) some investment banks effectively became reinsurer going direct to insurance companies...but now some are gone (Lehman, Bears Stearns) and others have curtailed there activities ... rather concentrated industry and if things go wrong for such companies, big gap

I've got to run to meetings, more later or if you want you can reach me at this screen name @ yahoo.com

Apr 01 07:58 AM

[AHJ:]

The comments about the guarantee funds have some merits but the accounting comments are ridiculous. In general, insurance company regulatory accounting is so absurdly conservative that it is a drag on the ability of the industry to raise capital. GAAP accounting (used for investor purposes) is on the other hand meaningless in the insurance industry. Generally neither too conservative nor too liberal, just a gibberish inappropiate attempt to be consistent with accounting methodology for other financial firms (e.g.banks) from which no conclusions can be reached. So this John Doe, when he mixes and matches comments about the parent company's position (a company reporting under GAAP because it presumably is a public company not reporting under NAIC standards), shows he has no idea what he is talking about.

It would be like saying. The Chicago Cubs won their Division last year and yet the Tribune still sold fewer want ads in their paper, proving conservatism in the reporting of the revenue from the want ads of the parent company (the Tribune). Every reader would know such reporting was foolish gibberish.

On Apr 01 07:48 AM michael55555 wrote:

> I think "John Doe" should be reported to the NAIC, because he clearly
> doesn't know what he's talking about and I have very serious doubts
> that he's licensed to sell life insurance. The separate account assets
> and liabilities are *always* at fair value. If a policyholder owns
> a separate account product then they have the only claim on the assets
> backing it. The term "variable" might it away, as in "variable universal
> life" or "variable annuity". In those cases there is *NO* counter-party
> risk to the cash surrender value. I'll repeat: NO COUNTER-PARTY RISK
> to the cash value. Guaranteed death benefits or guaranteed living
> benefits do have counter-party risk and are backed by the guarantee
> funds, within limits. The time to look at life settlements was a
> few months ago before they began pricing with an updated mortality
> table. The table reflects much longer life expectancy than they were
> pricing with before, so the payouts have dropped significantly. see:
> www.bloomberg.com/apps...;sid=aFktBLBpBWiE&...

Apr 01 09:22 AM

[Between The...:]

Just like MBS, reinsurance or credit-default swap can make a liability or asset seem whole on the balance sheet even when the underlying takes a hit to valuation. The company insuring the asset will have to make good on the underlying, so the counterparty risk is transferred from the front-line insurance company that you bought the policy from to the re-insurer. Without knowing how the company has hedged the policies, it makes it hard to make any sense of the balance sheet changes quarter to quarter.

Apr 01 08:28 PM

[mboaman:]

From a buyer's perspective in the life settlement market, the risk that the insurance company would collapse is a real one, however most funds will only purchase policies from carriers with A.M. Best, Moody's, S&P Ratings of A-/B+ or better or equivalent. Carriers such as AIG and Phoenix that have been downgraded are currently not being purchasing in the market.

If one carrier were to collapse, state's carry funds that will pay out partial or whole death benefits to the policy owners in the event the carrier does not fulfill their obligation to the client. However, many carriers would be bought out by one another as has happened a few times in the past.

Milestone Providers, LLC currently represents a few institutional investors in this asset class, including one of the world's top asset managers. If you have any policies with face values $50,000 or greater that you or your client(s) is considering cashing out or lapsing, we would appreciate the opportunity to evaluate and provide an offer if the policy has economic value.

For more information about life settlements and the process involved, feel free to visit our website at www.milestonesettlemen... or call me at 888-877-5686.

Matthew Boaman
Milestone Providers, LLC
milestonesettlements.com

Apr 02 05:03 PM