Title: Understanding Hidden Risks in Insurance Companies and Impact on BOLI Asset.
Prepare yourself for your bank owned life insurance (BOLI) annual review with a better understanding of insurance company "General Account" portfolio hidden risks.
Attendee and Guest: Kelly Coughlin, CEO, BankBosun; David Merkel, CEO, Aleph Investments, CFA and Actuary
Date: July 10, 2017
There are only two things as complicated as insurance accounting. And I have no idea what they are. Andrew Tobias, The Invisible Bankers
Kelly Coughlin is a CPA and CEO of BankBosun, a management consulting firm helping bank C Level Officers navigate risk and discover reward. He is the host of the syndicated audio podcast, BankBosun.com. Kelly brings over 25 years of experience with companies like PWC, Lloyds Bank, and Merrill Lynch. On the podcast Kelly interviews key executives in the banking ecosystem to provide bank C suite officers, risk management, technology, and investment ideas and solutions to help them navigate risks and discover rewards. And now your host, Kelly Coughlin.
Greetings, this is Kelly Coughlin, CPA, CEO and program host of BankBosun, helping C-Suite executives manage risk and discover reward in a sea of threats and opportunities. One of the classic risk management strategies is to use insurance to manage the risk of loss in many assets, whether it be a home, a car, a health, life, a revenue stream, a cyber hack, offloading the risk through a third party who assumes that risk and pay a fee, a premium, to do that has been employed for hundreds of years.
The first case of life insurance actually began in Philadelphia, providing a death benefit to the surviving widows of poor Presbyterian ministers in the 18th century. Today, life insurance is utilized by banks to manage the loss of key management, and as an alternative asset class to municipal bonds and mortgage backed securities. It’s called Bank-Owned Life Insurance or BOLI and it’s used by over 3600 banks that hold over $160 billion in assets.
As part of their annual report to the Board, and frequently regulators, the consultant involved in placing the BOLI asset with the bank with all the financial update on the insurance company or companies that hold the asset. And to get a famous plug but a fully disclosed plug I do independent consulting work with Equias Alliance, one of the best in the business for placing and monitoring the BOLI market. Most of the BOLI assets are placed in the general account portfolio of the bank which means the bank’s assets are held on the balance sheet of the insurance company, somewhat like a loan to the insurance company. And like any loan to a company, you want to look at the ability of the borrower to pay it back along with the expected interests.
So one of the things we do is look at the value of the insurance company. We frequently look to third party rating agencies to provide some sort of analyses on this, but I thought it would be interesting to have someone that has actually done this work as part of their career. David Merkel, CEO and CFA of Aleph Investments who has a BA and a MA in political economy from the prestigious Johns Hopkins University, was a senior analyst with Hovde Capital, a hedge fund, and he was chief economist and director of research for Finacorp. And David is an inactive fellow in the society of Actuaries. I have David on the phone, who is going to talk to us about valuation of life insurance companies.
Kelly: David, are you on the line there?
David: I am here, okay.
Kelly: Thank you for joining us.
David: Happy to join you.
Kelly: Give us a little bit of personal background.
David: Okay, I’m based in Ellicott City, Maryland, which is just outside Baltimore. My wife and I decided to try for something big and we were able to have three children and we adopted five more. The kids have a lot of fun, in my opinion. It has had its challenges, it has had its successes and failures but in general I loved doing it.
Kelly: Great, congratulations on that. Life insurance companies, at their core, are basically investment companies. Is that a fair statement?
David: Yes, and that’s become more true as the years have gone along. When I was a young actuary, the society of actuaries syllabus tended to work on a level saying, analyze the policies that you write. And they gave us all sorts of ways to do that, but they didn’t talk much about investments. But the company I worked for, initially, Pacific Standard, which was the largest consultancy of the 1980s. And since you have never heard of Pacific Standards, you know that the 1980s were pretty kind to life insurers that grew up a part of Junk bonds of Michael Milken.
The game changed and since that time virtually every insurance company that has failed has failed because of their asset policy. I think there has been a grand total of one that has failed for other reasons, and make that two, AIG and its derivative counter parties, that was another thing. But a lot of the failures there was apt an investing policy too.
I actually wrote a paper that was picked up by the special inspector general, the TARP on AIG to point out the aspects of the failure that was due to the securities lending agreements inside the life insurance companies. I spoke?? to Wall Street Journal and the New York Times and it had actually even got read by Warren Buffet who supposedly thought it was a good paper. But assets are the main factor of what makes insurance companies fail, that’s the long and short of it. That is why we should analyze it more.
Kelly: It seems to me, insurance companies are more like mutual funds so I would kind of like to start with that as kind of the baseline. Other than not being a completely separate legal entity, which a mutual fund is, how does a general asset portfolio resemble or differ from a mutual fund other than the fact that an insurance company has a mortality risk expense that’s kind of built into that? If you take the mortality risk expense out of there, doesn’t it resemble a mutual fund in that sense?
David: The main difference between a mutual fund and an insurance company in the way that you invest with them, because I have invested for both of them, is that with a mutual fund, you don’t have a balance sheet. Your mutual fund holders can come and go as they please and everything is valued at par. With a life insurance company, you have liabilities that are relatively sticky, at least many of them are sticky.
And one of the key aspects of trying to ascertain the riskiness of a life insurance company is in understanding how much of the portfolio of liabilities can run, i.e. there is no surrender charge, and there aren’t that many consequences for leaving and measure that against how much do you have in assets that can be rapidly liquidated. Because, again, it is risk based liquidity that is really the thing that you try to look at, in terms of the asset portfolio, to understand what is the true risk of a run on the company, and it does vary from company to company.
Kelly: And we’re talking about bank owned life insurance general asset portfolios, what are the types of liabilities that should cause concern, or at least tension, of a banker who is holding a GA portfolio.
David: Yeah, there are some liabilities that life insurers write that are not under-writable. In some cases, the insured knows more than the insurance company. The best recent example of that is long term care, in the sense that long term care policies have consistently lost money for insurance companies. And so you have to be weary of a company that writes too much long term care. I mean, generally if even as one of the bigger writers has gotten out of it that life is left writing business, that’s been one really ugly liability.
Kelly: Where can they find that on the balance sheet?
David: You would have to actually begin looking at the statutory statements to find out how much is long term care.
Kelly: There has got to be an asset and a corresponding liability related to that, correct?
David: It’s going to be, I guess, it’s another thing that’s written in the General Account. I know that the rating agencies will write up and describe how much of the business that a company has would be in long term care, if it is a material amount. Things that are a little more fuzzy these days though are the things where we don’t have either good ways of hedging or good ways of actuarially coming up with reserves. And those things are things like Universal Life, Secondary Guarantees, Term Life policies that are ultra long, that might go over the whole of someone’s life, that end up being lapse supported, and the reserving for those just does not work. We don’t have good models for that.
Kelly: Now, you are listing out the liabilities that should get attention, right, long term care, universal life with secondary guarantees?
David: I should mention that variable life and annuities that have secondary guarantees as well because there is no good way to hedge those and if there is no good way to hedge them there is no good way to price them either. There is no good actuarial basis that you can say, this is what it is worth and this is how we can invest to make sure that we are always going to have enough to pay our claims. That is probably the biggest single thing in the life insurance industry today.
If it stays small, I guess you don’t have to worry much but if it becomes a really big part of an insurance company, the secondary guarantees, then you have to begin to ask questions. And there are examples of companies that when they realize that they sold the secondary guarantee on an annuity, just as an example, a variable annuity, where it has some sort of income benefit, accumulation benefit, death benefit or withdrawal benefit.
When Cigna was originally writing the reinsurance for all the people who were doing the guaranteed minimum death benefits in the 90s, Cigna eventually ended up taking something like a $4 billion dollar hit because they did not understand what they were doing and how open ended the claims would be. With the Hartford, they were one of the biggest writers of these guarantees and had to scale it back dramatically.
They were going to people to buy out the liabilities because as they began to try to estimate what they might be worth because there is no actual way to truly know what they are worth. They were paying 110, 120, and in some cases 130 percent of the contract value to get out. And what I told the people who approach me, I said, the odds are, they are only giving you about half the premium you deserve. And so long term guarantees that involve investment risks mixed with other actuarial risks like debt or longevity are impossible to price. There is no good mathematical way to do it and all the reserving methods that are done on a statutory or a GAAP basis are inadequate. This is not a happy thing to think about but...so what I say to people, after I say this, is just make sure it’s not a large part of the General Account of the company.
Kelly: What’s a large part, 10 percent?
David: I would simply say, make sure that your company is below average with respect to it, versus the whole industry, because you don’t want to be in one of the companies, that is one of the early ones to blow up on something like those.
Kelly: Do you have any bench mark numbers on those three categories combined or separately what a kind of average is?
David: And one thing you have to realize, one of the secondary guarantees is that the actual contract value of the accumulated value of the variable life and variable annuities and variable universal life is in the Separate Account, however, all the secondary guarantees are in the General Account. This is one case where you have to really consider that the Separate Account do have an impact on the General Account, the degree that they have written business that has secondary guarantees.
Those are the types of liabilities that make me suspicious of a company but until the stock market falls hard most of these aren’t going to have any punch but if it’s down 40 or 50 percent and it stays there for a while, like after the great depression, you will once again find that the life insurance companies will have harder times. The ones that were launching variable business with the secondary guarantees. That’s the biggest one, and maybe other secondary guarantees, the little interest rate guarantees, are relatively small. The ones with the equity components are the big ones.
For the most part, if you get away from those, the ordinary life insurance and annuities that are written by insurance companies are easy liabilities to hedge and value. That should be 80 to 90 percent of the total liabilities of the General Account. But again, it’s a good question to ask and see who your consultants are.
Kelly: In your mind, how did we go about determining whether a life insurance management team is (a) competent and (b) conservative?
David: Okay, well starting with competent, the main thing is that they try to manage risk on the front end. And the example that I give is, some companies that write disability business will do significant underwriting on the front end before they write a policy but will not for every claim. But then the others who will write every policy and then basically force people, sue them to get the payment.
But the good companies that are competent do the risk management on the front end. And that applies to every aspect of writing a policy, whether it’s their investment policy, all the things that go into that. They are careful in choosing the lines of business that they go into. They are disciplined when it comes to doing mergers and acquisitions.
The really good companies will do small acquisitions and they will do it to gain competencies, synergies, new markets of distribution methods rather than doing big scale acquisitions. Large scale acquisitions have a large probability of failure and tend to be far more expensive than you might think when it comes to the total integration of it.
Competent managements tend to be good in using their excess capital whether it’s returning it to shareholders in a flow and disciplined way through dividends and buy-backs or to mutual policy holders through the dividend scale. Because, again, these places don’t just exist for themselves, they do have clients that they have to satisfy who are owners, whether mutual or stock. They will be careful in the way that they do send money back and how they use free cash for growth.
Now, as for conservatives, here are a couple things that I think about. They put profits ahead of growth and they are willing to grow more slowly when conditions are bad. They will try to grow free surplus so that they have more options in front of them rather than all those who consume their free surplus and be running as tightly as they can against the risk based capital levels. Conservative management, when you hear that they have adjustments they tend to be positive non-recurring adjustments.
They tend to be disciplined in reserving and in their credit analyses. The Companies that are taking a lot of risk in their assets are the ones that are always constraining that liquidity during their phase of the cycle. One other thing about the conservative management team is that even during the bull phase of the cycle they tend to grow a little slower than other companies. They pick their response and they are looking for profitable growth ahead of just growing to gain market share. They are not controlled by their marketers, they are controlled by businessmen
Kelly: What types of investments do these insurance portfolio managers invest in that are different from, say, a fixed income mutual fund? Do they tend to buy a lot of private securities, is that it? Is that accurate?
David: They do have more private securities. And private securities are not necessarily worst and often they’ll have better covenant of protection. It depends what they want to do. So, for example, some will have their own mortgage origination arms. Some will engage in doing credit tenant leases. Those aren’t bad asset classes and those can be done quite conservatively. It’s a question of what your stress on credit quality is.
One of the questions that I pose is, where do they look for returns greater than triple B corporate bonds? You take a look at a life insurance company’s portfolio, most of its public corporate and public mortgage backed and things like that, and that’s enough to get you to a certain level then maybe the last 10 percent of the portfolio has to be invest in somewhere. And there might be common stocks, and a lot of it will be in junk bonds, depending upon the company, and some will originate their own assets. The most traditional one is commercial mortgages; do you have a good credit discipline or not? And that, at least, you can track overtime because your mortgage losses are disclosed in the statutory statements of the life insurance company.
Those are tracked pretty carefully, ever since the mortgage defaults of the 1990s. The question I would pose is, every company tries to earn above average returns at some point, where are they doing it and why do they think they have expertise there? Since the insurance industry actually came through the crises better than the banks you might want to ask how did they do 1999 -2003. That was a much worst period.
Kelly: Do insurance companies tend to lump all of their general asset portfolios into one consolidated portfolio or do they segregate it by the underlying product type that brought in the assets?
David: Okay, we typically notionally do that. It will be one big account, as far as the investment department will be doing to manage, however, the actuaries will come along and say, “These assets provide the income for this segment of liabilities. These assets provide the assets for this segment of liabilities.”
And then they will try to match and then they will go back to the investment department and say, Okay, here is what we need for each individual line of business and here is what we have. Here are the tweaks we need in order to have something that’s good for the company as a whole in order to match up against our models for what assets are needed for each liability stream.
Kelly: If one of those, let’s just call them products, sub accounts, over-performed, let’s say the BOLI over-performed and then the universal life secured guaranteed underperformed, will they transfer some returns from the BOLI over to the universal life to lend them, so consequently, BOLI gives up its extra juice it got, how would that work?
David: As I said, the segments are notional, they are just one big general account and it’s the way that the actuaries then try to figure out, what is the true profitability of each line. It is something that is an internal calculation but the credit results are going to be spread across that general account portfolio. They will probably have the same credit quality across each of the segments but what vary is what the length of the assets purchased for each notional segment.
Kelly: The other long-term risk that one needs to think about?
David: These long-term risks that is not getting talked about enough is what happens if interest rates stay low. Because what’s happening at many insurance companies is that they bought long bonds and they thought it would be good enough to hedge all that they were doing.
Many of the annuities that they wrote in the 1980s, ‘90s, maybe even into the early 2000s, they carried long term guarantees that were sometimes as high as 6 percent per year forever. To have a stream like that for the remaining amount of annuities or life insurance is pretty considerable down at those guarantee rates and right now long bonds, long corporates, it’s pretty difficult on a conservative portfolio when you strip off the expenses for a life insurance company to have with things that can meet those long term guarantees.
And it gets a little worst every year as bonds mature on the life insurance portfolios. That’s the biggest challenge that virtually every life insurance companies are going through right now. Because if you look at the expected flow of liability cash flows versus the expectable on asset cash flows, even if you have the rough interest rate sensitivity of the match, you are going to have more liability flows then more asset flows and then more liability flows.
As these portfolios age, the real risks come if interest rates stay low. The optimal scenario for life insurers, that should it ever happen, is that interest rates rise slowly. If interest rates rise slowly, life insurers do wonderfully. That would be the ideal scenario for virtually every life insurer. When they do their interest rate test for their asset level liability management, typically these days, the worst scenario is, interest rates drop and stay down. And the best one is, interest rates slowly rise.
Kelly: Any quick dirty simple mathematic measures one can look at to determine long term credit quality of a life insurance company?
David: Yeah, one thing, not mathematical, just to start is that mutual companies tend to think longer term and tend not to make the best of what that company make. They tend to be better off through really long-term obligations, but do they maintain a high ratio of surplus to risk based capital? Now if you are looking for where you can find that, if you look in the blue book, that is the annual statement from the statutory statements of the life insurance companies. Those are published on the five-year historical pages. Aside from that there is no place publicly that they are published, unless you go to the rating agencies.
Now, rating agencies aren’t horrible, in fact, they are usually quite good. They failed in the early 1990s regarding guaranteed investment contracts. When the rating agencies tend to fail over time is when they deal with new things. Once something has been through a failure cycle the rating agencies are pretty good at analyzing. So, when you think of them on corporate credit they are usually pretty good but they were horrible though with structured corporate credit because they have never been through that. So when the financial crises they got floored.
Other things to look for, look for a slow rate of growth over time. You don’t want them shrinking. You don’t want them staying flat but you don’t want them running really quickly. Conservative management teams grow slowly and they are happy enough with it and they try to get more profitability out of what they are doing. Also, see if they lose money more rarely on a GAAP basis, they should make money in bad times. That’s the sign of a conservative management team. And if they have surprises they should be positive ones.
You want to see that they are better than their competitors. Over time, because conditions change I don’t give an absolute set of numbers for this, but you want them to be better than the average of their industry in these areas. But the one thing that I learned as an actuary who had to be at both ends for credit analyst and a portfolio manager for equities where I was analyzing insurance companies, it was that the most important things though, aside from a few basic mathematical calculations, is to try to understand the management team. And again, are they conservative, are they competent?
That would take you a lot further, particularly for long run judgments. And since you are thinking long run and since we are talking life policies, you should ask whether they have a culture that will maintain itself after the existing management team. Do they tend to reproduce managers that continue to be competent and conservative? I think often that the mutual companies tend to be better at that because they have no one else to report to. They don’t have to put out quarterly earnings, except to the state regulators.
And the companies that blew up, often life insurance companies often last 30-40 years, were the rapid growers. They had aggressive management teams, I worked for such companies, AIG was one of those. Always grow grow grow and take chances to do it, you know, you would never hear about the little dirty secrets inside most companies like AIG, just as an example, but in the early 90s my boss and I found five reserving errors that were greater than $100M each, and one was a billion, and these never came through the gap statements because AIG found a way to basically find sufficiency in their assets to cover it over. In general, the companies that are better managed tend to be moderate growers. They are trying to grow but they are not trying to grow faster than anyone else.
Kelly: You mentioned leverage, talk about that.
David: This comes in two forms. The more common form is if you are a stock company you are borrowing money at your holding company. The more that a company borrows at its holding company level, in general, the more aggressive they are going to be as a management team. The lesser way is if you are writing guaranteed investment contracts and other types of short term business. To the degree that you are doing that, that’s a form of leverage because that means that you are...and especially if you are writing anything like a floating rate contract that can be terminated within, say, seven days, those are the sort of things that if they get written you have to be really good at managing your liquidity as a company because you have big payouts that are happening in the short run. With most other life insurance or annuity portfolio that doesn’t happen.
Kelly: Great. The underwriting process, you distinguish between initial front end, heavy duty, due diligence and acceptance versus accept anybody but then be real tight with the payouts, how can one distinguish between those two?
David: Basically, it’s by reputation or you can...if you are looking for something that’s actual data, in the annual statement of every life insurance company there is a schedule as per denied claims. A good company has relatively few denied claims. It is the companies that have pages and pages of denied claims that you have to go, “what are these guys doing?”
Kelly: Right. Well, David that’s all I have. I appreciate your time, and do you have one of your favorite quotes that you operate by, your business life or personal life?
David: Here we go.
Kelly: Say it slowly.
David: It is appointed to men once to die and after that the judgment, so live your life in the sight of God and not because men are looking over your shoulder.
Kelly: Oh, very good that’s a nice one. David, that’s perfect, thank you very much for your time.
We want to thank you for listening to the syndicated audio program, BankBosun.com The audio content is produced by Kelly Coughlin, Chief Executive Officer of BankBosun, LLC; and syndicated by Seth Greene, Market Domination LLC, with the help of Kevin Boyle. Video content is produced by The Guildmaster Studio, Keenan Bobson Boyle. The voice introduction is me, Karim Kronfli. The program is hosted by Kelly Coughlin. If you like this program, please tell us. If you don’t, please tell us how we can improve it. Now, some disclaimers. Kelly is licensed with the Minnesota State Board of Accountancy as a Certified Public Accountant. The views expressed here are solely those of Kelly Coughlin and his guests in their private capacity and do not in any other way represent the views of any other agent, principal, employer, employee, vendor or supplier.