Why Insurance Companies Fail

IASA Ohio Chapter

November 2016

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Presentation summary

∙ What makes insurance unique and what responsibilities this creates for those who manage and govern?

∙ Regulation of insurance

∙ Insurance company failures

∙ What has changed?

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Insurance is a unique industry

∙ Traditional commerce involves a simultaneous exchange of currency and product

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Insurance is a unique industry

∙ Insurance buyers exchange currency today for the insurer’s promise to perform in the future

∙ That obligation may or may not come due

∙ The cost of that obligation is highly uncertain

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Insurance is heavily regulated

Society has an interest in making sure that financial institutions make good on their promises

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What could go wrong???

Insurance company failures • Looting of assets

• Failed investment strategies

• Management schemes

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Looting of Assets

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Sale to Known Looters

During the 1980’s many large corporations diversified into financial services, including insurance

Their timing corresponded to the emergence of asbestos and environmental remediation claims, which in turn led to decisions to divest

Sales were made to individuals with little or no insurance experience

• Many to S&L owners/executives who were sitting on underwater properties

• No regulatory background checks were required

∙ An Actual Legal Theory of Liability

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American Universal Insurance Company

Fortune 500 chemical manufacturer sells AUIC to an investor group that they knew had no insurance experience

• Investors use insurer’s assets for purchase price

• Liquidate conservative bond portfolio to purchase real estate and mortgage loans ‒ Properties owned by the investors

‒ Properties subject to S&L regulatory scrutiny

‒ Limited scope appraisals often performed by related parties

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Martin Frankel

Banned for life by the SEC in 1992 Charmed his way through CT and Palm Beach society into borrowing several million From there he purchased his first insurance company

• Transferred assets into his own custodial accounts

• Used those assets to pay off previous borrowers

• Bought another larger insurance company

• Repeat 12x

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Martin Frankel

Frankel accused of skimming $215mm from his insurance companies to support his lifestyle

Plead guilty and sentenced to 17 years in prison

Congress reviews these events: This fraud went on far too long, not because Mr. Frankel was clever and deceptive, but because he was operating in an environment where the regulators lacked the skill, authority, access to basic information, resources and ‘healthy skepticism.’

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Failed Investment Strategies

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Failures Stemming From Invested Assets

Interest rate spike of the late 70’s leads life insurers to develop new products to compete with banks, S&L’s and mutual funds

• UL and annuities with guaranteed minimum crediting rates

• As rates decline, insurers look to new instruments

‒ Mortgage loans ‒ ADC loans ‒ Real estate ‒ Junk bonds

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Failures Stemming From Invested Assets

Overbuilding during 1980’s contributes to real estate glut

• 1990-1991 recession

• Florida, Texas, Southwest and New England

Insurers forced to foreclose on mortgage loans and assume collateral properties

• Unfinished developments

• Golf courses

• Office buildings and malls

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Failures Stemming From Invested Assets

Regulators pressure insurers to divest from real estate holdings Insurers offer generous financing to any buyer

willing to pay book value • No money down

• Unqualified buyers

• Interest-only and cash flow loans

• Questionable appraisals used to support selling price

Many of these loans failed, and insurers forced to reacquire the properties

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Failures Stemming From Invested Assets

AM Best downgrades many insurers

Liquidation sales for insurers without sufficient capital to ride out the storm

Death by policyholder runs (large, sudden increase in policy surrenders) • “Insurance is the next S&L”

Many 100+ year old life insurers acquired or forced into liquidation

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Executive Life Insurance Company

Executive Life invested heavily in “high yield securities” Uncollateralized bonds used to finance leverage buyouts

Policies guaranteed twice the returns of competing insurers

• “Our competitors follow an obsolete business model”

Public soured on “junk bonds” in the early 1990’s after Milken indicted on securities fraud Policyholders made a run on ELIC, which

led to the largest insurance insolvency at the time

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Management Schemes

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Guarantee Security Life

∙ Purchased in 1984 by two investment brokers (Mark Sanford and William Blackburn)

• Primarily offering annuities with high guaranteed interest rates

• Grew from $100 million to $1 billion in assets between 1984 and 1991

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Guarantee Security Life

∙ Phantom Year-end Transactions with Merrill Lynch

• Sanford and Blackburn invested hundreds of millions of GSLIC dollars in high-yield, high-risk junk bonds

• Greatly exceeded regulatory caps for non-investment grade securities

• Merrill Lynch “swapped” these for U.S. Treasuries just before December 31

• In early January the transaction was reversed

‒ Phantom transaction

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Guarantee Security Life

∙ Equity Stripping

• Many junk bonds included warrants to purchase common stock in the issuer at a fixed price

‒ These warrants had value if stock price increased as a result of the leveraged buyouts

• Drexel Burnham Lambert detached the warrants, transferring them directly to Sanford and Blackburn’s personal accounts

• Sanford and Blackburn knew that the warrants were rightly the property of GSLIC and took care not to disclose their actions

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Guarantee Security Life

∙ Management’s Self Dealing

• Investment advisor fees

‒ Paid to companies controlled by the very persons already managing GSLIC

• Management fees

‒ Companies controlled by Sanford and Blackburn extracted a 20% markup on management expenses including payroll and rent

• Excessive executive salaries

∙ Sanford and Blackburn and companies owned/controlled by them looted over $80 million from GSLIC

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Guarantee Security Life

∙ In assessing the GSLIC matter, the Florida Commissioner of Insurance stated:

∙ “The fraud at Guaranteed Security was a carefully orchestrated bank robbery. But the thieves disguised themselves with the help of accountants and brokers and lawyers rather than wearing silk-stocking masks.”

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PIE Mutual Insurance Company

Founded in 1975, and became Ohio’s largest physicians insurer at the time of its failure in 1997

Expanded aggressively with low premiums and/or agents could offer discounts at their discretion • Despite AM Best ratings dropping each year

Agreement in place with a renowned law firm to provide all claim defense services in exchange for an up front percentage of written premium • PIE recorded no ALAE reserves since they were prepaid

• Until the law firm disbanded post-regulatory intervention, leaving a $100mm unfunded liability

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PIE Mutual Insurance Company

PIE was a significant political contributor • KY Insurance Commissioner approved PIE’s application to KY

over the objections of insurers, and later became PIE’s Executive Vice President for Governmental Relations

In the Fall of 1997, the CEO was paid $11.5 million without board approval, and a $1mm loan was forgiven. He also took a $265k cash advance on his future bonuses just days before regulators seized the Company

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Frontier Insurance Company

Formed in the 1930’s

Adopted an aggressive growth strategy in the early 1990’s following IPO

Writing over 2.2 to 1 leverage ratio

Expanded writing MPL in several states, as well as many specialty liability lines

Post-insolvency, president and CEO stated: “We did a poor job of determining which were the

good doctors and which were the bad,'' he said, adding that the consequences became apparent in the last few years

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Where Are We Today?

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Development of regulation over past 20 years

∙ Looting of assets

• DOI background checks on owners and directors • Annual statutory audits in addition to examinations • Appraisal requirements

∙ Investment strategies

• Risk-based capital, ERM and ORSA • Reporting of all investment transactions

∙ Management schemes

• Comprehensive disclosure in annual statement and audited financial statements

• Holding company statements

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Board oversight

∙ Establishing strategic objectives and risk tolerance

∙ Monitoring results versus expectations

∙ Audit committees monitor control environment and understand the key estimates and assumptions in the financial statements

What are we investing in?

Are we overly aggressive on yield?

Is our business plan reasonable?

Are we chasing topline growth?

Are we adequately reserved?

Does management put pressure on actuaries/auditors to hit numbers?

Are internal controls effective in producing accurate financial reports?

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Where will the next insolvency come from?

• Low interest rates / higher yielding investments • Erosion of tort reform • Natural disaster / pandemic • Changes in distribution methods • Automobile technology • Data security • Global financial crisis

Questions?

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Contact Information

∙ Heidi DeVette ∙ Senior Manager ∙ hdevette@johnsonlambert.com

∙ Phone: (847) 230-9755

∙ Carleigh Moore ∙ Tax Manager ∙ cmoore@johnsonlambert.com

∙ Phone: (919) 719-6429