Whole Life (WL) is the most complex product ever developed by the life insurance industry.
Anyone who intends to read this write should first read the “How it Works – Whole Life Box” write up. It provides a design framework that sets the stage for a more detailed discussion of WL’s various moving parts. I would also suggest reading the “WL Design Basics”, WL Guarantees” “WL Dividends” and WL Surrender Charges” write up’s before reading this one. The combination provides a sound foundation to understand the following discussion on public ownership versus the traditional mutual form of ownership and how WL products are impacted.
STANDARD INTRODUCTORY COMMENTS
The WL box story focuses on a conceptual understanding of the product. I would lobby a conceptual understanding is an essential first to gaining more knowledge on this ridiculously complex product.
That’s the reason the “How it Works” series contains a dozen or so WL related write ups. If it were indeed the simple product so many that sell it assume it to be, there would be no need for this avalanche of information… now would there? And yet here we are, literally buried in WL write ups.
What complicates matters with WL is the fact it is a bundled product where all the moving parts are obscured and no individual income or expense information is ever made available to those who sell it, or those who buy it. Some would argue with this statement, but only because they lack a full understanding of how the product is designed and how it operates in the real world we live in.
Sadly, and absent any ill intent, my experience suggests only a rare few of those who sell WL have any real grasp how it works. Instead, most base their understanding on a handful of half-truths and misunderstandings shared with them as fact by other under informed or misinformed (albeit well intentioned) mentors or peers.
Only when a properly educated individual asks detailed questions (the answers to which they already know) does the truth of the above statement become painfully clear. The few who know how WL works are endlessly amused (or saddened) when witnessing the floundering efforts of those who don’t attempting to explain how the product works.
It is also true that WL is often sold with an almost evangelical level of enthusiasm. Bold assertions made about its guarantees make the WL product sound as if it embodies all that is good and holy. Almost biblical.
Ill intent is not required to misrepresent a products features or benefits. Ignorance works just as well. Even those with the best of intentions can make blatant misrepresentations. Misrepresentations that can be every bit as damaging as the falsehoods shared by someone with ill intent.
So while ignorance may be bliss, it can still be hurtful when showered on others.
The WL product itself is neither good nor bad. It’s simply the result of a decades old design that allows cash values to accumulate within a life policy and death benefits to be paid when the insured passes away so long as the policy remains in force.
As with any product design, the WL design has its pluses and minuses. What makes it good or bad at any given time is more often than not the nature of what has transpired in the real world impacting the ability of a WL product to deliver its intended benefits..
So, it depends on economic and other realities whether WL is or isn’t the best product for any given person at any given point time. With today’s low interest rates combined with decades of regulatory miscues, blunders and missteps WL is unlikely to be best product to meet anyone’s life insurance needs.
This write up is intended to address the issue of how the shift to public (stock holder owned) from mutual ownership over the last few decades impacts the owners of life insurance. Not just WL, but certainly WL policy holders are impacted. And, not in a good way.
To understand why, please read on.
IMPACT OF PUBLIC OWNERSHIP
Decades ago the classic life insurance company’s ownership structure was “mutual”. Mutual insurance companies are technically owned by their policyholders. There are no stockholders.
Of course, the owners of life insurance policies don’t view their role as impacting the way the company is run. They don’t get to vote. They don’t hire the executives. They don’t appoint Board of Directors members. They are never asked their opinion on matters pertaining to the company’s financial health.
So what is the benefit of being a policyholder of a mutual company?
First, it is the opinion of State regulators that ownership as pertains to policyholders has an economic value. Which means if and when the company goes public the policy holders must be compensated.
Second, the theory is the executives have only the best interest of the policyholders to concern themselves with. There are no stockholders for the executives to worry about. A case can be made that publicly held companies are legally required to put the best interests of stock holders above that of policyholders. Which is a fact.
Third, and perhaps most important of all, is when it comes to publicly held companies the booking of expenses has a negative impact on the value of the company’s stock. This reality impacts the decisions made by a public company’s executives. Decisions which may not prove to be in the long term best interest of the company.
The reason is pretty straight forward. When reserves (which result in an offsetting expense) are booked by a mutual company there is no impact on the cash values of its outstanding WL policies. So policyholders do not experience a negative economic impact when reserves are booked.
This is dramatically different than the situation with the shareholders of publicly owned companies. A publicly owned company is owned by shareholders. The booking of reserves to write down asset values on a publicly traded company on its financial statements has an immediate impact on its shareholders.
The reason being booking a reserve increases expenses which in turn reduce operating profits. Potentially turning operating profits into reported losses. Losses reduce capital levels as well, which can create problems with the company’s financial strength ratings. Lower ratings can impact the value of its shares as well and they can also drive up the cost of debt; whether it’s in the form of bank loans or the issuing of bonds.
The reporting of profits and losses also directly impacts the value of executive owned stock purchase options. Meaning the company’s executives have another more personal reason to resist incurring expenses, including those created by asset write-downs.
The nation’s security regulators (the SEC) have enacted a host of rules intended to protect stockholders. Rules the management of these companies must adhere to or risk career ending repercussions. The executives of publicly traded companies are painfully aware of these rules and the consequences they may invoke.
State regulators have no such rules designed to protect policyholders of mutual companies. At least to the extent the SEC imposes itself on publicly held companies. Unless outright fraud brings a life insurance company to the brink of insolvency the idea a State regulator would take some sort of action is ludicrous.
The truth is State regulators typically have no idea what is going on at any given life company. It takes an absolute collapse of the company to get the attention of State regulators. For more commentary on that please consult the WL write up dedicated to “regulatory” matters.
Allowing a life company to avoid actions that would benefit policyholders at the expense of their capital strength is something State regulators view as in the best interest of its customers. Oddly enough, this can be at the expense of particular groups of policyholder, when an action (or inaction) is deemed to be in the best interest of most policyholders. Kind of like a “splitting the baby” Solomon like scenario.
All else being equal State regulators will rise to the occasion and defend policyholder rights. However, when doing so puts a company they regulate at risk of insolvency the focus of the regulator will shift to worrying about what is in the best long term interest of the company.
As noted, this is true even when decisions made are at the expense of the policy holders. Examples of this abound in the industry in the past and today. More on this, including real world examples, later in this write up.
THE CUSTOMERS vs. THE STOCKHOLDERS
Relative to publicly traded insurance companies owned by stockholders, policyholders are just customers. Customers don’t own an economic interest in publicly traded companies. Instead, they are a source of profits.
No one is directly in charge of protecting the customers of the nation’s life insurance companies. Unless that is one chooses to view the State insurance industry regulators as focused on that mission. An optimistic and highly debatable view at best.
The fact is, what benefits a customer does so at the expense of a company. Conversely, actions that benefit the company typically do so at the expense of customers. This is true for both mutual and publicly owned companies. But it’s fair to say with a public company this concern can and does rise to a higher level sooner.
As a fore instance, the higher the fees that are charged in a company’s products the more profitable the company will be. Conversely, the lower its products expenses, the more the customer will benefit. This creates and inherent conflict between shareholders and customers best interests, with management in the middle.
One can argue with a mutual company there is no benefit to increasing product fees since the customers own the company. Aside from the company maintaining a strong capital base and credit ratings it’s fair to say there is no real point to charging fees beyond what is necessary for the product to work as designed.
Clearly, that is not the case with public companies. When higher fees are charged inside a product it translates into higher levels of reported income. And higher levels of reported income translates into higher stock prices.
SEC vs STATE INSURANCE DEPARTMENTS
The Securities Exchange Commission (SEC) regulates publicly traded companies. They also have a “self” regulatory body called FINRA (a bunch of incompetent attorneys employed to harass and fine companies and invoke idiotic market conduct rules).
The SEC sets rules regarding what is legal and not pertaining to the behavior and financial dealings of executives who operate public companies. They also require specific types of financial reporting (quarterly and annual) which must include certain types of information. They also are charged with maintaining an orderly stock market (where they fail miserably relative to electronic trading) and are in theory focused on protecting stockholders.
The focus of the SEC is definitively on protecting stockholders.
The situation is not as clear with State insurance regulators. To a large degree it can be argued they are more closely aligned with what is in the best interests of the companies they regulate. All else being equal, which it usually isn’t, they are then concerned with protecting the best interests of policyholders.
Their primary focus is keeping the companies they regulate solvent so there is no need to utilize State guarantee funds. Which is deemed to be in the best interest of policyholders.
A situation exists within the insurance industry that best illustrates this point. It relates to a series of policies issued decades ago which later proved to be problematic for those who own said policies. Solving that problem would be “at the expense of” the insurance companies. A very high expense.
The situation and level of expense involved is tied to the way the expenses associated with issuing new policies is accounted for in the life insurance industry. Those expenses are very high. Much higher than most people would ever think possible. If they were “written off” in the year a policy was issued companies would report a major loss on each sale they made.
So instead, the expenses associated with issuing life insurance policies are written off over the anticipated life of the policies. Which, of course, would be the actuarial life expectancy of those that are being insured. The result is a very modest expense being recorded each year, instead of one massive expense recorded in the year of sale.
So what happens when an entire series of policies sold in the past becomes problematic to the policy owners. A problem where the only possible solution (considering the age and health of the typical insured at this later date) would be allowing policyholders to exchange their policies for a new series of policies that did not have the same problem.
Unfortunately, this solution would involve immediately writing off the remaining unamortized issuing expenses of the original policy series. This would create a major expense. If large enough it could not only trigger the reporting of losses for that financial period it could also negatively impact the company’s capital levels.
The amounts involved are large enough that they could trigger a drop in financial strength ratings, or worse, insolvency for a company with less than ideal capital levels.
Exchanging an entire series of problem policies to benefit the company’s customers, but it does so at the expense of stockholders. Even with a mutual company it can impact company ratings which drives up borrowing and bond related costs, and at a point might threaten company solvency by reducing capital levels.
As an example from the past we have a problem of this type that’s never been resolved. A situation where the senior executives of two very large life insurance companies have often discussed the fact a series of the first fixed interest universal life products they had sold were doomed to lapse before the insureds passed away.
A problem that could be resolved in one of two ways. Both unattractive, and with one financially damaging to the companies.
The products in question had been illustrated in the late 1980’s at the then current high double digit interest rate levels existing at the time (as if they would always remain that high). The problem being the illustrated rate of return (and income it would produce over the life of the policy) was used to calculate the premium level the policyholder would need to pay.
If the earnings rate in the future met the level illustrated there would be no problem. But those rates were ridiculously high and at a level that never had existed in the past. The idea they would continue at the level was absurd. But that’s the way State insurance regulators allow illustrations (the software which produces them which they approve) to be created.
As might well have been anticipated what actually transpired was a steep drop in interest rates to prior historical levels in the decades that followed. And to levels never anticipated in the decades after that. Meaning at the premium levels illustrated these policies were doomed to lapse long before the likely actuarial life expectancy of the insured parties.
NOTE: Money market interest rates in those days were in the 20% range. Therefore the regulators allowed those early UL products to be illustrated at those absurdly high rates. No one ever accused State Insurance regulators of making sense.
The problem was these companies kept billing the clients for the same premium amounts. As noted, amounts now hopelessly below the level needed to keep the policies in force for the longer term.
The reason being it would likely result in one of two undesirable scenarios. One being a great many of these policyholders would surrender their policies. The other being it would also likely trigger class action law suits if they were to inform the policyholders of the higher premium amounts needed to keep their policies in force for the lifespan of the insured party.
The executives of these two large companies consciously elected not to tell the policy owners what this situation meant. They just kept on billing the same low premium amounts the original illustrations had calculated.
These companies allowed the fear of widespread surrenders (which would have had a severe impact on their capital levels) and possible legal actions to dissuade them from informing the owners of these products what they really needed to pay going forward.
The other solution would have been to allow these now older and no doubt less healthy insureds to exchange the defective policies for a new series with more realistic assumptions. While the premiums would no doubt be larger, if the original age and health factors were allowed a reasonable result could be achieved.
However, this would involve all of the costs associated with issuing the series of policies to be written off at one time. The substantial impact on reported profits and or capital levels would be a disaster. While they were mutual companies it would impact their otherwise pristine ratings. As the public companies they later became, it would crush reported earnings and seriously impact stock prices.
Instead, all the executives did for decades was talk about an alternative “natural” solution. That being the number of these policies that were “running off the books” each year. Meaning some insureds were dying, some were letting polices lapse and a few were surrendering or exchanging their policies each year.
This slow “trickle” of deaths, surrenders and lapses had a minimal impact on capital levels. As opposed to an “all at once” avalanche that would have a major impact as all the original distribution costs were written off at once.
To be clear, the problem was if these companies offered a solution to allow these policies to be exchanged for a superior product they would have to write off all the unamortized sales costs at once, instead of over the life of these policies.
That write off would have an extreme and immediate negative effect, as opposed to just letting the policies “run off” over time. The gamble being the majority of them would “take care of themselves” prior to the time finally arriving when they would lapse.
Which was the action (or better said “inaction”) that these companies have elected. Which took place under both forms of ownership. Proof that in extreme situations the type of ownership becomes academic. Which is definitely not the case in less extreme cases.
STOCK OPTIONS – CONFLICT OF INTEREST
There is an inherent conflict of interest when it comes to a publicly traded company providing a good value for customers versus a profit and dividend income stream for its stockholders. Which is bad enough. A conflict does not exist with a mutual form of ownership.
What makes matters worse is there is also a conflict between the best interest of policy-holders and the executives of a publicly traded company. The reason being the stock options owned by the executives. Options that are impacted dramatically by even minor short term swings in reported income levels.
As noted earlier charging more expenses into a product creates a higher level of reported income and stockholder dividends. These factors in turn increase the value of a company’s stock and in the value of the stock options owned by its executives.
Under the mutual form of ownership, typical in decades past, the company’s executives did not own millions of dollars in stock options. There literally was no stock for them to own, or have options to purchase. While they might not wish to damage the company’s financial strength ratings by taking corrective actions of one sort or another the executives had no personal financial motivations to sway their thinking.
Under the mutual form of ownership the financial wealth of the company’s executives was not impacted if they decided to “do the right thing” and remedy a problem at the expense of the company. Which is absolutely not the case today since most companies are publicly owned.
Today the executives are indirect owners through the stock option positions they hold. These are “grants” allowing the executives to buy company stock at a set price. If the market value of the company stock rises above the option “strike” price, they options have a value.
The value of options held by executives typically dwarfs the actual number of shares they own. A value that is also incredibly volatile compared to the actual stocks itself (the reason for this is explained a few paragraphs further down).
This brings us back to a problem created by regulatory trends over the last few decades. This is discussed in detail in the “regulatory” write up. Certain asset classes (longer term and illiquid) have been deemed a potential risk based on past volatility. Asset classes that have also historically been the top earning assets owned by the nation’s life insurance industry.
Suffice it to say for purposes of this write up that certain types of assets (asset classes) have been deemed problematic. So regulations have been imposed to discourage their ownership. They do so by requiring reserves be set aside at the time these assets are purchased. The reserves have the impact of reporting an expense “today” with the goal of tempering the magnitude of possible losses that might result from a decrease in the market value of those asset classes in the future.
Setting up a reserve has the immediate impact of creating an offsetting reported expense. An expense that both lowers reported income and reduces capital levels.
The consistent purchase of these “problem” asset classes would involve equally consistent reserve related expenses being booked. This would be of no concern to a mutual company (or less of a concern), but it’s a major issue for publicly traded companies.
The trade off of not purchasing these asset classes is a longer term reduction in the earnings generated by the general account. The shorter term benefit gained by not purchasing them is the ability to avoid booking a required reserve expense write down.
Reserves lower the value of an asset on the books of the company when they are set up. They produce an offsetting immediate expense that reduces income and capital levels. The impact on the company’s outstanding stock value might be relatively modest. However, the impact of even a modest change in stock pricing can have a dramatic impact on the value of stock options (as explained shortly).
The net worth of executives is often comprised primarily by the value of the company stock options they own. These options typically can’t be cashed in until certain specified time frames elapse (their exercise date).
The same options can be worth millions, or nothing, and anywhere in between during the interim time frame between when they are “granted” and when they can be “exercised”. The value of the options is hyper sensitive to even small movements in a stock’s price, as the example below reflects.
EXAMPLE: Take a stock that is now worth $100 and an option grant from a year before that gave an executive the right to buy the stock at $95 five years in the future (the exercise date). The stock was trading at $90 when the option was granted so it had no value at that time.
A reported earnings increase caused the stock to go up to $100 over the last year. The theory behind granting options is it “incents” the executives to run the company in a profitable manner causing the stock value to increase accordingly benefiting the stockholders.
With the stock price at $100 each option is worth $5.00 since the executive has the right to buy the stock at a cost of $95 and could immediately sell the stock for $100. Which is what executives normally do when they exercise their options. When the stock exceeds the exercise price it’s referred as the option being “in the money”.
If the executive had been granted 1,000,000 options, they are now worth $5,000,000 at the $100 stock price. If the company stock declines just $6.00 (based on lower reported earnings) to $94 the entire $5,000,000 is wiped out. The options are then referred to as “out of the money” or “under water”. They are worth zero.
While the actual stockholder has only suffered a 6% decline with the $6 price drop. The executive has suffered a 100% loss.
So, it’s easy to see why an executive has a tremendous incentive to keep the stock value above $95, at least until the time the exercise date arrives five years after the option was granted. After which the executive has no incentive to care about the stock price at all. This clearly encourages short term thinking and other less than ideal actions from a longer term point of view.
Anyone who believes executives run a company for the long term benefit of its stockholders is deluding themselves. While that is the theory upon which our capitalist corporate ownership model is based, it is utter nonsense relative to the real world in which we live.
The advent of the use of options and the volatility of an options value with relatively small moves in the value of the company’s stock create a scenario where the executives own net worth is tied to short term time frames. A fact that is always on the executives mind.
It is unrealistic to expect an executive to ignore their own best interest for the sake of protecting the wealth of shareholders. People they don’t know since the makeup of the stock holder base changes daily. More so today than ever with the advent of high frequency computer driven trading. The entire outstanding share total might trade two or more times during a single year (or month, week or day with high frequency trading dominating the market).
Another fact to keep in mind is that senior top executives typically aren’t with large public companies for decades. More often than not the tenure of a typical top executive boils down to a three to six year “gig”.
Meaning the reality for many, if not for most, is they need to cash out while the cashing out is good. They are not in those positions to run a charity for the benefit of others who happen to own stock at any given moment in time, now or in the future.
A “long term” stockholder is a rarity in today’s day trading and electronic high frequency trading world. Once again, something the executives that actually run the company are well aware of. How can anyone be expected to be loyal to the best interest of short term day traders and or institution trading hundreds of millions of shares a second, and do so at their own expense.
The expectation is ridiculous. Even if it is the law of the land.
Executives are not blind to these facts. For most it’s far easier to see those who run the company as deserving to benefit more from its operations than an ever changing list of short term stockholders. That’s the reality of the world as it actually exists today, as opposed to the myth of long term public ownership that used to be taught in schools.
Then comes the price these executives pay in terms of personal time lost to running the company. Not to mention the never ending demoralizing ethics compromises senior level executives (CEO’s, COO’s, CFO’s etc.) often are forced to make. It takes its toll.
The price they pay is high; very high indeed. As such, they feel entitled to be paid as much as they can get to compensate for the sacrifices they make in their personal life. What’s more, they are in a position to make sure that’s exactly what happens most of the time.
So when it comes to bad news of any kind that might impact earnings the normal reaction is to bury it for as long as possible. Or actions that might trigger the reporting of expenses that can otherwise be avoided. Like buying higher paying, long term and illiquid assets in their general accounts.
Whenever possible the bad news, and resulting negative impact, are pushed into the future. The goal being to make it “the next guys” problem. The closer the senior executives are to their option exercise dates, the truer this is. And generally they all get their option grants at the same time, so they all have the same exercise dates to worry about.
The tie that binds them.
As such, most executives are not going to do anything that they know will degrade the current value of the firm’s stock and wipe out the value of their options. Add to this the fact they also risk dealing with class action litigation whenever shareholders incur an unexpected loss and you have another reason to delay.
Suffice it to say the existence of option based income incentives impacts executive behavior. The fact increased expenses can decimate their own personal fortunes by wiping out the value of the options they own is always on their mind. It dictates their behavior as it would anyone’s.
Basically, the public company business model as it exists today is a broken one. Day traders and electronic trading systems dominate the business of buying and selling stocks. No one other than Warren Buffet plans to own the stocks they buy for decades. And the magnitude of the options granted to executives dictate their behavior instead of the long term best interests of shareholders.
Perhaps a story for another day.
WRAP UP COMMENTS
The dramatic downward fluctuations in the value of certain asset classes in the past have focused the efforts of our nations regulators on avoiding a third repeat of those disastrous post 1987 and 2008 results. The regulations they have imposed put executives in a position they can either buy the higher yielding asset classes and incur short term expense write offs for funding reserves, or they can buy short term, highly liquid but lower yielding assets.
The makeup of the general accounts of the nation’s life insurance companies today tells everyone the choices they are making. They are buying short term, lower yielding and highly liquid assets. They are avoiding reserve expenses being booked whenever possible.
The result is constantly lower dividends being credited into WL policies. Lower to the degree that many, if not most, of these policies will lapse long before the insureds likely mortality date. Something the nation’s regulators have turned a blind eye to for decades now. A crisis slowly unfolding that will one day in the not too distant future dominate the news. At which time the regulators will waive their arms in horror, inflict fines and penalties on the life insurance companies and no doubt pass equally dysfunctional regulations to avoid in the future
