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 regulatory realities and their impact on WL products..

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 plusses 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 regulatory trends over the last few decades have resulted in a substantial degrading of the value of the WL product to any given buyer. 

INSURANCE REGULATORS

The States regulate insurance companies not the federal government.  Unlike banks and securities firms, there is no national regulator responsible for maintaining the integrity of what goes on with insurance companies. 

While some level of standardization does exist from State to State (more on that soon) there isn’t an identical set of rules all State regulators adhere too.  The rules can and do vary from State to State.

So there are 50 different State Insurance departments.  So potentially there are 50 different sets of rules that the nation’s insurance companies must comply with if they wish to do business in all 50 States. 

To make this more palatable State regulators have joined in a network called the National Association of Insurance Commissioners (NAIC). 

NAIC seeks to standardize as many rules as possible where States can agree.  The result is a general level of conformity from one State to another.  That said, there are still States that pride themselves on having far more stringent rules than other States.  Which NAIC allows.

There are also several non-regulatory entities that merit mention in the context of regulator.   The reason being they each have the ability to impact how insurance companies operate.  So, while they are not actually regulators it’s fair to say their impact on insurance company behavior is comparable. 

The best example is the American Institute of Certified Public Accountants (AICPA).  The AICPA is totally independent of any financial strings to the insurance industry.  The AICPA sets the financial reporting rules and standards for all publicly traded companies. 

These AICPA rules also impact the financial reporting of nonpublic companies.  Loan agreements and bond indenture agreements often require AICPA standards be adhered to in the company’s financial reporting of operating results and balance sheet values.   

A second category of “defacto” regulators would be the nation’s credit rating agencies; like S&P, Fitch and AM Best.  These companies, for a fee, rate the financial strength of a company.  Which also means there is an economic relationship between the companies they rate and the rating agencies. 

The companies are in essence customers of the rating agencies.  They pay for the ratings.  Which seems inappropriate on the surface, but that’s the way it’s always been.

The fees charged are not sufficient to allow for the ratings agencies to actually audit the financial statements of these companies.  The fees would need to range into the seven figures for larger companies if a true forensic audit were to be conducted. A price companies simply would be unwilling, or perhaps unable, to pay.

The little known (to the general public) fact is ratings are based on the “trust me” principal.  The idea being these companies are providing accurate financial statements and supporting data to State regulators.  Which the credit rating agencies obtain from State regulators and upon which they base their ratings. 

While little understood by the general public the fact is the rating agencies are not certifying the accuracy of the information there ratings are based on.  They are just evaluating the reported numbers and extrapolating a rating from that data. 

If the numbers reported are accurate, then so is the financial strength rating.  If not, the actual financial strength of the company is anyone’s guess.  Two classic examples are reviewed later in this write up demonstrating this fact.

The reason rating agencies can be viewed as regulators relates to the fact a bad rating can crush a company’s reputation with the public.  With an insurance company that promises to pay huge sums at dates far in the future the perception of financial strength is in essence what’s being sold. 

With life insurance companies the purchaser of a policy has to have faith the company can pay the death benefit purchased when the insured party passes away.  If a company has poor ratings their sales will suffer, premium income will decline and a downward financial spiral is virtually assured.

It’s also true that bad ratings can drive up the cost of borrowing dramatically.  Lenders will require higher interest rates as will the issuers of bonds.  A fact always on the minds of a life insurance company’s management team.

The bottom line is rating companies can drive behavior as executives seek to maintain high financial strength ratings to protect the company’s reputation and reduce borrowing costs. 

As can the AICPA reporting standards, especially those rules pertaining to expense recognition which can impact stock prices, reported earnings per share and capital levels.

PREMIUM TAXES

While the public is blissfully unaware of this, State insurance departments are empowered to collect a premium tax on the premiums paid for business done within their State.  This tax is deducted from the premiums customers pay and forwarded to the respective State that the customers reside in. 

Think of this as a sales tax paid by those who buy life insurance policies.  An invisible sales tax they don’t really know exists.  A tax that is deducted from the premiums they pay leaving a lesser amount available for the life insurance company to put to work for the policy owner. 

These premium taxes, at least in theory, are used to fund State Insurance department operations.  The actual use of the funds is, of course, determined by the respective States governing bodies.  Something else the general public is also blissfully unware of. 

It’s fair to say premium tax rates vary widely from State to State.  Some companies deduct actual State discreet tax rates from the premiums they collect.  Others simply average the premium tax rates of all States they do business in and deduct that average expense factor from the premiums they charge. 

Only the “net” of the premiums paid minus the tax due the State will end up benefiting the life policy buyer.  The premium tax itself, much like a sales tax charged by a regular retail merchant, is paid to the State by the insurance company.

The insurance premium tax rates currently being charged by any given State can be found in an online search. 

PRIMARY FUNCTiONS OF STATE REGULATORS

State insurance departments have three primary and many secondary functions.  The primary functions are outlined below. 

First and foremost is the fact they approve the insurance companies allowed to sell products within their State.  This function includes the power to:

• Require regular reporting of financial operations and supporting data.
• Conduct reviews and audits of the companies approved to do business to assure compliance with regulations.
• The power to impose fines and penalties to assure compliance with rules and regulations
• Protect the rights of State residents relative to market conduct issues pertaining to the sale of insurance products by companies approved to do business within the State.

The respective State insurance departments also have the right to approve (or not) the products offered for sale in their State by any given insurance company they have approved to do business within their State. 

• Companies are required to provide extensive information on the products they propose to sell; including marketing materials and illustrations systems.
• Companies cannot offer a product for sale in a State if they have not been approved to do so.  This includes policy updates, riders and ancillary policy provisions.
• Software used to produce illustrations and the content of those illustrations (numerical and text) must be approved by the State prior to its use.

State insurance departments also license the individuals approved to sell insurance products in their respective State.  States typically also allow licensing reciprocity, meaning if a sales associate has met the requirements of one State they can pay a fee and be appointed to do business in another State.  Some States make this more difficult than others so reciprocity isn’t always seamless.  It is the norm, not the exception, for insurance agents to be licensed in multiple States.  Obtaining a license typically requires:

• A stated number of hours of classroom or online training be completed on State insurance regulations.  The number of hours and content of the training varies widely from State to State.
• Applicants must pass exams demonstrating an understanding of their home States regulations.
• Agents must complete continuing education requirements (that vary from State to State) to maintain licensing.
• Compliance with State regulations pertaining to market conduct and ethical standards is mandatory for all licensees. 

PROS AND CONS OF STATE REGULATION

These three functions give State regulators substantial power over the insurance industry.  Sadly, these departments are typically run by political appointees who have at best limited knowledge of the products they are empowered to regulate.  They are staffed with bureaucrats, likely underfunded and are woefully ineffective on multiple levels. 

Other than that they do a great job (not).

Good intentions aside State regulators all too often enact rules that impact the financial operations of insurance companies.  This can degrade the ability of the products sold to deliver the benefits those who purchase them desire and need. 

The typical State insurance department only reacts “after the fact” and when they do the norm is they overreact.  Only in rare cases have taken steps to avoid problems before they occur. 

Some of them withhold approvals for certain products, riders or even particular policy provisions they object to for one reason or another.  Which serves to deprive their residents of cutting edge benefits they would most certainly benefit from having access to.   

Good intentions aside, their actions, rules or the requirements they impose can and do backfire to the detriment of their residents. 

This can easily occur when the economic realities prompting a rule change shift over time.  As is the norm as markets correct over time.  It also occurs when excessive zeal, all too often associated with public grandstanding to obtain politically motivated visibility, coincides with incompetence or ignorance.

New York State is considered to have the strictest insurance regulations.  NYS is a good example of both the pros and cons of State regulation.  Its residents have both benefited and been hurt in this regard.

Texas has historically been difficult relative to the licensing out of state sales associates wishing to do business in Texas.  A problem that has moderated somewhat over time.

California and Florida are little more than cesspools of incompetence where new product filings, including those quickly approved by most other States, go to die.  Either they are doing amazing levels of in depth analysis, or they are utterly indifferent to new product filings or incapable of processing them efficiently.  Let’s just say there is no evidence to support the former thought and plenty to support the latter. 

Relative to a positive impact of NYS’s insurance regulator benefiting its residents we need look no further than the products sold by Executive Life in the 1970’s and 1980’s. 

The NYS insurance department refused to approve its life policy filings for certain products.  This proved to be wise indeed when Executive Life later failed.  Executive Life had to open a separate subsidiary just to do business in NYS.  That subsidiary had its own capital base and it sold a different line of products approved for sale in NYS.  As a result NYS residents were not impacted by the failure of Executive Life. 

So there are definitely examples where stricter standards produce a positive result.

The offsetting bad news is NYS’s zeal relative to protecting its citizens has also backfired.  There are numerous and ongoing instances where the State’s reluctance to approve new products, or product features and riders, has consistently worked to the detriment of NYS residents.  Its residents are denied the ability to purchase highly prized and much needed protections readily available to residents of most, if not all, other States.

Of course, it’s actually impossible to tell if NYS’s current reluctance (or inability) to approve new products and riders, or improvements to existing products and riders, is the result of well-reasoned concerns, or outright incompetence.  While the former is always possible, the latter is always far more probable when a bureaucracy is managed by aspiring politicians. 

As referenced earlier, Florida is a difficult State when it comes to getting new products, riders, policy provisions and related illustration systems approved.  With Florida few would argue this is anything but the result of either under staffing or outright incompetence.  Likely both.

To put it bluntly, a strong case can be made that those appointed (or even those elected) to run insurance departments around the nation are generally disinterested and ineffective. 

Of course, there are exceptions to every rule, and surely a generalization of this type is unfair to someone at some point in time.  Still, this does not preclude the fact at other points in time a generalization like this may well be accurate and on point.

It’s not that appointees aren’t typically successful people.  To the contrary, they are usually well connected individuals who just happened to support the campaign of a newly elected governor.  No doubt little more than a coincidence (or not).   

Observers over the past few decades would most likely find only one thing is on the mind of most insurance commissioners.  That’s running for governor at some point in the future.  Aside from that most seem happy to sit on their temporary throne and enjoy the leverage that provides them with to move their careers along. 

WHY NO OUTCRY FOR CHANGE

There is no “upside” in pointing out the level of incompetence experienced relative to any given State’s insurance department.  Doing so would simply annoy or outrage that State regulator.  Much to the detriment of the person or company daring to make competence an issue. 

The idea it might lead of positive changes is so farfetched it isn’t even worth considering.  After all, how does one motivate 50 different bureaucracies around the nation to improve?  

It’s also true that insurance companies fear what might occur if Federal regulation were to replace State regulation.  We need to look no further than the debacle federal bank and investment company regulation has been over the decades.  Or, for that matter, pretty much any governmental agency one can name.

There is also another very real concern keeping insurance companies from mounting an effort to move to federal regulation.  The amounts required to “incent” members of the nation’s Congress to act are far greater than those required to motivate low level State regulators. Members of the US Congress don’t sell out cheap.  They require massive, regular and ongoing campaign infusions to stay in office. 

So there is little prospect for change and no upside to lobbying for change.  As the saying goes, it’s better to deal with the devil one knows.  And so it goes.

STATE GUARANTEE FUNDS

At the heart of each State’s insurance regulatory structure is a State guarantee fund.  A fund intended to support the guarantees included in the products approved for sale within any given State. 

This guarantee fund will in theory kick in whenever a company selling insurance products in that State fails.  Its purpose is to provide at least a minimum level of financial protection for residents who own policies sold by a failed firm.

The word “fund” might be misconstrued to suggest an actual pile of money exists to meet this need.  This is not the case.  There is no actual “fund” in the sense of a large pool of money held by each State for this purpose.

More on how the guarantee funds work shortly.

Relative to the guaranteed provisions in an insurance contract it’s fair to say they are far less than “current” non-guaranteed illustrated benefit levels.  Far, far less.  The purpose of a policy guarantee is to provide a minimal level of financial backup, not a maximum level of possible illustrated benefits. 

Each State publishes a schedule reflecting its guarantee fund limits for different types of insurance products.  It’s fair to say these limits differ widely from State to State.  It’s also fair to say they set relatively low levels of benefit geared to protecting the average buyer, not those who purchase large amounts of coverage. 

NOTE:  For instance, the first $250,000 of death benefit might be guaranteed by a State for life insurance products.  Any amount purchased above that level is only guaranteed by the company selling the product.  If the company later fails and an insured has passed away but the death benefit has yet to be paid, only the $250,000 amount will be supported by the State guarantee fund.

While obscured by time it may have been the original intent some portion of the premium taxes collected by any given State be set aside to accumulate an actual guarantee “fund”.  Whether this even was or wasn’t the intent at some earlier point in time, it is not what has transpired in today’s world. 

Which brings us to a reasonable question.  If there isn’t an actual “fund” to support the guarantees in products sold in any given State, when a company fails where does the money actually come from to protect State residents who purchased policies from that company.

The answer is it comes from all the other solvent companies doing business in that State.  They are assessed a pro-rata amount of the total needed to support the guarantees in the products of the failed company.  The calculation is typically based on the portion of premiums any given company collected in that State versus the total of premiums collected by all companies doing business in the State. 

These “post failure” assessments effectively pay for the cost of the guarantees stated in the failed companies products sold to residents of that State.  This assessment process is not a negotiation.  If a company fails to pay the assessed amount it will no longer find itself approved to do business in that State.

What also often happens is the State finds a far healthier company that is willing to take over the responsibility for the products the failed company had sold.  The State incents this by providing a level of support relative to crediting of guaranteed amounts, or payments of guaranteed benefits. 

Which does not in any way suggest the policyholders receive all the benefits they had been promised in the products they purchased.

Instead, the company acquiring the failed company’s products sets the level of benefit it is willing to provide.  Those clients who don’t like it are always free to surrender or lapse their policies.  Again, it’s not a negotiation. 

Either of the above approaches free the States from the burden creating and managing an actual guarantee fund.  This is the way it is, has been and the way it’s going to stay.  There is no one clamoring for the State’s to build an actual fund for this purpose. 

No matter what transpires the State itself will in no way be financially impacted when a company approved to sell insurance products in the State fails.  They simply pass along the cost of that failure to the remaining companies still doing business in that State.  Aside from some possible level of embarrassment for the State insurance department, it’s a nonevent.

Not a bad deal since each State collects an incredibly substantial level of premium tax.  It’s kind of a “head’s we win, tails you lose” scenario.  It’s nice to make the rules.  This is kind of like legalized black mail if you think about it.  Companies must agree to pay this “tax” in order to do business in a State. 

When organized crime does something like this its illegal.  When a governmental body does it, it’s entirely legal.  No wonder greed driven people flock to political positions.  It gives them a license to steal.  How good is that (for them).

REGULATORY WINDFALL OPPORTUNITIES

The effectiveness of fifty separate States attempting to regulate an incredibly complex industry is highly debatable.  If anything, history suggests this fractured division of regulatory responsibility is ineffective at best.     

Oddly enough, when major problems do arise, it’s actually a plus for the States that regulate the industry.  A windfall opportunity.  A windfall funded by the massive fines that can be inflicted on the deep pockets of the insurance industry.    

Fines are publicized as intended to change bad behavior and or protect the best interest of the residents of any given State.  A claim that all too often rings hollow upon closer review.  Few if any of the dollars raised in this manner ever find their way into the pockets of customers of the insurance industry.  Instead, they end up in the State’s treasury. 

It is also a fact most of the situations resulting in fines and penalties have absolutely nothing to do with bad management or criminal behavior on the part of executives.  Instead, they tend to be triggered by macro-economic trends or the actions (or inaction) of regulators themselves.

The real purpose of these fines and penalties is to give the public the impression their State regulator is on top of whatever is going on.  Not only on top of the problem at hand, but also taking corrective action to avoid a repeat of whatever has occurred. 

The goal being to portray the State’s insurance commissioner as a champion of the public.  A punisher of bad behavior.  An ideal candidate for higher levels of public office.

Which is even more amusing when the truth is regulations imposed by the States (or not imposed may actually have done more to cause the problem at hand, or aggravate it, than fix it. 

There are generally two types of problems that arise which trigger regulatory action.  One being a windfall opportunity.  The other not so much. 

As a fore instance of the latter situation we have the occasional isolated individual company failure.  Sadly for the State’s coffers it’s often impossible to collect fines or penalties from a failed company.  So these usually don’t benefit the State coffers.

Then we have the far more lucrative scenario which occurs when economic trends or an unforeseen triggering event of one sort or another occurs.  After which, in perfect hindsight, State regulators descend on the insurance industry spouting all manner of self-serving righteous indignation.  These are the perfect opportunities to impose fine and penalty driven corrective actions. 

The idea being companies should have been able to predict or control the macroeconomic trend had evolved or head off the impact of an unforeseen triggering event.  Of course, both of these things are completely beyond the control of any given companies management team.      

Left unsaid is why the regulators themselves are in no way responsible for failing to see what was coming.  Or for their failure to impose corrective measures ahead of time to forestall whatever negative result has transpired.  The problem being regulators specialize in hindsight.  As far as seeing into the future, they have a dismal record at best. 

So one rarely sees is a “proactive” action taken by a State insurance department before a problem arises.  Yes, there is the rare and occasional exception (as with NYS in the 1980’s and the Executive Life debacle).  But generally it’s fair to say regulators only spring into action when a problem explodes into public view. 

Rather than continuing with this sort of negative generalization, let’s pause for a quick overview of a few classic problems of both types from the past.  Problems that impacted the insurance industry and its customers.

INDIVIDUAL COMPANY FAILURES

We need only go back a few decades for two glaring examples of regulatory ineffectiveness pertaining to large insurance company failures. 

Both failing companies were highly rated (AA/AAA) at the time they failed, indicating a failure by the rating agencies.  Both were among the largest in the nation at the time.  Indicating a systemic failure of State regulators. 

No doubt entire documentaries, novels and or full length movies could be written about both.  However, all we have time for here is a brief and likely over simplified outline of what occurred.

EXECUTIVE LIFE:  The entire industry had been screaming that something was wrong relative to this company.  All of this falling on deaf ears when it came to rating agencies and all but one State regulator. 

As noted above, kudos must be given to NYS’s insurance department on this one.  They prohibited the sale of this companies products in NYS.  A wise and reasonable action on their part that spared their residents from harm.

Executive Life had for a decade or more been illustrating and paying dividends and interest rates several percentage points above the rest of the life industry.  The industry outcry was based on the idea Executive Life could not consistently out earn the rest of the industry year after year and do so in a responsible manner. 

A few shared by many companies, many authors of articles and by thousands of licensed agents seeking to meet the needs of their clients and earn a living while doing so.  All of which fell on deaf regulatory ears.  Not to mention the rating agencies that happily charged this firm fees to provide what turned out to be grossly inflated ratings. 

So, it was obvious to all but the rating agencies and 49 out of 50 State regulators that something was amiss.  There is no way one company can consistently out earn all other companies and follow all applicable rules and reporting regulations.  No way.  Period. 

The financial disclosures filed by this company with State regulators disclosed large bond portfolios.  Portfolios with higher than typical yields.  These were “junk” bonds most of which were sold to Executive Life by Michael Milken.  A broker who later spent time in prison. 

Articles printed in industry publications routinely pounded on the fact rates illustrated and actually credited seemed impossibly high.  Not to mention the fact that many junk bonds in the market place were suffering large face amount declines as the financial health of the companies issuing them worsened.  A problem Executive Life alone seemed to be immune to. 

A “red flag” regulators and rating agencies alike ignored.  Keep in mind there was a good reason these bonds paid higher yields and were labeled as “junk”.  The companies issuing them had to pay more to borrow because they had well documented problems.  Something everyone knew at the time the bonds were sold.

The companies selling junk bonds were also often over leveraged (excessive borrowings versus their capital levels) which increased their risk of failure.  The higher debt levels and related high interest costs raised substantially the risk these companies might fail.  A problem that all too often came home to roost.

Low and behold, overnight it was found that the values reported by Executive Life (which the States and rating agencies blindly accepted as fact) on its financial statements were grossly overstated.  These bonds had been left on the books at their historical cost while the actual values had plummeted to far lower levels. 

Most were actually worth only a fraction of that amount.  What a shock!  The difference should have been booked as an expense, which would lower the firm’s capital levels.  As it turns out, doing so would have entirely wiped out Executive Life’s reported capital. 

The company was actually insolvent for years before its actual failure.  Years where ratings were reaffirmed and State regulators blindly and without question accepted overstated financial statements.

So it turned out that the bulk of these junk bonds had collapsed in value to half or less of their original purchase price.  Many were actually worth nothing at all.  While AICPA accounting rules dictated these bonds be written down (which would have collapsed the company) those rules had been ignored.

This perhaps could be forgiven based on the companies deception had it not been for the universal industry outcry which had been completely ignored as well.

This problem only surfaced after enough policy holders, disturbed by what competing agents from other companies were telling them, moved to surrender their policies.  An action that sought to move the cash values shown on their policy statements to other “safer” companies. 

The fact is agents of other companies literally caused the collapse of Executive Life by spreading the word “all was not well”.  While such actions can become a self-fulfilling prophecy scenario creating a problem where none exists, in this case it caused a real and hidden problem to rise to the surface for all to see.

NOTE:  State regulators actually have imposed “market conduct” rules prohibiting sales methods tied to replacing policies of other companies.  They regularly fine companies that allow agents to process more than a few of these in any given multi-year period.  The result being companies seek to punish and even terminate agents who have replaced (exchanged) more than a few policies issued by other companies.  This is an example of State regulators taking steps to protect “at risk” companies by forestalling a “run on the bank” scenario, as opposed to protecting the best interests of the policy holders of those “at risk” company’s allowing them to move their cash values to other safer, financially healthy companies.

One would have expected the wide spread discussions “that something was clearly wrong” at Executive Life to trigger some level of additional review by State regulators or the rating agencies.  Why it didn’t is anyone’s guess.

Their inaction literally forced the hand of the only people that really cared about the clients.  That being the ethical agents working in the industry that wished to serve the best interests of their clients.  

NOTE:  It is only fair to note some of the agents were the very same agents that had in good faith sold the Executive Life policies in the first place.  As time went by they too came to realize something was amiss.  And to their credit took steps to protect their clients. 

Suffice it to say, when most agents stumbled upon Executive Life policy holders back then they drummed into them the message that “all was not well”.  While it’s easy to ignore one or two competing agents telling them this, it got a lot harder to ignore as literally every agent they encountered had the same story to tell. 

And so it was only the steady stream of policy surrenders and exchanges to other companies that forced Executive Life to sell its junk bonds to raise the cash needed to fund transfers of their policies cash values to other companies.  Eventually, Executive Life just ran out of bonds to sell since each sale was being made at a fraction of the price originally paid to buy the bonds being sold. 

EXAMPLE:  It’s one thing to leave a bond that is now only worth fifty cents on the books at a dollar (the cost to buy it).  It’s another thing to have to sell a bond for fifty cents when a dollar must be paid a customer surrendering or exchanging a policy.  It was actually necessary to sell two bonds worth fifty cents to raise the needed dollar.  At that rate all the bonds will be sold while half the cash value on the client’s policy statements remains to be repaid.  The literal definition of insolvency.  It didn’t take long once the pace of surrenders and exchanges picked up to result in the sale of all Executive Life’s bonds.  When none were left to sell no more surrenders or exchanges could be processed.  At that point the alarm bell rang.  The game was over.

So, once there were no more bonds left to be sold to fund these transactions the “house of cards” that was Executive Life came tumbling down.  Seemingly overnight to the casual observer (which sadly included State regulators and the rating agencies), but totally expected by the rest of the industry.

The result was everyone that had not cashed out their Executive Life policy now owned a policy sold by an insolvent company.  The rating of Executive Life fell from AAA to bankrupt literally overnight. 

Of course, the problem was State insurance regulators and rating agencies alike had relied on the values reported in annual disclosures.  No audit of the actual asset values was ever conducted, in spite of the industry “noise” that something was amiss.  Noise that permeated the entire insurance community for many years.  Go figure.

It would actually have been a very simple matter indeed for anyone to audit the current market value of the bonds held by Executive Life.  Bonds are actively traded, meaning unlike real estate and mortgages, they are pretty easy to value.  

It’s not like trying to figure out what an office building or piece of property is worth, or a mortgage secured by them.  The only problem being in this case no one even bothered to look.

It is to the eternal shame of State regulators and the nations rating agencies that they failed to take this logical step when everyone knew a problem clearly existed. 

MUTUAL BENEFIT:  This was a long established industry leading and highly rated life insurance company from several decades ago.  It was found, albeit after the fact, to have the bulk of its general account assets invested in just a few S. Florida mega condominium projects. 

The investment was in the form of construction loans; a type of mortgage loan made to the developers.  These loans are secured by the land on which the buildings are to be built and the buildings themselves as they are built.  It is this type of loan that allows developers to build the projects they envision.  Rare is the developer that builds for cash. 

So this is how the construction of homes, condos and office buildings is typically financed.  Decades ago the nation’s largest insurers were the providers of many, if not most, of the largest construction loans.  They financed the building of the world’s largest properties and complexes.  Local Savings &Loans (a now extinct dinosaur like banking institution) being the loan source for most smaller and mid-size residential developments.

Sadly for Mutual Life’s policyholders no geographical based breakdown were required by regulators and rating agencies.  So this unwise concentration of construction loans in a very finite area was not visible in the reports they reviewed.  Further, appear on a company’s books at the amount advanced to date as long as interest payments are current. 

Constructions loans pretty much always have an interest reserve component.  Meaning money is advanced under the loan to the developer to allow for the payment of interest.  As a result, these loans typically are current on their interest payments during their term.

As a cautionary measure, before construction loans are made the lender will typically require a certain percentage of the units in a development or large building to have already been sold.  This requirement typically might range between 50% and 80% depending on the economic realities at the time. 

The sales to retail buyers are supported by contracts signed by the buyer.  Usually accompanied by a 10% to 20% deposit being required.  Which may, or may not, be refundable if the buyer is unable to close on the sale when construction is completed.  This might be subject to financing being available at the time the buyer is to close.  Which might be a year, or years, in the future. 

A cautious experienced buyer might require the deposit be escrowed until the closing. This means the builder/developer can’t access and use those funds before the closing of the sale, after completion of the unit.  Other less cautious buyers, those who may not be aware of all that can go wrong over a years (or more) time in the construction industry typically forego this very wise requirement. 

Lenders know requiring “pre” sales before advancing construction funds greatly reduces the risk associated with lending money to develop and build major complexes and large buildings, which can take years to complete.  The goal is to avoid building something that no one buys, since the ultimate buyer is the source of the construction loans repayment.

A large multi-story condo building might have many hundreds of units.  A large condo development might have dozens of these buildings.  It might literally require several thousand buyers to purchase all of the units being built in a mega project. 

Anyway, under normal circumstances having With the buyers already in place with contracted sales prices and substantial deposits virtually assures the repayment of the construction loans used to complete the buildings. 

The world “virtually” being the operative word to focus on in this case.  Normally, this system works well to protect the lender.  Except when what’s normal changes dramatically while the loans are still outstanding.  As was the case with Mutual Benefits condo construction loans.

The problem in this case was the fact the condo market in S. Florida had totally collapsed while the projects were being built.  This happened after the pre-sales were made but long before the condo buildings were completed and sales could be closed with the buyers. 

The end result of the collapse was a dramatic decline in condo prices.  A decline that made it impossible for the pre-sale buyers to find mortgage lenders to finance the balance of their unit’s price (sale price less deposit) when the buildings were complete and ready to close. 

They buyers were faced with a situation where they either forfeited their deposits, if not escrowed or subject to financing being available, or they had to come out of pocket to pay the contracted sales price agreed to years before.  A price that was now double or more what the units currently could be sold for.    

The bottom had literally dropped out of the S. Florida condo market.  So the construction loans that were supposed to be repaid when buyers closed on their units were not being repaid.

Not surprisingly, few if any buyers were inclined to come out of pocket and pay twice (or more) of what their units were now worth in order to close on the purchase.  It was the lesser of two evils to just walk away from the deposits they had made, or if they were wise (escrowed) and or lucky (contract subject to financing) get back the deposits they had made. 

NOTE:  Just requiring financing be available at the time of closing isn’t always going to result in the return of a deposit if it’s not.  The reason being the developer can have spent the funds.  Since the building in the situation noted above is likely facing insolvency, the recovery of the deposit becomes unlikely.  Another reason to require deposits be escrowed when buying a unit or building yet to be built.

Making matters worse, many buyers of S. Florida condos had purchased multiple units with the plan of selling the ones they wouldn’t be living in for a profit.  A plan that no longer was workable.  Which simply added to the “out of pocket” funds they’d have to pony up to fund a closing on the purchases. 

Accounting rules generally require loans be valued at the worth of their collateral.  That said, when loan interest is being paid currently these rules can be sidestepped.  When loans are being paid per their terms, and the lump sum balance isn’t due for some time, all can appear to be well.  Even when it clearly isn’t.

The problem in this situation, as previously noted, is construction loans include funds to pay interest on the loan during the construction period.  They usually have a “drop dead” balloon principal payment date when the bulk of the principal must be repaid. 

The idea being the closing of units as they are completed will actually repay the entire loan prior to that balloon payment date.   Until then, so long as the loan is “current on its interest payments” it isn’t likely to be viewed as “troubled” and subject to write down.

So as long as Mutual Benefit continued to advance the funds needed for the developer to pay the interest on the loans (so they were “current” per their terms) it was easy enough to avoid calling attention to them and side step the need to write down the value of the loans. 

Relative to Mutual Benefit at the time the failure to pay interest currently by these condo developers would have had dire consequences.  It would have triggered massive write downs resulting in reported losses that would have reduced the capital level of the company to the level of insolvency.  Not to mention the impact on its financial ratings. 

So Mutual Benefit continued to add money to the loan balances by advancing the funds to pay interest.  Basically, adding to the problem while pretending there was no problem at all. 

So the situation was the S. Florida condo market had collapsed as tens of thousands of condo sales contracts were defaulted on while Mutual Benefits projects were still being built.  A problem that in no way did Mutual Benefit create.  A problem Mutual Benefit was little more than a victim of.  Aside, that is, from its failure to voluntarily disclose the problem prior to things blowing up. 

So the condo market meltdown was a problem that went far beyond Mutual Benefit.  It was a problem that was impacting a large number of S&L’s, REIT’s and other lenders.  All of which were providers of construction loans to builders and developers. 

One of the main reasons the condo market collapsed had to do with the collapse of certain S. American economies and subsequent restrictions placed on moving monies out those S. American countries.  The combination of these factors made it impossible for S. American buyers to close on the purchase of the units they had contracted to buy even when they wanted to.  They simply couldn’t move their money into the US to facilitate the closing.

This had a major impact since for a decade or more the bulk of those buying S. Florida condominiums were S. American’s who were seeking to move their fortunes out of their respective countries and into US based properties so their wealth would be protected and denominated in US dollars. 

So, at a point there was no market for the condo units being completed.  The overwhelming majority of buyers defaulted.  No new buyers existed.  The collapse in condo property values was mirrored in the collapse of the mortgage values secured by those properties. 

So, eventually the date rolled around where Mutual Benefits construction loans matured and the balloon principal payments were due.  Or, when the interest reserves that had prolonged the “current paying status” of the loans ran out.  At that point the “house of cards” upon which Mutual Benefit was built collapsed for all to see

The end result being another overnight failure. 

Once again a AA/AAA rated company collapsed into insolvency from one day to the next. Yet another totally unexpected failure on the part of regulators and rating companies. 

Admittedly, the problem faced by Mutual Benefit was not widely known to exist outside the Board room of Mutual Benefit.  Everyone was surprised.  It was far less apparent than the Executive Life debacle.

Relative to the State’s and rating agencies the cause for this overnight debacle was the same.  Once again it was their reliance on the values reported to them on a company’s financial disclosures being accepted as gospel, with no actual review or audit of those values.

While valuing real estate is far more difficult than valuing bonds, the fact all these mortgages were concentrated in one small geographic area known to be “in trouble” should have merited an in-depth review.  The fact Mutual Benefit had a concentration of large condo construction loans in S. Florida should have been a screaming red flag given the widely known condition of the condo market at that time. 

As noted above, subsequent investigations found most of the condo units supporting these loans were “pre” sold to citizens of S. American countries.  No surprise since that was the norm in S. Florida anyway. 

When it came time to close on the sale the buyers were unable to do so. They either forfeited deposits, or if the deposits were escrowed, the deposits were returned to the defaulting buyers. 

With no market for the completed condo units the construction loans to the developers could not be repaid.  Mutual Benefit failed as soon as this was known.

MACRO ECONOMIC SHIFTS

As the above examples reflect, the failure of individual companies can often be traced to factors that precipitated the collapse. 

Often, a management failure or bad decision of one sort or another.  Sometimes the result of intentional acts of deception.  Other times just plain old bad judgement possibly accompanied by the hope a problem situation will resolve itself over time.  

Company specific failures often become apparent in a “straw that broke the camel’s back” scenario.  For instance, a typically innocuous action like one more policy being surrendered exposing a cash problem that causes the “house of cards” to collapse.  The result being a seemingly healthy company implodes overnight.

Macro-economic trends on the other hand are a horse of a different color.  These often unfold slowly over time.  Time periods that may extend to decades, not just years.  They don’t happen overnight.

Unfortunately, the damages they cause tend to be far more wide spread and extreme.  Multiple companies, and even an entire industry may be impacted. 

These create scenarios ripe for regulator “after the fact” grandstanding or “in perfect hindsight” actions, reactions or over reactions.  These are the windfall opportunities State regulators pray for.  Situations ripe for the imposing of fines and penalties and rift with opportunities for grand standing media fueled diatribes.   

Aside from fines and penalties that enrich State coffers, macro-economic scenarios generally result in the creation of well-intentioned regulations.  Rules designed to stop whatever transpired from repeating in the future.  Kind of like closing the barn door after all the animals have run away. 

What we actually have relative to regulatory efforts is a “to little, too late” reality.  A reality made worse by the fact the problem prompting the new regulation(s) has past.  While the new regulations enacted to solve a now non-existent problem persist long afterwards.  Often with unintended consequences.

Take for instance a collapse in real estate values triggered by a tax or economic change.  History says real estate values have always recovered to “pre” collapse levels in the years that follow.  It is also true every stock market collapse has been followed by periods where the market recovers to prior levels and then advances even further.  And, periods of high interest rates have always been followed by periods where interest rates decline. 

The point is, once a problem has occurred the opposite scenario is likely to unfold in the years that follow.  Putting in place regulations that discourage the ownership of whatever asset class was adversely impacted in the immediate past simply assures the following offsetting recovery of values will be missed. 

Even worse, the corrective actions (new regulations) themselves ultimately create scenarios that result in problems that can be far worse than the problem the regulations were intended to prevent. 

Potentially far worse.  As is the case with general account returns and whole life policy dividends today.

Two macroeconomic events relating to real estate have occurred over the last few decades.  Both resulted in classic bureaucratic regulatory over reactions.  Regulations designed to discourage the ownership of real estate and derivative asset classes (mortgages) were imposed. 

As a result, those asset classes which historically paid the highest earnings rates are now virtually non-existent in the nation’s general accounts.  This has led to the unintended detriment of WL policy owners.  A situation where general account earnings are insufficient to allow for the crediting of previously anticipated dividend levels.  To a degree that many companies can no longer afford to credit any dividends into their whole life policies. 

As suggested above, these types of events result in a “fines and penalties” bonanza for the State insurance departments.  Something that they delight in.  Nothing makes a politician feel more righteous than enriching the State coffers while punishing troubled companies along with the joy of pontificating about the failures of those who led these companies.

Sadly, the fines and penalties they impose do little more than weaken the companies they regulate further, to the detriment of their policy holders.  The irony being that these fines and penalties are being imposed by the very same regulators who also failed to see the slowly evolving problems coming and take corrective actions in advance.

A brief discussion of two such macro-economic events follows.

1986 TAX REFORM ACT:  The tax code prior to 1987 featured an ever increasing table of ever higher tiered tax rates.  The higher the tax payers reported income, the higher the tax rate they had to pay.

The top tier tax rate for the three decades prior to 1982 never dropped below 70%.  They were actually as high as 90% at times.  Then came a tax rate reduction which dropped the top tier rate from 1982 to 1987 to 50%. 

These high tax rates applied to what the IRS defined as “ordinary income”.  This consisted of money earned either as a self-employed professional or regular employee.  It also included interest, royalties and rental income.  

The tax code prior to 1987 allowed losses from one source (like rentals, owned business income, CD’s, bonds, etc. often referred to as “passive”) to be written off against “earned” income.  The 1986 Tax Reform Act changed that.  Passive activity losses could no longer offset earned income.  They could only offset income from a similar passive source.  The same for investment gains and losses. 

This is important because by the time the 1980’s rolled around an entire industry of lawyers and investment firms had been built around the then existing tax code.  They created businesses (in the form of limited partnerships) designed to create large “paper” (not cash) losses in their early years. 

The losses typically came in the form of depreciation expenses where a building or piece of equipment could be “written down” over a period of five, ten or even twenty years.  The time frame, stipulated in the tax code, varied based on the type of property involved. 

The idea being these losses could be used by the limited partner investors to offset earned income that would otherwise be taxed at 50%, 70% or more at points in time).  Money was also often borrowed to help make the purchase of the building or equipment to be depreciated, allowing for higher levels of depreciation to be booked.  However, the limited partner could only write off losses to the extent of their total investment.  So this strategy had its limits.

Limited partners had no role in operating the partnerships.  So long as that was the case they had no further exposure to losses if anything else went wrong while the partnership was in existence.

These “tax shelters” were extremely popular with people who earned enough to be in top tier tax brackets.  This included millions of taxpayers since the income levels needed to trigger those top tier tax rates were not as high as one might guess today.

Ultimately, the “plan” was the underlying and by then fully depreciated asset owned by the limited partnerships (typically office buildings or equipment) would be sold to recover the assets original cost.  The sale might even produce a large gain above the original assets cost, as might occur with a fully occupied office building leased to a Fortune 500 company that had been held for many years.  

After the property owned by the limited partnership was sold, the partnership was liquidated.  At that time the gains from the sale of the assets were distributed to the partners. Along with cash to the extent it was available up to the total gain amount the tax payer was to report on their individual return.  

The added key was, as long as the property had been held for a year or more, the gain would be considered a “long term capital gain”.  This type gain was only taxed at rates that varied over those decades between 20% and 28%.  Of course, to a large degree, the gain on the sales of the property actually consisted of what is referred to as “recaptured depreciation”. 

Meaning, the value of the asset had been written down (depreciated) on the books of the limited partnership by recording depreciation expense write-downs each year (according to “useful life” schedules included in the tax code).  This is the way the IRS allowed the cost of an item to be expensed over a longer period of time, not all in the year the asset is purchased. 

Often the assets original cost had been totally written off prior to its sale.  So, in that situation, when it was sold the entire sale price was a gain.  The asset had a zero value on the books based on the amount of depreciation expense that had been recorded.

The net effect of this “tax scheme” was to transfer earned income that would have been taxed at 70% (or later 50%) into income that would later be taxed at the far lower long term capital gains rates.  A tax that would not need to be paid for many years in the future to boot. 

A double win. 

The result was a huge windfall for the high income taxpayer.  A massive tax savings resulted.  The tax savings was the difference between the ordinary income tax avoided (say 70%) and the long term capital tax rate (say 20%).  The result being a 50% tax savings.  Not to mention the benefit of a long delay in when taxes would need to be paid.  

So needless to say, these limited partnerships were extremely popular.  They were virtually always recommended CPA’s and investment professionals alike to their high income clients. 

As a result, limited partnerships were widely owned.  So widely owned in fact that the 70% and 50% tax rates were only rarely being collected.  Instead, the tax code itself spawned an entire industry devoted to avoiding the need to pay the top tier tax rates.  Go figure.

So the appetite for these limited partnerships was tremendous.  The consequence of which was the pricing of the types of assets they were formed to own had risen dramatically over the decades prior to 1987. 

The Tax Reform Act of 1986 eliminated the tax code approach that had spawned the limited partnership industry.  It only took two changes to gut the industry.  And, perhaps as an unintended consequence, to collapse the values of the types of assets limited partnerships typically owned.

First, the ordinary income tax rate was lowered to 28%.  Second, the ability to offset “earned” income with “passive” losses from another sources (like rental and investment related business losses) was eliminated. 

The new tax code rules stated Income from a given source could only be offset by losses from the same source.  Of course, there is no such thing as losses stemming from earned income for the average worker.  Either you get paid for the work you do, or you don’t. 

The two tax rule changes absolutely gutted the entire limited partnership industry.  No one had a reason to own an entity designed to produce losses for a number of years.  Nor was there any longer a reason to form these entities for that purpose.

The unintended consequence was a total collapse in the value of the types of assets that had typically been purchased and owned by limited partnerships; office buildings and equipment of various types.

Unfortunately, the general accounts of the nation’s insurance industry often held large percentages of those asset classes.  Often as much as 30% to 60% of general accounts were invested in directly owned real estate (usually office buildings rented out to the fortune 500) and mortgages that financed office buildings owned by other entities.  

And so it was that the value of these income producing properties plummeted over night when the new tax code was enacted.  While these asset types were still producing high levels of income for the general accounts, an entire industry devoted to buying these types of assets no longer existed. 

Making matters worse was the fact the depreciation of these types of assets no longer had any benefit to the limited partners in existing entities.  All they wanted now was to recoup the value of their investment. Which, of course, required the sale of the partnership assets. 

So instead of being major buyers of these types of assets limited partnerships now became hyper motivated sellers of them.  They flooded the market.  The result was an excess supply and an absence of buyers.  The value of these asset types collapsed.

The AICPA rules then kicked in doing further damage.  Companies holding these assets were forced in many cases to write them down. 

While the write downs were just “paper” bookkeeping entries, not actual realized losses triggered by the sale of said assets, the resulting write-downs none the less created reported losses.  Losses that reduced capital levels. 

The collapse in the value of these types of assets, especially office buildings, became so extreme it brought some of the nation’s largest insurance companies, like Equitable Life Assurance for example, to the brink of insolvency. 

The financial ratings of these companies also collapsed.  This resulted in a never ending stream of articles telling readers these life insurance companies were at extreme risk of failure.  Which caused a sense of panic in those who owned policies issued by these companies. Something those working for companies less impacted by the tax reform act delighted in bringing up whenever the opportunity to do so presented itself.

The surrendering of policies creates a scenario akin to a run on a bank.   Each policy surrender creates the need to provide the cash value of the policy to the policyholder directly, or to move that cash value amount to another company (an exchange). 

As the media beat the “end of the world” drum the pace of policy surrenders picked up. This created a cash crunch requiring the sale of general account assets intended to be held for the long term to satisfy.  Assets that had to be sold at a large loss since the market for them had dried up totally. 

Illogically, the collapse included properties rented by AAA rated Fortune 500 companies current on paying their rent and the mortgagees on similar properties that were current on paying their mortgage interest.

Insurance companies don’t just sit on the cash they receive from premium paying clients.  Like banks, they invest most of the cash in assets that allow them to earn a return sufficient to credit dividends to the policyholders paying the premiums.

So when a large number of policy holders move to surrender their policies in a short time frame it’s a problem.  At a point high earning assets must be sold.  Even at prices far below their original purchase price triggering realized losses and a drop in the general accounts average earnings rate.

If this scenario continues long enough, at a point there will be no assets left to sell.  Which in turn means a large number of policyholders will still show cash value balances on their statements that unfortunately no longer have any assets left supporting those values. 

The very same assets that had for many decades been the highest earning assets held in most insurance company’s general accounts had overnight become problem assets.  Even while many of these assets still continued to generate a high and consistent streams of rental and interest income.   

All of this having been the direct result of a change in the nation’s tax code and having nothing to do with the management of these companies. 

The reaction of regulators was the levying of massive fines and penalties, along with constant grandstanding and the imposition of new rules intended to discourage the ownership of real estate related assets.

2008 REAL ESTATE MARKET COLLAPSE:  Two decades later another disaster unfolded that once again impacted real estate and mortgage values.  This time it was the combined result of two factors.  One tied directly to governmental incompetence.  The other compliments of the AICPA’s angst over how best to value assets on a company’s financial statements.

The first source of the problem can be traced to the idiotic policies enacted by the Democratic congress years before.  They created regulations that facilitated allowing low income borrowers to qualify for mortgage loans far beyond their ability to repay. 

As if that wasn’t problem enough the situation was made worse when competitive pressures in the industry caused lenders to make loans with low or no down payments and little or no actual income verification.  As if nothing could ever go wrong. 

The goal of the well intentioned legislation was to make the dream of home ownership a reality for a larger portion of the population.  The result was the creation of a dubious class of mortgage assets labeled as “sub-prime” loans.

Sub-prime loans carried higher interest rates recognizing the risk associated with their less than ideal attributes.  The resulting higher monthly payments actually increased the risk the borrower would one day fall behind in payments and default on the loan.

Mortgage loans are rarely held for long by the companies that make the initial loan.  Instead they are packaged (combined in groups of loans) based on loan attributes.  

A “package” might consist of thousands of loans with similar down payments, credit ratings and interest rates all issued around a given point in time.  These loan packages were often sold and resold many times between various institutions over the life of the mortgages they contained.

Unfortunately, intentional mislabeling and outright manipulation of the makeup of some of these blocks of mortgage loans occurred.  So not every firm that purchased a block of mortgages got what they paid for.  It was later discovered some packages marketed as having higher quality attributes included a number of sub-prime loans.

Making matters worse, and adding to the incentive to mislabel these loans, was the fact certain investment firms not only packaged the sub-prime loans they also created the investment pools that purchased them funded by their retail customers. 

By falsely inflating the quality of the mortgages included in a package as the seller they could command a higher price.  This allowed less than ethical companies or individuals within those companies to earn an excess profit by marking up the value of the mislabeled subprime loan they put into the package.  It also made it easier to attract new money into the accounts they sought to open with retail or institutional customers based on the perception the packaged loan pool consisted of higher quality mortgages with better than average yield rates.

This mislabeling only became known “after the fact” as subsequent investigations revealed the temptation to mislabel subprime loans was apparently irresistible to some very large and otherwise credible and highly regarded firms.  The mislabeling created an added barrier to reselling these loan packages later since buyers had to be concerned the loans they contained might not have been properly categorized.

Credit for the second cause of this crisis goes to the AICPA.  Not only did it represent an act of incredible stupidity on their part, but it also displayed might well be the worst case of bad timing in recorded history. 

After years of theoretical ivory tower debates by “men in suits” the AICPA board decided it was time to inflict a new asset valuation rule, known as the “mark to market” rule, on the nation’s corporate world.  CPA’s are adverse to over stating the value of an asset on a firm’s financial statements.  Allowing that to happen can disguise a problem that exists today allowing it to not become apparent until much later on.

As fate would have it, and as already suggested above, the AICPA could not have picked a worse possible time to make this well-intentioned but ill-conceived change. 

It triggered a “perfect storm” scenario when the first financial reporting quarter under this new “mark to market” rule arrived for corporate America.  The reason being this new rule was imposed at the same time an increasing number of sub-prime loan defaults had come to light.

The prior rule pertaining to valuing assets like directly owned real estate and derivatives like mortgage loans ignored current market values for those assets, so long as they were being “held for the long term”.  The valuing of assets so labeled was tied to the payment history of the assets. 

If rents and or mortgage interest were being paid on time they value on the books was left alone.  If payments were late a reserve was set up, creating an offsetting expense reported at that time and lowering the value of the asset on the company’s books. 

After all, if a firm is not planning to sell an asset for ten, twenty or thirty years what would be the point of writing down its value simply because current market values for similar assets have declined.  More to the point why write down an asset that is paying rental income or mortgage interest on time and per the terms of the related lease or mortgage loan agreement.  Especially when the renter or borrower is a top rated Fortune 500 company. 

Under the prior rule the only time these assets would be written down would be when the payment of rents or interest was past due.  The more delinquent the payment the higher the level of write-down of the underlying asset.  All of which was based on a large set of past data correlating future defaults and foreclosures to the level of delinquency. 

The valuation of these asset types was focused on the “credit worthiness” of the entity making the payments and the timeliness thereof.  Not the current “market value” of that type of asset at any given point in time.

The real estate and mortgage assets held by the nation’s largest banks, insurance companies and investment firms were being valued accordingly. 

If the payment history was “current” no write down was required.  The further behind in payments the higher the percentage of write down.  Only extreme levels of delinquency resulted in extreme levels of write downs. A well-reasoned and data supported approach that overnight would be tossed aside in favor of a “mark to market” valuation regimen. 

And so it was, overnight the new “mark to market” valuation rule came into being at the same time the sub-prime mortgage loans had been going into default with increasing regularity.  And, at the same time it was becoming apparent loan pools packaged and sold as consisting of higher quality loans also apparently contained varying numbers of sub-prime loans as well.

The direct and immediate result the day these “mark to market” financial statements began to hit the street was chaos.  Not to understate the situation; absolute and insane chaos. 

Prior to the new rule being applied real estate and mortgages had been valued on financial statements at their historical cost or they had been marginally written down if payments were a month or two delinquent.  Overnight, those same assets had to be revalued based on the concept of the price a “knowledgeable buyer and seller” would pay for it. 

But how do you place a market value on an asset type that no one is willing to purchase at any price?  Which was the situation at that point in time.

So absolute valuation chaos ensued when the first reporting quarter under the “mark to market” rule arrived.  Chaos so severe it virtually overnight led to the collapse and bankruptcy of some of the nation’s largest and most profitable investment firms.  Going one step further, and in no way is this an overstatement, to the near collapse of the entire US economy.

The problem was made worse based on the doubts that existed as to the content of any given loan package.  Something there was no practical way to quickly evaluate.  No firm wanted to purchase the potentially failing assets of another firm.  Most already had enough difficulty dealing with problems created by the loan packages they already owned.   

So the market for mortgage loan packages had totally dried up.  The value of the collateral supporting the loan no longer really mattered either.  If the loan itself could not be sold, the “mark to market” rule said it was worthless.  It needed to be written down to zero until such time as there was a willing buyer offering to buy it at a stated price.

Normally, absent this idiotic “mark to market” rule this sort of problem would have created a relatively short term liquidity crunch.  One that would have worked itself out over a matter of months, or perhaps at worse a few years.  

Over time the paying loans could be separated from the non-paying loans.  Only the more delinquent loans would have to be written down in value.  The rest would remain on the books at the price paid for them so long as they were being held for the long term.

Instead, these entire loan packages were worth nothing since there was no price to buy them anyone could agree to.  Meaning the value of the entire loan package had to be written down to zero.  An extreme action to be sure, but one the AICPA now required.

The “old” credit worthiness rules were out.  The new “mark to market” rules were in.  So when that first reporting quarter under those rules rolled around and companies began releasing quarterly financial reports containing massive losses.  Losses created by required bookkeeping entry write-downs so severe and extreme they wiped out the entire capital base of most if not all of these companies. 

Overnight the largest and strongest financial companies in the nation, and many banks and insurance companies, went from investment grade A, AA and AAA status to insolvent.  At which point all hell broke loose.  Even assets that were current relative to the collection of rents and mortgage interest were unsalable at any price.

The result for firms required to adhere to AICPA standards, which most were legally required to do, was the immediate write down of untold billions of dollars in real estate and mortgage assets.  Write downs that were solely the result of a bunch of CPA’s making bookkeeping entries to record the new AICPA mandated rule.  Sheer stupidity coupled with blind obedience.  Made all the more ridiculous by the fact the bulk of these assets were continuing to generate high levels of rental and interest income.  Go figure.

This was an ill-timed act of absolute stupidity inflicted on the nation by a bunch of suit wearing, risk adverse old men sitting in fancy rooms debating theoretical nonsense.  There’s no other way to put it. That’s what happened. 

Once again the average investor sustained massive losses and endured the complete loss of liquidity at the hands of the nation’s politicians, with a major assist from the AICPA.  Once again, a problem having nothing to do with the people running the nation’s largest banks, insurance companies and to some degree investment firms (some of which were subsequently proved to be complicit in the subprime fiasco). 

And once again, the regulators solved the problem with punishing fines and penalties and the creation of regulations designed to lock a barn door that had already been left open allowing the animals to escape.  Regulations that are now creating a far greater problem than the one they were imposed to avoid. 

IMPACT OF THE AICPA

The AICPA is not a regulator.  Yet, as noted previously, it takes center stage in a portion of this write-up dealing with regulatory realities? 

The reason for this is the AICPA sets the rules for publicly held company’s regarding how profits and losses are reported on financial statements.  Which is tied directly to how assets are valued on a company’s balance sheet. 

Setting up loss reserves by writing down asset values creates an equal and offsetting expense being reported.  The direct consequence of reporting an expense (even one created solely by a journal entry made by an accountant to set up a reserve) is a reduction in a company’s reported profit levels. 

A large reserve being set up can actually result in a loss being reported.  A loss reduces a company’s capital level.  This in turn can impact financial strength ratings and in the extreme put at risk the very solvency of the company itself.

The loss reserves created by the new AICPA “mark to market” rule were massive in the extreme.  A scenario that for some reason seemed to come as a shock to the voting members of the AICPA.  It turns out they never intended to wipe out the entire capital base of the largest companies in the nation or imagined their new rule would cause that result.

But that’s exactly what they did by imposing this new rule at the time they imposed it. 

Since most large life companies today are publicly held the AICPA has as much, or perhaps in some respects more, impact on how they operate than do State Insurance departments that regulate these companies.

It’s important to understand if a CPA runs afoul of the AICPA’s rules they lose their CPA license.  A career ending event.  So the firms that audit the financial statements of public companies adhere as closely as possible to AICPA reporting standards.  They do so whether the results make sense or not.    

All publicly held companies are required to publish annual and quarterly financial statements; referred to as 10Q’s and 10K’s.  These statements must adhere to all of the requirements imposed by the AICPA pertaining to asset valuation, establishing of reserves and recording of income and expenses.

When the AICPA makes a rule, it has a wide spread and immediate impact on the profits or losses reported by all publically held companies.  So, to that extent, the AICPA is an indirect regulator of the insurance industry.

REGULATORY TRENDS AND REALITIES

Economic realities, like low interest rates, are one thing. 

It’s very clear they no longer favor the sale of WL products. True because interest rates have been and are today at abysmally low levels verses those typical of decades past.  Long term interest rates must be in the high single digits for WL to work well.

The reason being WL is an interest sensitive product.  WL’s dividend generating potential is strictly interest rate driven.  So historically low interest rates are a very real problem for WL policies.  The fact is the overwhelming majority of WL policies in force today are at an ever increasing risk of lapse.

For more on that topic please read the WL write-up that discusses economic factors impacting WL.

As if abysmally low interest rates aren’t problem enough for WL policyholders, it’s also true regulations added over the years also have a negative impact on WL products.  Regulatory changes over the last few decades have dramatically changed the way general account values are invested.  Changes that are to the detriment of those who own WL products.

The change pertains to both the mix of general account asset classes held in the nation’s general accounts and the length of average maturity durations. 

It’s like a perfect storm scenario which finds regulatory actions further aggravating the problems created by decades of low interest rates.  Making a bad situation even worse.  

The combination create an apples and oranges situation relative to citing past performance to justify the sale of WL products.  It also sounds the death knell for WL products.  Economically speaking, or from a regulatory stand point, there appears to be no objective justification for any company to sell WL products today.

Understanding the impact of today’s current realities is important if for no other reason than the fact those who sell WL today dwell heavily on past performance to justify its purchase.  As if the results of the past are infinitely repeatable into the future.  Even when the facts indicate this simply is not the case. 

The purpose of this write up is to make clear why changes in regulations make the use of past performance inappropriate.  The resulting mix of asset classes is dramatically different today, as are the average maturity durations of the assets supporting WL cash values. 

GENERAL ACCOUNT MAKE UP

If we look back two, three, four or more decade’s real estate and mortgages often made up 40% or more of the nation’s largest life insurers general account investment portfolios.  The rest being made up mostly of mid and long term bonds with ratings typically ranging from BBB to AAA (investment grade).

The result was a healthy rate of return being earned on the invested assets.  A return level that substantially exceeded the returns produced by shorter term and totally liquid assets. 

Average yields on the assets held in general accounts in the 80’s and 90’s were often in the 10% or slightly higher range.  This double digit level of earnings empowered the WL products of yesteryear to produce high dividend levels that in turn fueled significant policy cash value growth. 

The reason being those earnings levels were substantial enough to offset operating, overhead and investment related costs, as well has the payout of death benefits.  High enough to still deliver a solid cash value increase to WL policy holders over longer time frames.

Even a cursory look at the composition today’s general accounts shows the asset class make up and average maturities thereof have changed dramatically from the past. 

Comparing past and present general account holdings finds two distinct direct changes in the make-up of these portfolios.  Changes driven by todays dysfunctional albeit well intended regulations, as noted below: 

• There is a glaring absence of illiquid assets in the general account holdings.  Real estate and mortgages are no longer asset classes that find their way into most general accounts.

• The bulk of their holdings consists of bonds.  Bonds purchased with far shorter maturity terms than typical of the past.  The maturities purchased today typically are no longer than ten years. The majority of general account durations today range from 8 to 12 years.

Ask yourself, how much can be earned by investing a 10 year bond or in Treasury notes.  Clearly, not much.  Somewhere between 2% and 3% as of this writing and the preceding decade.

So how much in policy cash value growth and future dividends can this type of portfolio be expected to deliver?  Not much is the answer. 

LIQUIDITY CONCERNS AND REGULATIONS

The ability of a life insurance company to liquidate out of a given asset class to reduce exposure to further market declines has become a singular and myopic focus of regulators.  The volatility of asset values is defined as “risk” and risk must be protected against.

Real estate and mortgages are notoriously difficult to sell when values are declining.  So they are treated as the riskiest of assets.  Exactly what regulators are attempting to protect against.  They do so by discouraging their ownership.

Requiring “reserves” is the tool they use to accomplish this.  Companies that invest in these asset classes are now required to actually “write down” the value of the asset they’ve just purchased.  Write downs create offsetting expense entries that lower income and as a result capital levels of the company. 

This has the effect of recognizing a loss on the books of the company before it actually occurs; before the asset goes down in value.  Which may or may not ever actually occur.  The use of reserves effectively creates a “buffer” avoiding the need to book a write down expense at some point in the future if the asset does go down in value. 

The idea being this would eliminate the need to write the asset down then, which might mitigate further spiraling declines that can occur when large write downs occur with steep market value declines.

EXAMPLE:   If a 10% reserve is set up when an asset is acquired (a mortgage or office building) the first 10% of a future possible decline in value will not require a write down at that later point in time.  So the reserve is a buffer absorbing that level of decline before an added loss entry would need to be made.

By requiring high levels of reserves for these asset classes a company is effectively punished if they choose to invest general account funds in those types of higher yielding, but illiquid assets.   Punished in the sense they have to book an immediate expense in the form of an asset value write down.  Expenses reduces reported income levels which in turn impacts the price of the company’s stock. 

This also effectively lowers reported capital levels, so it can also impact the company’s financial strength ratings.  Another factor that can impact the price of the company’s stock.

The executives of public companies are required by law to protect the value of the company’s stock for the benefit of its shareholders.  It is a primary responsibility the failure of which can result in shareholder class action litigation.  And, when the stock of a public company goes down in value, so does the value of the options the executives own (see public company write up).

So regulatory imposed reserve requirements incent executives to invest general account assets in shorter term and liquid assets.  The intended result has been achieved.  The general accounts of the nation’s publicly traded  insurance companies (which most now are) clearly reflect that bias.

The regulators also understand that longer term maturities in interest sensitive assets including bonds creates asset valuation risks as well.  The reason being, as interest rates move up the value of longer term bonds go down.  The lower interest rates are currently, the greater the risk in a future decline in value as rates increase.  So longer term maturities are also “punished” with added reserve requirements.

As such, the ownership of longer term maturity higher yielding instruments is also discouraged.  The negative of this being longer term maturities tend to pay higher rates than shorter term maturities.  Again, lowering the average returns earned in the general accounts of the nation’s life insurance companies.

The bottom line is when the regulators require higher levels of reserves for a given asset class or maturity level it has an impact on the earnings in the general account and the bottom line (net income) of the company.  Therefore executives are hesitant to invest in those types of assets.  Which is the case today.

UNFORTUNATE FUTURE CONSEQUENCES

Without a doubt the regulars are not concerned about the decline in general account yields.  They remain oblivious to the impact it has, and will continue to have, on accumulating WL policy values.  The fact dividends illustrated at the time of sale will never be credited is not a concern that has risen to the level it’s caught their attention. 

At least not yet.

As is ever so typical, regulators ignore the obvious albeit unintended but disastrous consequences of this unfolding scenario.  As usual only when things actually blow up in their faces and the media and legal eagles get involved do they realize a problem exists. 

This time a problem they alone have created.    

It’s as if a train is once again rolling down the life insurance track towards a certain disaster.  The light at the end of the life insurance tunnel, in the form of regulations intended to protect policyholders against declines in asset values, is instead an approaching train that will derail their WL policies.    

Disaster awaits all WL policy owners on board the train.  Derailment in the form of policy lapses awaits them just around the proverbial corner.

There are only two ways for WL policy owners to avoid this.  The first is to die young before the policy lapses.  The second is to exchange their WL policy for another type of non-interest sensitive life product (like indexed UL) if their health allows them to do so. 

Absent either of the above bad news awaits a great many senior citizen WL policy owners living on fixed income.  They will sooner than later be asked to reach into their pockets to pay WL premiums.  Premiums that past credited dividends have allowed them to not have to pay for years or even decades.  Premiums they never thought they’d have to pay again.  Premiums they simply cannot afford to pay.

As suggested earlier in this write up, regulators are much better at looking back after problems have occurred than they are at looking forward and seeing problems coming before they arise. 

When viewed in perfect 20/20 hindsight problems provide a chance to grandstand, levy fines and bask in the lime light as the defender of all that is good and holy.  Defenders of the people.  A view that every politician craves. 

The clarity of perfect hindsight allows them to craft and advertise what they view as perfect solutions.  Solutions designed to solve problems that have already occurred.  As if locking the barn door after all the animals have run away does anything to solve the problem. 

But rarely is a moment’s thought given to what else might then go wrong as the future unfolds.  The impact their well-intentioned regulation will have on the subsequently far different economic reality that exists after a macroeconomic event has occurred.  A point in time where a new economic reality exists.  One usually the total opposite of the event that created it.

A blind man can easily see there has been an obvious and absolutely undeniable collapse in general account returns.  It’s not just low interest rates causing that.  Regulations are also at fault. 

History clearly also tells us asset classes that have collapsed for one reason or another in the past later recover and return to prior levels.  Those who remain invested in those asset classes recover their losses.  Those who hide out in “safer” alternatives do not.  Examples of this scenario are endless. 

Which is why creating regulations that discourage ownership of a prior problem asset class backfire.  One does not have to be an Albert Einstein level genius to figure this out.   

This information on today’s general account make-up is reported annually to every insurance regulator in every State by every company doing business in that State.  It’s not like its being hidden from the regulators by the insurance companies.  The regulators have it all.

It is glaringly apparent the makeup of the general accounts is now incapable of supporting the WL policies that have been sold.  It is clear an avalanche of future lapses is building. 

So if the regulators were at all concerned about the collapse in earnings rates it would seem they would have already taken steps to address the problem.  They need to lower the high levels of asset class reserves imposed on directly owned real estate and mortgages.  The forces that triggered prior declines in value have already occurred.  The values of these asset classes have and still are recovering.

The things that triggered these events, tax law changes and AICPA foolishness, are unlikely to repeat themselves.  If for no other reason because the impact of said actions are clearly etched in everyone’s memories. 

So the reasons triggering the prior steep declines should not be repeating in the future. And rules designed to protect against them that create equal and offsetting problems aren’t helping.  They are instead hurting the very people the regulators are supposed to be protecting.  The owners of WL insurance products. 

Recapping the situation, we find the reasons supporting doing so are twofold:

• The impact of the 1987 Tax Reform Act was absorbed decades ago.  Tax rates remain at historical lows and the inability of passive investment income to offset earned income remains in place.  Tax shelter based limited partnerships are a thing of the past.

• Once the AICPA backed off on how the “mark to market” rule was administered and shifted back to the less volatile approaches of the past, the impacted asset values returned to more normal historical levels.  The crisis was and is over.  Sub-prime loans are not being made in high volumes because higher down payments are required and actual credit checks are being made.  And, hopefully packages of mortgage loans are not being sold with intentionally deceptive labeling.

And yet, the rules designed to punish companies for holding those type assets remain in place. So those assets are now absent from the over whelming majority of insurance company general accounts.

This is what happens when people who don’t really grasp the realities of how the products they regulate work make the rules.  And when they only look back and never look ahead. 

Of course, the people who run the companies that sold those products could ring the warning bell.  They could lobby the regulators to change the rules.  But this would only annoy the regulators and bring unwanted scrutiny.

Instead, company executives are inclined let the problems fester, focusing instead on protecting the value of their company’s stock (and their stock options) in the hope they can cash out and exit the picture before the next debacle unfolds.   

Taking it one step further, the laws that govern their corporate behavior actually would punish them for ringing the alarm bell.  Doing so might protect or help some WL policy holders but it could collapse the value of the publicly traded shares their stockholders own. 

So it can be argued company executives are caught between the proverbial “rock and a hard place”.   Until executives are granted the authority to invoke short term pain to forestall long term problems this situation will persist.  It is also merits mention that allowing executives to own stock options clearly incents short term thinking at the expense of the long term value.

Executives today face a no win situation for sure.  Unless, that is, they can escape with their options having been cashed in before the house of cards they are being paid to finally collapses. 

FUNCTIONAL vs. DYSFUNCTIONAL

Ours is a largely dysfunctional world on many levels.  The public corporate ownership structure being one example (please see that separate write up).  Another being the gross over reactions and short sighted solutions imposed by regulatory knee jerk reactions. 

That’s just the way it is, and it isn’t likely to change any time soon.

When it comes to WL policies, the impact of low interest rates and regulatory actions is a formula for total disaster.  What was a long slow trickle of lapses is building quickly into a steady stream that will one day in the not too distant future morph into a literal flood. 

At some point the media will catch on to the fact a problem exists. Then the attorney’s will come out of the woodwork filing class action law suits.  After which the regulators will finally wake up and come screaming down on life insurance companies with fines and penalties. 

History will repeat itself.  It always does.  The executives who happen to run those companies at that time will be blamed, admonished and shamed.  Still, it is likely they will enjoy the benefit of a forced retirement tempered with golden parachutes sufficient to mend their wounded egos. 

The irony, of course, is the past ill-founded over reactions of the regulators themselves will have had more of a negative impact than anything the industries overpaid executives ever did.

And so it goes in a less than perfect world. 

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.

Regulators today are myopically concerned about stability in the value of the assets owned by the companies they regulate.  They know shorter term, liquid and highly rated asset classes are less prone to extreme fluctuations in value.   So that’s what they want life companies to invest in, irrespective of the impact on the value of the products the life companies sell, and more to the point, have in the past sold.

Our nation’s regulators have skewed the rules to promote the behavior they wish to see.  And those rules have worked as intended but in the process created yet another problem.  One likely to be worse in its impact than the problem those regulations were intended to avoid. 

At least for those who own and buy WL policies.

Clinging to the past returns earned in WL products as a basis for selling today’s WL policies is pure unadulterated foolishness.  The reality has changed behind how the assets supporting WL policies are invested and the result is returns that are unable to generate the results enjoyed decades ago by those who owned WL policies.

Those who own a WL policy, and who still have the illustrations they were shown when they made the purchase, have an easy way to verify this is so.  All they need to do is call the 1-800 number on their statements and for an “in force” illustration (which they must clarify should show only their intended premium and loan interest payment scenario).   

The resulting “in force” illustration will show dramatically lower cash values than were originally illustrated when the product was sold.  It will also very likely show the policy will lapse many years before the likely mortality age of the insured person. 

A lapse means all the payments made over the years will have been wasted.  No cash value and no death benefit will remain to be paid when the insured party dies.

Even worse, if the owner of the policy at any time used policy loans to make premiums payments (as many policy holders do) and even worse if they used loans to also pay the interest on the loan as well (as many do), the balance of that loan or a substantial portion of it will be treated by the IRS as taxable to the owner when the policy lapses.    

This is an economic disaster that unfortunately is now befalling and will continue to befall a great many WL policy owners around the nation on a daily basis.  The IRS is unrelenting in this situation.  The taxpayer will have no way out of the tax trap they find themselves embroiled in.

The bad news is WL policies still in force today are financial time bombs waiting to explode.  It’s just a matter of time until that day arrives.   This is why it makes sense to understand the products one owns.  Especially, when the reality of the world as it exists today differs so dramatically from the reality that existed when the policy was sold.

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