Friday, November 20, 2015

No. 128: SEC Files Securities Fraud Charges Against James Torchia

On November 10, 2015, the Securities and Exchange Commission (SEC) filed a civil complaint against James A. Torchia and five entities he controls. The SEC alleges securities fraud, including the operation of a Ponzi scheme. The SEC identifies two aspects of the alleged fraud. One is the marketing of unregistered promissory notes arising from subprime automobile loans. The other is the marketing of unregistered fractional interests in viatical and life settlements. (See SEC v. Torchia, U.S. District Court, Northern District of Georgia, Case No. 1:15-cv-3904.)

The Defendants
Torchia, a Georgia resident, is the lead defendant and controls the entities that are the other defendants. Georgia-based Credit Nation Capital LLC sold promissory notes arising from subprime automobile loans. Texas-based Credit Nation Acceptance LLC sold fractional interests in viatical and life settlements. Georgia-based Credit Nation Auto Sales LLC was a used automobile dealership that is now closed. Georgia-based American Motor Credit LLC was an entity through which Credit Nation Capital made subprime automobile loans. Nevada-based Spaghetti Junction LLC was a vehicle used to funnel money to Torchia and members of his family. All the defendants are represented by James Johnson of the Atlanta law firm of Knight Johnson LLC.

The Complaint
The complaint says Torchia, through Credit Nation Capital, raised tens of millions of dollars from investors who purchased unregistered promissory notes, most of which promised a 9 percent return. The notes were described as "100% asset backed" and "backed by hard assets dollar for dollar." The notes were promoted through newspaper and radio advertisements. Here is one of the radio advertisements:
Attention investors. My name is Bob Guess. I'm with Credit Nation and I'm here to help. Don't get blindsided by the next stock market correction. Remember the correction in 2008; some investors lost 40 to 50 percent of the money that they had in brokerage and retirement accounts. Well, history tends to repeat itself. It's not too late to lock in your gains and take the stock market risk out of your portfolio. If you need income, we have a blended asset investment that'll pay you nine percent annual return. Your investment is backed dollar for dollar with hard assets and is non-correlated to the stock market. For those who don't need additional income but are looking for growth, we have investments that have historically produced double-digit returns that are also non-correlated to the stock market. Give us a call at 1-800-542-9513, that's 1-800-542-9513. Don't gamble with your financial future. Call us today for an appointment. 1-800-542-9513.
The complaint consists of eight counts. There are three counts of securities fraud, one count of offering unregistered securities, and four counts of aiding, abetting, and causing violations of securities laws. The SEC asks for a temporary restraining order, preliminary and permanent injunctions, an accounting, disgorgement of ill-gotten gains, pre-judgment interest, civil penalties, an order freezing the defendants' assets, an order preventing defendants from destroying or concealing documents, and the appointment of a receiver.

Other Filings
On the day the complaint was filed, the SEC filed an emergency motion for a temporary restraining order, an asset freeze, and the appointment of a receiver. On that day the SEC also filed an affidavit from an SEC staff accountant who had scrutinized the defendants' documents.

The next day the SEC filed an amended emergency motion for a temporary restraining order, an asset freeze, and the appointment of a receiver. The amended emergency motion was based on the findings of the staff accountant.

General Observations
The Torchia case is still in its early stages. The extent to which Torchia allegedly engaged in the extensive commingling of funds among his entities is troublesome. At one point in the complaint, the SEC alleges that Torchia "has stolen investor money." I believe that the charges are serious, and that they border on criminal activity. The SEC has demanded a jury trial. I plan to report further as the case progresses.

Available Material
I am offering as a complimentary 39-page PDF the SEC complaint against Torchia and his five entities. E-mail and ask for the complaint in the case of SEC v. Torchia.


Monday, November 16, 2015

No. 127: Tontines Are Not Likely to Stage a Comeback

A recent article about tontines and an intriguing new book on which the article is based are not likely to revive the ancient scheme. However, they provide an opportunity to revisit an interesting but almost forgotten piece of insurance history.

The Article and Book
The recent article about tontines, written by Jeff Guo of The Washington Post, is entitled "It's sleazy, it's totally illegal, and yet it could become the future of retirement." The article was posted on September 28, 2015, as a "Wonkblog" of the "Wonkbook Newsletter." I believe that the article did not appear in the newspaper. Here is the lead sentence: "Over 100 years ago in America—before Social Security, before IRAs, corporate pensions and 401(k)s—there was a ludicrously popular (and somewhat sleazy) retirement scheme called the tontine."

Guo's article was based on a 2015 book entitled King William's Tontine. The author of the book is Moshe Milevsky, a professor at the Schulich School of Business and a member of the Graduate Faculty in the Department of Mathematics and Statistics at York University in Toronto. I read the book with great interest.

The Word "Tontine"
The 11th (2003) edition of Merriam-Webster's Collegiate Dictionary defines "tontine" as "a joint financial arrangement whereby the participants usually contribute equally to a prize that is awarded entirely to the participant who survives all the others." That definition does not do justice to the complexity of tontines.

Tontines are named after Lorenzo A. Tonti, an Italian banker who has received credit for inventing the scheme. Tonti suggested the idea to the government of King Louis XIV of France as a method by which the government could raise money. As Milevsky points out, tontines were used primarily to help governments raise money to wage wars.

A tontine investor enrolled in the scheme by buying a share for a lump sum, and in exchange received interest payments. No return of principal was involved. The investor designated himself or herself as the "nominee," on whose life the tontine was based, or the investor designated another person, perhaps a grandchild, as the nominee.

The nominees were divided into age classes. Initially the interest on a class's share of the tontine fund was divided among all the nominees in the class. As nominees died, the interest on the class's share of the fund was divided among fewer and fewer surviving nominees in the class, thus generating larger and larger interest payments to the survivors. The last several surviving nominees in the class received very large interest payments, and the interest payment to the last surviving nominee in the class amounted to a bonanza. (Milevsky points out that tontines often were modified to prevent large benefits to the last surviving nominees in a class.) When the last survivor in the class died, interest payments to the class stopped and the government did not have to repay the principal of the class's share of the tontine fund.

Relationship to Life Annuities
The expression "life annuity," as used here, refers to what is sometimes called a "pure life annuity" or "straight life annuity." The annuitant receives payments as long as he or she lives, and no payments are made after the annuitant dies. Milevsky points out that there is a close relationship between tontines and life annuities. However, life annuities involve payments that are partly interest and partly a return of principal, whereas tontine payments are entirely interest.

Furthermore, as Milevsky emphasizes, the issuer of a life annuity (normally an insurance company or a pension fund) assumes longevity risk, or the risk that annuitants will live longer than was anticipated in the original pricing of the annuity. Indeed, Milevsky believes that issuers have been underpricing life annuities significantly. His favorable view of tontines is based to a large extent on the fact that the tontine issuer does not assume longevity risk, because the tontine issuer never has to repay the principal of the tontine fund.

Full-Tontine Policies
In the U.S. in the middle of the 19th century, participating (dividend paying) "full-tontine" life insurance policies paid the death benefit on the death of the insured, but provided no surrender values. Insureds were divided into age classes. Dividends were not paid each year to the insureds, but instead were deferred and ultimately were distributed to the remaining survivors at the end of a tontine period such as 20 years. Thus the remaining insureds profited directly from the deaths of other insureds and from lapses by other insureds. Although glowing sales illustrations showed large amounts to be paid to surviving and persisting insureds, full-tontine policies did not gain significant traction with the public.

Deferred-Dividend Policies
A later and much more widely sold version of the tontine policy was the "deferred-dividend" policy, which was also called the "semi-tontine" policy. Deferred-dividend policies included surrender values. Insureds who survived and persisted to the end of a tontine period such as 20 years benefited from the forfeiture of deferred dividends by insureds who lapsed their policies during the tontine period. However, because of the surrender values, the losses suffered by insureds whose policies lapsed during the tontine period were not as large as in the case of full-tontine policies. Glowing sales illustrations appealed to the gambling instincts of the public, and deferred-dividend policies were heavily sold during the final quarter of the 19th century.

It is important to point out that insurance companies were not required to establish reserve liabilities for the deferred dividends. Thus companies selling deferred-dividend policies accumulated large surpluses that were used in part to pay agents large commissions for selling the policies and in part to create a slush fund that could be dissipated by insurance company executives.

The glowing sales illustrations did not work out, not only because the assumptions were unrealistic, but also because the large surpluses were squandered. The result was policyholder disappointment and anger, and deferred-dividend policies became fodder for the muckrakers of the day. Some insurance companies, most notably Equitable Life Assurance Society of the United States, vigorously promoted deferred-dividend policies. Some companies, notably Connecticut Mutual Life Insurance Company, strongly opposed the sale of deferred-dividend policies.

Henry Hyde was the founder of Equitable. Later, in a classic example of nepotism, his son James Hyde became a vice president of Equitable. On January 31, 1905, James Hyde sponsored, at company expense, a "Parisian Ball" at a swanky New York City restaurant. The ball was said to have cost a fortune. James Hyde had spent several years in France and had become addicted to Parisian styles. He did not realize or did not care that his ostentatious behavior would generate massive negative publicity. Nor did he understand how his squandering of company funds would be viewed by the public.

In September 1905, the famous Hughes-Armstrong investigation began in New York. There were several components to the scandal that led to the investigation, and the deferred-dividend policy was one of them. Some historians believe that, if there had been no Parisian ball, there would have been no investigation.

One of the statutory requirements that grew out of the investigation was that dividends had to be distributed annually. Thus deferred-dividend policies became illegal in New York, and several other states followed New York's lead. Thus the death of tontines was not caused by the deferred-dividend policies themselves, but rather by the marketing, accounting, and executive abuses associated with those policies.

The Milevsky Book
Milevsky has a knack for presenting complex mathematical material in an amusing and readable manner. The thrust of his book is his belief that tontines have gotten a bad rap, and that they should become the basis for retirement systems that would have significant advantages over existing retirement systems. In the end he says it is time to embrace tontines, and he assures us he would be among the first to sign up.

General Observations
I disagree with Milevsky because I have two fundamental problems with tontines. First, I think it is inappropriate and distasteful for people to profit directly from the deaths of others. Milevsky may be correct when he says there is no evidence in the history of tontines that foul play occurred in the late years of a tontine scheme, notwithstanding several novels about fictional tontines involving all manner of skullduggery. Nonetheless, I am uncomfortable with the idea of gambling on human life, and the idea of people profiting directly from the deaths of other people.

Second, tontines make no provision for family members who survive the death of a tontine nominee. Milevsky and others may believe that retirement funds should be used to care only for retirees, and that the next generation should fend for themselves. However, I think many retirees want to leave some of their retirement assets for the next generation.

It is fun to read and think about tontines. In my view, however, it is preferable to leave them on the scrap heap of history.

Finally, readers of The Insurance Forum over the years, and readers of chapter 19 (especially pages 189-191) of my new book entitled The Insurance Forum: A Memoir, know I have two fundamental problems even with life annuities. First, it is difficult if not impossible to determine the price of the protection provided by a life annuity; that is, the price of the protection against living too long. Second, as in tontines, there is no provision for those who survive the death of the annuitant, except to the extent that extra costs are incurred for temporary "certain" periods following the death of the annuitant.

I prefer systematic monthly withdrawals equal to minimum distributions required by the Internal Revenue Code, even for nonqualified retirement funds. After the death of the annuitant, such an approach is likely to leave substantial funds for the next generation. However, I recognize that, for persons without substantial retirement accumulations, the minimum distribution may not be enough to live on. Thus a life annuity, which involves invasion of principal, may be needed to provide more generous retirement benefits.

Available Material
The Milevsky book entitled King William's Tontine and my book entitled The Insurance Forum: A Memoir are available from Amazon. My book is also available from us; ordering instructions are on our website,, and I will autograph it upon request.


Thursday, November 12, 2015

No. 126: Life Partners—Recent Adversary Proceedings in the Bankruptcy Case

Life Partners Holdings, Inc. (LPHI) and its operating subsidiaries were participants in the secondary market for life insurance for many years. Now they are involved in bankruptcy proceedings. The trustee in the bankruptcy case is H. Thomas Moran II. (See In re LPHI, U.S. Bankruptcy Court, Northern District of Texas, Case No. 15-40289.)

An "adversary proceeding" is a lawsuit filed within a bankruptcy case and assigned its own case number. In September and October 2015 Trustee Moran filed two adversary proceedings in the LPHI bankruptcy case. One is a complaint against Brian Pardo, the former chief executive officer of Life Partners. That complaint was later amended and nine plaintiffs were added. The other was a complaint against 30 licensees of Life Partners. The complaints are discussed here.

The Complaint against Pardo
On September 11, 2015, Trustee Moran filed a complaint against Pardo seeking $41 million for the benefit of the bankruptcy estate and investors allegedly victimized by actions of LPHI and its subsidiaries. The amount sought represents salaries, bonuses, dividends, and other personal remuneration received by Pardo. In No. 117 (September 21, 2015), I wrote about the complaint. (See Moran v. Pardo, U.S. Bankruptcy Court, Northern District of Texas, Case No. 15-04079.)

The Amended Complaint against Pardo and Others
On October 5, 2015, Trustee Moran filed an amended complaint. The amount sought for the benefit of the bankruptcy estate is increased to $75 million, and the allegations are expanded. Nine defendants are added: Deborah Carr, daughter of Brian Pardo and former vice president of administration of Life Partners; Kurt Carr, husband of Deborah Carr and former vice president over policy acquisition of Life Partners; R. Scott Peden, former president, general counsel, and secretary of Life Partners; Linda Robinson, also known as Linda Robinson-Pardo; Pardo Family Holdings Ltd., a Gibraltar corporation; Pardo Family Trust, a trust domiciled in Gibraltar; Pardo Family Holdings US LLC, a Delaware limited liability company; Paget Holdings Inc., a Texas corporation; and Paget Holdings Ltd., a St. Vincent partnership.

The introductory section of the amended complaint contains a paragraph describing the allegedly "fraudulently inflated arbitrage." The paragraph reads:
It was a further part of the scheme to defraud the investors that, in or about January 1999, Pardo and the Defendant Executives hired a medical doctor, Donald Cassidy ("Cassidy"), with no actuarial experience or training, and no experience in rendering life expectancies, to prepare a life expectancy ("LE"), which Pardo and his team used to market the fractional interests to investors. Life Partners typically purchased those policies on which a significant discrepancy existed between the independent LE and the Cassidy LE, so that it could create a fraudulently inflated arbitrage between the low price (based on the longer LE) it paid for the policy and the higher price (based on the shorter Cassidy LE) at which it sold investment contracts to investors.
The factual background section of the amended complaint mentions an article that appeared in The Wall Street Journal on December 21, 2010 about the activities of Life Partners. Exhibits to the amended complaint show e-mail correspondence between Pardo and Journal reporters Mark Maremont and Leslie Scism that preceded publication of the article.

The amended complaint has 12 counts. There are two counts of actual fraudulent transfer, two counts of constructive fraudulent transfer, one count of preferences, one count of fraud, one count of breach of fiduciary duty, one count of alter ego and/or sham to perpetrate a fraud, one count of unjust enrichment and constructive trust, one count of RICO [Racketeer Influenced and Corrupt Organizations Act], one count of disallowance of defendants' claims, and one count of equitable subordination.

Trustee Moran seeks return of funds from the defendants, actual damages, consequential damages, exemplary damages, pre-judgment interest, and post-judgment interest. He also seeks attorneys' fees and costs.

The Complaint against Licensees
On October 28, 2015, Trustee Moran filed a complaint against 30 licensees. He seeks recovery of what he alleges were excessive fees and commissions received from Life Partners. (See Moran v. Sundelius, U.S. Bankruptcy Court, Northern District of Texas, Case No. 15-04087.)

The introductory section of the complaint against the licensees describes the alleged scheme to defraud investors. Here is the final paragraph of that section:
Life Partners and its Licensees perpetrated the fraud on the Investors by (1) accepting fees and commissions well in excess of industry norms and often exceeding the true value of the underlying life settlement policy; (2) misrepresenting the nature and accuracy of the life expectancy of the insured, including concealing the existence of longer estimated life expectancies; and (3) misrepresenting the likely returns on investments, among other things.
The "factual background" section of the complaint describes, among other things, the procedural history of the bankruptcy case, how Life Partners acquired policies, contractual arrangements with investors, the network of licensees, and the undisclosed and allegedly exorbitant fees and commissions received by licensees. The complaint also alleges wrongful conduct by the licensees.

The licensee defendants, mostly from Texas, are the individuals and firms that received the largest amount of fees and commissions from 2008 through February 2015. The total of the fees and commissions received by the licensee defendants is $91.7 million, which is 56 percent of all the fees and commissions received during that period by the entire network of Life Partners licensees. Trustee Moran seeks to recover the $91.7 million for the benefit of the investors, as well as attorneys' fees and costs. Here is the list of licensee defendants, with amounts shown in millions of dollars:
James Sundelius (TX) 13.1
B G & S Management Consultants (TX) 10.4
Life Insurance Settlements Inc (FL) 7.8
Life Settlement Exchange LLC (TX) 7.8
American Safe Retirements LLC (TX) 6.8
Advanced Settlements LLC (FL) 6.0
Tolleson Investments LLC (TX) 4.3
Fred A. Cowley (TX) 4.2
Security Reserve Financial Inc (TX) 3.0
Gallagher Financial Group (TX) 2.3
ASR Alternative Investments LP (TX) 2.2
JL Providers Inc (NY) 2.1
New Asset Advisors LLC (TX) 1.9
Frank W. Bice (TX) 1.9
Edward G. Burford Corp (TX) 1.9
Trinity Financial Services LLC (FL) 1.7
Sun Safety Inc (TX) 1.6
Abundant Income LLC (TX) 1.6
Life Distributors of America LLC (CA) 1.5
Faye Bagby (TX) 1.5
Ella Oliver (TX) 1.4
Lakeside Equity Partners Inc (TX) 1.3
Wealthstone Financial (TX) 1.1
Falco Group LLC (TX) 1.0
Alpha & Omega Global Risk Management LP (NV) 1.0
Rangetree Strategies LLC (CA) 0.9
Mark McKay (TX) 0.8
Kainos Asset Management (TX) 0.3
Life Strategies LLC (TX) 0.2
H. Peyton Inge (TX) 0.1
The complaint has five counts. There are two counts of actual fraudulent transfer, two counts of constructive fraudulent transfer, and one count of claim for contribution from the licensee defendants for their participation in and facilitation in the scheme to defraud Investors.

General Observations
The trials in the two adversary proceedings are tentatively scheduled for March and April 2016, respectively, before the bankruptcy court judge. From what I have heard about the trials in adversary proceedings in bankruptcy cases, they are relatively brief and disposed of fairly quickly. Whether that will happen here remains to be seen.

Available Material
I am offering a complimentary 78-page PDF consisting of the 62-page text of Trustee Moran's amended complaint against Pardo and others, 14 pages of exhibits showing correspondence in 2010 between Pardo and two reporters for The Wall Street Journal, and a 2-page cover sheet. Send an e-mail to and ask for the amended complaint in Moran v. Pardo.

I am also offering a complimentary 51-page PDF consisting of the 37-page text of Trustee Moran's complaint against the licensees, a 1-page exhibit showing the payments to the licensee defendants, and 13 pages of exhibits showing samples of licensee agreements. Send an e-mail to and ask for the complaint in Moran v. Sundelius.


Friday, November 6, 2015

No. 125: Backdated Capital Contributions—the NAIC Response to Questions

In No. 123 (October 27, 2015), I discussed a capital contribution shown in the statutory statement of Senior Health Insurance Company of Pennsylvania (SHIP) as of December 31, 2014. The contribution was in the form of a $50 million surplus note issued February 19, 2015. Thus the issue date of the note was 50 days after the "as of" date of the statement. SHIP filed the statement with the Pennsylvania Insurance Department in a timely manner on March 2, 2015, or 11 days after the note was issued.

I said I would send No. 123 to the National Association of Insurance Commissioners (NAIC), I showed four questions about backdated capital contributions, and said I would report the responses. The communications department of the NAIC responded one week later.

The First Question
First, I asked whether the NAIC agrees with me that a backdated capital contribution falsely portrays the financial condition of a company as of the statement date. I also asked for an explanation if the NAIC does not agree with me. The NAIC did not answer yes or no to the basic question, but provided this explanation:
The statutory financial statements are the reporting mechanism in which state insurance regulators assess the financial condition of the insurance entities subject to their regulation. Pursuant to the Preamble of the NAIC Accounting Practices and Procedures manual, the primary responsibility of each state insurance department is to regulate insurance companies in accordance with state laws with an emphasis on solvency for the protection of policyholders.
The NAIC went on to explain surplus notes, although I had not asked for an explanation of surplus notes. Next, referring to Statutory Accounting Principles (SAP) and Statements of Statutory Accounting Principles (SSAPs), the NAIC said:
Ensuring timely receipt of funds, prior to the issuance of the statutory financial statements, which are first committed to policyholders and other claimants, should likely be perceived as an appropriate regulatory action consistent with the responsibility to provide protection to policyholders.

For SAP purposes, this approach is consistent with a Type 1 subsequent event under SSAP No. 9, as the conditions warranting the need for a surplus note existed as of the financial statement date. Furthermore, actions are perceived to be in place prior to the statement date to develop the note, obtain commissioner approval, and obtain funds from the actual issuance of the note timely to receive the funds prior to the issuance date of the statutory financial statement.
The Second Question
Second, I said SSAP No. 9 and SSAP No. 72 were effective January 1, 2001, and asked when the NAIC began to allow backdated capital contributions. In response, the NAIC mentioned Financial Accounting Standards (FAS), the Financial Accounting Standards Board (FASB), the FASB Emerging Issues Task Force (EITF), the American Institute of Certified Public Accountants (AICPA), and Generally Accepted Accounting Principles (GAAP). The NAIC said:
The guidance reflected in SSAP No. 9 is adopted from FASB. The Statutory Accounting Principles (E) Working Group [of the NAIC] adopted SSAP No. 9 to be effective January 1, 2001, as part of the original codification of SAP. The original guidance was adopted to be consistent with the AICPA Statement on Auditing Standards No. 1, Section 560—Subsequent Events. In 2009, FASB issued FAS 165, Subsequent Events, and revisions were reflected in SSAP No. 9 to reflect the adoption of this guidance. The adoption of FAS 165 should not have resulted in significant changes in the subsequent events that an entity reports, through either recognition or disclosure in the financial statements. The revisions adopted from FAS 165 included guidance to ensure assessment of subsequent events through the date the financial statements are issued, or when financial statements are available to be issued.

The Statutory Accounting Principles (E) Working Group [of the NAIC] adopted the guidance in SSAP No. 72 to be effective January 1, 2001, as part of the original codification of SAP. The referenced paragraph for capital contributions was included in the original adoption after considering GAAP guidance.

Although the SAP guidance in SSAP No. 72 provides an explicit direction regarding these notes or other receivables as Type 1 subsequent events, the guidance was developed after considering EITF 85-1 (currently reflected in 505-10-45 of the FASB Codification). The EITF 85-1 GAAP guidance is technically rejected in SSAP No. 72, but in Issue Paper No. 72, this rejection is noted as EITF 85-1 generally requires these contributions to be recorded as a debit to equity instead of an asset, but could allow for such notes to be recorded as assets if collected in cash before the financial statements are issued.

For SAP purposes, and the consistency concept, the statutory accounting guidance is explicit that such notes are admitted assets if they are satisfied by receipt of cash or readily marketable securities prior to the filing of the statement. If the notes or other receivables are not satisfied, they are nonadmitted. Furthermore, the domiciliary commissioner must approve the capital contribution under SSAP No. 72 and the cash or securities must be infused prior to the filing of the statutory annual financial statements.
The Third Question
Third, I asked why the NAIC allows backdated capital contributions. The NAIC said:
The NAIC does not establish statutory accounting provisions. The guidance reflects the decisions of the Statutory Accounting Principles (E) Working Group [of the NAIC]. See questions 1 and 2 regarding the ultimate objective of the regulators in providing protections to policyholders, the background for the guidance, and related FASB guidance.
The Fourth Question
Fourth, I asked whether banks and other regulated financial institutions are allowed to accept backdated capital contributions. The NAIC said it "cannot advise on specific rules regarding these institutions."

The 1988 Executive Life Incident
Chapter 7 of my new book, The Insurance Forum: A Memoir, is entitled "The Collapse of Executive Life." On page 84 in that chapter, I discussed a backdated capital contribution to Executive Life Insurance Company (ELIC) from ELIC's parent company. The transaction was in the form of a $170 million surplus note that was reflected in ELIC's statutory statement as of December 31, 1987. However, the note was not executed until March 7, 1988. In response to my inquiry to ELIC, the company's general counsel said the
subject transactions were given effect for accounting purposes at year end 1987. They were given such effect because under the circumstances present, applicable statutory accounting principles so permit.
Back in 1988 I called that explanation nonsense. I said the company officers who sign the statutory annual statement swear the statement is "a full and true statement of all the assets and liabilities and of the condition and affairs of the said insurer as of the thirty-first day of December last." The backdated capital contribution was one of the factors that caused me to view ELIC as insolvent three years before the company failed.

The 2008 IndyMac Incident
On May 21, 2009, the Office of Inspector General (OIG) of the U.S. Department of the Treasury issued an "Audit Report" entitled "Safety and Soundness: OTS [Office of Thrift Supervision] Involvement with Backdated Capital Contributions by Thrifts." The report grew out of a May 2008 capital contribution from IndyMac's parent company backdated to March 31, 2008. The effect of the transaction "was that IndyMac was able to maintain its well capitalized status, and avoid the requirement in law to obtain a waiver from FDIC [Federal Deposit Insurance Corporation] to accept brokered deposits." In the report, OIG "reviewed the backdating of capital contributions at IndyMac and five other thrifts and concluded that "the backdating of these transactions was inappropriate under GAAP for all six thrifts."

Years before the financial crash of 2008, American International Group selected OTS to be its regulator. Today, as a result of investigations conducted in the wake of the crash, OTS no longer exists.

Evolution of the Jurat
At the bottom of the first page of the statutory annual statement form promulgated each year by the NAIC is a sworn, notarized statement called a "jurat." As a result of No. 123 and the NAIC's responses to my questions, I became interested in the evolution of the jurat. First, I looked at the 1960 statutory statement. Here is the language of the jurat:
[The officers of this company, with their names and titles shown in the jurat itself], being duly sworn, each for himself deposes and says that they are the above described officers of the said insurer, and that on the thirty-first day of December last, all of the herein described assets were the absolute property of the said insurer free and clear from any liens or claims thereon, except as herein stated, and that this annual statement, together with related exhibits, schedules and explanations therein contained, annexed or referred to are a full and true statement of all the assets and liabilities and of the condition and affairs of the said insurer as of the thirty-first day of December last, and of its income and deductions therefrom for the year ended on that date, according to the best of their information, knowledge and belief, respectively.
Second, I looked at the jurat in the statutory statement for 1999. By that time, the jurat had been modified. Near the end, this language was inserted beginning with the words "on that date" and ending with the words "according to":
on that date, and have been completed in accordance with the NAIC annual statement instructions and accounting practices and procedures manuals except to the extent that: (1) state law may differ; or, (2) that state rules or regulations require differences in reporting not related to accounting practices and procedures, according to
By 2014, the jurat had been modified to incorporate the names of the NAIC Annual Statement Instructions and Accounting Practices and Procedures manual. Also, two sentences had been added at the end of the jurat relating to electronic filing of the annual statement.

General Observations
The NAIC did not use the word "backdated" in its responses. Perhaps the NAIC views the word as pejorative.

It is interesting that the "NAIC does not establish statutory accounting provisions" even though "guidance reflects the decisions of" an NAIC working group. I do not know whether the NAIC membership as a whole, or the NAIC Executive Committee, or any other NAIC body signs off on the work of the Statutory Accounting Principles (E) Working Group of the NAIC.

I reviewed several FASB documents mentioned in the NAIC's responses. I believe that backdated capital contributions were not among the items FASB had in mind when it talked about "subsequent events." There were many examples of subsequent events, but backdated capital contributions were not among them.

In No. 123, I expressed dislike for backdating because it falsely portrays a company's year-end financial condition. I still believe that backdated capital contributions are contrary to accounting principles, and that insurance companies should not be permitted to use them.

Available Material
I am offering a complimentary 34-page PDF of the 2009 Treasury OIG Audit Report on Backdated Capital Contributions. Send an e-mail to and ask for the 2009 Treasury OIG Audit Report.

Monday, November 2, 2015

No. 124: Annuity Sales Incentives—Results of the Investigation by U.S. Senator Elizabeth Warren

On April 28, 2015, U.S. Senator Elizabeth Warren (D-MA), the Ranking Member of the Subcommittee on Economic Policy of the Committee on Banking, Housing, and Urban Affairs, sent letters to 15 major issuers of annuities seeking "information on rewards and incentives offered by your company to brokers and dealers who sell annuities to families and small investors." The companies were AIG, Allianz, American Equity, Athene, AXA, Jackson National Life, Lincoln Financial, MetLife, Nationwide, New York Life, Pacific Life, Prudential, RiverSource, TIAA-CREF, and Transamerica. In No. 97, posted May 4, I wrote about Senator Warren's investigation.

Results of the Investigation
On October 27, Senator Warren released a report indicating that all 15 companies responded at least in part and describing the results of the investigation. The report is entitled "Villas, Castles, and Vacations: How Perks and Giveaways Create Conflicts of Interest in the Annuity Industry." Here are some "key findings" mentioned in the executive summary:
  • The majority of companies admitted to providing rewards and inducements, such as expensive vacations and other prizes, to annuity agents in exchange for sales.
  • Companies also create conflicts of interest by offering perks and inducements to annuity sales agents through third party marketing organizations.
  • Current disclosure rules are inadequate to ensure that customers are informed about the incentives agents receive for selling them specific financial products.
  • Existing rules and regulations to deter conflicts of interest are completely inadequate.
The report includes an introduction, findings, and policy options to address conflicts of interest in the sale of annuities. The report mentions the draft of a rule proposed by the U.S. Department of Labor (DOL). Here is the conclusion in the report:
This investigation reveals that companies representing tens of billions of dollars in annuity sales are allowed to offer and do offer a variety of kickbacks, from lavish vacations to golf outings to gift cards to iPads, either directly to sales agents or indirectly to these agents via third-party marketing organizations, in exchange for selling a specific company's products. Disclosure of these perks and payments to consumers is inadequate, and even with regulations designed to curb these kinds of payments, some companies have identified and taken advantage of numerous loopholes in those rules so they can continue to offer these kickbacks.
The perks offered by companies to agents create a conflict of interest that result in consumers—many of whom are at or near retirement age—receiving advice about investments in annuities that may not match their needs. The annuity industry is not the only industry affected by these conflicts. Across the financial industry, conflicts cost American investors an estimated $17 billion in retirement savings every year. New regulations are needed to protect consumers and end this financial conflict of interest.
My Public Records Requests
In May 2015, I learned that the New York Department of Financial Services (DFS) had asked the 15 companies for copies of their responses to Senator Warren's letters. On May 29, I filed with DFS, pursuant to the New York Freedom of Information Law, a request for copies of the responses. On June 25, DFS said it needed additional time to respond to my request because the documents "require specialized review." In response to my inquiries, DFS said all 15 companies had filed copies of their responses, and DFS intended to respond to my request by August 25. On October 28, having heard nothing further, I contacted DFS again. I have not yet received a response.

When this item is posted, I will send it to Senator Warren's office. At the same time, pursuant to the federal Freedom of Information Act, I will file with her office a request for copies of the 15 companies' responses.

General Observations
In No. 97, I expressed the opinion that the widespread use of annuity sales incentives is a serious problem. I also expressed disappointment at the comments made in April by the American Council of Life Insurers (ACLI) and the National Association of Insurance Commissioners (NAIC) suggesting that existing laws and regulations are adequate. According to the recent Warren report, at least two of the companies made similar comments in their responses. The report does not identify those companies.

Available Material
I am offering a complimentary 12-page PDF containing the October 2015 report on Senator Warren's investigation. Also, the complimentary 19-page PDF offered in No. 97 is still available; the package includes a sample of Senator Warren's letters to the 15 companies, examples of annuity sales incentives, a press release about the Warren investigation, the ACLI and NAIC comments about the investigation, and information about the DOL proposed rule. Send an e-mail to and ask for the October 2015 Warren report, the May 2015 package about the Warren investigation, or both.


Tuesday, October 27, 2015

No. 123: Surplus Notes—Another Dimension of a Bizarre Financial Instrument

Readers of The Insurance Forum over the years, and readers of chapter 25 of my new book entitled The Insurance Forum: A Memoir, know I take a dim view of surplus notes. Those bizarre financial instruments represent debt, but the insurance company that borrows the money is not required to establish a liability. Thus the amount borrowed is treated as an asset and increases the company's surplus.

Most of the insurance company executives who decide to issue surplus notes, and most of the state insurance regulators who approve the issuance of surplus notes, will be long gone when the debt comes due and has to be repaid. That is just one of the reasons why I call surplus notes a classic example of a WWNBA transaction: We Will Not Be Around.

Another Dimension of Surplus Notes
For several years, Senior Health Insurance Company of Pennsylvania (SHIP) has been running off the long-term care insurance business of a former subsidiary of what at the time was Conseco, Inc. In August 2015, a reader sent me—out of the blue—SHIP's statutory statement as of December 31, 2014. My reader did not say why he sent me the statement, but he may have done so because he was aware of my keen interest in surplus notes.

The statement reflects the recent issuance of a $50 million surplus note. As indicated in the "Notes to Financial Statements," the interest rate on the surplus note is 6 percent, and the maturity date is April 1, 2020. Thus the maturity date is five years away, in contrast to the 20-year or 30-year maturities of most surplus notes. SHIP issued the surplus note to (in other words, borrowed the money from) Beechwood Re Investments, LLC, a unit of Beechwood Bermuda International, Ltd. (Hamilton, Bermuda).

The big surprise was that the surplus note was issued February 19, 2015, seven weeks after the "as of" date of the 2014 statement. The statement, which had to be filed around March 1, 2015, did not show the $50 million surplus note as an asset; instead, the statement showed a $50 million surplus note receivable as an asset, which in turn increased SHIP's surplus by $50 million.

I asked Patrick Carmody, senior vice president and general counsel of SHIP, whether the Pennsylvania Insurance Department had approved the inclusion of the surplus note receivable as an asset in the 2014 statement. Carmody graciously provided a copy of a letter dated February 12, 2015, to Brian Wegner, president and chief executive officer of SHIP, from Stephen Johnson, deputy insurance commissioner in the Pennsylvania Department. Johnson granted SHIP's request to issue the surplus note no later than February 15, 2015. (SHIP missed that date by four days.) Johnson's letter also said:
Additional approval is granted for the transaction to be booked with a December 31, 2014 effective date, in accordance with SSAP 72, paragraph 8. As required by SSAP 72, paragraph 8, the company must submit to the Department evidence that the surplus note receivable was collected in cash prior to filing the company's financial statement as of December 31, 2014. The transaction must also be disclosed as a Type I subsequent event, in accordance with SSAP 9, in the company's financial statement as of December 31, 2014. To the extent any of the surplus note receivable is not collected prior to the filing of the financial statement as of December 31, 2014, it shall be non-admitted.
SSAPs (Statements of Statutory Accounting Principles) are promulgated by the National Association of Insurance Commissioners (NAIC). I wondered about the exact language of the two SSAPs referred to in the Johnson letter. Here is paragraph 8 of SSAP No. 72:
Notes or other receivables received as additional capital contributions satisfied by receipt of cash or readily marketable securities prior to the filing of the statutory financial statement shall be treated as a Type I subsequent event in accordance with SSAP No. 9 and as such shall be considered an admitted asset based on the evidence of collection and approval of the domiciliary commissioner. To the extent that the notes or other receivables are not satisfied, they shall be nonadmitted.
Paragraph 3 of SSAP No. 9 says "material subsequent events" are either Type I "recognized subsequent events" or Type II "nonrecognized subsequent events." Here are the definitions:
Type I: Events or transactions that provide additional evidence with respect to conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.
Type II: Events or transactions that provide evidence with respect to conditions that did not exist at the balance sheet date but arose after that date.
SHIP's Explanation of the Problem
SHIP's 2014 statement shows a net loss of $56 million in 2014, compared with a $3 million net loss in 2013. When I asked Carmody for the Department's letter, I also inquired about the primary drivers of the relatively large net loss in 2014. The response, from a senior paralegal writing on behalf of Carmody, is somewhat technical. However, I show it here for those readers who will understand it:
2014 results were impacted by reserves [sic] changes in the Company's "TLI" book of business. Actual-to-Expected ratios did not decline as much as expected and reserves were adjusted accordingly. Those ratios are showing signs of declining in 2015. Financial projections continue to show lifetime solvency, therefore the Company is continuing to refrain from seeking rate increases; its mission is to serve the interests of the policyholders, not to accumulate surplus.
SHIP's Risk-Based Capital
SHIP's risk-based capital (RBC) numbers show what may have prompted the issuance of the surplus note. Here is the relationship between each RBC "level" and company action level: company action level is 100 percent, regulatory action level is 75 percent, authorized control level is 50 percent, and mandatory control level is 35 percent.

SHIP's total adjusted capital as shown in the 2014 statement, which was filed around March 1, 2015, was $118 million. Its company action level was $109 million. Therefore SHIP's RBC ratio was 108 percent ($118 million divided by $109 million, with the quotient expressed as a percentage), and was slightly above company action level of 100 percent.

Consider the situation, however, without the $50 million capital contribution that resulted from showing the surplus note receivable as an asset. SHIP's total adjusted capital would have been $68 million ($118 million minus $50 million). Therefore SHIP's RBC ratio would have been 62 percent ($68 million divided by $109 million, with the quotient expressed as a percentage). Thus SHIP's RBC ratio would have been below regulatory action level of 75 percent but above authorized control level of 50 percent.

General Observations
It is likely that SHIP discovered—while preparing its 2014 statement early in 2015—that its RBC ratio was below regulatory action level. That normally would trigger a regulatory investigation. To avoid such an investigation, SHIP needed what was in essence a backdated contribution to its total adjusted capital to improve its RBC ratio.

It is also likely that SHIP discussed the matter with the Pennsylvania Department immediately upon discovering the problem. The Department may have suggested the idea of issuing a surplus note and showing the "surplus note receivable" as an asset. An alternative would have been for Beechwood to backdate the surplus note to December 31, 2014. However, it is possible that state insurance regulators prefer an "in essence" backdated capital contribution rather than a truly backdated capital contribution. I dislike backdating in any form, because it falsely portrays a company's year-end financial condition.

When this item is posted, I will send it to the NAIC and ask the following questions. (1) Do you agree with me that a backdated capital contribution falsely portrays the financial condition of a company as of the statement date? If you disagree with me, please explain. (2) When did you begin allowing backdated capital contributions (the two SSAPs discussed here were effective January 1, 2001)? (3) Why do you allow backdated capital contributions? (4) Are banks and other regulated financial institutions allowed to accept backdated capital contributions? Also, I will tell the NAIC that I will report its responses in a future blog post.

Available Material
For readers who want to see the relevant items in SHIP's 2014 annual statement, I am offering a complimentary 51-page PDF of the statement. E-mail and ask for SHIP's 2014 statement. The relevant items are the sworn statement at the bottom of page 1, lines 25 and 2501 on page 2, line 32 on page 3, lines 35 and 48 on page 4, paragraph 13(11) on page 19.12 (page 30 of the PDF), and lines 30 and 31 on page 22 (page 45 of the PDF).


Thursday, October 22, 2015

No. 122: Risk-Based Capital—A Classic Example of the Perennial Confusion over the Denominator of the Ratio

On October 13, 2015, MetLife, Inc. (NYSE:MET) filed an 8-K (material event) report with the Securities and Exchange Commission. The report provides a classic example of the perennial confusion over the denominator used in calculating risk-based capital (RBC) ratios.

The Nature of the Confusion
An RBC ratio is a comparison of two numbers. The numerator of the ratio is "total adjusted capital" (TAC), which is the company's net worth with a few adjustments. The denominator of the ratio, in theory, could be any of the several RBC "levels." However, companies invariably use either "company action level" (CAL) or "authorized control level" (ACL). CAL is exactly twice ACL.

The responsibility for the confusion rests with the National Association of Insurance Commissioners, which made a politically motivated change when the RBC system was adopted in the early 1990s. I discussed the problem on pages 308-310 in my recently published book, The Insurance Forum: A Memoir. I concluded the discussion there by saying that one thing is certain: whenever an RBC ratio is mentioned, it is essential to indicate what RBC level was used as the denominator.

The Language in the 8-K Report
In the recent 8-K report, MetLife said its "Combined RBC Ratio" at the end of 2014 was 398 percent "instead of in excess of 400% as previously reported in the 2014 10-K and 410% as previously communicated on the Company's first quarter 2015 earnings call." I do not know what was said on the earnings call, but the recent 8-K report did not say what denominator was used in calculating the combined RBC ratio.

To find out, I reviewed MetLife's 10-K report for the year ended December 31, 2014. I found the answer buried on page 299 of the 361-page 10-K report. The denominator was CAL.

The Language in the 10-K Report
One paragraph in the 10-K report explains the RBC system. It is necessary to read the entire paragraph carefully to learn that CAL was the denominator used in the combined RBC ratios mentioned in the recent 8-K report. Here is the full paragraph:
The states of domicile of MetLife, Inc.'s U.S. insurance subsidiaries imposes [sic] risk-based capital ("RBC") requirements that were developed by the National Association of Insurance Commissioners ("NAIC"). American Life does not write business in Delaware or any other domestic state and, as such, is exempt from RBC requirements by Delaware law. Regulatory compliance is determined by a ratio of a company's total adjusted capital, calculated in the manner prescribed by the NAIC ("TAC") to its authorized control level RBC, calculated in the manner prescribed by the NAIC ("ACL RBC"). Companies below specific trigger levels or ratios are classified by their respective levels, each of which requires specified corrective action. The minimum level of TAC before corrective action commences is twice ACL RBC ("Company Action RBC"). While not required by or filed with insurance regulators, the Company also calculates an internally defined combined RBC ratio ("Combined RBC Ratio"), which is determined by dividing the sum of TAC for MetLife, Inc.'s principal U.S. insurance subsidiaries excluding American Life, by the sum of Company Action RBC for such subsidiaries. The Company's Combined RBC Ratio was in excess of 400% for all periods presented. In addition, all non-exempted U.S. insurance subsidiaries individually exceeded Company Action RBC for all periods presented.
An Omission from the 10-K
MetLife did not disclose in the 2014 10-K report the CAL RBC ratios for its principal U.S. insurance subsidiaries. To calculate the figures, it is necessary to obtain—from the statutory annual statement for each subsidiary—TAC and ACL, multiply ACL by two to determine CAL, divide TAC by CAL, and express the quotient as a percentage.

Although the combined CAL RBC ratio was 398 percent, according to the recent 8-K report, there may be a wide range of CAL RBC ratios among MetLife's principal U.S. subsidiaries. To get an inkling of the range, I reviewed the year-end 2014 statutory annual statements of three subsidiaries. Here are the TAC, CAL, and CAL RBC ratios:
(in millions)
(in millions)
MetLife Ins Co USA
Metropolitan Life Ins Co
Metropolitan Tower Life Ins Co
Three Companies Combined
The CAL RBC ratios for the three subsidiaries are all comfortably in the adequate zone; that is, they are all well above the CAL RBC ratio of 125 percent, which is the "red flag level." Thus no type of corrective action is necessary.

Also, as indicated in the table above, I calculated the combined CAL RBC ratio for the three subsidiaries, using the methodology described in the quoted paragraph from the 2014 10-K report. The combined CAL RBC ratio for the three subsidiaries is 393 percent, which is close to the 398 percent combined CAL RBC ratio cited in the recent 8-K report for all the principal U.S. subsidiaries of MetLife other than American Life.

Availability of My New Book
Ordering information for The Insurance Forum: A Memoir is available at The book is also available from Amazon.