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 jmbelth@gmail.com 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).