Wednesday, October 19, 2016

No. 183: The Surplus Note at Senior Health Insurance Company of Pennsylvania—Further Information and a Correction

Senior Health Insurance Company of Pennsylvania (SHIP) is a long-term care insurance company in runoff. On February 19, 2015, SHIP issued a $50 million five-year surplus note to Beechwood Re, a Cayman Islands-based reinsurance company. The interest rate is 6 percent. SHIP used the $50 million as an urgently needed surplus infusion. The infusion was shown in SHIP's December 31, 2014 financial statement, which was filed with the Pennsylvania insurance department on March 1, 2015. I wrote about the SHIP/Beechwood surplus note in Nos. 123 (10/27/15), 125 (11/6/15), 174 (8/11/16), 180 (9/19/16), and 182 (10/7/16). Here I provide further information and correct a statement I made in No. 182.

The Bizarre Nature of a Surplus Note
A surplus note is a bizarre financial instrument. The money received by the company issuing the note increases the company's surplus. That happens because state surplus note laws say the company issuing the note does not have to establish a liability. A surplus note is subordinate to all the company's obligations. A surplus note can be issued only with the prior approval of the insurance commissioner in the issuing company's state of domicile. Interest and principal payments on a surplus note can be made only with the prior approval of the commissioner.

The Unpaid Interest
In No. 182, I said SHIP missed three $1.5 million semiannual interest payments on the surplus note (in August 2015, February 2016, and August 2016) for a total of $4.5 million. A SHIP spokesman confirmed that the company has not made interest payments. I asked him whether SHIP asked the Pennsylvania commissioner for permission to pay interest and was denied permission, or whether SHIP did not ask for permission. He said SHIP did not ask for permission to pay interest.

In No. 182, I also said the failure to pay interest means the surplus note is in default. One of my readers said the failure to pay interest on a surplus note is not a default. His comment prompted me to look closely at the wording of SHIP's surplus note. I asked SHIP for a copy of the surplus note, but the spokesman said SHIP would not provide it.

Therefore I reviewed the offering circulars for surplus notes issued by several large mutual life insurance companies in the 1990s. Through the review, I learned that my reference to default was incorrect, and that my reader was correct. Here is some language in one of the circulars:
  • Each payment of interest on and the payment of principal of the Notes may be made only out of [the Company's] surplus and with the prior approval of the Insurance Commissioner of [the Company's state of domicile] if, in the judgment of the Commissioner, the financial condition of [the Company] warrants the making of such payments.
  • The Notes will constitute debt obligations of the type generally referred to as "surplus notes." The net proceeds of the issuance of the Notes will be recorded by [the Company] as additional admitted assets. For statutory accounting purposes, however, the Notes are not part of the legal liabilities of [the Company]. Accordingly, [the Company's] surplus will be increased by the net proceeds from the sale of the Notes.
  • Any such payment [of interest or principal] will reduce [the Company's] surplus.
  • If the Commissioner does not approve a payment of interest on or principal of the Notes, the applicable interest payment date or the maturity date, as the case may be, will be extended until such time, if any, as such approval is obtained. Interest will continue to accrue on any unpaid principal amount of the Notes (but not on unpaid interest the payment of which has not been approved) during the period of such extension.
  • The Notes will be expressly subordinate in right of payment to all existing and future Senior Indebtedness and Policy Claims of [the Company], including all future indebtedness issued, incurred or guaranteed by [the Company], other than any future surplus notes or similar obligations of [the Company].
  • To the extent authorized by [the Company's] Board of Directors, [the Company] may continue to declare policyholder dividends and to make dividend payments on its participating policies regardless of the effect any such declaration or payment may have on the Commissioner's decision regarding the payment of interest on or principal of the Notes. [Note: I believe that SHIP does not offer participating policies, but I included this point to help readers gain a further understanding of surplus notes.]
In short, if interest or principal payments are not made, the due dates of the payments would be extended indefinitely. Thus the party that purchases a surplus note would have no recourse if the company that issued the surplus note misses interest or principal payments.

The Invention of Surplus Notes
Surplus notes were invented more than a century ago as a vehicle through which a mutual insurance company in financial trouble can obtain a surplus infusion. A mutual company has no shareholders who can provide a surplus infusion. Also, a company cannot obtain a surplus infusion by borrowing the money through an ordinary loan, because the asset (cash) received would be offset by a liability and there would be no increase in surplus. The early state surplus note laws allowed only mutual companies to issue surplus notes, but the laws were later amended to allow stock companies to issue them.

The Income Tax Issue
A question arose concerning federal income taxation of the interest an insurance company pays on a surplus note. Insurance companies argued that the interest is deductible because it is interest on debt. The Internal Revenue Service (IRS) argued that the interest is not deductible because it is in the nature of a dividend on stock. The insurance companies won the argument, but it made little difference at the time because surplus notes were issued only in small amounts by companies in financial trouble.

The Revolution of 1993
Then came the revolution of 1993, which I discussed in the February 1994 issue of The Insurance Forum. Prudential Insurance Company of America, a mutual company at the time, was not in financial trouble. Yet the company issued $300 million of surplus notes in a private offering. The company used the net proceeds to prefund a voluntary employee benefit association (VEBA) providing certain post-retirement benefits for certain employees. The company used surplus notes solely for one reason: the interest was deductible. Goldman, Sachs & Co., Prudential's adviser on the surplus note offering, put it succinctly: 62 percent of the contribution to the VEBA came from Prudential and the other 38 percent came from the IRS. The transaction also could be viewed as increasing our annual deficit, increasing our national debt, and burdening other taxpayers.

At the end of 1981, small life insurance companies in financial trouble had about $400 million of surplus notes outstanding. Prudential's 1993 action touched off an avalanche of surplus note offerings by major insurance companies that were not in financial trouble. By the end of 2012 (based on the final tabulation I published in the August 2013 issue of the Forum), life insurance companies had $28 billion of surplus notes outstanding, and property insurance companies had $14 billion outstanding.

For many years the only holdouts among major life insurance companies were Northwestern Mutual Life Insurance Company and Teachers Insurance and Annuity Association of America. When they succumbed to the temptation to issue surplus notes, I wrote about their actions in the August 2010 issue of the Forum.

The surplus note activity that began in 1993 stemmed from the deductibility of the interest paid on surplus notes. I think the IRS was correct. A surplus note is not a "debt obligation" (despite what offering circulars say), and the interest paid on a surplus note is not interest on debt. I think the interest is in the nature of a shareholder dividend, which is not deductible.

An Interesting Coincidence
In SHIP's annual statement for the year ended December 31, 2015, Schedule BA - Part 2 shows "other long-term invested assets acquired." The schedule says SHIP, on February 19, 2015, acquired an "other long-term invested asset" from "Beechwood Re Investments" for $50,168,039. SHIP made the acquisition on the very day SHIP issued the surplus note to Beechwood Re, and the cost of the acquisition was almost identical to the amount of the surplus note. In other words, on that day SHIP received a $50 million surplus infusion from Beechwood pursuant to the surplus note, and SHIP handed over about $50 million to Beechwood.

General Observations
In No. 182, I expressed the belief that the SHIP/Beechwood surplus note was not an arm's-length transaction, because an interest rate of 6 percent did not compensate Beechwood for the risk involved in lending money to SHIP, a company which was at the time and still is in fragile financial condition. I also expressed the belief that the $50 million surplus infusion was a gift from Beechwood in exchange for SHIP's investing money with Beechwood. The schedule in SHIP's 2015 statement supports my beliefs.

The "other long-term investments" schedule in SHIP's 2015 statement shows some SHIP investments in Platinum Partners, a hedge fund, near the end of 2015. The SHIP spokesman said SHIP was deceived, because in early 2015 Beechwood did not tell SHIP about Beechwood's close ties to Platinum, and because Beechwood transferred the invested funds to Platinum without SHIP's knowledge or consent. Those SHIP allegations resemble the allegations in CNO Financial Group's lawsuit against Platinum/Beechwood officials. I discussed the lawsuit in No. 182.

Available Material
I am offering a 15-page complimentary PDF consisting of excerpts from the February 1994, August 2010, and August 2013 issues of The Insurance Forum. Email and ask for the October 2016 surplus note package.