Thursday, December 21, 2017

No. 245: Shadow Insurance and Cost-of-Insurance Increases—Recent Lawsuits Involving the Confluence of Those Topics

"Shadow insurance" (also called "captive reinsurance") and "cost-of-insurance (COI) increases" are topics on which I have blogged extensively. Recently I learned of five lawsuits—four in federal courts and one in a state court—involving the confluence of those two topics. Here I identify the cases, describe their general thrust, and quote from one of them.

The General Thrust of the Cases
For several years some life insurance companies have been engaging in transfers—through captive reinsurance subsidiaries—of large amounts of liabilities on universal life insurance policies. Some of the captive reinsurance subsidiaries are based offshore and some are based in states that have enacted laws and adopted regulations allowing the creation and operation of limited purpose subsidiaries (LPSs). To offset the liabilities that the LPSs acquire, the LPSs often use as assets items such as parental guarantees, letters of credit, credit-linked notes, and other phony assets that are permitted by the regulators in the domiciliary states of the LPSs but are not permitted under generally accepted accounting principles or under statutory accounting principles promulgated by the National Association of Insurance Commissioners. After unloading their liabilities, the parent insurance companies of the LPSs are able to pay large dividends to their ultimate parent companies, and the ultimate parent companies are able to pay large dividends to their shareholders. In that fashion the ultimate shareholders receive large dividends long before earnings materialize to justify those dividends. When the problem emerges, as it invariably does, the parent insurance companies try to survive by imposing large COI increases on their policyholders with the argument that future expectations are far below what had been anticipated.

The First Banner Case
In January 2016 Richard Dickman and one other individual filed a 79-page, four-count complaint against Banner Life Insurance Company and two Banner affiliates. Here, with italics as in the original and without citations, is the nine-paragraph introduction to the complaint:
  1. Banner Life Insurance Company ("Banner") is a for-profit life insurer organized under Maryland law. Legal and General America, Inc. ("LGA"), Banner's immediate parent, owns all of Banner's Class A common stock, Class B common stock, and preferred stock. Full control of LGA ultimately resides with Legal and General Group Plc ("L&G"), a United Kingdom company.
  2. Banner, LGA, and L&G, working in concert with each other, embarked upon a scheme to take funds, which were designated as support for reserves [liabilities] and set aside to pay American policyholders' death claims, and convert them to L&G's investors' and executives' benefit.
  3. For more than a decade, Banner, under the direction of its ultimate parent, L&G, put investors and executives ahead of their own policyholders. In doing so, Banner pretended to offload billions of dollars of liabilities, a la Enron, from Banner's balance sheet to its wholly-owned "captives" and other affiliates. As false "surplus" was created by this scheme, L&G caused Banner to pay more than $800 million in "extraordinary stockholder dividends."
  4. Importantly, L&G executives have stated, in press releases to its United Kingdom investor audience, that it was repatriating capital and profits from Banner, its American insurer, through an "internal reinsurance arrangement."
  5. This "internal reinsurance arrangement" has been called "financial alchemy" by New York's former Superintendent of Financial Services, Benjamin M. Lawsky. In reality, Banner merely dumped approximately $4 billion worth of liabilities into wholly-owned captive reinsurance companies that are incapable of satisfying their assumed obligations, thereby freeing up hundreds of millions of dollars Banner would otherwise be legally required to hold as reserves.
  6. Banner's captive reinsurance companies are strategically domiciled in jurisdictions that, amazingly, allowed the "reinsurers" not to file any public financials, hiding the true nature and details of these transactions.
  7. After engaging in this financial alchemy for a decade, Banner decided to embark upon a new scheme to take U.S. policyholder funds and send them to L&G, ultimately to benefit shareholders. In September 2015, Banner suddenly increased the Cost of Insurance ("COI") charged to certain universal life insurance policyholders; in some cases, by as much as 620 percent.
  8. Through mailers, press releases, and myriad other mediums, Banner has told policyholders that dramatic COI increases are necessary because "the company did not adequately account for future experience." Banner and LGA define "experience" as "the number and timing of death claims; how long people would keep their policies; how well the company's investments would perform; and the cost to administer policies." Apparently suffering from corporate amnesia, Banner, LGA, and L&G forgot that they told insurance examiners, policyholders, rating agencies, and shareholders the exact opposite for more than a decade to justify paying extraordinary dividends and encourage investment by both policyholders and shareholders.
  9. Since September 2015, Banner has systematically raided policyholder accounts, arguing that its action is permitted by the policies' terms. In reality, the justifications offered by Banner are false, and merely a guise to accomplish two objectives: (1) find new cash with which to fund future dividends, and (2) rid itself of near-term liabilities, and delay inevitable financial disaster.
In December 2016 the two affiliates were dropped from the case. The case is progressing. (See Dickman v. Banner, U.S. District Court, District of Maryland, Case No. 1:16-cv-192.)

The Transamerica Case
In November 2016 Tommy Hill filed an 86-page, nine-count complaint against Transamerica Life Insurance Company and three Transamerica affiliates. In January 2017 the three affiliates were dropped from the case. The case is progressing. (See Hill v. Transamerica, Circuit Court of Jefferson County, State of Alabama, Case No. 2016-6000401.)

The Voya/Lincoln Case
In February 2017 Monte Swenson and five other individuals filed a class action complaint against Voya Financial Inc. and one Voya affiliate, and against Lincoln National Corp. and two Lincoln affiliates. The case was filed initially in federal court in Washington State. In June the judge granted a motion by the defendants to transfer the case to New York. The number of plaintiffs expanded to 15 individuals. In August the plaintiffs filed a first amended complaint. In October the plaintiffs filed a 98-page, 14-count second amended complaint that included two RICO (Racketeer Influenced and Corruption Organizations Act) counts. In November the plaintiffs filed a notice of voluntary dismissal "without prejudice to Plaintiffs' right to refile." (See Swenson v. Voya, U.S. District Court, Eastern District of Washington, Case No. 2:17-cv-48, and Southern District of New York, Case No. 1:17-cv-4843.)

The Second Banner Case
In March 2017 irrevocable insurance trusts of Robert Appel and one other individual filed a 32-page, one-count class action complaint against Banner. In June the plaintiffs stipulated that the case was stayed until final resolution of the first Banner case. (See Appel v. Banner, U.S. District Court, District of Maryland, Case No. 1:17-cv-759.)

The William Penn Life Case
In July 2017 Lesley Rich filed a complaint against William Penn Life Insurance Company of New York. In October the plaintiff filed an 83-page, two-count amended complaint. The case is progressing. (See Rich v. William Penn Life, U.S. District Court, District of Maryland, Case No. 1:17-cv-2026.)

The Book about Enron
The third paragraph quoted above from the introduction to the complaint filed in the first Banner case refers to Enron. In 2003, two years after Enron filed for bankruptcy, a 435-page book about the Enron case was published. The book is entitled The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. The authors are Bethany McLean and Peter Elkind. A tenth anniversary edition was published in 2013; it includes a foreword by Joe Nocera and an afterword by the authors. Many view the book as the definitive account of the Enron scandal, and I strongly recommend the book.

General Observations
I refer to the use of shadow insurance as a shell game often used to impose large COI increases on the owners of universal life insurance policies. It is a shell game because the details of the phony assets are shielded from public scrutiny. I have tried to see those details, but have been rebuffed. In Iowa, where Transamerica Life is domiciled, I tried to examine the phony assets used by the company's Iowa LPSs. After the Iowa insurance division denied my requests under the Iowa open records law, I filed a lawsuit against the division seeking access to the documents. I lost the case on the grounds that Iowa laws and regulations (drafted by insurance company attorneys) render the documents confidential.

I do not know when or how, but there is no doubt that the shell game will collapse. When it does, I fear that the primary victims will be life insurance policyholders who placed their faith in the companies.

Available Material
I am offering a complimentary 103-page PDF consisting of the complaint in the first Banner case (79 pages) and the Lawsky report alluded to in the fifth paragraph of the complaint in that case. (24 pages). Email and ask for the December 2017 package about shadow insurance and COI increases.


Monday, December 11, 2017

No. 244: Long-Term Care Insurance and Philip A. Falcone

In No. 242 (posted November 20, 2017), I discussed the sale of a closed block of long-term care (LTC) insurance policies to a subsidiary of HC2 Holdings, Inc., a public company controlled by Philip A. Falcone. He is the founder of Harbinger Capital Partners LLC, a New York hedge fund. I expressed deep concern about the fate of the 30,000 LTC insurance policyholders remaining in the closed block. The reason for my concern is that in 2013 Falcone entered into a settlement with the Securities and Exchange Commission (SEC) under which he paid a large fine, admitted wrongdoing, and agreed to be barred from the securities industry for at least five years. Here I provide further details about the Falcone case.

SEC Complaints Against Falcone
On June 27, 2012, the SEC filed two related complaints. One was against Falcone and two units of Harbinger Capital. The other was against Falcone, Harbinger Capital, and Peter A. Jenson. The first paragraph of the first complaint summarized the allegations:
This case stems from an illegal "short squeeze"—a form of market manipulation that occurs when a trader constricts the available supply of a security with the intention of forcing settlement from short sellers at the trader's arbitrary and inflated prices. Falcone engineered and carried out a squeeze in a series of distressed high-yield bonds issued by MAAX Holdings, Inc., through two unregistered investment managers he controls [two units of Harbinger Capital].
The second complaint contained other allegations. The first two paragraphs of the second complaint summarized the allegations:
First, Falcone and Harbinger, aided and abetted by Jenson, engaged in a fraudulent scheme to misappropriate $113.2 million from a Harbinger fund in order to pay a personal tax obligation owed by Falcone. Instead of paying his personal taxes with his own assets, which may have required Falcone to curtail his lifestyle and personal expenditures, Falcone obtained $113.2 million from a hedge fund that Falcone and Harbinger managed during a period when Harbinger had precluded investors in the fund from redeeming their interests. The Defendants neither sought nor obtained investor approval for the related party transaction. Having structured the transfer of fund assets to Falcone as a loan with a highly favorable interest rate, Falcone and Harbinger, aided by Jenson, concealed the related party transaction from fund investors for approximately five months. To give the appearance of legality, the Defendants engaged a law firm to advise them; however, the Defendants failed to disclose all material information to the law firm. In addition, the Defendants did not act in accordance with the advice that they did receive from the law firm.
Second, in order to obtain investor approval to impose more stringent redemption restrictions on investors in a second Harbinger fund, Falcone and Harbinger engaged in a scheme to grant certain large investors favorable redemption and liquidity terms in return for their vote to approve the restrictions. Falcone and Harbinger concealed this scheme from the fund's board of directors and the other investors, even though Falcone and Harbinger knew, or should have known, that only the board, and not Falcone or Harbinger, had the authority to grant such preferential rights.
The complaints alleged violations of federal securities laws and rules. The first complaint included two claims for relief, and the second complaint included five claims for relief. In the first complaint, the SEC sought a permanent injunction against future violations, disgorgement of ill-gotten gains, and civil monetary penalties, and, in the second complaint, a permanent prohibition against Falcone serving as an officer or director of a public company. (See SEC v. Falcone, U.S. District Court, Southern District of New York, Case Nos. 1:12-cv-5027 and 5028.)

Settlement with the SEC
On August 16, 2013, Falcone and the Harbinger units settled with the SEC on both complaints through a consent agreement and an attachment. They admitted the facts in the attachment, agreed to issuance of a final consent judgment, and agreed to appointment of an independent monitor for two years. Falcone and the Harbinger units agreed to payment of civil penalties of more than $18 million.  Falcone also agreed to be barred from the securities industry for at least five years, but he was not barred from serving as an officer or director of a public company. On October 1, 2014, Jenson agreed to pay a civil penalty of $200,000.

Admission of Wrongdoing
In No. 242 I said that the defendants' admission of wrongdoing was important, and that the case was one of the first SEC settlements requiring such an admission. In a January 2014 speech, then SEC Chair Mary Jo White discussed the subject. Here are excerpts from her speech:
As you know, for many years, the SEC, like virtually every other civil law enforcement agency, typically did not require entities or individuals to admit wrongdoing in order to enter into a settlement. This no admit/no deny settlement protocol makes a great deal of sense and has served the public interest very well. More and quicker settlements generally mean that investors receive as much (and sometimes more) compensation than they would after a successful trial—and without the litigation risk or the inevitable delay that comes with every trial. Settlements also can achieve more certain and swifter civil penalties, and bars of wrongdoers from the [securities] industry or from serving as officers or directors of public companies—all very important remedies for deterrence and the public interest.
So, why modify the no admit/no deny protocol at all?... Because admissions can achieve a greater measure of public accountability, which can be important to the public's confidence in the strength and credibility of law enforcement and the safety of our markets. It is not surprising that there has also been renewed public and media focus on the accountability that comes with admissions following the financial crisis, where so many lost so much....
As United States Attorney, I made the decision that companies should, in certain circumstances, admit their wrongdoing, even if they were not criminally charged, but where there was a special need for public accountability and acceptance of responsibility. That is why, when I negotiated the first deferred prosecution for a company, back in 1994, I required an admission of wrongdoing, and I brought that mindset to the SEC when I became Chair last April [2013]....
To be sure there was no ambiguity about the misconduct of a defendant who was continuing to deal with investors, we required a hedge fund adviser [Falcone] to not only agree to a bar from the securities industry for five years, but to also admit to misuse of more than one hundred million dollars of fund assets in order to pay his personal taxes through a personal loan that was not timely disclosed to investors....
HC2 Filings with the SEC
As mentioned in No. 242, Falcone is now chairman, president, and chief executive officer of HC2 Holdings. I searched through many of its filings with the SEC, including the 10-K annual reports filed after the settlement with the SEC. Falcone's positions with HC2 are shown, but I found no disclosure of the SEC settlement. However, the HC2 10-K report for the year ended December 31, 2016 contains a three-sentence paragraph on page 36 about an arrangement between Falcone and the New York Department of Financial Services (NYDFS). The arrangement grew out of the 2013 settlement with the SEC. Here is the paragraph:
On October 7, 2013, the New York State Department of Financial Services announced that Philip A. Falcone, now our Chairman, President and Chief Executive Officer, had committed not to exercise control, within the meaning of New York insurance law, of a New York-licensed insurer for seven years (the "NYDFS Commitment"). Mr. Falcone, who at the time of the NYDFS Commitment was the Chief Executive Officer and Chairman of the Board of HRG Group Inc. ("HGI"), also committed not to serve as an officer or director of certain insurance company subsidiaries and related subsidiaries of HGI or to be involved in any investment decisions made by such subsidiaries, and agreed to recuse himself from participating in any vote of the board of HGI relating to the election or appointment of officers or directors of such companies. However, it was also noted that in the event compliance with the NYDFS Commitment proves impracticable, including in the context of merger, acquisition or similar transactions, then the terms of the NYDFS Commitment may be reconsidered and modified or withdrawn to the extent determined to be appropriate by the NYDFS Insurance regulatory authorities may [sic] consider the NYDFS Commitment in the course of a review of any prospective acquisition of an insurance company or block of insurance business by us or our insurance segment, increasing the risk that any such transaction may be disapproved, or that regulatory conditions will be applied to the consummation of such an acquisition which may adversely affect the economic benefits anticipated to be derived by us and/or our Insurance segment from such transaction.
It is ironic that HC2 disclosed the NYDFS Commitment, but apparently failed to disclose the SEC settlement agreement that prompted the NYDFS Commitment. With regard to Falcone's disclosure practices, see White's comments in the final paragraph of what I quoted above from her January 2014 speech.

NYDFS Press Release
On October 7, 2013, NYDFS issued a press release describing the NYDFS Commitment. I am including the press release in the complimentary package offered at the end of this post. The press release includes a link to the SEC settlement but does not include a link to the NYDFS Commitment. Therefore, pursuant to the New York Freedom of Information Law (FOIL), I asked NYDFS for the NYDFS Commitment. NYDFS denied my request on the grounds that the document is confidential under the New York Insurance Holding Company Law. I have not yet decided whether to appeal the denial.

Continental General's Statutory Filings
In the statutory financial statements filed by Continental General Insurance Company, a subsidiary of HC2, I found no disclosure of Falcone's settlement agreement with the SEC or the NYDFS Commitment. I reviewed Continental's statutory annual statements for 2015 and 2016, and its statutory statement for the quarter ended September 30, 2017. The latter financial statement, under "subsequent events," includes a note about the acquisition of the closed block of LTC insurance policies and the need for various regulatory approvals, such as from the South Carolina and Texas insurance departments.

The three statutory statements did not mention Falcone, despite his positions with Continental's parent company. Also, Falcone was not mentioned as a member of Continental's board of directors. The only familiar name I saw among the directors, in all three of the statutory statements, was James P. Corcoran. He served as New York State's superintendent of insurance from 1983 to 1990.

Biographical Affidavits
When an individual or entity seeks to acquire an insurance company, the relevant state insurance regulator must approve the acquisition. To obtain approval, the acquirer must submit information to allow the regulator to determine that the acquisition does not present a danger to the public. The required information includes biographical affidavits of the principals involved in the acquisition. State statutes relating to the information that must be provided to regulators refer to those affidavits, which include these two sentences:
No such person has been convicted in a criminal proceeding (excluding minor traffic violations) during the past ten years. No such person has been the subject of any disciplinary proceedings with respect to a license or registration with any federal, state or municipal government agency, during the past ten years.
The second sentence above seems highly relevant to Falcone, who must have been required to describe his settlement with the SEC and the NYDFS Commitment. However, the biographical affidavits invariably are deemed confidential. Presumably the reason for confidentiality is that a biographical affidavit includes information of a personal nature. In No. 139 (January 19, 2016), I described my inability to obtain copies of biographical affidavits in an Indiana situation.

General Observations
I am disturbed that the public is not entitled to relevant information about the principals in acquisitions. It would be appropriate to redact from the biographical affidavits the private information and leave unredacted the information that should be in the public domain.

With regard to the closed block of LTC policies referred to in this post and in No. 242, insurance regulators in South Carolina and Texas probably are aware of Falcone's settlement with the SEC, but nonetheless have approved or will approve the acquisitions relating to the closed block. I hope the regulators have imposed or will impose safeguards to protect the interests of the policyholders in the closed block.

Available Material
I am offering a complimentary 60-page PDF consisting of the first SEC complaint (27 pages), the second SEC complaint (28 pages), the consent order relating to both complaints (3 pages), the NYDFS press release (1 page), and the note in the Continental General statutory statement (1 page). Email and ask for the December 2017 package about Falcone.


Friday, December 1, 2017

No. 243: Guardian Life's Problematic Dividend Announcement

On November 16, 2017, Guardian Life Insurance Company of America issued a press release entitled "Guardian Announces Largest Policyholder Dividend in Company's History." It is subtitled "Board of Directors Approves $911 Million Dividend Allocation to Participating Individual Life Policyholders." The press release quotes Deanna M. Mulligan, Guardian's president and chief executive officer, as referring to "our 5.85% dividend rate." A small-type footnote at the bottom of the press release, below the section entitled "About Guardian," reads:
Dividends are not guaranteed. They are declared annually by Guardian's Board of Directors. The total dividend calculation includes mortality experience and expense management as well as investment results.
I immediately emailed Guardian's media contact person. I forwarded my blog post No. 10 (November 25, 2013) entitled "The Danger of Announcing Dividend Interest Rates," which relates to a November 2013 dividend announcement by Massachusetts Mutual Life Insurance Company. I asked that the email be forwarded to Ms. Mulligan. I received neither an acknowledgment nor a reply to my email.

The Problem
I have long expressed the opinion that announcing dividend interest rates associated with traditional participating life insurance policies is a deceptive sales practice. The footnote in Guardian's press release fails to disclose the seriousness of the problem. As indicated in the footnote, dividend calculations generally include interest, mortality, and expense components. For as long as I can remember, life insurance companies have maintained total secrecy about the calculation of dividends on their participating life insurance policies.

In recent years, during a period of low interest rates on new investments, some life insurance companies have begun to relax the secrecy on the calculation of the interest component of the dividend while continuing to maintain secrecy on the calculation of the mortality and expense components of the dividend. The problem is that there can be no assurance that the disclosed dividend interest rate is in fact the dividend interest rate. For example, it would be possible for a company to decrease the expense component of the dividend and thereby seemingly increase the interest component of the dividend. Moreover, there is no limit to the possible extent of such a practice, because it would be possible to decrease the expense component of the dividend all the way into negative territory.

The Regulators
It is natural to wonder what state insurance regulators are doing about the problem. In that regard, most states do not have the resources to address the problem. The last time I checked, most state insurance departments did not have a full-time actuary on staff. I believe that only the New York State Department of Financial Services pays attention to dividend matters.

A Solution to the Problem
A solution to the problem is to require all companies that issue or have issued participating life insurance policies to disclose fully the details of their dividend calculations. I do not suggest that disclosure of such complex information should be made directly to policyholders. Rather, I suggest that the companies should be required to file such information every year with state insurance regulators, and that such information should be made available to interested members of the public through state open records laws.

It is my understanding that some years ago Northwestern Mutual seriously considered the idea of voluntarily providing such disclosure to state regulators. In the end, however, the company decided such unilateral disclosure would place the company at a disadvantage, because competitors would be able to criticize the company's methods without themselves being subjected to scrutiny. In other words, a solution to the problem is to require that all companies file the information publicly.

Another Solution to the Problem
Another solution to the problem is for regulators and legislators to require life insurance companies to provide rigorous point-of-sale and post-sale disclosure to life insurance consumers. I have long suggested imposing such a requirement, but have met with no success. My most complete description of a rigorous disclosure system is in an article published in the December 1975 issue of the Drake Law Review. The system includes disclosure of, among other things, point-of-sale and post-sale year-by-year disclosure of the yearly price per $1,000 of the protection component of life insurance policies, and point-of-sale and post-sale year-by-year disclosure of the yearly rate of return on the savings component of cash-value life insurance policies.

General Observations
I do not intend to suggest that any of our few remaining great mutual life insurance companies—Guardian Life, Massachusetts Mutual, New York Life, Northwestern Mutual, and Penn Mutual—would engage in the kind of manipulation discussed in "The Problem" above. However, many stock life insurance companies (some of them former mutual companies) have issued and may still be issuing participating policies, and some stock life insurance companies that have never been mutual companies have issued and may still be issuing participating policies.

Available Material
I am offering a complimentary 27-page PDF consisting of the recent Guardian Life press release (1 page) and my 1975 article in the Drake Law Review (26 pages). Email and ask for the November 2017 package relating to dividend interest rates.