Friday, January 1, 2010

(No.71) Betting against your clients

When years ago many Canadian life insurance companies jumped eagerly into the market to sell something 'new' -- aggressively priced Term-to-100 policies based on lapse-supported pricing -- I was strongly critical in editorials in The Canadian Journal of life Insurance and in speeches to industry audiences.

I argued then and still believe that to sell those policies was ethically dubious for any life insurance company. The fact that it was legal did not justify the activity any more than a theoretical legality justified the greed and incompetence of the financial services CEOs who came close recently to creating a complete financial services meltdown -- and then sought to pay themselves bonuses while employees, shareholders and taxpayers suffered the negative financial consequences.

Term -to -100 policies were originally sold with great enthusiasm to Canadian consumers by many life companies as a form of lifetime life insurance protection and often represented to the buyer as being cheaper and more desirable than whole life (permanent) coverage. Yet the life insurance company issuing such policies knew -- indeed counted on -- the fundamental premise of the policy's pricing being that a significant proportion of those to whom T-100 was sold as coverage for their lifetimes would lapse their 'lifetime' protection or have it replaced by a sales intermediary. In terms of policy profitability for the company the more policyholders who lost their lifetime protection (and the sooner they lost it ) the better. It turned upside down the traditional shared interest of the company and its policyholders in their retention of their lifetime insurance coverage on the company's books.

Consider the reality of this equation: the life company issuing lapse-supported T-100 and its policyholders who bought the coverage no longer have a common goal, i.e., the retention of the policyholder's life insurance coverage. Rather the company is betting against its policyholders' interests; indeed their interests are diametrically opposed because the sooner the insured loses his or her lifetime insurance protection the better for the company whose policy pricing assumptions require such a result for many of their clients.

I was reminded of this Term-to-100 ethical conundrum (albeit one never publicly acknowledged by the Canadian life insurance industry) by the New York Times revelation (Dec 24,2009) that in the run up to the Wall Street meltdown Goldman Sachs among other financial firms had "created mortgage-related securities ... that were intended to make money for Goldman if the housing market collapsed. And just as planned, the firm pocketed huge profits when they did turn sour."

American financial regulators are now -- belatedly of course -- looking into the creation and peddling of these securities known as CDOs ( synthetic collateralized debt obligations). They are "looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them setting their clients up to lose billions of dollars if the housing market imploded ..." And it did.

In hindsight one might say that this was yet one more obscene manifestation of the greed and lack of ethics of so many in financial services leadership. And so it appears to be. However it is also for me strikingly reminiscent of the approach taken by too many of those responsible for life companies in Canada during the hustling to the public of the first generation of a Term-to-100 product which, at its core, was a bet against the client.

The early company enthusiasts for T-100 got it badly wrong and their pricing assumed lapse levels (especially those caused by policy replacement activity) that did not materialize. Indeed I was told by a federal insurance regulator that a number of brokerage companies which jumped into the T-100 competition with both corporate feet arrived at a point at which they would have been judged insolvent had Ottawa publicly required them to abruptly increase their reserves to match their liabilities based on their actual lapse experience with the T-100 business they had sold by the truckload, experience much lower than lapse rates assumed in the pricing assumptions on which their reserving was based. They were allowed by Ottawa to quietly increase their reserves over time to get onside thus avoiding scandal and financial disaster.

In fact, after it became fairly widely understood in the business that the pricing of the first generation of Term-to-100 was so wildly offbase in terms of assumed lapse rates, the best agents and brokers advised their clients (whether those clients had purchased their T-100 policies from them or not) to hold on to them; the cost of these policies was very favourable in comparison with Term-to-100 policies issued after the necessary upward repricing of T-100.

So anxious did some of the companies become to get alot of this first generation T-100 business off their books that (as I was told from the field) holders of some of the larger face amount but cash valueless T-100 policies were cautioned by their own life insurance advisors to diarize the annual premium payment so their policies would not lapse if they did not receive an annual premium notice from the issuing company -- in the obvious hope that the policy would be lapsed inadvertently by the policyholder. First generation T-100 policies became desirable because of the issuing companies' erroneous pricing assumptions; they still are. If you have one, treasure it.

The Mutual Life of Canada, after Term-to-100 hit the market, refused to issue T-100 policies. It was a source of pride for some of us who then worked for Mutual Life. I would like to believe that this refusal was a matter of principle -- and principle was certainly something which came up in internal discussion at the time.

In retrospect I think the reality was that the decision was as much or more because Mutual Life's superior exclusive career agency distribution system gave the company the industry's lowest lapse rate and highest agent retention rate. Therefore any pricing changes or new policy introduction tied to realistic lapse rate assumptions for Mutual Life would not have even begun to generate the basis for the sort of lapse-supported pricing common in that market segment. (Mutual Life accepted individual policy business only from its own agents, unlike Sun Life today which operates what was formerly the Mutual/Clarica career agency system but also an MGA brokerage arm as well as making certain of its policies available to "national accounts", i.e., other companies).

Whatever the T-100 decision-making process in each company in those days, when executives who felt uneasy about their companies selling the product sought some form of Balm of Gilead to apply to this ethical skin condition, they often -- as with much else -- invoked sales people as their excuse. As one executive in a company for which I had considerable regard (and still do) said to me: "We don't really want to be issuing issue Term-to-100 but the field wants it."

My answer was then and remains: don't blame agents/brokers for selling the products with which companies equip them. If the company does not want to sell a certain type of product, then don't issue it. The responsibility is the company's.

Alastair Rickard