Thursday, July 22, 2010

(No.105) Making money in a race to the bottom

The financial services analysts, media et al, the experts I have dubbed the financial services paparazzi (see, column No.46 "Manulife, Sun Life & shop-worn insights") are getting ready to pronounce on the 2nd quarter 2010 results of the major Canadian life insurance companies -- to be unveiled in early Aug.

Analysts' predictions of what those results should/will be will reappear like bees in amber once the results are out and cited as reference points for company success -- or not. This world of confident assertion has long interested me as both a journalist and industry executive because so many of the financial services paparazzi appear to have such a tenuous hold on what the life insurance business is about, at root: i.e., selling stuff.

But even when a kernel of basic life insurance business reality creeps into a report, however belatedly, it tends to stop short of providing realistic analysis of core operational issues. For example: a mid-July piece in the Globe and Mail Report on Business about the forthcoming second quarter results and the predictions of various analysts actually concluded with a brief allusion to the possible relevance of individual policy pricing to the making of a profit.

In fact the declining average premium charged per thousand of life insurance death benefit coverage (i.e., related to under-pricing of a great deal of individual risk ) has been a feature of much of the Canadian industry since the early 1970s. This pattern has been both encouraged and to a significant extent sustained by the ongoing "reinsurance war" -- as I referred to it in numerous editorials in the Canadian Journal of Life Insurance. The competition for reinsurance market share among the big international 'exclusive' reinsurance companies ('the pros') both stimulated and helped increase the allowances (i.e., subsidies) paid by the pros to the issuing life companies. They made real the onset and continuation of the race to the bottom in policy pricing.

Not all that long ago there were nearly a dozen reinsurance companies active in Canada, a few of them Canadian-controlled. However the competition in this part of the life insurance business has continued for so long and grown so intense, pervasive and irrational that, as a recent correspondent quite accurately pointed out (see the third letter in column No. 100) a dangerously high proportion of individual policy life risk in Canada [77% in 2008] is now reinsured AND reinsured with just 3 international companies: Swiss Re, Munich Re & RGA Canada.

The Canadian public is unaware of the extent to which the insurance on their lives is actually NOT in the hands of the dozens of retail life companies from which they bought their policies and assumed were carrying the insurance on their lives but rather on the books of three foreign companies which given, say, the potential conjunction of two or three major disasters affecting their non-life and/or life business could face a threat to their financial health. The blame for this dangerous situation can be spread widely, including among insurance regulators.

There are many factors contributing to this state of affairs and to the presence of billions of dollars of risk on the books of companies which is under-priced and therefore under-reserved and, for the issuing companies, offers too little margin or in some cases none at all. Not the least of the factors of interest to me has been the stampede in this decade by the biggest Canadian companies after they demutualized (Mutual, Manulife, Sun and Canada) to stop selling participating policies.

Why? Because the priority, some would argue the only real priority for the boards and senior managements of stock life companies, became to please the market, the shareholders; policyholders are merely clients. And because in Canada life insurance company shareholders are only permitted to share in a small proportion of the profits generated by participating policies. Indeed for that very reason -- the financial aggrandizement of shareholders at the expense of policyholders -- there are examples of a company's par policyholder fund being allocated an inappropriate share of a company's expenses.

It is interesting that among Canadian stock life insurance companies, one stands out for the sale of par policies -- London Life. This developed as part of the London Life culture over decades when the company was controlled and directed by the Jeffrey family. Subsequent corporate owners have wished this to be less the case and have worked to make it so but it is a lingering part of the sales culture of London's career agency system. Indeed under the former control of the Jeffrey family London Life was, in my view, operated as much like a mutual company as any stock company could be in terms of its treatment as a priority of the interests of both its par policyholders and its agents. I once put this view to former federal Supt. of Insurance K.R. MacGregor -- and he agreed with me.

Participating par policies and the par dividend mechanism provide a way for both the issuing life insurance company and its policyholders to benefit even as times and investment experience change. The Mutual Life of Canada (before it demutualized, became Clarica Life and was taken over by Sun Life) sold virtually nothing but par policies. Even its Universal Life policies were designated as participating, a fact that allowed Mutual's UL policyholders to benefit from both of its special ownership dividends in the years preceding demutualization [when the practise of mutuality by Mutual Life was re-emphasized under CEO Jack Masterman] and ultimately through the allocation of shares in the demutualized company [Clarica Life] to Mutual's par policyholder-owners.

Sun Life's Canadian operation, like Malcolm Muggeridge rediscovering Jesus, is currently engaged with the matter of a successful introduction of a par whole life policy -- back to the future. More than anything else this strikes me as a response to interest and demand from its Canadian career agents, many of whom have been in the business long enough to know about both the strength and appeal of par policies.

The fiscal implications of 'financial reinsurance' and related financial games played (with regulatory permission) by life insurance companies in Canada and elsewhere apparently make it difficult for those outside the industry to appreciate how too many companies have been engaged for too long in a race to the bottom in policy pricing, in a competition based on attracting new life business with under-priced and (too often) over-compensated policies. This race has been, as much as anything, about public [investor] perception of short term success in growing Canadian market share while soliciting 'attaboys' from analysts based on total sales numbers rather than any actual likelihood of long term profitability on the policies sold. Major industry changes should have been prompted long since. But that's a story for another column.

Remember: when the quarterly earning numbers come out next week for the big Canadian life insurance companies the interesting company stories hardly lie merely with whether or not a shareholder dividend was off by a dime or two from what some security firm analyst had predicted. Rather it will be wrapped up in such things as whether or not, using Sun Life as the example, its Canadian operation (on whose ongoing churning out of a disproportionately large share of Sun's worldwide profit the company continues to depend) is selling enough profitable policies to enough Canadians -- and is likely to continue doing so.

I have commented extensively on the problems I see in the Canadian life insurance industry and in particular the reasons for the declining effectiveness of the Mutual Life/Clarica Life career agency system since it was taken over by Sun Life. I won't rehearse the reasons here.

On Nov. 9, 2009, at the conclusion of a 5 column series on Sun Life (, column Nos. 50,52,60,61 & 62), I observed that "Sun Life still has in place in Canada the essential elements of a successful career agency distribution system. ... It remains to be seen whether the potential of Sun Life's career system wll be enhanced or dissipated."

Recent signs are encouraging.

Since the return in January 2010 of Kevin Dougherty to head Canadian operations the general situation in Sun's Canadian operation is improving, including the performance of Sun's Canadian career agency distribution and, vitally important to sales growth, career agent morale and their attitude to Sun Life itself. While Dougherty was never in the agency system in the field he has demonstrated an instinctive understanding of and empathy for career agents, their role and its importance to clients and the company.

As a matter of direct knowledge I can say that this is not an act by Dougherty (as it so often is by industry executives who have vocational reasons for pretending to like agents and brokers and relate to them). Such executive pretence is almost always counter-productive since most agents have highly developed bullshit detectors. Sun career agents came to like Dougherty and have been pleased to see him back. He and senior players in Sun's Canadian Individual operation ( Kevin Strain and Vicken Kazazian in particular) seem to have stopped the decline and begun the climb back for Sun's Canadian career distribution, in turn the foundation on which rests much of Sun's reliable present and future profitability.

However it is still early days and it remains to be seen if Sun Life is now really prepared to invest appropriately over time in the enhancement and growth of its main Canadian agency distribution system. So, the opening of the champagne should be put on hold but the more recent 'Sun signs' analysts ought to be noting in this respect are positive -- regardless of what the short term result looks like based on Q2.

Alastair Rickard