Moral hazard in the insurance industry.
Published March 1, 1993 | March 1993 issue
"When I invested my hard-earned money 10 years ago, Executive Life was a health[y] company. ... Well, we know what happened. ... The management of Executive Life took a lot of risks. They invested in things I would never have touched. ... Meanwhile, nobody let me know what they were doing. I trusted, perhaps foolishly, the manager of that company, and even worse, I trusted my Government to watch over their actions for me. ... On April 11,  11:30 a.m., the State took over Executive Life and stopped all annuity checks. Mine included. ... I now stand to lose everything."
The fear Donn Sigerson expresses in his testimony before Congress has proven groundless. Not one of the thousands who put their savings into Executive Life's investment-oriented products will lose everything. Nevertheless, the 1991 failure of four large insurance companies that generated most of their revenue from these new products has prompted Congress and the financial press to examine public policy toward the life insurance industry. The prevailing view seems to be that these failures show that the United States needs both stronger regulation of insurance companies and also stronger, more uniform government guarantees for those who buy their products.
The prevailing view is wrong. The two most popular types of these products, single premium deferred annuities (SPDAs) and guaranteed investment contracts (GICs), are sold based on their high fixed rate of return and thus have more in common with bank certificates of deposit than with traditional life insurance products. By offering high rates of return on products that are guaranteed by the government, aggressive insurers quickly attract vast sums. Just as it did with banks and S&Ls, government protection creates moral hazard: that is, since these products are insured by a third party, those who do the investing have no incentive to care about what is done with their money. Moral hazard encourages insurers to invest funds in risky ventures, recreating the kind of heads-I-win, tails- others-lose situation associated with guarantees of the deposit liabilities of banks and S&Ls. Strict regulation can curtail this tendency. But experience in the insurance as well as in the banking industry suggests that successful regulation is costly and difficult to sustain.
Instead, policymakers should eliminate all government guarantees on investment-oriented insurance products, especially SPDAs and GICs, and should require that insurance companies disclose to their investment customers the nature of the products they are buying.
A Sweet New Tune for Insurers in the 1980s ...
At the beginning of the 1980s, investment-oriented products were a promising sideline in an industry whose main product was still insurance against abnormally early or late death. By the end of the 1980s, the industry was generating about half its annual revenue from investment- oriented products that featured high fixed or quasi-fixed rates of return and little or no insurance aspect. The bulk of these were SPDAs and GICs.
Purchasers of SPDAs pay a single premium up front in return for a promise of something later. The something to be returned later (usually five or 10 years later) is not in any important sense an annuity but is rather a sum of money equal to the original premium plus interest earned at the rates specified in the contract. The typical SPDA is thus essentially a long-term, quasi-fixed-rate certificate of deposit.
GICs lack even the trappings of an insurance contract. The guarantee referred to in their name is just the insurance company's promise to pay a fixed rate of interest for a specified period on funds invested at or after the signing of the contract. Like SPDAs, they also are essentially certificates of deposit. Unlike SPDAs, GICs are not sold to individual investors but are typically bought by a pension fund on behalf of employees contributing to a defined-contribution pension plan. The contract is thus between the insurance company and the pension fund, which means that the liability of the insurance company selling a GIC is not assigned to specific individuals. This liability feature can make it more difficult for GIC investors to collect from their state guaranty fund, should their insurance company fail.
SPDAs and GICs are radically different from traditional insurance products, and what is most striking about their new preeminence in the industry is how fast they allow it to grow. SPDAs and GICs are widely sold through brokerage houses now, magnifying their ability to attract savings previously held in other forms. This enhanced capacity for rapid growth underlines the need to reevaluate public policy toward guarantees of these products.
... But Who Pays the Piper?
Although insurance companies promise holders of SPDAs and GICs fixed returns on their investments, the true worth of these promises is not easy to ascertain. Holders of SPDAs and GICs have difficulty judging the value of their claim on the assets of the company that issued their policy, and the very existence of a system of guarantees weakens their incentive to try.
Like bank depositors, insurance company claimholders get little information about what an insurance company will do with their money. The potential mutual fund investor, in contrast, receives a detailed prospectus and knows whether his or her savings will be used to buy hog futures, commercial real estate, U.S. government bonds, or shares traded on the Kuala Lumpur stock exchange. Insurance company claimholders have no such prior knowledge of the relative riskiness of their investments.
Further, since claims on insurance companies are not explicitly tied to specific parts of the insurance company's portfolio, the value of these claims depends on the overall financial strength of the life insurance company. Judging the health of life insurance companies is not easy. Several companies that specialize in the financial rating of life insurers rated Executive Life highly until little more than a year before the company failed. Only four months before it failed an internal memo by the National Association of Insurance Commissioners (NAIC) declared that the company was in no imminent financial danger. Clearly, it would be difficult for investors like Donn Sigerson to know what the experts didn't.
Giving Consumers the Business
Perhaps most unsettling of all is that even accurate information about an insurer's financial strength may be useless to an investor. This stems from insurers' practice of transferring books of business. In effect, what this means is that an insurance company can get out of a contract by substituting a different insurer in its place. A reform movement is gathering steam, but in most states this is legal even without the prior consent of the insured individuals. The effect of this transfer practice is that an individual policyholder is not investing in a specific insurance company but rather in some company-to-be-named-later, as if all companies should be interchangeable from the consumer's point of view. (The laws governing transfers of books of business could easily be reformed to require that the initial insurer retain residual financial liability. That is, it would honor the claims of the holders of transferred policies if the second insurer subsequently became insolvent.)
This interchangeability, at least with regard to financial safety, is strongly reinforced by the current system of government regulation and guarantees of life insurance contracts. The explicit and implicit promises that government and the life insurance industry will somehow protect consumers from significant financial loss increasingly resembles the situation in the banking and S&L industry, where deposit insurance has absolved depositors from almost all responsibility for worrying about the safety of their investment.
Where Guaranty Fund Coverage Isn't Enough ...
The explicit safety net now consists of 50 state-mandated guaranty funds. Most states have adopted some version of the NAIC model law, but coverage of investment-oriented products isn't uniform and payment can be slow. Unlike the Federal Deposit Insurance Corp. (FDIC), which protects bank customers, most state guaranty funds do not assess premiums to build up a reserve in anticipation of future failures. Instead, when a life insurance company fails, the state fund assesses the surviving life insurers in the state to cover the payments due to policyholders. When the volume of claims exceeds the legal maximum the fund can assess state insurers per year, or when there is a delay in liquidating or restructuring a failed company, individuals may have to wait to gain access to their funds.
... Bailouts Fill in the Gaps
Often they don't have to wait long. The implicit impression that any insurance company product is a safe investment has been fostered by the willingness of insurance companies, state legislators and regulators to arrange ad hoc consumer bailouts. When Baldwin-United, a major supplier of SPDAs, failed in 1983, thousands of policyholders had no explicit guaranty fund coverage. Thousands more around the nation were explicitly protected only by the state guaranty fund of Indiana, which didn't have adequate financial resources to pay them all. Nonetheless, state regulators and several major life insurance and brokerage companies reached an agreement that made many of these individuals whole (or nearly so) while spreading the costs broadly across the insurance and brokerage industries. When Executive Life's problems became apparent in 1990, the California Legislature quickly passed a bill setting up a life insurance guaranty fund, and some have suggested that state regulators may have deliberately refrained from closing the company until after the fund was up and running. In 1991, when the sudden decline of Mutual Benefit of New Jersey took state regulators by surprise, the Legislature acted to create a state guaranty fund on the very day the company failed.
Other Implicit Safeguards
The state guaranty fund system and ad hoc bailouts aren't the only consumer safeguards, however. Each state also has an insurance commissioner whose staff is charged with regulating insurers doing business in the state, and one of their duties is to conduct periodic financial examinations of those insurers. The mere fact that states have this responsibility encourages investors like Donn Sigerson to assume the government is keeping an eye on their insurance company for them. So even without a state guaranty fund, investors might well conclude that if a company passes their state's insurance exam it must be safe enough.
Taxpayers provide the final safeguard. As with the FDIC, the burden of shoring up life insurance guaranty funds ultimately extends to everyone. Since fund assessments are a full or partial credit against an insurer's state taxes, other taxpayers must pick up the slack.
From the investors' point of view, though, the clear message in all this is that somebody, somehow, will save them when their insurer goes broke, so they have no need to worry about what insurance companies do with their money.
Moral Hazard's Potent Effects
The man Donn Sigerson was relying on to watch over his money at Executive Life had what might seem to many to be a curious aversion to debt. Executive Life CEO Fred Carr "would lecture in his annual reports and in other forums on the evils of debt. He would shout, 'We have no debt at First Executive Corporation [the holding company for Executive Life]. No long term debt. No short-term debt. None,'" according to The Fall of First Executive: The House that Fred Carr Built, a 1991 book by Gary Schulte. Since most insurance policies are a kind of credit instrument and most policyholders are thus creditors, Fred Carr obviously did not hope to build a major insurance company by avoiding all forms of debt. What Fred Carr really sought to avoid was debt to those who would have either imposed restrictions on Executive Life's investment strategies or demanded interest rates commensurate with the risks of its portfolio.
To understand the nature of the moral hazard created by guarantees on SPDAs and GICs, first consider what happens when a firm tries to issue 10- year bonds in the bond market. For every dollar of bonds sold, the firm would promise to pay back (1+r)$10, 10 years later, where r is the annual rate of interest promised. To back up this promise, the firm would have to issue a prospectus containing additional promises, called covenants. The prospectus and its covenants would make clear what debts would have prior claims on the firm's assets if the firm were unable to pay all its debts, and it would clarify whether the bondholders' claims would come before any claims arising from subsequent borrowing by the firm. The prospectus would also explain how the firm's existing assets are invested, whether the firm plans to reallocate them significantly, and how the proceeds of the bond sale would be invested.
Insurers like Fred Carr would clearly prefer SPDA and GIC investors, who demand none of these things before investing their money. From 1974 to 1990, thanks in part to the explicit and implicit guarantee system described here, Fred Carr's Executive Life companies were able to raise billions of dollars from hundreds of thousands of docile lenders like Donn Sigersonpeople whose money was then invested, often without their knowledge or consent, in risky assets.
In fact, all the major insurance companies that failed in 1991 engaged in financial strategies that put their ability to pay claims at substantial risk. As did Executive Life, First Capital and Fidelity Life invested heavily in high-yield, high-risk corporate debt, commonly known as "junk bonds." Junk bonds comprised over 60 percent of the asset portfolio at Executive Life and about 40 percent at Fidelity Bankers and First Capital, according to the US General Accounting Office. Through mortgage lending and direct investment, Mutual Benefit Life of New Jersey was heavily exposed to risky commercial real estate ventures. During the 1980s, most of these companies also engaged in complicated reinsurance schemes that had the effect of meeting regulatory requirements for equity capital without actually providing a cushion of safety for the policyholders.
Though smaller in overall scale, these 1991 failures closely parallel the pattern of failures in the S&L industry in the 1980s. Due to the moral hazard created by the perception of explicit or implicit guarantees on deposits and policies, both the S&L and the life insurance industry had access to vast sums of credit from uncritical lenders. The regulators of both industries tried to limit the consequences of this moral hazard but were unable to prevent aggressive risk taking on a large scale. In both industries, it was thus only a matter of time before a wave of insolvencies would cause these uncritical lenders to look to their real or perceived guarantees for relief.
If Extending Guarantees and Regulation Is the Answer ...
As Executive Life and other major insurance companies active in the SPDA and GIC market crumbled and finally fell during 1990-91, the public, the press and Congress began to analyze what had gone wrong and what needed to be done about it. Blame was attributed to the current mix of fuzzy and inconsistent guarantees, financial innovations, moral hazard and, especially, an overmatched regulatory system. The unsurprising result was that most proposed solutions involved more complete guarantees for policyholders combined with more effective regulation of insurers.
The combination of more dependable guarantees and tougher regulation is logically balanced. It recognizes that more generous guarantees increase moral hazard but attempts to limit the potentially negative consequences of increased moral hazard by means of tougher regulation of insurers. In that sense, it avoids the cart before the horse policy that was applied to the S&L industry in the 1980s, when increased deposit insurance coverage was combined with looser regulation.
... Policymakers Will Have Misunderstood the Question
Despite the logic of combining tighter regulation with any increase in SPDA or GIC guarantees, the results are likely to be disappointing. On the one hand, regulators might be able to limit SPDA and GIC interest rates and to channel the premiums into investments that always yielded enough to repay policyholders. Such products would merely duplicate existing consumer options. On the other hand, even enhanced powers might not be enough to help regulators keep up. If insurers stayed one innovation ahead of regulators, moral hazard problems would reappear and again lead to resource misallocation and financial crises.
More stringent regulations would also impose costs. Effective regulation would mean boosting the number and average skill level of insurance examiners. That costs a lot of money. And while tough regulation does work, it often stifles legitimate innovation in the process.
Finally, although there are many talented and hard-working insurance examiners, the reality is that even in well-funded insurance departments like New York's the average level of salary and financial expertise lags behind those of the companies they are regulating, and the politics of the regulatory process often subverts the efforts of even highly competent regulators. (See "The Politics of Regulating Moral Hazard," below.)
So What's to Be Done?
An obvious alternative to increased guarantees and tougher regulation exists. State and federal governments could make it clear that they neither insure SPDAs, GICs and similar investment-oriented products of life insurance companies nor mandate guarantees funded (nominally, at least) by the life insurance industry itself. Governments would still enforce criminal statutes against fraud and embezzlement, but they would not encourage policyholders to think that some third party would bail them out if a risky financial strategy caused their insurer to go broke.
Eliminating guarantees on SPDAs and GICs while guarantees on other life insurance products are maintained does present some problems. Nonetheless, since SPDAs and GICs have few, if any, life insurance characteristics, it seems inappropriate to shelter them under the umbrella of a guaranty system specifically designed to protect life insurance customers. And since their fast growth makes them a more potent vehicle than traditional life insurance policies for exploiting moral hazard, policymakers need to give prompt and serious attention to ending all guarantees on these products to avoid repeating the S&L disaster.
The Politics of Regulating Moral Hazard
The moral hazard that arises from guarantees on the investment returns offered by life insurers and other intermediaries shifts the responsibility for evaluating investments from investors toward regulators. If regulators take this responsibility seriously, they are likely to come into conflict with managers and shareholders of those intermediaries that pursue risky investments. These conflicts sometimes spill over into the political arena. For example, federal regulators who sought to restrain the risky investment strategies of aggressive S&Ls sometimes found that politicians sympathetic to the S&L industry would discourage or even block their regulatory efforts.
Insurance regulators have had similar problems. At the state level, regulators' efforts to limit the junk bond investments of Executive Life and other life insurance companies became politicized, in part because the regulators did not have clear authority to impose junk bond limits and therefore sought such authority from state legislatures. The following accounts from New York and California are examples of the sort of powerful political opposition regulators encountered.
Terence Lennon, assistant deputy superintendent and chief examiner for the New York State Insurance Department, in testimony before Congress, described political reaction to the department's efforts to limit life insurer's junk bond holdings this way:
The early bird does not always get the worm. The first year that ELNY [Executive Life of New York] was up to about 19 percent in junk bonds they were called in and told that junk bonds were a new investment vehicle and 19 percent concentration seemed too high. ... The next year ELNY increased their junk bond concentration to about 33 percent. We called ELNY again with concern over the high concentration and were told not to worry. ELNY said they knew how to manage their finances and were probably not going to acquire much more. The following year their concentration reached the high 40s and we decided not to call them in, having already heard their presentation.
At that point we began drafting legislation to limit life insurance companies' concentration in junk bonds. It was 1986, in the heyday of junk bonds. Drexel Burnham had a very powerful lobby and the legislators heard something entirely different from them than they heard from us. When it was quietly suggested that we do it as a regulation, we proposed one. Then we were called to a hearing by the Legislature and excoriated for proposing the limitation as a regulation. By the time the regulation was promulgated in 1987, ELNY had increased its concentration in junk bonds to about 70 or 75 percent of assets.
In his 1991 testimony to Congress, Tom Sutton, chairman and CEO of Pacific Mutual Life Insurance and spokesperson for the American Council of Life Insurance, posed this question to Congress: Why was Executive Life allowed to take the actions which led to its demise? The following experience was part of his answer:
Executive Life, together with others in the Milken daisy chain, had substantial lobbying power in Sacramento. For example, last year I testified in favor of a legislative limit on below-investment grade securities [junk bonds] before the California assembly insurance and finance committee. Intense lobbying by those opposed to such a limit led to only 4 affirmative votes out of a committee of more than 20. Could we have done more at the time? Perhaps, but the combination of financial euphoria and political clout would have made success extremely difficult.