The Liquidation of Executive Life
of New York
Christopher Olson FCAS, MAAA
Structured Settlements
MNCAS Fall 2012
STRUCTURED SETTLEMENTS AND THE LIQUIDATION OF EXECUTIVE LIFE OF NEW YORK
• Structured Settlements definition and general overview • Factoring Transactions
• Current State
• Liquidation of Executive Life of New York (ELNY) • First Executive Corporation (FEC) Origins
• Downfall of FEC
• Spin-off of ELNY into rehabilitation • Failure of rehabilitation
• Liquidation Process • Gibson Report
STRUCTURED SETTLEMENTS
• Structured Settlement Fundamentals: Basic ingredients of structures:
1. Agreement to resolve a physical injury tort claim or workers’ compensation claim through scheduled future periodic payments, often including payments for the injured claimant’s life time.
2. A funding asset, typically an annuity contract. Funding assets are utilized because:
a. Settling defendants do not want to administer the life contingent future payments.
b. Settling claimants generally do not want to rely on the
continuing ability of defendants and/or their insurers to make payments that may stretch out over decades.
STRUCTURED SETTLEMENTS
• Structured Settlement Fundamentals: Origins and purposes of structures:
1. First developed in 1960’s and ’70’s.
2. Did not realize widespread use until tax treatment was clarified 3. Federal tax code change in 1982 made all payments made from a
structured settlement free of federal tax.
4. At that time, only bodily injury claims from liability coverage (e.g. auto bodily injury claims, medical malpractice claims,
products/general liability bodily injury claims) qualified for this treatment.
STRUCTURED SETTLEMENTS
• Why incentivize claimants to take structured settlements?
Basically, people in general are not good at managing large sums of money.
Desire to ensure seriously injured people have long-term stable income. Structured settlements are seen as a way to keep seriously injured
people off government support.
• What is the incentive for P&C insurers to agree to a structured settlement? Financial advantage
STRUCTURED SETTLEMENTS
• “Qualified Assignment” versus “Buy and Hold”
In a “Qualified Assignment” transaction, the P&C insurer is released from all future liability.
1. The P&C insurer sends money to a third party (generally the holding company of the life insurer issuing the annuity or a special purpose entity that specializes in this). The payee is not allowed to own the annuity and still retain the tax benefits.
2. The third party purchases the annuity and retains contingent liability for the annuity payments should the life insurer default.
3. The vast majority of structured settlement transactions fall into this category.
In a “Buy and Hold” transaction, the P&C insurer retains the contingent liability. They buy the annuity from the life insurer.
1. Sometimes required by state regulation.
2. P&C insurer contingent liability is disclosed in Note 27 of Statutory Annual Statement.
3. A 2007 NAIC Advisory group said that the total contingent liability for structured settlements for P&C industry was about $9 billion (TRV has $3 billion!)
STRUCTURED SETTLEMENTS
• Other structured settlement fun facts:
Structured settlements can be a stream of periodic payments, lump sum payments, or a combination of periodic and lump sum payments.
The periodic payments can (but are not required to) have escalation features e.g. an increase in payments every year to reflect inflation. As far as I can tell, these escalation rates have to be fixed i.e. not vary with macroeconomic conditions.
MetLife and Prudential are the biggest issuers of structured settlement annuities accounting for over 40% of the market.
Structured settlements have their own advocacy organization, the National Structured Settlement Trade Association (NSSTA). www.nssta.com
STRUCTURED SETTLEMENTS
SSA Premium by Year
($ in Millions)
2002
$6,142
2003
$5,965
2004
$6,135
2005
$6,125
2006
$6,112
2007
$5,998
2008
$6,227
2009
$5,384
2010
$5,524
2011
$4,975
Source: Report by Melissa Evola, President, Structured Financial AssociatesSTRUCTURED SETTLEMENTS
• How big is this market?
$6 billion per year for much of last decade.
Premium declines after 2008.
Rose from $350 million in 1980 to $3.75 billion in 1989
(source: Structured Settlement Wiki on “Beyond Structured Settlements” blog).
$6 billion corresponds to about 8% of paid losses in the
lines of business typically eligible for structured
settlements i.e. Commercial Auto Liability, CMP Liability,
Other/Products Liability, Medical Malpractice, and
Workers’ Compensation (doesn’t seem to be used much for
Private Passenger Auto Liability).
STRUCTURED SETTLEMENTS
• How big is this market (continued)?
Texas Department of Insurance publishes an annual closed
claim study for commercial liability (no Workers’
Compensation).
This study excludes small claims (defined as less than
$10,000 until 2009 when it changed to less than $25,000).
They typically see about 13% - 15% of their annual paid
losses involve structured settlements.
Given that they exclude small losses (which probably have
no structured settlements) and workers’ compensation, not
necessarily inconsistent with industry-wide figure.
Structured Settlement Dollars by LOB for TRV Workers' Compensation 20% Medical Malpractice 5% General/Product Liability 45% Auto Liability 30%
Structured Settlement Counts by LOB for TRV Workers' Compensation 40% Medical Malpractice 3% General/Product Liability 30% Auto Liability 27%
STRUCTURED SETTLEMENTS
• Factoring Transactions
Think J.G. Wentworth (among others)
444-CASH-NOW
Payees sell all or part of their structured settlement
payment stream to a third party for a lump sum cash
amount.
Basically undoes what the statutes were trying to
incentivize i.e. ensuring that people with serious injuries
had a long-term source of income.
Started in the early 1990’s and featured aggressive sales
tactics and sometimes exorbitant discounts (equivalent in
some cases to annual interest rates of as much as 70%)
STRUCTURED SETTLEMENTS
•
Factoring Transactions (continued)
Because of this, calls for remedial legislation were made. Most states now require factoring transactions to have court
approval.
1. How hard it is to get this approval varies a lot by state.
The court must opine on whether the transfer is “in the best interest of the payee, taking into account the welfare and support of the payee’s dependents.”
Structured settlements for Workers’ Compensation claims are not eligible for factoring because it is statutorily mandated that those benefits cannot be assigned to an unaffiliated party.
1. In practice, this probably still happens but if it gets challenged the transfer will be voided.
STRUCTURED SETTLEMENTS
• Factoring Transactions (continued)
If a factoring transaction is not approved by a court, the
factoring company is subject to a 40% excise tax.
This market is estimated to be around $900 million per
year.
Approximately 14 companies are active in this market
Over 50% of these transactions only involve a percentage
of the structured settlement. However, some payees then
do multiple factoring transactions over time.
STRUCTURED SETTLEMENTS
• Current macro factors affecting the structured settlement
market:
The volume of structures settlements has materially
declined since 2008.
In the early 2000’s, structured settlements were often
encouraged by claim departments of P&C companies.
This is no longer the case as investment yields have
declined to the point where the economics don’t work as
well.
Claimants more often than not drive these transactions in
the current environment.
STRUCTURED SETTLEMENTS
• Current macro factors affecting the structured settlement
market (continued):
Volume of settlements is also affected by the change in the
eligible population of claim payments.
Over the last decade, total P&C direct paid losses have
increased at roughly 2.5% - 3.0% per year.
Commercial liability direct loss payments are basically flat
over that period.
Workers’ compensation direct loss payments have
increased roughly 2.0% - 2.5% per year.
Liquidation of Executive Life of New York (ELNY)
• ELNY was a major issuer of structured settlement annuities
(SSAs) in the 1980’s.
• ELNY was a subsidiary of Executive Life Insurance Company
(ELIC) which was itself a subsidiary of First Executive
Corporation (FEC).
• FEC collapsed in 1991 and ELIC was seized by the California
Insurance Department.
• ELNY at this time was placed into rehabilitation under the
Superintendent of Insurance for New York.
Liquidation of Executive Life of New York (ELNY)
•
First Executive Corporation
Largest insurance failure in history CEO from 1974 to 1991 was Fred Carr
a. Fred Carr managed a mutual fund in the 1960’s which at first spectacularly outperformed their peers but then tanked.
Carr was an early advocate for and investor in high yield securities i.e. junk bonds.
Formed a strategic alliance with Michael Milken to buy significant amounts of the junk bonds Milken packaged.
This allowed FEC to create very competitive interest rate sensitive life insurance products e.g. single premium deferred annuities
(SPDA) and guaranteed investment contracts (GICs).
Source: “The Fall of First Executive” by Gary Schulte
Liquidation of Executive Life of New York (ELNY)
•
First Executive Corporation (continued)
Purported quid pro quo between FEC and Milken i.e. in exchange for FEC buying junk bonds, Milken would provide a market for FEC equity issuance. This resulted in a vast source of potential capital. Carr was hailed as a model CEO:
1. “Executive Life’s capital structure and, hence, operating leverage are
substantially more conservative than virtually all its “AAA” rated counterparts.” – Standard & Poor’s November 3, 1986
2. “I’d rather have Fred Carr running my company than the people who
run General Motors.” – Peter Lynch, Magellan Fund, in Barron’s
February 2, 1987
In 1986, the Ivan Boesky scandal erupted and junk bond prices began to fall.
Many of the junk bonds were used to fund leveraged buyouts. These companies were underfunded and in the late 1980’s their bonds
Liquidation of Executive Life of New York (ELNY)
•
First Executive Corporation (continued)
Executive Life began to experience large numbers of SPDA surrenders.
In the first half of 1990 alone, there were $2 billion of surrenders. A “run on the bank” atmosphere took hold.
California Insurance Department seized ELIC on April 11, 1991.
In the end, Executive Life was known for four things, three of which are bad:
1. Innovative products 2. Junk bonds
3. Aggressive mortality assumptions
Liquidation of Executive Life of New York (ELNY)
• In conjunction with California seizing ELIC, ELNY was
placed into rehabilitation under the supervision of the New
York Superintendent of Insurance.
• ELNY was considered to be solvent, if stressed, at this time.
• Roughly 50% of ELNY’s statutory reserves at that time were
associated with structured settlement annuities (SSAs)
• SSA’s are not “surrenderable” i.e. cannot be cashed in.
• Upon being placed into rehabilitation, ELNY’s non-SSA
Liquidation of Executive Life of New York (ELNY)
•
United States federal bankruptcy law expressly excludes
insurance companies from the definition of “debtor.”
As a result, when an insurer fails, it does not enter
bankruptcy.
Insurance commissioner or superintendent places
company into receivership.
Three states of receivership:
1. Conservatorship
2. Rehabilitation
3. Liquidation (most serious)
Liquidation of Executive Life of New York (ELNY)
• ELNY Rehabilitation
Concern grew that policy surrenders were eroding ELNY’s
assets “to the detriment of policyholders with
non-surrenderable policies, primarily structured settlement
annuities.”
In March 1992, a Plan of Rehabilitation was submitted that
provided that most of ELNY’s cash and investment grade
assets were to be transferred to MetLife in connection with
MetLife assuming ELNY’s retirement annuities and
traditional life insurance obligations.
ELNY’s SSA and certain other annuities were left with its
rehabilitation estate along with an investment portfolio
initially comprised of junk bonds and common stocks.
Liquidation of Executive Life of New York (ELNY)
• ELNY had ceased writing new policies and now was in runoff.
• ELNY was left with about $1.6 billion in both assets and
liabilities (both on a present value basis).
• An actuarial solvency analysis was done at the time of
rehabilitation and concluded that the assets and investment
returns would be enough to fund the liabilities and
administrative expenses in over 90% of all future outcomes.
• Because it was now in rehabilitation, ELNY was no longer
subject to “regulation” and did not have to file public reports
of its finances. It was placed under the authority of the New
York Liquidation Board (NYLB).
Liquidation of Executive Life of New York (ELNY)
Year Assets ($ Millions) Liabilities ($ Millions) Surplus/(Deficit)
1995 $1,657 $1,624 $33 1996 $1,678 $1,633 $45 1997 $1,794 $1,697 $97 1998 $1,857 $1,710 $147 1999 $1,926 $1,724 $202 2000 $1,770 $1,613 $157 2001 $1,646 $1,605 $41 2002 $1,465 $1,575 ($110) 2003 $1,528 $1,643 ($115) 2004 $1,495 $1,642 ($147) 2005 $1,429 $1,621 ($192) 2006 $1,379 *$2,645 *($1,266) 2007 $1,345 $2,539 ($1,194) 2008 $1,042 $2,438 ($1,396) 2009 $984 $2,516 ($1,532) Source: “The Trouble with ELNY” by Peter Bickford
Liquidation of Executive Life of New York (ELNY)
• What happened in 2006???
– First external audit.
– Two major risks for a runoff SSA portfolio are reinvestment risk and mortality risk.
– Most likely explanation is that the liabilities were re-valued using new interest rate and mortality assumptions.
– ELNY had used aggressive mortality assumptions, particularly in their use of ‘rated ages.’
– The interest rate environment in 2006 was much different from that in 1992. Re-investment risk was taking a toll as the higher-yielding
securities matured. Thus the discount rate used for liabilities was reduced.
This is hitting all life insurers who have annuity portfolios. It helps explain why MetLife is trading at 60% of book value.
Liquidation of Executive Life of New York (ELNY)
• The initial assumption regarding investment returns in the
solvency analysis done in 1992 was 10% (
source: Peter Bickford blog “Insurance IOI”, quoting Mark Peters who was the head of the NYLB in 2007).
• An assumed investment return of 10% probably implies that
ELNY liabilities were discounted at around 9%.
• Bickford claims that simply changing the discount rate cannot
account for the increase in the deficiency.
• However, given that the average payout lag for ELNY
liabilities is about 25 years (with a modified duration of about
14.5), a drop of 400 basis points or so could explain most of
the change.
Liquidation of Executive Life of New York (ELNY)
• It was becoming clear the ELNY would have to be liquidated.
First multistate life insurer to fail since 1994.
ELNY’s negative surplus is large compared to previous liquidated life insurers.
• On August 31, 2011, the New York Superintendent moved for
entry of an order finding ELNY insolvent and placing it in
liquidation.
• The case was put before the Nassau County Supreme Court in
March 2012.
• The court rendered its verdict on April 16, 2012 finding that
“ELNY is insolvent.”
Liquidation of Executive Life of New York (ELNY)
• So how does this liquidation process work?
ELNY assets at the time of closing (now projected to be about 32% of the value of the outstanding liabilities) will be transferred into a
successor entity called Guaranty Association Benefits Corporation (GABC).
Funds from Guaranty Associations will also be transferred to GABC. Additional funds from a consortium of life insurers, designed to
mitigate adverse impacts from ELNY’s liquidation, will also be transferred to GABC.
A “Total Percentage of Contract Protected” for each annuity contract will be calculated for each of the roughly 10,000 contracts ELNY still has liability for.
For each future payment due, GABC will pay an amount equal to the future payment multiplied by the above percentage.
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract
Protected” calculated?
GABC Funding Sources:
1. ELNY Assets
2. Guaranty Association Funds 3. Orphan Coverage
4. Article 75 Coverage from New York State 5. Wrapper Enhancement
6. Supplemental Top-up Funds
#2 is funded via assessments on member life insurers by
the respective state guaranty associations.
#4 is an old New York guaranty association statute that
provides for up $50 million of net coverage.
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Guaranty Association Coverage
1. Each of the 10,000 contracts is assigned to a specific state
guaranty association (roughly 35 – 40 state guaranty associations are involved with this liquidation).
2. Each state has its own coverage limit e.g. New York covers $500,000 per contract while Michigan covers $100,000 per contract.
3. If a contract cannot be assigned to a specific state guaranty
association, it is designated as an “orphan” and receives Orphan Coverage. This equates to Guaranty Association coverage of $100,000.
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Article 75 Coverage
1. New York has a second (older) guaranty association
statute that provides up to $50 million in net coverage.
2. This coverage is spread pro-rata to the amounts left
uncovered by guaranty associations or orphan
coverage for contracts issued before August 2, 1985.
Wrapper Enhancement
1. For all contracts with uncovered amounts, the benefit
payments are “enhanced” by a factor of 103%.
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Supplemental Top-up Benefits
1. Extra enhancement designed to give each annuity
contract at least $250,000 in covered benefits
($250,000 is the guaranty association limit in the
NAIC model law).
Hardship Fund
1. $100 million committed by life insurers to help payees whose payments will be reduced as a result of the liquidation of ELNY. 2. These payments will not be made through GABC and are not part
of the restructuring agreement.
3. These payments will be administered by JAMS (Judicial Arbitration and Mediation Services).
Liquidation of Executive Life of New York (ELNY)
Source of GABC Assets
Source
($ in Millions)
ELNY Assets
919
GA Contributions
651
Article 75
50
Orphan Coverage/Wrapper
Enhancement
41
Supplemental Top-Up
30
Source: The Gibson ReportLiquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Example: Contract with present value of $275,000 with GA
coverage from Michigan with an assumed Liquidation Ratio (ELNY Assets/ELNY Liabilities) of 32%:
1. GA limit is $100,000. Of this amount, the Michigan GA will pay (1-.32) x $100,000 = $68,000. ELNY assets will cover the
balance ($32,000).
2. Orphan coverage is not applicable.
3. The amount uncovered at this point is $175,000. Article 75 coverage will total $50 million net (which equates to $50/.68 = $73.5 million gross) for contracts issued before 8/2/1985. This amount is spread pro rata across all eligible contracts with
uncovered amounts at this juncture. Let’s assume that the $73.5 million/(all uncovered amounts) = 7%. Thus Article 75 will
cover $175,000 x .07 = $12,250 for this contract. Of this 12,250, Article 75 will kick in .68 x $12,250 = $8,330. ELNY assets
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Example (continued):
4. The amount covered at this point equals $112,250 leaving $162,750 uncovered. ELNY assets will cover 32% of this amount i.e. $52,080.
5. The $52,080 is then “enhanced” by a factor of 1.03 (Wrapper Enhancement) which provides an additional $1562 of coverage. 6. Total coverage now equals $112,250 + $52,080 + $1562 =
$165,892
7. The difference between $250,000 and $165,892 ($84,108) is
picked up by Supplemental Top-up Benefits. If coverage prior to Supplemental Top-up benefits is $250,000 or greater, no
additional protection is provided.
Liquidation of Executive Life of New York (ELNY)
•
How is the “Total Percentage of Contract Protected”
calculated? (continued)
Example (continued):
9. So the “Total Percentage of Contract Protected” for this contract equals $250,000/$275,000 = 90.9%
10. Thus, if nothing changes between now and the bankruptcy
closing, GABC will pay 90.9% all of all future payments under this annuity.
11. What happens to the other 9.1%?
a. If the annuity is owned by a P&C insurer (i.e. the structured settlement was “buy & hold”) the P&C insurer now has to pick up the 9.1% of each payment.
b. If the structured settlement was “qualified assignment” it most likely is owned by FEC which is a bankrupt shell and thus has no money. Payee can apply to the hardship fund administered by JAMS.
Liquidation of Executive Life of New York (ELNY)
• Roughly 85% of ELNY contracts will be covered 100% by
GABC.
• The larger the contract, the greater the uncovered amount:
The “Total Percentage of Contract Protected” varies between roughly 35% to 100%.
Per “The Gibson Report” (an actuarial solvency analysis done for GABC) roughly $1.7 billion of ELNY’s $2.6 billion of liabilities will be covered.
ELNY’s SSAs were roughly split 50-50 between buy & hold and
qualified assignments. It is unknown how that breaks down relative to uncovered dollar amounts.
Liquidation of Executive Life of New York (ELNY)
• The effect of guaranty association coverage limits for SSAs is
upside down in relation to need.
Level of coverage is capped to limit financial strain on
solvent companies.
Theory is that the “little guy” should be fully covered while
large claimants only get partial coverage as they are better
able to absorb the loss.
The exact opposite is the case for SSAs. Those with the
largest payments are those with the most serious injuries
and largest medical care expenses.
The Gibson Report
•
Actuarial solvency analysis has been performed on GABC
by Jack Gibson of Tillinghast (report is available at
www.elny.com
)
•
Report concludes that there is zero chance of GABC being
unable to satisfy its obligations.
•
Conclusion is supported by “three pillars”:
1. Initial assets provided to GABC.
2. Guarantees behind the contributions from guaranty associations and consortium of life insurers.
3. Restructuring agreement provides that in the event GABC cannot pay its obligations, it can summarily reduce its obligations.
The Gibson Report
• As stated before, the two major risks GABC faces are
reinvestment risk and mortality risk
• The “Baseline Scenario” consists of 1000 interest rate
scenarios with current mortality assumptions.
Interest rate projections based on Brennan-Schwartz two-factor method.
Incorporates mean reversion to long-term treasury yields e.g. 3 month maturity = 4.0%, 10-year maturity = 5.0%.
• Gibson also modeled 8 “stress tests”:
Four stress tests changed investment assumptions e.g. reduced credit spreads, lower mean reversion targets.
Three stress tests changed mortality assumptions e.g. substandard lives (i.e. rates age contracts) modeled as standard lives.
One stress test combined mortality and investment stressors.
The Gibson Report
Sufficiency/Deficiency of GABC Assets
Present Value Dollars ($ Millions)
Percentile Baseline Baseline + 8 Stress Scenarios Worst (26) (130) 99.5th 5 (60) 99th 16 (49) 98th 34 (35) 95th 47 (16) 90th 67 6 80th 89 32 70th 103 51
The Gibson Report
Stochastic Interest Rate Scenarios 10 Year Rates
Starting August 2011
Percentile One Month One Year
Maximum 2.89 5.56 90th 2.49 3.77 75th 2.38 3.32 Median 2.25 2.80 25th 2.14 2.33 10th 2.03 1.96 Minimum 1.70 1.13 Actual 1.92 – 9/30/11 1.57 – 8/31/12
The Gibson Report
•
Range of modeled outcomes seems kind of narrow.
Range from median to worst modeled outcome (even with stress scenarios) is only about 13% of beginning assets.
Hard to square with ELNY’s performance in rehabilitation where its deficit grew to approximately 100% of beginning assets over 15
years.
Do models that use mean reversion work well in current environment?
GABC does have advantage of starting with low investment return assumptions:
1. Inflation helps GABC because benefit payouts are fixed save for mortality.
Current Status
• Liquidation Order is on appeal.
• Two primary appeals:
SSA payees were denied due process because they were not given sufficient time to prepare for the liquidation hearing.
The New York Superintendent of Insurance should not have been granted immunity by the court.
