I wrote the John Davidson series initially because I wanted to explain conditions in the life insurance industry, given the present credit crisis. As I continued to write, I noticed my bias was coming out, against management teams that stretch/break accounting, in an effort to make money in bonuses through sales.
Alas, in three of the four companies that I worked with closely, this factor was in play. I sometimes think that companies like that employed me more readily, because they wanted talent, and did not care about my rough edges. (I’m ugly and opinionated, what can I say?)
The ending of the series was as I intended from the beginning. I spared readers an extended tour through the obscurities of life insurance accounting, while giving some punch to issues where life insurers test the limits of the accounting.
I have known insurance CEOs like John Davidson, but typically, they haven’t been asset gatherers. That is part of the reason why I made the holding company private, with a wealthy family behind it. John Davidson did not focus on asset gathering or investment income.
Brent Fowler — I have met him twice, and perhaps more. Too often, the bonuses favor simple outcomes like higher sales, without focusing on the quality of sales, which also can be measured, but usually isn’t. Growth of the top line is easy, growth of the bottom line takes work, but growth of net worth in the long long run is desperately tough. More often than you can imagine, the integrity of the accouting gets compromised.
With that, I offer you A Day in the Life of John Davidson, in full.
The alarm rang. John shook himself awake, and rolled out of bed. He dreaded that the day had come, but he was determined to face it like a man.
Things were tough since the credit bubble burst. Almost nothing worked that way it should, and today the CEO would tell him whether his subsidiary would live or die.
Mega Insurance was a privately owned stock insurance holding company, owned by the Bullards, a wealthy New England extended family. John Davidson ran one of the life insurance subsidiaries, Wonderful Life. In the midst of the credit crunch, the holding company was doing triage. Excess capital at the holding company was there, but not plentiful, and the Bullards did not want to pony up more capital. As it was, they wanted to make sure that their capital was used in the best risk-adjusted way.
Wonderful Life was a pretty bread-and-butter company as life companies went. No equity indexed products, no variable annuities — just a variety of individual deferred and immediate annuities, structured settlements, term and permanent life products sold through their own field force. They sat in the shadow of their more successful sister company, Whata Life.
Whata Life had most of the lines of Wonderful LIfe, but they sold through independent agents. They also sold EIAs, Variable Annuities and Life products, and had a group life, specialty heath, and pension business as well. They had grown dramatically over the last decade, eclipsing Wonderful Life.
John wondered why he had pursued such a conservative course as he drove to Mega’s headquarters. He felt he could have entered many of the same lines of business, but the fixed costs would have proven too great of a hurdle, and the agency force was not anxious to do it. Self-recrimination was easy, and John knew it was a weakness of his, so he laid it aside, putting his trust in God.
Arriving at Mega’s headquarters, he met his longtime friend and colleague Peter Farell, the Chief Investment Officer for Mega. Peter greeted him:
P: Well, I’ve prepared the exhibits that you asked me to. On the bright side, we didn’t do as much with hybrid securities in your subsidiary, because you asked us not to. We still have the losses from Lehman, AIG, and many of our positions in financial bonds are trading rather poorly.
J: How are the commercial mortgages?
P: Under stress, but we stopped originating for you in 2005, so you aren’t that bad off.
J: Any bright spots?
P: Well, the long dated GSE debt that we bought when it was under stress was a hit, and the higher quality portfolio that you requested is holding up better than many of the other subsidiaries. Also, the tactical move to buy a small amount of low investment grade and high yield in November paid off.
John thanked Peter, and considered that maybe he wasn’t as bad off as he thought. Sure, his division was a slow grower, but it threw off excess cash flow which Mega usually clipped as dividends. Trouble was, that dividend would be reduced this year. John paused and remembered what the prior CEO of Wonderful Life had told him regarding dividend reductions to Mega Insurance: “They fired that guy so fast that his severance check arrived home before he did.”
Checking his watch, the big meeting was in a half hour. He prayed in his own head and went to the boardroom.
John looked at the deep brown wood. When he first came to the boardroom ten years ago he was impressed at its seeming splendor, and thrilled to be a new CEO of Wonderful Life. Today, the thrill was gone and the wood just seemed dark.
“Hiya, Johnny! Howya doin’?”
With a jolt, John Davidson turned to face Brent Fowler, CEO of Whata Life. He answered, “Just fine, Brent, and you?”
“Oh, Johnny. There are always opportunities to be pursued in our business, and we are doing well in exploiting all of them.”
“Indeed, sir. Congratulations on another good year.” John choked up a bit as he said this, because he did not get how Whata Life could be so profitable and grow so fast at the same time.
“Thaaank you , Johnny. If you are in the right place at the right time, the profits just flow, and that is where we aim to be!”
John didn’t have much to say to that, so he bid Brent adieu for the moment, and bumped into Henry Goldsmith, who was the head of Mega’s Bermuda P&C reinsurance company. He had always found Henry to be a straight shooter, so he smiled as he asked, “Hi Henry, how goes it on the rock?”
Henry smiled and said, “Not so bad. No major disasters, so we make a lot. We just have to leave some of it to the side for future disasters. And you?”
“Could be better, Henry. The credit crunch is eating at our assets, and growth has been marginal, despite our best efforts.”
“How much money have you lost?”
“We’re making money, Henry, but less than last year. We can’t dividend as much back to Mega.”
Henry’s eyes widened, and he said, “Oooh. My sympathies. Look, it’s a tough environment; every life company is having a rough time of it. Just look at AFLAC. If they can’t make it, no one can.”
“Very true. Thanks, Henry.”
“Don’t mention it, John. Hey remember, if things go bad, I’m here for you.”
“Thanks again, Henry.” John knew that Henry kept his word, so he considered it an offer to help him in his next job search. Good guy, bad day. At that moment the head of domestic P&C, Marc Blitztein, walked into the room. “Hey, John, old man, how’re you doing?”
Marc was the youngest of the subsidiary managers, but he had turned around the flagging domestic P&C division by focusing on new quantitative underwriting tools before most of the smaller competition caught on.
“Good to see you, Marc. How’s business?”
“Could be better. Competition is rough, but we keep finding new ways for people to know us.”
“Indeed you do. That Zebra mascot of yours is ubiquitous.”
“Ziggy? What a concept! It’s amazing what one good idea will do.” John wished that he had Ziggy. Maybe that Zebra could sell life policies as well. Alas, he had no fancy logos or cartoon pitchmen.
John said, “Well, more power to you. Worried about this meeting?”
“A little. We aren’t growing the way we used to; we’re only around 10% growth, and loss costs are catching up with us, somewhat. How about you?”
John shook his head. “I don’t know. Things weren’t great prior to the credit crunch, but given the effect on asset values, we are pinched here. We won’t be able to dividend as much next year.”
Marc looked at him sympathetically, and said, “I’ve heard what that can mean. My heart goes with you.”
“Thanks,” said John, distracted as his cell phone bleeped. It was his wife.
“Hi honey, you won’t believe what John, Jr., did today…”
“Uh, dear? Can I call you back this evening? The big meeting is about to happen.”
“I’m sorry, dear. Call me back. I’m praying for you. Love you.”
“I love you too dear. Bye.”
As he turned his cell phone off, he saw that the CEO of Mega Insurance, Brad Baldwin, had entered the room, together with Stan Bullard, scion of the family that owned Mega. Behind them was the CFO, the corporate actuary, and a person he had never seen before. John wondered what might be going on, and thought that this would be one bad day.
“Take your seats, Gentlemen.” Brad Baldwin intoned. John headed for his seat, and realized that one of the heads of the subsidiaries was not yet there. Where was the head of credit-related insurance, Jan Kimmelman?
As John sat down, Brad said, “You may note that Mr. Kimmelman is not here. We fired him this morning, and his subsidiary is going into liquidation, depending on what we believe our best options are in the current economic environment.”
That news sent a chill through the room. No subsidiary of Mega Insurance had ever been eliminated in its 40-plus-year history. What else could happen?
Peter Farell, the Chief Investment Officer walked in, saying to Brad Baldwin, “Your special reports are ready.” Then, looking at Stan Bullard, he said, “And yours are ready too.”
This floored John. He had asked Peter for reports to bolster his case, but what would these other reports show? The CEO never had extra reports on investments, and Bullard was always silent… what would he have to say?
Before his thoughts were complete, Brad said, “We will follow our ordinary procedures. Each one of you will present the report for your subsidiary. We will do a presentation of our own. After that we will ask you questions. Any questions?”
Total silence, partly out of shock.
“Fine then. Mr. Goldsmith, your report.”
Henry rose and referred to papers he had previously distributed. There were shuffling noises for a moment, and he began his report. Pricing trends were neutral-to-good. They had pared back in competitive lines, and were expanding in lines where pricing was showing some strength. Profits were adequate, and reserves were at the high end of reasonable.
John thought that Henry was the best. He understood the economics of his business, and played the pricing waves like a pro at the top of his game.
At the end, Henry said, “Though conditions appear good now, and we will aim to do better next year, our profits could be affected by major disasters in the next year. This is a cyclical business.”
At that, Baldwin said, “Mr Blitztein?”
Marc stepped forward, and began to discourse on competitive dynamics in the P&C business, particularly the short tail areas where they focused, and where the Law of Large Numbers could apply. They were getting good results in auto and home insurance, and some of their specialty coverages were gaining traction. Growth was slow, but they thought that the future could be better.
John thought, “Well good for you. At least you don’t have asset problems to worry about… can your Zebra character come work for me?” John shook his head. Henry and Marc were in no danger, and Jan was gone. Brent was obviously successful, which left him as the scapegoat. His subsidiary could easily be merged into Whata Life, and most of Wonderful LIfe’s employees dismissed. Great. John had been a second father to many of his employees. They weren’t just numbers to him — he wanted his employees to benefit from the success of the company. As it was, he did not see how that would happen, given this meeting. Bowing his head, he prayed quietly to Jesus.
With Marc’s presentation complete, Brad said, “Mr. Davidson, it is your turn.”
John looked at Peter, who acknowleged the glance, and then rose to speak to the meeting. HIs stomach was quivering, but he knew he must give it his best.
Smiling, John showed how Wonderful Life had been executing better than other companies with similar product mixes. Internally, he knew it was a weak argument. In the back of his mind he could hear, “Why didn’t you enter other lines of business?” He pointed out the relatively low cost nature of the dedicated field force, and how surrenders were lower and mortality ratios as well.
As he talked about industry conditions, he looked around the room. Goldsmith, Farell, and Blitztein were giving him full attention, but Baldwin and Bullard looked bored. Brent Fowler sat there, playing with his Blackberry.
He thought to himself, “Okay, time to take the bull by the horns,” and then said, “Peter prepared these final exhibits for me at my request. If you don’t like what I have to say here, blame me, not Peter.” He looked at Peter, who gave a small smile, then Baldwin and Bullard, who looked vaguely puzzled.
“In early 2007, we began making our asset portfolio more conservative. We felt we were not getting compensated for taking risks on lower investment grade bonds, junk bonds, and even commercial mortgages. We further emphasized industrial and utility bonds over financials, difficult as that was to do. We accelerated that process in early 2008. This cost us yield, be we aimed for safety in what we thought was a bad environment. We do not think it is time to begin taking risk in a major way now, but we do believe we are ready to make more money when the bond markets reliquefy. We have begun edging back into junk bonds and low investment grade corporates.”
“The bad news from this is our spreads on investments were pinched to the point where we will not be able to pay as big of a dividend in 2009 that we paid in 2008. Nonetheless, we believe we are better positioned for long term growth.”
As he sat down, he prayed. “That was my best shot,” he thought. Baldwin simply said, “And now you, Fowler, finish up.”
Brent Fowler took a very different tack from John Davidson. He pointed to the considerable growth in premiums — indeed, he was near the top in the industry in percentage terms. He talked about new products that were gaining market share, and the considerable profits they were gaining from new and existing business. Fowler concluded by saying, “There are always opportunities in Life Insurance and Annuity marketing if one simply opens his eyes and grabs hold of them.”
John noticed that much of the growth came from new variable annuity products with secondary guarantees, and EIAs, but aside from that he thought, “I’m sunk. His profits are up and mine are down. He’s the successful risk-taker, and I’m just a stodgy loser.” He waited to hear what would come next from Baldwin and Bullard.
Brad Baldwin began by saying, “Thank you gentlemen. This has been a hard environment for all of us, and your efforts are appreciated. Unfortunately, at this time, we must assess what is working and what is not. We must…”
“Brad. Allow me.” Stan Bullard stood up and said, “Gentlemen, I am younger than all of you, but I am the chosen leader of the Bullard extended family. My Grandfather and Father built this business, and I have no intention of letting it fail. Times are tough, and we may need to take tough actions.”
Looking at the CFO and Corporate Actuary, he continued, “I’ve studied the history of our company, and tried to understand our culture. I may be young, but I recognize the value of wisdom accrued of lifetimes. Our culture has been relative decentralized and free. We have allowed subsidiaries to set their own accounting policies and their own investment strategies. That might be fine during boom times, but it is never acceptable during times of economic crisis. Since we can’t predict when crises will come, that means these policies are not ever acceptable.” Looking at Peter Farell, he said, “From now on, all investment policy will be determined by our Chief Investment Officer, Peter, in consultation with the CEO and the Board of Directors.”
Looking at the CFO, he added, “Also, accounting will be centralized as well. Because of deviations from accepted accounting practices, we must standardize accounting across all of our subsidiary companies.”
John wondered at that statement. “Deviations? Huh?” he thought.
Brad picked up the conversation, and added, “There is more. Let me introduce our guest, Caleb Matmo. As a private stock company, our risk analyses are a little behind the rest of the industry. We have Statutory and Tax valuation bases, but we do not do GAAP as publicly traded companies do. Our one bow to GAAP is the debt covenants with our bankers, which thankfully we have no difficulty complying with.”
“Mr. Matmo and his firm have pored over our financials and our businesses in detail, in order to understand the risks involved, and give us a feel for whether we are taking too much risk relative to the returns that we receive.”
John wished his Chief Actuary, Greg, was with him. Greg was conservative, but not foolishly so. It would be useful to have an independent perspective on this new consultant.
Caleb Matmo stood up and said, “For over one decade, my firm has been evaluating insurance risks and I beieve that we have a good process. We use a rigorous actuarial risk model, and we give little credit to financial risk models as are commonly used by hedge funds.”
“Maybe Greg would like this,” thought John.
“Pass out the reports, Miss Kendall.” A young lady passed out three reports, two from Peter Farell and one from Caleb Matmo, to each person at the meeting.
“Before I go on,” Brad Baldwin said, “I need to tell you about our defunct financial guarantee insurer. We have put it into runoff. Given that we have removed the manager, we will need a manager to manage the runoff, until it is so small, that we sell it off. Marc and Henry, either one of you may manage the runoff, or you could recommend external managers to us.
John looked at the handouts, and thought, “You know, maybe I have a chance here.”
“Cash flow is the blood flowing through the circulatory system for businesses,” said Caleb Matmo. “This is true of any sort of company, but with a financial company, the answer is tricky, because one has to take into account the change in capital required to support the business. Also, with insurers, we try to equalize reserving, so that conservatism or liberalism gets stripped out. This applies to both assets and liabilities.”
John thought about it. “Hmm — I always said to my Chief Actuary, Greg, ‘No negative surprises. We must not over-report earnings.’ Let’s see what happens next.”
Matmo continued, “Working with your actuarial staffs and with Peter, we have constructed a new accounting basis that reflects your ability to dividend to Mega.”
“Uh, oh,” thought John.
“But in the process, we have reflected standardized procedures for reserving, and capital levels as well. Where the regulatory capital basis is too lenient we raised the level of capital necessary to support the business. Companies should not dividend back funds necessary to support the business, even if the regulators might let them do it. Think of the recent demise of your financial guarantee insurer as an example. They sent ample dividends to the holding company, and all the while their business was deteriorating.”
John thought, “True enough. So maybe dividends to Mega aren’t everything?…”
Stan Bullard said, “Mr. Matmo? It’s time for a break. After we come back, summarize your comments regarding each insurance subsidiary, and then Brad and I will take it from there, with your help.”
“Of course, Mr. Bullard.” said Caleb Matmo.
John got up and stretched. He was bewildered at the turn of events, but he picked up the reports and headed to the Mens room. “Time for analysis, but I need relief,” he thought. The room went many different directions, but John ignored it.
John was the first to make it to the Men’s room. Finding the most distant stall, he bolted the door, and said to himself, “This is what you get for having too much tea.” Not long after that thought, he heard the bathroom door open, hearing the voices of Brent Fowler and Henry Goldsmith.
HG: I don’t know how you do it, Brent. Isn’t life insurance supposed to be a slow growing business?
BF: If you motivate your sales force effectively, life insurance can be a growth business. There are always ways to sell policies and add assets effectively if you just spot the opportunities and seize them. v I have a motivated sales cuture that thrives on the challenge of doing more — beating our prior best performance!
HG: I get it, Brent. But what if underwriting suffers? In my end of the insurance business, fast growth and bad underwriting go hand-in-hand.
BF: We watch our underwriting carefully. Our agents are our first line of defense in underwriting.
HG: But how do they balance the objectives of growth and safety? — that seems tough, particularly with long-dated contracts. Mine are short, so I don’t have to worry so much.
BF: That balance is one of my secrets, and why I have done so well….
The voices trailed as they left, to be replaced by the voices of Marc Blitztein and Peter Farrell.
PF: Your simple investment needs are a plus for you in this environment.
MB: Thanks, but what of the rest? How is John doing?
PF: John? God bless him, he’s the responsible one. He pulled in his horns, hurting immediate profitability before the crisis began. Brent, on the other hand, continued to be a yield hog. I can’t tell you how big his current unrealized capital loss is, but he is stubbornly focused on current income, because his bonus is largely based on that. John’s bonus is the same, but he cared more about the long-term safety of the company.
MB: That’s John alright… they don’t make many like him, and I hope he survives this.
PF: Me too… I really like his style.
Their voices drifted off. John wondered if he should leave, when he heard three more voices — Stan Bullard, Caleb Matmo, and Brad Baldwin. John thought, “Grand Central Station…”
BB: I appreciate your work, Mr. Matmo.
SB: And I as well. For a relative neophyte like me, you have made our decisionmaking process clearer.
CM: Thank you both. I have simply tried to think like a businessman, and analyze the need for free cash flow, which is often obscured in insurance organizations.
BB: You have made it clear to me.
SB: And me as well, though it is a pity that we will have to eliminate one of our life companies and merge it into the survivor.
CM: We must focus on the risk-adjusted growth of free cash flow. That is the lifeblood of our business, and with out that companies die.
As they exited the Men’s room, John left the stall, thinking, “I do not know what is going on, but if I am going out, I am going out with the flags flying. I have done my best for this firm; I have nothing to be ashamed of.” He washed his hands, and returned to the conference room.
John was ready to make his defense to those assembled. He had a grim determination akin to a gladiator going into his last fight. He bowed his head and prayed. Looking up, he saw Brent Fowler looking at his packet from Caleb Matmo. It was an odd sight, because he had never seen Brent scowl before. It made him curious about about his own packet, and so he began to look at it more closely.
Before John could dig in too deeply, Stan Bullard said, “Mr. Matmo, please complete your report.”
Caleb spoke up and said, “Insurance accounting is tricky.” Looking at Henry and Marc, he added, “For short-tail P&C reinsurance and insurance, okay, not so tricky, particularly if your asset policies are conservative, as it is for both of you. Your reserves validate themselves every year, and you have reserved prudently.” Henry and Marc visibly relaxed and smiled to each other.
Caleb turned to the other side of the room and looked at Brent and John. “Life insurance is tougher, much tougher,” he said, “The long tail nature of the business, and the lower asset quality, together with hard-to quantify guarantees makes the accounting much more difficult. Also, the risk-based capital rules are a little weak in some areas, making economic decisions difficult for executives that rely only on those metrics. Beyond that, how one values policy options and illiquid assets makes quite a difference. Also, reinsurance treaties can obscure the underlying economics of the business.”
John quickly looked at Brent. He had never seen Brent’s face turn red before. There was a sense of anger spouting from his brow.
Caleb continued, “We have in front of us polar opposites in terms of the two insurance companies held by Mega Insurance. One is extremely conservative, and underappreciated. The other has been liberal in accounting and actuarial practices, and has grown like a weed.”
Brent Fowler stood up and said, “I resent that. My company has topped the industry in volume growth over the past five years.”
Brad Baldwin looked him in the eye and said, “Sit down, Mr Fowler. Mr. Matmo is not done yet. Caleb?”
“If I may, let me characterize the difficulties at Whata Life. 1) Their aggressive asset portfolio has the company as a whole underwater on a mark-to-market basis. 2) Though the RBC guidelines indicate the company is fine, our risk-based capital model, which is tougher, indicates that Whata Life is in need of more surplus. Why? 3) Whata life financed much of their growth through selling off much of their statutory profits through reinsurance treaties. If the volume growth ever stops, so do their profits. 4) They have systemically mishedged their options exposure, leaving a deadweight loss that the accounting presently papers over. 5) All of this allow Whata Life to grow rapidly on a thin capital base when measured properly.”
“Whata Life made money in the past, but correcting their accounting to reflect release from risk (eliminating reinsurance), derivative pricing, and likely future losses, their profitability has been decidedly subpar.”
John tried to not smile, but the sight of Brent Fowler gritting his teeth was astounding to see.
“As for Wonderful Life, we have few difficulties. They chose the conservative ways to reserve, and so their earnings are a worst case estimate of profitability and dividend capacity. Their products and assets are simple, and so our adjustments are positive, but not large. The rest is in your packets in detail. Please review it and give us your comments.”
Brad Baldwin Stood up and said, “Thank you, Mr. Matmo. As you all know, these are tough times. We cannot afford to be imprudent. We passed Mr. Matmo’s analysis by two other actuarial consulting firms, and they agreed with his analysis. Our decision is complete. Mr. Fowler, you are being replaced by Mr. Davidson, and the two firms will be merged.”
Brent Fowler spouted, “You can’t do this! You will hear from my lawyer!”
“Consult your employment contract and be wise, Mr. Fowler, lest this be a termination for cause, as we might have reason to apply.” said Brad.
Brent stormed from the room, and John, widening his eyes, wondered at the matter. Henry said, “Way to go , John.” Marc added, “Man, you survived.”
Stan Bullard took the floor saying, “Yes, John survived, but now he has the tough task of reforming Whata Life. Conserve the good, and eliminate the bad. Don’t rely on the parent company.”
John looked at Stan with concern. Stan answered, “John, we know you. Just don’t ask for a lot as you reconcile matters at Whata Life.” John relaxed and sighed. He quietly thanked Jesus, and said, “I will do my best, as always.” Brad said, “That’s all that we expect. Have at it, John.”
The meeting dispersed. Marc offered the use of Ziggy, which John readily accepted. Henry offered operational help with Whata Life, though John knew that he could do better.
After many congratulations, John left the room, and picked up his cell phone. Punching in the phone number, his wife answered, and he said, “Hi dear, so what did John, Jr. do today?”