A Failure of Insurance Regulation

Credit: Bloomberg || Graph of Penn Treaty’s stock price 2002-2009


I wrote about this last in October 2009 in a piece lovingly entitled: At Last, Death! (speaking of the holding company, not the insurance subsidiaries).  I’m going to quote the whole piece here, because it says most of the things that I wanted to say when I heard the most recent news about Penn Treaty, where the underlying insurance subsidiaries are finally getting liquidated.  It will be the largest health insurer insolvency ever, and second largest overall behind Executive Life.

Alas, but all good things in the human sphere come to an end.  Penn Treaty is the biggest insurer failure since 2004.  Now, don’t cry too much.  The state guaranty funds will pick up the slack.  The banks are jealous of an industry that has so few insolvencies.  Conservative state regulation works better than federal regulation.

Or does it?  In this case, no.  The state insurance regulator allowed a reinsurance treaty to give reserve credit where no risk was passed.  The GAAP auditor flagged the treaty and did not allow credit on a GAAP basis, because no risk was passed.  No risk passed? No additional surplus; instead it is a loan.  I do not get how the state regulators in Pennsylvania could have done this.  Yes, they want companies to survive, but it is better to take losses early, than let them develop and fester.

A prior employer asked me about this company as a long idea, because it was trading at a significant discount to book.  I told him, “Gun to the head: I would short this.  Long-term care is not an underwritable contingency.  Those insured have more knowledge over their situation than the insurance company does.”  He did nothing.  He could not see shorting a company that was less than 50% of book value.

It was not as if I did not have some trust in the management team.  I knew the CEO and the Chief Actuary from my days at Provident Mutual.  Working against that was when I called each of them, they did not return my calls.  That made me more skeptical.  It is one thing not to return the call of a buyside analyst, but another thing not to return the call of one who was once a friend.

Aside from Penn Treaty, the only other company that I can think of as being at risk in the long term care arena is Genworth.  Be wary there.  What is worse is that they also underwrite mortgage insurance.  I can’t think of a worse combo: long term care and mortgage insurance.

The troubles at Penn Treaty are indicative of the future for those who fund long term care.  Be wary, because the troubles of the graying of the Baby Boomers will overwhelm those that try to provide long term care.  That includes government institutions.

Note that Genworth is down 60% since I wrote that, against a market that has less than tripled.  If their acquirer doesn’t follow through, it too may go the way of Penn Treaty.  (Give GE credit for kicking that “bad boy” out.  They bring good things to “life.” 😉 )

Okay, enough snark.  My main point this evening is that Pennsylvania should have had Penn Treaty stop writing new business by 2004 or so.  As I wrote to a reporter at Crain’s back in 2008:

On your recent article on Penn Treaty, one little known aspect of their treaty with Imagine Re is that it doesn’t pass risk.  Their GAAP auditors objected, but the State of Pennsylvania went along, which is the opposite of how it ordinarily works.
Now Imagine Re takes advantage of the situation and doesn’t pay, knowing that Penn Treaty is in a weak position and can’t fight back, partially because of the accounting shenanigans.
It is my opinion that Penn Treaty has been effectively insolvent for the past four years.  I don’t have any economic interest here, but I had to investigate it as an equity analyst one year ago.  Things are playing out as I predicted then.  What I don’t get is why Pennsylvania hasn’t taken them into conservation.

Another matter was that Imagine Re was an Irish reinsurer, and they have weak reserving rules.  That also should have been a “red flag” to Pennsylvania.  The deal with Imagine Re was struck in late 2005, leading to upgrades from AM Best that were reversed by mid-2006.

It was as if the state of Pennsylvania did not want to take the company over for some political reason.  Lesser companies have been taken over over far less.  Pennsylvania itself had worked out Fidelity Mutual a number of years earlier, so it’s not as if they had never done it before.

Had they acted sooner, the losses would never have been as large.  I remember looking through the claim tables in the statutory books for Penn Treaty because the GAAP statements weren’t filed, and concluding that the firm was insolvent back in 2005 or so.  Insurance regulators are supposed to be more conservative than equity analysts, because they don’t want companies to go broke, harming customers, and bringing stress to the industry through the guaranty funds.

The legal troubles post-2009 probably had a small effect on the eventual outcome — raising premiums might have lowered the eventual shortfall of $2.6 billion a little.  But raising premiums would make some healthy folks surrender, and those on benefit are not affected.  It would likely not have much impact.  Maybe some expenses could have been saved if the companies had been liquidated in 2009, 2012, or 2015 — still, that would not have been much either.

Some policyholders get soaked as well, as most state guaranty funds limit covered payments to $300,000.  About 10% of all current Penn Treaty policyholders will lose some benefits as a result.

Regulatory Policy Recommendations

Often regulators only care that premiums not be too high for the insurance, but this is a case where the company clearly undercharged, particularly on the pre-2003 policies.  For contingencies that are long-lived, where payments could be made for a long time, regulators need to spend time looking at premium adequacy.  This is especially important where the company is a monoline and in a line of business that is difficult to underwrite, like long-term care.

The regulators also need to review early claim experience in those situations (unusual business in a monoline), and even look at claim files to get some idea as to whether a company is likely to go insolvent if practices continue.  A review like that might have shut off Penn Treaty’s ability to write business early, maybe prior to 2002.  Qualitative indicators of underpricing show up in the types of claims that arrive early, and the regulators might have been able to reduce the size of this failure.

But wave goodbye to Penn Treaty, not that it will be missed except by policyholders that don’t get full payment.