How Safe Are Insurers? : Pacific Mutual Chief Discusses Industry’s Woes
The savings and loan industry has been ravaged and the banking industry is on the ropes. Can the insurance industry be far behind?
Consider three recent news items:
* First Executive Corp., a Los Angeles holding company for life insurance carriers, has been in serious financial trouble because of its heavy investments in risky, high-yield corporate securities known as junk bonds. It defaulted on bank loans and canceled dividends on $1.1 billion of preferred stock.
* Travelers Corp. has pulled out of the California and Pennsylvania automobile insurance market and stopped offering auto and homeowners insurance in nine other states, saying they couldn’t make a profit in those areas. The company, based in Hartford, Conn., lost $500 million in the third quarter last year.
* Equitable Life Assurance Society, the nation’s third-largest life insurer, is radically altering its ownership structure to raise more capital. The New York-based company is facing major losses, partly because of the declining value of its investments in real estate, mortgage loans and junk bonds. The company has denied rumors that it is headed for bankruptcy.
But the industry, particularly the life insurance side, is not going the way of banks and S&Ls;, said Thomas C. Sutton, chairman and chief executive of Pacific Mutual Life Insurance Corp. in Newport Beach.
Sutton, as head of the state’s largest and the nation’s 24th-largest life insurer, has worked on an industry task force to develop guidelines and to propose legislation that would help the industry avoid the fate of banks and S&Ls.;
He talked recently with Times staff writer James S. Granelli about industry woes and the latest threat to industry stability--the war with Iraq.
Q. What impact will the Persian Gulf War have on the life insurance industry?
A. The major impact would come from the war’s impact, in turn, on the economy. Short-term, interest rates would go up, and that would have a negative effect here on the economy. It would depreciate our assets, our bond holdings. To that extent, we’d have an immediate negative impact. The issue would be how long interest rates would stay high. That’s connected to what form the resolution of this war is going to take. Is it going to be long and protracted? Is it really going to be brief and everything’s going to be beautiful afterwards? I can’t predict that. Fundamentally, we’re in a time of great uncertainty.
Q. Would financial institutions in general be hurt more than other companies?
A. If the war results in inflation, it would be more damaging to financial institutions than to other companies because it would depreciate assets. Also, if it’s long and drawn out, there would be added pressure on the national budget. The government is going to have to pay down the national debt and fund the war. How is the money going to be raised? To the extent that we would have to support the cost of the war on top of an already large national deficit, it would prolong the recession we’re already in.
Q. Will life insurance companies be paying out an inordinately high amount of death benefits for U.S. casualties?
A. From the point of view of life insurance coverage, I don’t see a major impact. There wouldn’t be many lives lost in relation to the normal death benefits that we pay.
Q. Since Iraq invaded Kuwait in August, has Pacific Mutual been doing anything to prepare itself for the possible effects of war?
A. Yes, in the sense of reducing risk exposure on volatile elements. We’ve reduced our common stock exposure considerably. That was the main action we took. Aside from that, it was basically focusing on our capital and surplus, making sure that it’s adequate.
Q. Has anyone from the company gone overseas?
A. There’s only one person we know about. He was a reservist who was called up and is over there. At least monthly, our (company) newsletter has reports on what he’s doing. And he gets a lot of care packages.
Q. While the insurance industry could be hurt financially by the war, it already is in some trouble. What is ailing the industry?
A. Generally, the insurance industry suffers from weak earnings, as opposed to suffering from potential insolvency. I can’t imagine economic circumstances bad enough to make even companies like Equitable and Travelers, which have been in the news for specific sets of problems that they have, insolvent. I think they’ll have weak earnings for a period of time, they’ll undergo some restructuring, but they’ll be continuing players.
Q. Do you see parallels, as some federal officials do, between the industry’s woes and the early problems of the savings and loan industry?
A. Not really. I think the savings and loan industry issues came about as the result of deregulation, with S&Ls; moving into new markets in a massive way. I think that one of the signals for problems or potential problems in a financial institution is rapid growth, and that was especially true for the extremely rapid growth in the S&L; industry from the early 1980s until at least the mid-’80s and somewhat beyond. The S&L; industry also had a completely changed regulatory structure that I would almost regard as institutionalized fraud in the regulatory accounting principles that were used. There’s nothing like that in the life insurance business.
Q. But insurers started seeing increased competition in the early 1980s, prompting them to offer higher-yield products, such as annuities. In turn, insurers had to put premiums in even higher-yield investments, typically risky commercial mortgages and junk bonds. Isn’t that scenario similar to the early troubles in the S&L; industry?
A. I think everything is a matter of degree. The industry total of junk bonds is under 5% of assets. That is a fairly low percentage. And also, speaking for us in particular, the diversity of the investments is pretty wide too. If you take a point of view that junk bonds are merely a more highly secured form of equity or stock, you might ask a question about common stocks. To what extent do companies invest in common stock? Is that a good idea or a bad idea? I think that up to a point it’s a good idea. A key element for us is diversification of risk, whether it is asset risk or business risk. We don’t want to bet the company on any particular course of action.
Q. The insurance industry has 20% of its assets in commercial mortgages and nearly 5% in junk bonds. Isn’t that a lot to have in such severely depressed markets?
A. In the last 10 years, the insurance industry has had a decreasing percentage of its assets invested in commercial mortgage loans. The other difference with the S&Ls; that is really important is that insurers are long-term lenders. They’re the lenders after the initial development of a property--after the building has been completed and substantially leased. That’s done on a wide geographical basis for most insurers. Whereas, S&Ls; were focused geographically and were usually at the front end in lending or investing, either starting with raw land or in the developmental process.
Q. S&Ls; were long-term lenders as well.
A. That was how they were supposed to be operating. I don’t know that that’s how some of them were operating.
Q. Are you saying, in effect, that your industry has better quality loans and junk bonds than the S&L; industry had and that, therefore, it won’t experience the same problems?
A. In terms of real estate, yes, it is better quality. On average, the seasoning of the loan portfolio--the length of time that the mortgages have been in place--is far longer than with the S&Ls.; Even under current conditions, which are fairly adverse, the primary problems are in office space. It was way overbuilt. It was overbuilt as a result of improper tax incentives during most of the ‘80s. That’s where the focus of the problem is. As for junk bonds, I think the insurance industry’s rate of defaults is lower than that of the S&L; industry. There is a saying that S&Ls; have “junk” and insurance companies have “junque,” which is a way of saying that our industry’s portfolio has better quality securities than the S&L; industry. Also, S&Ls; were forced to sell their bonds (under a 1989 federal law) and they’ve been putting the bonds into a market swamped by sellers but with few buyers, increasing their losses. The insurance industry is under no requirement to sell its portfolio.
Q. The insurance industry has played a big part in overbuilding the market for office buildings, hotels and shopping centers, investing $265 billion in commercial mortgages by mid-1990. Is that cause for worry?
A. Not in and of itself. What would be a cause for worry first is diversification. How much of it does a given company have in relation to its other investments? And, secondly, what is the underlying quality and condition of those loans? If you only loan 75% of the value, you’ve got some safety margin in there.
Q. But the industry’s troubled loans increased from 1% of total loans to 3%. Bankers look at that figure and start worrying about knocking it down. How do insurers feel about that bad loan figure?
A. I’d agree that it’s abnormally high because the current economic situation is adverse. Certainly, on average, you want to keep the figure under 1%, but over an extended period of time like five years. Our average has been well below that. I see what’s going on now as really a shakeout of some of the things that went on in the ‘80s in terms of motivation for overbuilding and extension of credit beyond the level that seems prudent.
Q. Insurers are not required to set aside reserves for mortgage problems. Could that have an impact on future earnings?
A. I would make a distinction between required reserves and prudent management. On a statutory basis, there is a thing called the mandatory securities valuation reserve, which is designed as sort of earmarked capital for potential securities problems. There’s a formula for generating that reserve. And there’s a lot of discussion currently about having a similar component for mortgages, which personally I think is a good idea. But right now, (by law) it isn’t required. What we do, and what I know a number of other companies do when they’re looking at their capital base, is that they determine a benchmark capital amount that’s risk-related. So you take each category of asset that has different levels of risk and there is a factor that you apply to it. So you come up with what represents the right amount of capital necessary to provide adequate coverage for the risk that you’re undertaking.
Q. Arizona and New York have enacted laws curbing investments in junk bonds. Does California have any plans to do so?
A. Well, it was attempted. It was defeated, perhaps because of the effect of lobbying. I don’t know. Personally, I think that there ought to be restrictions on percentages of one’s assets in various high-risk categories. They should be reasonable, but they should legislatively prevent a company from betting the store on a particular asset category.
Q. Customers are told to look at ratings of insurance companies to find good insurers. But with three major companies putting out ratings, and charging insurance firms for the service, is there a danger that insurers may get a better rating than they deserve?
A. I think the ratings are very useful in making decisions about companies. For many years in the insurance business, A. M. Best & Co. was the only rating company. I think the lack of competition is not good in any sphere of activity. Standard & Poor’s and Moody’s started coming into the field about five to six years ago, and I think that everybody has benefited from that process. You don’t just send them your financial statements and then they send you a rating. Aside from the financial material, they interview management. They ask you why you’re doing things, what your plans are, how you view the external environment, how you view competition and whether you did what you said a year ago you were going to do. I think they’re doing a whole lot better job of really analyzing companies effectively than previously.
Q. Nearly each state has a guaranty association. What kind of protection do those associations provide consumers?
A. In general, they support the relatively unsophisticated buyer. In case an insurer goes insolvent, they provide that a policyholder would have protection up to about $100,000 of cash value (principal and accrued interest) and $300,000 of death benefits. The funds to do that come by assessing the solvent insurance companies in that state. Rarely have people lost any death benefits available or cash values because of insurance company insolvency.
Q. California’s newly adopted guaranty association law is different. What does it do--or what doesn’t it do--for policyholders?
A. The thing that’s different about California is that it protects 80% of cash value or death benefit, up to certain levels. One reason for the lower protection is that, in terms of a public policy, it seems ultimately better for everyone if a buyer has a continuing motivation to pay attention to a financial institution with which the buyer is doing business. I think there ought to be substantial protection for people, but I don’t think it should be 100%. I think people should still bear some degree of responsibility for their own financial decisions.
Q. Last year, a Congressional subcommittee issued a report saying that state regulators generally had inadequate resources, lacked coordination, infrequently examined insurers, can’t fully investigate why companies fail and inadequately punished those responsible for causing the failures. Do you agree?
A. I think there’s enough truth in that. It may overstate the case a little bit. Many state insurance departments are underfunded and haven’t been able to hire the level of competent staff that they really should have.
Q. How did the industry respond to the report?
A. The industry response was to put together a task force. I was a member of that. We issued a report recently on the solvency of life insurance companies and described our perspective of the situation. We made 16 specific recommendations, many of which related to legislation that the states should pass. But I have to tell you that legislation has been a consistent problem. Even though the National Assn. of Insurance Commissioners may adopt model legislation to cover a particular point, such as fraud or accounting certification, it takes many years to pass those measures through the states. And some states never do pass them. I think that’s a real defect, and I think that our industry needs to be much more proactive in trying to get that legislation passed.
Q. Insurance industry insolvencies, though not approaching those in the S&L; industry, have prompted renewed calls for federal regulation. Why have insurers traditionally opposed federal regulation?
A. One reason is related to the fact that there is a large number of life insurance companies, most of which are local or regional. Take a California company: Would you rather go to Sacramento to talk about your problems or would you rather fly to Washington? So I think some of it is logistical. My personal reaction is that the industry ought to be open to considering the alternatives related to some kind of federal involvement in the regulation of insurance.
Q. Is there also some sentiment that insurers like their understaffed, under-resourced state regulators a little more than a possibly stronger, more powerful federal regulator?
A. Let me give you two different perspectives. One of them is mine, the other one is kind of speculative. Mine, on behalf of Pacific Mutual, is that if you’re a company that is operating in a large number of states, particularly ones like California that do have large insurance departments that are reasonably well funded, you are going to operate more or less uniformly in all the states. So the fact that a small state somewhere doesn’t have much of an insurance department isn’t particularly relevant to us. I think that if you were a local company, a one-state company in a state that had very lax regulation, there is the potential for abuse.
