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Who are really the smartest guys in the room? How Insurance Companies Forgot Their Way

December 17th, 2008 · 18 Comments

Today’s guest post is courtesy of the author of the Thicken My Wallet blog. You can subscribe to the feed here.

I want to thank Canadian Capitalist with giving me the opportunity to guest post on his well-deserved vacation. If you are a regular reader of this blog, you know that Canadian Capitalist is rightfully a passionate supporter of the KISS (keep it simple stupid) principal of personal finance (my words, not his) and that fees destroy returns over the long term.

As this age of financial excess is unwinding itself ever so painfully, it is interesting to note how the smartest guys in the room are probably not the financial wizards the media makes them out to be.

For example, CC wrote a recent series on Manulife’s IncomePlus products — a stunningly successful product for the company. But, as CC noted, the product had many flaws including an outrageous MER of approximately 3.5%. A moderately educated investor could replicate the product’s return using a portfolio of bonds.

So Manulife has designed a fail-proof product for itself and we should invest in the issuer and not the product right? Well… the Globe and Mail ran an interesting article on Manulife’s recent troubles resulting in part from products like IncomePlus.

In the simplest sense, insurance is like banking without money. Like banks, insurers are regulated and the regulators demand that a certain portion of money be set aside to cover its liabilities. Conventionally, an insurer’s largest liability is that all of the insurance policies it underwrote are called at once (analogous to all the bank’s customer’s withdrawing their money at once). The chances of everyone passing away at the same time are quite remote so an insurer’s risk is, statistically speaking, quite low.

But, insurance companies started dabbling into more exotic financial instruments. One such product is something known as viable annuities. Like a regular annuity, an investor pays the insurance company a sum of money in return for guaranteed payments in the future.

However, an investor in a variable annuity is also asking the insurance company to invest the money in the stock market for them and to participate in any profit the insurance company makes (IncomePlus is a variable annuity). The key attraction is that no matter how badly the insurance company invests your money, the investor will be guaranteed a stream of money in the future- so, theoretically, no down-side, all upside.

If you are a regular reader of this blog, you understand that active management of funds statistically underperforms the board based equity index. Thus, even in regular markets, one is already giving money to the “smartest guy in the room” (sorry, they are mostly guys who got us into this mess) to under perform.

In markets such as this? Remember that the insurance company has to guarantee the annuity payment but it has taken the investors’ money and lost a lot of it in the stock market. The only way to make up that loss is to take profits and top up the reserve fund mandated by the regulators to ensure that the annuities are paid on time.

The topping up of reserve funds can only be accomplished mainly through a couple of different methods: (i) issuance of new shares, creating a dilution issue; (ii) raising debt, leveraging the company more; and/or (iii) move profits into the reserve fund, reducing earnings per share. Manulife has done all three and its shareholders have suffered as a result; it posted its first loss ever since the company went public.

Why didn’t Manulife hedge its position? According to the Globe article, it stopped doing it in 2004 (remember they thought they were the smartest guys in the room).

Is Manulife in trouble? It will most likely feel a lot of short-term pain but its trouble pale in comparison to many of its industry counterparts and the money in the reserve funds can be moved back into earnings over time (to be clear, this is an industry issue not particular to Manulife).

Is a Manulife annuity in trouble? Most likely not since it reserve funds have been sufficiently topped up (in other words, it has the money).

The moral of the story?

The smartest guys in the room are not very smart when it is not their money.

The author is a shareholder of Manulife and, obviously, not a very happy one.

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18 responses so far ↓

  • 1 DM // Dec 17, 2008 at 9:27 am

    Thanks very much for your article. I wasn’t aware of this new type of insurance product. I’m wondering, and this is obviously a very broad question, to what extent do you think the regulators should be blamed for the worrying increase in the number and use of these exotic financial instruments? As we’ve learned, one of the main reasons for the US subprime crisis was that nobody fully understood the intricacies (i.e. where the risk lay) of exotic securitization products. (And I read in the G&M on Saturday that subprimes actually did creep North!) Anyway, my view is that it is not enough for companies to obey the law (Manulife is not breaking any laws with these new products). They must hold themselves to a much higher standard, because a) securities/financial laws move at a glacial place compared to advances in financial engineering; and b) securities regulators (especially in Canada!) are toothless anyway. Thanks again for the article!

  • 2 Finance Matters // Dec 17, 2008 at 9:52 am

    I know how you feel as I also own some Manu stock.

  • 3 Nurseb911 // Dec 17, 2008 at 11:05 am

    Everyone is going to make a mistake from time to time and the stock price will reflect that.

    My concern if I were able to talk to the people “in the room” would be:
    - What did you learn from your mistake?
    - How are you going to prevent it from happening again?

  • 4 2op mike // Dec 17, 2008 at 12:15 pm

    As another Manulife stock victim/holder, I rest comfortably knowing that Manulife fits into the too big to let fail camp, at least in Canada. The interesting thing is the Income Plus made great sense if an investor foresaw the significant market correction. At this time however, if you believe the market is going to bounce back (at some point) you may be better off to pay the penalties and ditch the product and high fees, and gain the full bounce back in equities. The major benefit of the “guarantee” has been gained already, why pay for the rest of the ride!
    As to new depositors, who needs a market guarantee after the crash….but I bet advisors keep pushing it.

  • 5 Sampson // Dec 17, 2008 at 1:07 pm

    To add to your comment 20p mike, I’ll even wager that this product has been MORE successful after this crash. I know Manulife has been aggressively pitching the product on the TV anyway.

    I had been juggling MFC, SLF, and GWO for the longest time and actually chose GWO because it seems like a purer insurance play. This market has showed me that complicated conglomerates as balanced as they may seem have really been falling apart.

  • 6 Paolo // Dec 17, 2008 at 3:48 pm

    First, it is called a “variable annuity” not viable. : )

    Second, in Canada VAs are called segregated (seg) funds.

    Third, you can purchase a VA/seg fund without the guarantees. The guarantees are an optional cost.

    Fourth, the losses MFC has suffered recently are paper losses only. Those losses should reverse themselves going forward (on the assumption that markets do not fall further).

    Fifth, I do not have access to that Globe article you mentions, however I am unaware of any hedging program that was discontinued in 2004. Their hedging program was recently started. Although MFC can be blamed for only hedging certain blocks of business as opposed to the entire block of seg fund guarantees.

    Sixth, the type of guarantees offered by MFC today are not as rich as they once were. Their initial launch of GIF in the mid to late 1990s had a 100% maturity guarantee after 10 years, with optional resets. You could take this guarantee and buy yourself a lifetime annuity paying out 8-12% annually depending on your age (no period certain). With Income Plus, you are looking at a 5% lifetime benefit. I rather take the former.

    Seventh, your description of a variable annuity is not quite correct. An investor does not ask the insurance company to invest the money for them. They are given a selection of segregated funds (ie, mutual funds) to invest in. The guarantees are only available on certain funds and would not be available on high risk funds such as high tech or emerging markets. There is also usually a fixed income component to the funds with guarantees. So MFC has not lost the investor’s money in the stock market. The investor has lost his money in the stock market. MFC has sold the investor a guarantee (basically a put option), which the company backs with its general account assets, usually fixed income.

    MFC is a risk management company. These guarantees are just one of the risks in its portfolio. Is it a greater risk than its mortality and morbidity risks? Probably. But what if something tragic happened to its life insurance portfolio? Would we then complain that MFC should not be in the life insurance business? SARS was only a few years ago, and luckily for the world it was contained. But if it had not been contained, and there was an epidemic, MFC (and other insurers) would have paid the price in terms of higher than expected death claims. Similarly, what if a tsunami happened on one of the American coasts wiping out millions of lives? Again, MFC would be hit with mortality losses.

    If anything, I think the recent market performance will cause insurers to increase the price and/or scale back the benefits of these products.

  • 7 2op mike // Dec 17, 2008 at 6:07 pm

    Paolo, your rosy view of Manulife is not shared by all. The folling is a quote from Fitch when they downgraded Manulife on Dec 8th:

    “”The Negative Outlook reflects Fitch’s concerns regarding MFC’s increased volatility in earnings and capital due primarily to increased actuarial reserves and capital requirements related to variable annuities with embedded guarantee features in its U.S. insurance operations, but also in its rapidly growing Canadian and Japanese divisions. “”

    I won’t claim to be an expert or an analyst but a tsunami is a generally unpredictable occurrance. Market declines….not so much! I don’t know how you hedge SARS or any other catastrophic plague, but I do know you can easily hedge market risk. I do own Manulife, and will continue to, however it does not change my view on this product in this kind of market. Thanks for your insights. My money hopes you are right.

  • 8 TStrump // Dec 17, 2008 at 7:45 pm

    It seems to me that some professionals may not be the ’smartest in the room’ due to commissions.
    While I have no problem with someone making money off me, you have to wonder if there’s a conflict of interest when someone is paid huge fees.
    Will that sway their decision?

  • 9 Phil S // Dec 18, 2008 at 12:25 am

    Outside of being a component of some mutual funds, I am not a shareholder in Manulife. Canadian insurance companies take two distinct structures, one is a corporation like Manulife. The other is a Mutual insurance company where the policy holders are the owners of the company. I was only using Mutual insurance companies until one converted to a corporation (Provident). When Provident converted to becoming Nationwide, I received a nice cheque in the mail for several hundred dollars which represented my share of the business as a policyholder! Yay! More recently I also received another hundred dollars from the result of a class action lawsuit related to that conversion. Anyways, I digress.

    Outside of that life insurance plan, my auto & home insurance is with State Farm Mutual. Aside from the potential of receiving cash for what can be perceived as doing nothing (like in my previous example), I like that the interest of management and the interest of policyholders are aligned in a Mutual insurance company. If you don’t like the way the company is heading, you go somewhere else, essentially “voting with your feet” as it were.

  • 10 EconStudent // Dec 18, 2008 at 12:18 pm

    Phil S- That was a very informative post. I never knew that there are such distinctions between insurance corporations and mutual insurance company. I have auto & home insurance with State Farm (Mutual) too.

  • 11 Kurt // Dec 18, 2008 at 3:55 pm

    Hey,

    You know that TV show ‘Til Debt Do Us part? Well the host Gail Vaz-Oxlade has put out a 2009 Life Planner with a tonne of financial tips and money saving strategies.

    Thought the canadian capitalist community might like to know!

    Check it out!

    http://www.shopfranticfilms.com

  • 12 Four Pillars Investing // Dec 22, 2008 at 6:04 am

    [...] Canadian Capitalist reports on the smartest guys in the room. [...]

  • 13 Redfly // Dec 26, 2008 at 10:51 am

    Paolo, I belive all VA/seg funds must have some guarantee of capital or they would not qualify as “life insurance” products and would be mere mutual funds that life co’s could not sell. Even on risky/volatile funs. You will pay more for an optional 100% guarnatee, however.

    I agree that we may see higher fees and less product benefits in the future. Manu made record sales with its GMWB product – unfortunately, it could not do so at a worse time for itself, as the markets crashed soon after.

  • 14 Weekly Dividend Investing Roundup - December 27, 2008 | The Dividend Guy Blog // Dec 27, 2008 at 7:01 am

    [...] insurance companies lost their [...]

  • 15 Jerry // Jan 2, 2009 at 2:49 am

    The most intriguing and important part of your incisive commentary about the insurance companies is the last sentence, about how they are not as smart when it is not their own money. That is SO true, and it leads me to wonder about a lot of larger players in the financial industry. They get so big that they lose sight of the things that made them successful… and they can become very stupid in a hurry! Great thread, by the way.
    Jerry

  • 16 2op mike // Jan 2, 2009 at 3:04 pm

    It is always disappointing to see marketing injected into a blog discussion. It can make one question whether any true opinions exist out there.

  • 17 Paolo // Jan 5, 2009 at 6:58 pm

    @20p mike – I guess I am an optimist. I expect the markets to recover over the next few years so those losses at MFC should unwind.

    I agree that a tsunami is not a predictable event. But neither was a 40%-50% market decline. However, both are 1 in 100 year (or 200 or 300) events. Insurance companies cannot predict these events, but they can (and have) happened. Maybe a more “predictable” event would be an earthquake in California wiping out half the state. Should an insurance company issue insurance in California?

    Hedging would have mitigated MFC’s risks. However, hedging costs money, and I guess MFC felt that it was better spent elsewhere.

    (P.S. – good blog)

    @Phil S –Not all policy holders are owners of mutual companies. You have to have a “participating” (or “par”) policy. You can buy a non-par policy from a mutual company and not have any voting rights. (Similarly, you can buy a “par” policy from a stock company and participate in the performance of the par fund.)

    @Redfly – you are correct, there is some guarantee of capital. The minimum I believe is 75%. However, the guarantee can only be for death benefits only. So you can offer a seg fund with a 75% death benefit guarantee only, no maturity or withdrawal guarantees. The death benefits are a small cost compared to the maturity or withdrawal guarantees.

  • 18 Thicken My Wallet » Blog Archive » Is the Manulife dividend cut cause for larger concern? // Aug 10, 2009 at 4:57 am

    [...] sales and bet on the market- unhedged- and lost (Canadian Capitalist allowed me to guest post on Manulife’s variable annuity problem last December if you want some more detail).  How badly did it lose? $22.42 billion. In relative [...]

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