MNCAS Fall 2012 Structured Settlements The Liquidation of Executive Life of New York Christopher Olson FCAS, MAAA

MNCAS Fall 2012 Structured Settlements The Liquidation of Executive Life of New York Christopher Olson FCAS, MAAA

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 Current Status 2

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. 3

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. 5. Workers compensation claims were added to the code in 1997. 4

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 Can close a claim at potentially lower cost than otherwise. 5

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!) 6

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 7

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 Associates 8

STRUCTURED 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). Seems to account for a smaller percentage of paid loss in Workers Compensation than in the liability lines. 9

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. 10

Structured Settlement Dollars by LOB for TRV Workers' Compensation 20% Auto Liability 30% Medical Malpractice 5% General/Product Liability 45% 11

Structured Settlement Counts by LOB for TRV Auto Liability 27% Workers' Compensation 40% Medical Malpractice 3% General/Product Liability 30% 12

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%) 13

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. 14

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. 15

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. Also, fewer P&C companies with affiliated life companies. 16

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. 17

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. 18

Liquidation of Executive Life of New York (ELNY) First Executive Corporation Largest insurance failure in history CEO from 1974 to 1991 was Fred Carr Source: The Fall of First Executive by Gary Schulte 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). 19

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 began to fail. 20

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 4. Poorest service to agents and policyholders in the industry 21

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 policies began to experience high surrender rates 22

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) As stated above, ELNY was initially placed into rehabilitation. 23

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 nonsurrenderable 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. 24

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). 25

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) 2010 $906 $2,474 ($1,568) Source: The Trouble with ELNY by Peter Bickford 26

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. 27

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. 28

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. This liquidation order is currently on appeal. 29

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. 30

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. #3, 5, and 6 are provided by a consortium of life insurers. 31

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. 32

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%. 33

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). 4. Not used in calculating Total Percentage of Contract Covered. 34

Liquidation of Executive Life of New York (ELNY) Source of GABC Assets Source ($ in Millions) ELNY Assets 919 GA Contributions 651 Source: The Gibson Report Article 75 50 Orphan Coverage/Wrapper 41 Enhancement Supplemental Top-Up 30 Total 1,691 35

Liquidation 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 pick up the balance. 36

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. 8. So the total amount covered for this contract is $250,000. 37

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. 38

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. 39

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. 40

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. Absent pillars 2 and 3, Gibson concludes that GABC s initial assets are sufficient in 90% of modeled outcomes. 41

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. 9000 total scenarios. 42

The Gibson Report Sufficiency/Deficiency of GABC Assets Present Value Dollars ($ Millions) Baseline + 8 Stress Percentile Baseline Scenarios Worst (26) (130) 99.5 th 5 (60) 99 th 16 (49) 98 th 34 (35) 95 th 47 (16) 90 th 67 6 80 th 89 32 70 th 103 51 60 th 114 68 50 th 126 82 43

The Gibson Report Stochastic Interest Rate Scenarios 10 Year Rates Starting August 2011 Percentile One Month One Year Maximum 2.89 5.56 90 th 2.49 3.77 75 th 2.38 3.32 Median 2.25 2.80 25 th 2.14 2.33 10 th 2.03 1.96 Minimum 1.70 1.13 Actual 1.92 9/30/11 1.57 8/31/12 44

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. 45

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. Appeals will probably be heard sometime during the fall. If the appeals are successfully defended, ELNY liquidation will most likely close in the first half of 2013. 46

Additional Sources of Information www.elny.com Beyond Structured Settlements blog by Patrick Hindert Insurance IOI (Items of Interest) blog by Peter Bickford QUESTIONS? 47