United
States
~nera[
Accoun4in~
~f14ce
~
~,5~
I4
'Testimony
Before
the
Committee
on
Banking,
Housing,
and
Urban
Affairs
United
States
Senate
~~
°"
D~'i"pry
Il
~1
~
U]~AN~E
10:00
a.m.,
EST
~~„
`
~~~~
o
~
145965
Tuesday
`
•W
February
1
B,
1992
The
Failures
of
Four
Large
Life
Insurers
Statement
of
Richard
L.
Fogel,
Assistant
Comptroller
General,
General
Government
Programs
GAOIT-GGD-92-13
cao
Foy
i6o
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as
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s~~~
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_
SUMMARY
OF
STATEMENT
BY'
Richard
L.
Fogel
Assistant
Comptroller
General
General
Government
Programs
GAO
is
testifying
on
the
financial
characteristics
and
regulation
of
four
large
insurance
companies
recently
taken
over
by
state
regulators.
GAO's
observations
about
the
regulation
of
the
insurers
are
preliminary
because
its
review
of
the
performance
of
state
regulators
is
not
yet
complete.
Executive
Life
and
its
subsidiary
xecutive
Life
of
Net~t..Ynrk
were
taken
over
in
April
1991
by
state
reguS8t7Srs
in
CaYifornia
and
New
York,
respectively.
First
Capital
and
Fidelity
Bankers
were
taken
over
in
May
1991
by~~California
and
Virgint~t'~""~e~pectively.
These
failures,
due
in
large
part
to
a
reckless
strategy
of
high
growth
and
investment
in
high
-risk
assets,
hive
had
national
consequences.
The
four
insurers
had
a
total'of
more
than
900,000
policies
with
policyholders
and
annuitants
in
every
state.
During
the
1980s,
the
assets
of
the
four
insurers
grew
sit
to
ten
times
faster
than
assets
of
the
life
insurance~~
,
industry
overall.
This
growth
was
fueled
primarily
by
sales
of
high
-yield
retirement
investment
products,
not
traditional
life
insurance
policies.
To
cover
the
high
rates
paid
to
policyholders
and
maintain
profitability,
the
insurers
invested
heavily
in
high
-
risk
assets
--most
notably
junk
bonds.
High
upfront
costs
due
to
rapid
growth
seriously
depleted
the
insurers'
surplus,
or
riet
worth.
To
bolster
their
statutory
surplus
gnd
reported
financial
condition,
the
four
insurers
reduced
policy
reserves
on
their
balance
sheets
through
reinsurance
transactions
ar~d
received
from
their
parent
holding
companies
millions
of
dollars
in
surplus
infusions
and
loans.
Although
reinsurance
fs~8
legitimate
practice
in
the
life
insurance
industry
to
reduce
the
strain
on
surplus
of
selling
new
policies,
the
Executive
Life
insurers
and
First
Capital
relied
on
questionable
reinsurance
transactions
to
artificially
inflate
their
surplus.
Without
reinsurance
and
borrowed
surplus,
the
Executive
Life
insurers
would
have
been
insolvent
as
early
as
1983.
Dwindling
surplus
due
to
rapid
growth
together
with
massive
junk
bond
holdings
of
the
four
insurers
led
to
a
loss
of
policyholder
confidence,
subsequent
policyholder
runs,
and
eventual
state
takeovers
of
the
companies.
California
and
New
York
regulators
of
the
Executive
life
insurers
recognized
before
the
takeovers
that
the
insures
had
serious
solvency
problems,
and
California
and
Virginia
regulators
recognized
that
First
Capital
and
Fidelity
Hankers,
respectively,
were
undercapitalized.
However,
the
regulators'
oversight
of
the
insurers
was
not
effective
in
stemneing
their
financial
deterioration.
although
GAO
hay
not
yet
determined
the
full
extent
o~
inadequacies
in
state
handling
of
these
in~urera,
it
has
observed
significant
weaknesses
in
the
regulatory
oversight
of
the
four
insurers.
State
insurance
regulators
lacked
timely,
complete,
and
accurate
information
needed
to
effectively
monitor
the
four
troubled
insurers.
Regulators
did
not
get
financial
data
early
enough
to
identify
and
react
to
the
insurers'
problems.
Moreover,
the
statutory
financial
statements
did
not
fairly
reflect
the
insurers'
true
conditions.
Even
though
regulators
were
aware
that
the
Executive
Life
insure=s
and
First
Capital
had
serious
solvency
problems,
they
examined
the
insurers
only
once
every
3
years.
Regulators'
efforts
to
limit
junk
bond
holdings
and
restrict
unacceptable
reinsurance
were
not
effective
in
stemming
the
solvency
problems
of
the
four
insurers.
Regulators
did
not
know
about
the
quality
Dr
value
of
the
insurers'
junk
bond
holdings
and
did
not
have
specific
authority
to
limit
such
holdings
when
the
insurers
built
up
their
portfolios.
Even
when
New
York
and
California
acted
to
limit
more
dunk
bond
acquisitions
by
the
insurexs,
these
limits
did
not
reduce
the
insurers'
exposure
to
mounting
junk
bond
losses.
Whereas
New
York
took
forceful
--
albeit
lade
--action
to
eliminate
reinsurance
problems
at
Executive
Life
of
New
York,
California
practiced
regulatory
forbearance
for
•Executive
Life
and
First
Capital.
Finally,
holding
companies
are
a
regulatory
blind
spot.
State
holding
company
laws
rely
an
insurer
disclosure
to
monitor
affiliated
relationships,
and
some
states
require
prior
regulatory
approval
to
prevent
abusive
transactions.
Except
for
infrequent
field
examinations,
regulators
have
no
way
to
verify
insurer
-reported
information.
GAO
does
not
know
to
what
extent
interaffiliate
dealings
may
have
contributed
to
the
failures
of
the
four
insurers
in
part
because
regulatory
examination
reports
from
New
York
and
Virginia
are
nod
yet
available.
However,
on
the
basis
of
preliminary
work
in
California,
GAO
found
that
Executive
Life's
failure
to
comply
with
state
holding
company
laws
undermined
California
regulators'
efforts
at
solvency
monitoring.
Mr.
Chairman
and
Members
of
the
Committee:
We
are
pleased
to
be
here
today
to
diacus~
the
financial
characteristics
of
four
large
insurance~compaaies
that
were
taken
over
by
state
regulators
and
our
preliminary
assessment
of
the
regulatory
actions
rege~ding
those
insurers.
Today,
I
will
provide
you
with
a
picture
of
the
companies'
financial
condition
leading
up
to
their
failures
and
our
observations
thus
far
about
the
performance
of
the
state
regulators
as
they
supervised
the
four
insurers.
Exac.utiv9._Life
and
its
subsidiary
Executive
Life
of
New
York
--
both
owned
b
First
F.
~r»t-i
~~~""
'~"""
y
,,,.,..~,
ue..,
~arparaton-=were
taken
over
i'n
April
1991
by
state
regulators
in
C~li,fornia
and
New
~~ar~C,.
~.:.
respectively.
Fir$,~,Ca~tal
.
and,Fidelity
Bankers
--subsidiaries
of
First
Capital
Holdings,,.Corporation--were
taken
oVer~.~,n
May
1991
?~y
C~Y'ii`~o~Crita
and
Virginia,
respectively.
In
'egch
caae~
state
regulators
took
these
actions
to
stop
policyholder
runs
and
protect
the
insurer's
assets.
These
insurer
failures
have
had
national
consequences.
When
they
were
taken
over,
the
four
insurers
had
a
total
of
nearly
$85
billion
in
business
and
more
than
900,000
policies
with
policyholders
and
annuitants
in
every
state.
As
a
result
of
certain
moratoria
imposed
when
the
states
took
over
the
insurance
companies,
policyholders
concerned
about
the
Security
of
their
savings
have
been
unable
to
cash
in
their
policies.
Moreover,
the
-75,040
annuitants
of
Executive
Life
have
been
paid
only
70
percent
of
their
benefits.
Dw~.ndling
surplus
due
to
rapid
growth
together
with
massive
junk
bond
holdings
of
the
four
insurers
led
to
a
loss
of
policyholder
confidence,
subsequent
policyholder
runs,
and
eventual
regulatory
takeovers
of
the
companies.
Despite
untimely,
incomplete,
and
inaccurate
information,
California
and
New
York
regulators
of
the
Executive
Life
insurers
recognized
before
the
takeovers
that
the
insurers
had
serious
solvency
problems.
California
and
Virginia
regulators
recognized
that
First
Capital
and
Fidelity
Bankers,
respectively,
were
undercapitalized.
Th,e
regulators'
actions
clearly
were
not
effective
in
stemming
the
financial
deterioration
of
the
companies.
However,
we
have
not
yet
determined
the
full
extent
of
inadequacies
in
state
regulatory
handling
of
these
troubled
insurexs.
We
obtained
financial
information
about
the
four
insurers
from
annual
statutory
financial
statements
filed
with
state
regulators,
10-K
statements
filed
b~y
their
garent
holding
companies
with
the
Securities
and
Exchange
Commission,
public
reports
of
regulatory
financial
examinations,
and
analyses
done
by
insurance
rating
services.
To
identify
what
actions
were
taken
by
state
regulators
and
the
National
Association
of
Insurance
CQmmissioner~
~,NAIC
),
,
we
d'i'd"
`f
i"e~'dwork'
a~t
the
Californ~.a
Department
of
Insurance,
and
we
met
with
regulators
in
Virginia.
We
also
reviewed
records
of
recent
congressional
hearings
about
these
failures.
I
went
to
~mphasi~e
that
California,
New
York,
and
Virginia
were
cooperative
in
our
Current
review.
However,
we
do
not
have
statutory
access
to
state
insurance
departments
or
NAIC.
This
lack
of
access
had
on
several
occasions
limited
our
ability
to
assess
the
effectiveness
of
state
insurance
regulation.
BACK~AOUND
During
the
late
1970s
and
1980s,
investment
strategies
in
the
life
insurance
industry
changed,
and
profit
margins
dropped
due
to
increasing
competition
from
mutual
funds,
savings
and
~,oans,
and
other
financial
institutions
that
offered,investment
products
at
comparatively
higher
rates
of
return.
Before
the
late
1970s,
life
insurance
companies
focused
on
bearing
risks
of
death
and
illness
and
sold
products
offering
a
relatively
low
but
stable
return
for
policyholde=s.
In
response
to
increasing
competition
for
policyholders'
savings,
insurers
began
issuing
new
interest-
~ensitive
products
such
as
universal
li€e,
single
-premium
annuities,
and
guaranteed
investment
contracts
(GICs).
The
increasing
emphasis
on
selling
investments
had
significant
financial
effects.
The
higher
rates
of
return
insurers
offered
to
be
competitive
substantially
narrowed
their
profit
margins.
Also,
in
an
attempt
to
pay
these
higher
rates
and
maintain
profits,
some
insurers
--including
the
ones
we
are
discussing
today
--invested
heavily
in
high
-risk,
high
-.return
assets
such
as
noninvestment
grade
bonds
(junk
bonds)
or
speculative
commercial
mortgages
and
real
estate.
Competitive
strategies
like
these
have
strained
many
insurers
and
increased
the
number
of
insurer
insolvencies.
The
number
of
life/health
insolvencies
averaged
about
five
per
year
from
1975
to
1983.
Since
that
time,
the
average
number
more
than
tripled
to
almost
18
per
year,
with
a
high
of
47
in
1989.
Insurance
companies
are
subject
to
solvency
monitoring
in
each
state
in
which
they
are
licensed
to
do
business.
Once
regulators
identify
a
troubled
insurer,
they
must
be
able
and
willing
to
take
timely
and
effective
actions
to
resolve
problems
that
would
otherwise
result
in
insolvency.
When
problems
cannot
be
resolved,
regulators
must
be
willing
and
able
to
close
failed
insurers
in
time
to
protect
policyholders
and
reduce
costs
to
state
guaranty
funds.
The
insurance
department
of
the
state
in
which
the
company
is
domiciled
has
primary
responsibility
for
taking
action
against
a
financially
troubled
insurer.
State
regulators
do
not
regulate
insurers'
parent
holding
companies
or
noninsurance
affiliates
and
subsidiaries
of
insurers.
Instead,
most
states
have
various
statutory
guidelines
for
transactions
between~an
insurer
and
affiliated
companies,
and
some
states
require
prior
regulatory
approval
for
significant
interaffiliate
transactions.
2
r
Executive
Life,
Executive
Life
of
New
York,
First
Capital,
and
Fidelity
Sackers
shared
characteristics
worth
noting:
rapid
growth,
a
concentration
of
risky
assets,
and
dwindling
policyholders'
surplus,
or
net
worth.
These
insurers,
to
bolster
their
statutory
surplus
and
reported
financial
condition,
reduced
their
required
policy
re$erva~
through
reinsurance
transactions
and
received
from
their
parent
holding
companies
surplus
infusions
and
loans.
Such
a
strategy
can
significantly
effect
the
appearance
of
financial
strength
as
reflected
in
an
insurer's
financial
statements.
Without
reinsurance
and
borrowed
surplus,
the
Executive
Life
insurers
would
have
been
insolvent
as
early
as
1983.
Rapid
Growth
The
growth
in
assets
of
the
four
insurers
during
the
1980s
dramatically
outpaced
the
overall
asset
growth
of
the
life
insurance
industry.
While
assets
industrywide
nearly
tripled
in
the
last
decade,
rising
from
$481
billion
to
$1.4
trillion,
assets
of
the
four
failed
insurers
grew
at
six
to
ten
times
the
industry
average,
as
shown
in
Table
1.
Table
1:
Percentage
Growth
in
Reported
Assets
For
the
Life
Insurance
Industry
and
the
Four
Companies
(1980-1990)
Period
Industry
Executive
Executive
First
Fidelity
covered-
average
Life
(CAS
Life
jNY)_
Capital
Bankers
1980-1985
95~
824
1,021
844$
34~
1985-1990
66
82
35
139
1,685
1980-1990
223
1,578
1,273
1,917
2,294
Source:
Best's
Insurance
Reports
(Life/Health
Editions).
At
its
peak
in
1989,
Executive
Life
reported
$13.2
billion
in
assets
--more
than
21
times
its
size
in
1980.
Executive
Life
of
New
York
peaked
in
1988
at
$4
billion
in
assets,
more
than
17
times
its
1980
level.
First
Capital
also
experienced
rapid
growth,
with
assets
increasing
to
$4.7
billion
in
1989,
over
21
times
the
1980
level.
Unlike
the
other
three
insurers,
fidelity
Bankers
did
not
grow
rapidly
during
the
first
half
of
the
1980x.
Its
reported
assets
had
increased
34
percent
by
1985.
However,
in
late
1985
it
was
purchased
by
First
Capital
Holdings
Corporation
and
was
reporting
X4.1
billion
in
assets
by
1990
--about
24
times
its
1980
level.
During
the
1980s,
the
four
insurers
grew
mainly
by
selling
high
-
yield
retirement
investment
products.
All
or
most
of
the
3
insures'
policy
r~~~rvea
were
far
annuities--~imil~r
to
long-
term
certificates
of
deposit
--rather
than
traditional
lifer
insurance.
Ex~cutiv~
Life
also
sold
a
large
number
of
GICs
th~~
had
no
life
insurance
features.
Figure
1
showy
the
annuity
reserves
as
a
percentage
of
tatai
policy
reserve
~riat
the
four
insurers
yet
aside
from
19$0
through
1990.
Fiq~re
21•
Annuity
Reserves
as
a
Percentage
of
Total
Reserves
for
the
Four
Insurers
(1980-1990}
t00
~~"'
90
80
70
BO
50
40
30
20
10
•/pA,M~~l~r~diwYfllY~A~~~~--
0
1980
1981
19$2
1983
1984
1985
1988
198'7
1986
1889
1990
Cd~nd~r
Yvan
~~
Executive
Life
of
California
-~
~.
Executive
Life
of
New
York
~~
Fist
Capital
Life
■~~■
Fidelity
Bankers
Lffe
Source:
Best's
Insurance
Reports
(Life/Health
Editions).
~r~vestments
in
Risky
Assets
To
cover
the
high
rates
paid
to
policyholders
and
maintain
profitability,
the
four
insurers
invested
in
relatively
risky,
high
-yield
assets,
most
notably
junk
bands.
These
insures
became
heavily
concentrated
in
this
risky
market.
Table
2
shows
the
junk
bond
holdings
reported
by
the
four
insurers
in
1990.'
'In
statutory
financial
statements
filed
with
state
regulators,
life
insurers
generally
carry
bands
at
amortized
value
(purchase
price
adjusted
to
decrease
or
increase
the
book
value
to
par
at
4
Table
2:
Junk
Sow
HQ~,~y
the
Four
Insur~re
a~
a
Pexc~n~a~e
of
Assets
in
1940
(Dollnre
in
billions)
Executive
Life
(CA)
X6.,4
63~
Executive
Life
(NY)
2.0
64
First
Capital
1.6
36
Fidelity
Bankers
1.5
40
Source:
Best's
Insurance
Reports
(1991
Life/Health
Edition).
The
four
insurers
did
not
have
had
adequate
statutory
reserves
against
their
bond
portfolios
to
cushion
against
potential
losses.
Under
statutory
accounting
rules,
the
maximum
reserve
required
ageinst
a
life
insurer's
junk
bond
holdings
is
10
to
20
percent.
2
Due
to
mounting
bond
losses,
the
Executive
Life
insurers'
reserves
against
future
loss
represented
about
1
percent
of
their
junk
bond
holdings.
As
a
result,
a
10
-percent
loss
on
their
junk
bond
holdings
-
would
have
wiped
out
the
reserves
and
net
worth
of
the
two
insurers.
Similarly,
a
10
-
percent
loss
on
junk
bonds
would
have
left
First
Capital
and
Fidelity
Bankers
seriously
undercapitalized.
Table
3
shows
the
Ensurers'
security
valuation
reserves
in
1990
as
a
percentage
of
their
junk
bond
holdings
and
the
percentage
loss
in
junk
bond
values
that
would
have
eliminated
the
insurers`
surplus
and
bond
reserves.
maturity
date).
Bonds
in
or
near
default
are
carried
at
the
lesser
of
amortized
or
market
value.
2
The
"mandatory
securities
valuation
reserve"
is
intended
to
buffer
surplus
from
losses
or
fluctuations
in
the
market
value
of
securities
held.
Higher
reserves
are
required
for
junk
bond
than
for
higher
quality
bonds
with
a
maximum
reserve
of
20
percent
for
defaulted
bonds.
The
security
reserve
may
be
accumulated
over
10
to
20
years.
fable
~
•
Band
Reserves
~n
1990
as
a
~ercenta~e
o~
Junk
Bonds
and
the
Percentage
Bond
Loss
to
Eliminate
Surplus
and
Reserve
Reserves
as
a
percent
of
Percent
loss
to
wipe
dunk
bonds
out
surplus
and
reserves
Executive
Life
(CA)
0.8~
8.3$
Executive
Life
(NY)
1.3
10.4
First
Capital
4.5
11.2
Fidelity
Bankers
3.6
11.7
Source:
Insurer
'
1990
annual
financial
statements
and
Best's
Insurance
Reports
(1991
Life/Health
Edition).
Public
awareness
of
the
risks
and
increasing
losses
associated
with
these
extensive
junk
bond
holdings
led
to
policyholder
runs
an
the
insurers.
FSrst
Executive
Corporation
--the
parent
of
the
Executive
Life
insurers
--announced
a
$847
million
charge
for
bond
defaults
and
losses
during
1989.
The
February
1990
failure
of
Drexel
Burnham
Lambert
exacerbated
the
collapse
of
the
junk
bond
market.
These
events
led
to
a
massive
run
on
Executive
Life
and
Executive
Life
of
New
York,
with
policyholders
withd=awing
a
total
of
about
~4
billion
in
1990.
According
to
regulators,
the
April
1991
takeovers
of
Executive
Life
and
Executive
Life
of
New
York
spurred
policyholder
runs
nn
junk
bond
laden
First
Capital
and
Fidelity
Bankers.
Dwindling
Surplus
To
bolster
their
statutory
surplus,
the
insurers
resorted
to
the
use
of
questionable
reinsurance
transactions
to
reduce
required
policy
reserves
on
their
balance
sheets.
They
also
received
surplus
infusions
and
loans
from
their
parent
holding
companies.
Statutory
surplus
is
a
measure
of
an
insurer's
solvency.
Under
statutory
accounting
practices,
an
insurer's
costs
of
selling
policies
--such
as
agent
sales
commissions
--are
charged
to
expenses
when
they
occur.
Because
most
premium
income
is
deferred
and
expenses
are
charged
off
immediately,
an
insurer's
surplus
shrinks
as
the
company
grows.
For
the
tour
insurers,
rapid
growth
had
the
effect
of
depleting
their
surplus
to
levels
that
were
much
lower
than
the
industry
as
a
whole.
Surplus
Relief
Reinsurance
All
four
insurers
relied
heavily
upon
reinsurance
to
relieve
the
strain
of
growth
on
their
surplus.
Under
a
reinsurance
contract,
the
original
insurer
transfers
or
"cedes"
to
another
insurer
(the
"reinsurer")
all
or
part
of
the
financial
risk
accepted
in
selling
policies
to
the
public.
The
reinsurer,
for
a
premium,
agrees
to
indemnify
or
reimburse
the
ceding
company
for
all
or
part~of
the
losses
that
the
latter
may
sustain
from
claims
it
6
r~c~iv~s.
In~ur~r~
routinely
use
reineuranc~
to
transfer
ri~k~
under
large
policies
in
excess
of
a
specified
retention.
Reinsurance
has
both
legitimate
and
illegitimate
use$.
It
is
a
legitimate
practice
in
the
life
insurance
industry
to
diversify
risks
and
reduce
the
surplus
drain
from
selling
new
policies.
A
ceding
company
obtains
surplus
relief
to
the
extent
that
it
can
reduce
its
required
policy
reserves
for
liabilities
transferred
to
reinsurers.
However,
reinsurance
can
also
be
used
to
mask
an
insurer's
true
financial
condition
by
artificially
inflating
its
surplus.
Some
financial
or
so-called
"surplus
relief"
reinsurance
transactions
transfer
little
or
no
risk
of
loss
to
the
reinsures.
These
transactions
distort
an
insurer's
financial
statement
by
decreasing
its
required
policy
reserves
and
thus
increasing
its
surplus,
even
though
the
insurer's
liability
remains
the
same.
Executive
Life,
Executive
Life
of
New
York.,.
and
First
Capital
relied
on
surplus
relief
reinsurance
to
artificially
inflate
their
surplus.
3
These
insurers
were
paying
reinsurance
premiums
for
the
benefit
of
claiming
credit
on
their
statutory
financial
statements,
even
though
the
financial
reinsurers
were
not
liable
to
pay
any
claims.
For
example,
Executive
Life
paid
$3.5
million
to
reinsurers
in
exchange
for
reserve
credits
of
$147
million
in
1990;
however,
the
reinsurers
had
-no
contractual
liability
to
reimburse
any
of
the
~l
billion
in
claims
supposedly
covered
by
the
reinsurance
treaties.
Executive
Life
was
not
reinsuring
against
the
risk
of
loss
due
to
policyholder
claims;
the
company
was
renting
surplus.
Without
surplus
relief
reinsurance
and
the
commensurate
increase
in
spurious
surplus,
the
Executive
Life
insurers
would
have
been
insolvent
as
early
as
1983.
Suralus
Infusions
During
the
1980s,
all
four
insurers
also
received
millions
of
dollars
in
surplus
aid
from
their
parent
holding
companies.
Without
surplus
infusions
from
Executive
Life
to
its
New
York
subsidiary
and
from
First
Executive
to
the
California
company,
both
Executive
Life
insurers
would
have
been
insolvent
in
1986.
Although
these
infusions
allowed
the
insurers
to
meet
minimum
capital
requirements,
surplus
aid
represents
a
temporary
solution
that
does
not
correct
underlying
causes
of
capital
deficiencies.
The
continuing
need
for
surplus
infusions
demonstrated
the
inherent
capital
inadequacies
of
the
four
insurers.
In
addition
to
direct
infusions
of
cash,
the
surplus
aid
also
took
the
form
of
loans
from
the
parent
holding
companies
to
the
3
We
could
not
obtain
data
on
surplus
relief
reinsurance
for
Fidelity
Bankers
because
the
regulatory
examination
report
is
not
yet
available.
7
insurers.
Sorrowed
surplus
is
referred
to
as
a
surplus
note
or
contribution
certificate.
Since
the
loans
were
subordinated
debt
and
could
not
be
repaid
without
regulatory
approval,
the
insurers
were
allowed
to
count
the
borrowed
funds
as
surplus
on
their•
statutory
financial
statements
without
recognizing
the
liability
to
repay
the
funds.
Table
4
shows
the
surplus
reported
by
each
insurer
at
year-end
1990
and
the
amounts
of
surplus
notes.
Table
4:
Reported
Surplus
and
Surplus
Nates
for
1990
(Dollars
in
millions)
Surplus
°
surplus
notes
Executive
Life
(CA)
$474
$300
Executive
Life
(NY)
185
131
First
Capital
107
36
Fidelity
Bankers
122
50
Source:
Insurers'
1990
annual
financial
statements
and
Best`s
Insurance
Reports
(1991
Life/Health
Edition).
°Figures
are
inflated
by
surplus
relief
reinsurance.
See
p.
22
for
Executive
Life
and
First
Capital.
In
summary,
the
insurers'
continued
solvency
depended
on
the
willingness
and
ability
of
their
parent
holding
companies
to.
infuse
surplus.
Both
First
Executive
Corporation
and
First
Capital
Holdings
Corporat~an
borrowed
money
to
capitalize
their
insurance
companies
and
depended
on
payments
from
their
insurance
subsidiaries
to
service
the
debt.
In
fact,
the
insurance
companies
represented
collateral
for
the
holding
companies'
debt.
With
holding
companies
borrowing
based
on
the
performance
of
the
very
insurance
companies
that
they
were
propping
up
with
borrowed
money,
management
was
in
essence
constructing
a
financial
house
of
cards
that
was
bound
to
collapse.
REGULATORS
LACKED
CRUCIAL
INFORMATION
AND
THEIR
ACTIONS
WERE
NOT
EFFECTIVE
IN
STEMMING
THE
INSURERS'
PROBLEMS
State
insurance
regulators
used
untimely,
incomplete
and
inaccurate
financial
reports
to
monitor
the
four
troubled
insurers.
Even
though
regulators
were
aware
that
the
Executive
Life
insurers
and
First
Capital
had
serious
solvency
problems,
they
examined
the
insurers
only
once
every
3
years.
Regulators'
efforts
to
limit
junk
bond
holdings
and
restrict
unacceptable
reinsurance
were
not
effective
in
stemming
the
solvency
problems
of
the
four
insurers.
Even
when
New
York
and
California
acted
to
limit
more
junk
bond
acquisitions
by
the
insurers,
these
limits
did
not
reduce
the
insurers'
existing
exposure
to
mounting
junk
bond
losses.
Whereas
Hew
York
took
forceful
--albeit
late
--action
to
eliminate
8
reinsurance
problems
for
Executive
Life
of
New
York,
California
practiced
regulatory
forbearance
for
Executive
Life
and
First
Capital.
In
part,
California
regulators'
efforts
to
monitor
Executive
Life
were
undermined
by~the
in'surer's
failure
to
comply
with
state
holding
company
laws.
Regulators'
Information
Was
Neither
Timely,
Complete,
Nor
Accurate
State
regulators
did
not
have
timely,
complete
and
accurate
information
to
monitor
the
four
troubled
insurers.
Without
timely
financial
statements
that
fairly
present
an
insurer's
true
condition,
regulators
cannot
act
quickly
to
resolve
problems.
We
have
identified
a
number
of
areas
where
regulators
lacked
crucial
information
about
the
four
troubled
insurers.
First,
financial
statements
filed
in
accordance
with
statutory
accounting
practices
did
not
fairly
reflect
the
four
insurers'
true
financial
condition.
For
example,
as
I
previously
discussed,
reported
surplus
was
artificially
inflated
by
surplus
relief
reinsurance.
However,
the
financial
statements
did
not
provide
information
necessary
for
regulators
to
distinguish
between
valid
reinsurance
and
this
statutory
accounting
gimmick.
In
addition,
statutory
financial
statements
for
1989
filed
by
the
Executive
Life
insurers
did
not
reflect
known
losses
on
their
junk
bond
holdings.
The
two
insurers
wrote
off
only
$335
million
in
losses
and
did
not
even
disclose
$435
million
in
additional
impairments.
Second,
an
insurance
holding
company
is
not
required
to
file
consolidated
financial
statements
based
on
statutory
insurance
accounting.
Such
information
would
be
useful
in
assessing
interaffiliate
transactions
and
the
overall
financial
condition
of
the
holding
company
system.
Insurance
regulators
instead
use
10-K
reports
for
publicly
traded
insurance
holding
companies.
However,
the
10-K
report
is
based
on
generally
accepted
accounting
principles,
which
may
be
more
or
less
restrictive
than
statutory
accounting.
Third,
regulators
relied
on
infrequent
field
examinations
to
verify
financial
data
reported
by
the
insurers
and
detect
solvency
problems.
Such
examinatipns
were
done
about
once
every
3
years
and
took
months
or
even
years
to
complete.
4
Appendix
I
shows
the
time
lags
between
the
examinations
of
the
four
insurers
and
reporting
delays.
California
and
New
York
regulators
waited
until
1990
in
the
triennial
schedule
to
examine
the
Executive
Life
companies
again,
even
though
regulators
had
identified
4
Hereafter,
the
year
of
the
examination
refers
to
the
year
under
review,
not
the
year
in
which
the
examination
took
place.
D
continuing
prabl~ms
in
the
1986
and
1987
examinations.
For
example:
--
New
York
regulators,
in
their
1980
examination
of
Executive
Life
of
New
York,
found
internal
control
problems,
including
a
blurring
of
the
separate
operating
identities
of
Executive
Life
of
New
York
and
its
parent
Executive
Life
as
well
as
improper
allocation
of
income
and
expenses.
The
1983
examination
of
Executive
Life
of
New
York
revealed
more
control
deficiencies,
including
failure
to
maintain
proper
records.
The
1986
examination
found
that
control
deficiencies
identified
in
the
earlier
examinations
still
had
not
been
corrected.
--
California
regulators,
in
their
1983
examination
of
Executive
Life,
found
problems
with
poor
record
keeping
and
unacceptable
reinsurance.
The
1986
examination
of
Executive
Life
revealed
continuing
problems
with
reinsurance.
In
fact,
California
regulators
found
the
problems
to
be
so
serious
that
they
extended
the
examination
to
1987.
Fourth,
regulators
did
not
get
financial
information
early
enough
to
identify
and
react
to
the
rapid
deterioration
that
these
insurers
experienced
in
1990.
For
example,
in
January
1990
when
First
Executive
Corporation
announced
the
massive
bond
losses
and
policyholders
began
a
run
on
the
Executive
Life
insurers,
the
last
complete
financial
statements
available
to
state
regulators
were
already
more
than
a
year
old;
regulators
did
not
receive
the
1989
annual
financial
statements
until
March
1990.
Even
quarterly
statements
were
not
timely
enough
to
keep
the
regulators
up
to
date.
Starting
in
March
1990,
the
troubled
Executive
Life
insurers
provided
monthly
and
even
weekly
reports
so
that
the
regulators
could
track
the
policyholder
runs
and
mounting
bond
losses.
5
First
Capital
and
Fidelity
Bankers
were
required
to
provide
monthly
reports
in
early
1491.
Finally,
the
states
did
not
keep
each
other
informed
about
solvency
problems,
despite
their
interdependence
in
monitoring
the
troubled
insurers.
For
example,
when
California
regulators
were
doing
their
1987
examination
of
Executive
Life,
the
most
current
information
available
from
New
York
about
the
insurer's
major
subsidiary
was
more
than
3
years
old.
New
York
regulators'
report
on
their
1986
examination
of
Executive
Life
of
New
York
was
not
provided
to
other
state
regulators
until
1990.
In
addition,
Minnesota
and
New
Jersey
regulators
said
that
their
states
had
trouble
getting
information
about
Executive
Life
from
California.
In
early
1990,
NAIC
formed
a
multistate
working
S
The
Executive
Life
insurers
provided
weekly
reports
of
daily
surrender
activity,
bimonthly
reports
of
insurance
operations,
and
monthly
reports
of
cash
€low
and
investment
activity.
10
group
to
help
di~~minat~
financial
information
and
gtatu~
reports
to
other
atat~s
where
the
Executive
Life
insurers
were
licensed.
'
Regulators
Lac
~d
~nform~tion
to
Evaluate
and
Authar~ty
to
Limit
Junk
Bond
Holdings
Regulators
also
had
inadequate
information
about
the
quality
of
the
four
insurers`
bond
holdings
and
inadequate
regulatory
authority
to
limit
~u~k
bond
holdings
during
the
period
that
the
four
insurers
built
up
their
portfolios.
Before
1990,
NAIC's
bond
rating
system
did
not
fully
disclose
an
insurer's
holdings
of
noninvestment
grade
bonds.
NAIL
acknowledged
that
its
old
system
counted
some
junk
bonds
as
investment
grade,
but
its
new
classification
system
is
intended
to
better
reflect
the
quality
of
an
insurer's
bond
portfolio.
Under
NAIC's
old
rating
system,
First
Executive
reported
in
1989
that
35
percent
of
its
bonds
were
investment
grade.
However,
according
to
Standard
&
Poor's
rating
system,
less
than
8
percent
of
the.Executive
Life
companies'
bond
portfolios
in
1989
was
investment
grade.
Not
only
did
regulators
not
know
the
extent
of
the
insurers'
junk
bond
holdings,
but
they
did
not
know
what
those
bonds
were
worth.
Regulators
knew
that
the
market
values
for
the
junk
bonds
were
less
than
the
amortized
values
in
the
insurers'
1989
statutory
financial
statements.
According
to
the
chairman
of
NAIC's
working
group,
regulators
needed
to
know
which
bonds
might
default
and
how
much
the
insurers
would
lose.
Because
the
California
department
did
not
have
the
expertise
to
evaluate
Executive
Life's
portfolio,
in
early
1990
it
had
to
get
an
independent
actuarial
firm
to
assess
whether
the
insurer's
assets
could
support
its
liabilities.
The
actuarial
firm,
however,
relied
on
optimistic
assumptions
about
default
rates
and
investment
income
provided
by
Executive
Life;
actual
bond
losses
surpassed
even
the
worst
-case
scenario
in
the
actuarial
studies.
Regulators
did
not
request
an
independent
evaluation
of
the
default
risk
for
Executive
Life's
portfolio
until
February
1991.
Even
if
they
had
accurate
and
up-to-date
information,
regulators
dfd
not
have
specific
statutory
or
regulatory
authority
to
limit
junk
bond
holdings.
In
1987,
New
York
limited
insurers'
holdings
of
junk
bonds
to
20
percent
of
assets.
However,
the
New
York
regulation
did
not
correct
Executive
Life
of
New
York's
problems
because
the
insurance
company
was
grandfathered
and
did
not
have
to
divest
of
junk
bond
holdings
in
excess
of
the
cap.
In
1990,
Executive
Life
of
New
York's
junk
bond
holdings
were
64
percent
of
assets
and
represented
962
percent
of
the
insurer's
reported
surplus
and
bond
reserves.
Even
though
California
did
not
adopt
investment
limits
on
junk
bonds
until
1991,
Executive
Life
agreed
in
1990
not
to
acquire
more
funk
bonds.
Virginia
has
a
bill
pending
to
limit
insurer$`
11
junk
bond
holding
.
In
Junes
1991,
NAIL
adapted
a
model
regulation
limiting
an
in~urer'a
investment
in
medium
and
lower
grade
bonds
to
20
percent
of
itg
assets.
According
to
NAIC,~16
states
had
set
specific
limits
on
holdings
of
high
-yield,
high
-
risk
bonds
as
at
November
1991.
Regulators
Tried
to
Curb
Re~n~u~~nce
P~obl~ms
Until
the
early
1980a,
surplus
relief
reinsurance
was
largely
unregulated.
In
its
1980
examin8tion,
New
York
found
that
Executive
Life
of
New
York's
surplus
would
have
been
nearly
depleted
without
surplus
relief
reinsurance.
By
the
1983
exam,
surplus
relief
reinsurance
exceeded
the
insurer's
surplus.
In
1985,
New
York
issued
a
regulation
prohibiting
credit
for
surplus
relief
reinsurance
that
did
not
transfer
risk
to
the
reinsurer
and
allowed
3
years
to
write
off
such
existing
financial
reinsurance.
In
the
1986
exam,
New
York
found
that
Executive
Life
of
New
York's
problems
with
unacceptable
surplus
relief
reinsurance
persisted
and
that
its
reinsurance
program
was
rife
with
internal
control
deficiencies.
In
198$,
New
York
disallowed
X148
million
in
reinsurance
credits
on
the
insurer's
1986
financial
statement.
Further,
New
York
Fined
the
Executive
Life
of
New
York
;250•,000
and
required
three
officers
to
~esign.
g
According
to
New
York,
the
insurer
no
longer
had
any
surplus
relief
reinsurance.
As
early
as
the
1983
field
examinations,
California
detected
certain
financial
reinsurance
arrangements
that
did
not
transfer
risk
and
which
were
not
in
compliance
with
state
law.
However,
California
allowed
3
years
for
Executive
Life
and
First
Capital
to
write
off
the
unacceptable
surplus
relief
reinsurance.
In
the
1986
examination
of
First
Capital
and
the
1987
examination
of
Executive
Life,
California
found
that
both
insurers
had
entered
into
even
more
surplus
relief
reinsurance
arrangements
to
support
their
explosive
growth.
In
contrast
to
the
forceful
--albeit
late
--actions
taken
by
the
New
York
regulators,
California
again
did
not
immediately
disallow
the
unacceptable
surplus
relief
reinsurance
but
instead
let
the
insurers
amortize
the
amounts.
California's
bulletin
restricting
surplus
relief
reinsurance
was
not
issued
until
1989
and
even
then
granted
another
3
-year
write-
off
period.
As
a
result,
Executive
Life
still
had
X147
million
in
unacceptable
surplus
relief
reinsurance
in
1990
while
First
e
These
three
officers
continued
to
work
for
Executive
Life
in
California
after
their
dismissals
from
New
York.
'Executive
Life
did
have
$180
million
in
surplus
relief
reinsurance
disallowed
in
the
1987
examination
due
to
defective
lettgrs
of
credit
from
an
off
-shore
reinsurer.
12
Capital
had
X65
million.
Many
states
still
have
nat
acted
to
restrict
use
of
this
statutory
accounting
gimmick.
e
~,
,
.,
,
Holding
Companies
Are
a
Regulatory
Blind
Spot
State
insurance
regulators
have
limited
capability
to
evaluate
and
control
an
insurer's
relationships
with
its
holding
company
and
affiliated
entities.
State
holding
company
laws
rely
on
insurer
disclosure
to
monitor
affiliated
relationships,
and
some
states
have
prior
regulatory
approval
requirements
to
prevent
abusive
transactions.
Regulators
cannot
effectively
assess
interaffiliate
transactions
if
the
insurer
fails
to
report
either
the
identity
of
its
affiliates
or
the
transactions.
Except
for
infrequent
field
examinations,
regulators
have
no
way
to
verify
the
insurer's
reported
information.
Interaffiliate
transactions
Can
mask
an
insurer's
true
condition,
and
improper
transactions
with
affiliates
have
caused
previous
life
insurer
failures.
g
We
do
not
know
to
what
extent
interaffiliate
dealings
may
have
contributed
to
the
four
insurance
failures
in
part
because
reports
of
the
latest
regulato=y
examinations
by
New
York
and
Virginia
are
not
yet
available.
However,
on
the
basis
of
our
preliminary
work
in
California,
we
found
that
Executive
Life's
failure
to
comply
with
state
holding
company
laws
undermined
California's
solvency
monitoring
efforts.
Executive
Life
repeatedly
failed
to
report
and
get
approval
for
transactions
with
its
parent
and
affiliates.
As
a
result,
California
regulato=s
could
not
effectively
assess
the
impact
of
those
transactions
on
the
insurer's
solvency
and
protect
policyholder
interests.
For
example,
--
Executive
Life
did
not
get
California's
approval
before
it
made
a
$131
million
surplus
loan
to
its
New
York
subsidiary
in
1987.
The
transaction
removed
cash
from
Executive
Life
when
the
insurer
was
already
seriously
troubled.
That
money
will
not
be
available
to
pay
policyholders
of
the
Cali,~ornia
~In
1986,
NAIC
adopted
a
model
regulation
do
life
reinsurance
agreements
based
on
New
York's
law.
As
of
October
1991,
only
19
states
--including
Virginia
--had
acted
to
adopt
the
model.
Since
this
model
is
required
for
NAIC
accreditation,
NAIL
expects
more
states
may
adopt
surplus
relief
reinsurance
regulations.
9
Abusive
interaffiliate
transactions
caused
the
Baldwin
-United
failure
--the
largest
life
insurer
failure
before
the
Executive
Life
takeovers.
According
to
state
regulators,
the
parent
holding
company
milked
the
insurance
subsidiaries
to
service
its
own
debt.
13
inaur~r
unlee~
New
York
lets
the
s~ubeidiary
relay
Executive
Lite.
--
Executive
Life
shifted
X789
million
of
its
dunk
bond
holdings
to
unreported
affiliates
in
1988.
Th0
tr8n8aCtlon
had
the
~gteCC
of
reducing
the
insurer's
bold
reserves
~Ad
inflating
its
surplus
by
about
X109
million,
thus
absauring
ita
true
financial
condi~ion.
10
--
Executive
Life's
1990
annual
statutory
statement
did
not
identify
36
aff111ates
and
subsidiaries,
even
though
the
insurer
had
invested
in
many
of
those
affiliated
companies.
CONCLUSIONS
The
reckless
growth
pursued
by
these
four
insurers
was
supported
by
questionable
business
strategies.
The
four
insurers
were
heavily
invested
in
poor
quality
assets.
They
relied
on
phony
financial
reinsurance
and
money
borrowed
£rom
their
parents
to
artificially
inflate
their
surplus
and
mask
their
true
financial
conditions.
Without
surplus
relief
reinsurance
and
borrowed
surplus,
the
two
Executive
Life
insurers
would
have
been
insolvent
in
the
early
1980s
while
First
Capital
and
Fidelity
Bankers
would
have
been
undercapitalized.
Despite
untimely,
incomplete,
and
inaccurate
information,
state
regulators
were
aware
of
the
troubled
conditions
of
the
four
insurers
before
the
companies
were
taken
over
but
did
not
take
effective
action
to
stem
the
financial
deterioration
of
the
companies
or
minimize
losses.
Only
after
the
insurers
hemorrhaged
from
policyholder
runs
did
state
regulators
move
to
take
them
over.
As
I
mentioned
at
the
outset
of
my
remarks,
we
are
still
reviewing
the
performance
and
capabilities
of
the
state
regulators,
so
my
observations
today
do
not
represent
our
final
assessment.
This
completes
my
prepared
statement.
I
would
be
pleased
to
answer
any
questions.
1°
In
1990,
California
regulators
made
Executive
Life
reverse
the
bond
transactions
and
restate
its
financial
statements.
14
State
insurance
departm~nta
generally
do
on
-site
field
examinatiana
of
inaurer~
every
3
to
5
years,
though
a
troubled
insurer
could
be
examined
more
frequently.
The
state
of
domicile
leads
the
examination,
and
examiners
from
other
states
in
which
the
insurer
is
licensed
can
participate.
After
the
examiners
finish
their
fieldwork,
they
submit
the
report
to
the
heads
of
the
insurance
departments
participating
in
the
examination
--the
report
date.
The
company
examined
then
has
the
opportunity
to
review
the
report
and
submit
comments.
The
final
report
is
then
distributed
to
all
states
where
the
company
is
licensed
and
filed
as
a
public
document
--the
filing
date.
Executive
Life,
Executive
Life
of
New
Fidelity
Bankers
were
examined
about
were
the
examinations
infrequent,
but
even
years.
Table
I.1
includes,
for
four
insurers,
the
period
covered
by
and
the
filing
date,
where
available.
r
15
York,
First
Capital,
and
every
3
years.
Not
only
reporting
took
months
or
examinations
done
on
these
each
exam,
the
report
date,
APPENDIX
I
~PP~IIDIX
Y
e
I.1:
Period
Report
F11ing
covered
date
date
Executive
Life
of
California
December
31,
1987
to
4/5/91
Not
filed
December
31,
1990
(Draft}
December
3Y,
1983
to
4/1/88
7/14/88
December
31,
1987°
December
31,
1980
to
5/10/85
11/14/85
December
31,
1983
Executive
Life
o~
New
York
Janua=y
1,
1986
to
Ongoing
Not
December
31,
1990
applicably
January
1,
1984
to
5/6/88
5/x/90
December
31,
1986
January
1,
1981
to
x/28/87
3/2/87
December
31,
1983
First
Capital
°
December
31,
19$6
to
1/30/91°
Not
filed
December
31,
1989
December
31,
1983
to
8/28/87
12/Q7/88
December
31,
1986
December
31,
1980
to
4/24/85
7/29/86
December
31,
1983
Fidelity
Bankers
Life
d
December
31,
1988
to
Ongoing
Not
December
31,
1990
applicable
December
31,
1985
to
9
/
2
9
/
8
9
12/19/89
December
31,
1988
16
APPENDIX
I
°
Period
covered
by
exam
origin~lly
ended
12/3
1
/
8
6
but
way
extended
to
12/31!87.
b
The
company
was
named
E. F.
Hutton
Life
until
1987,
when
it
was
purchased
by
First
Capital
Holdings
Corporation.
°The
draft
examination
report
was
submitted
for
the
insurer's
review,
and
the
comment
period
ended
May
5,
1991.
d
The
company
was
purchased
by
First
Capital
Holdings
Corporation
in
1985.
Sources:
Financial
examination
reports.
a
17
~:
rt<:;:'-;l-.--
..........
~......:.;.....-
.........
~
..........
----
.....................
~~~~~~
...........
""'"'"""~---~
..........
~~--~
..........
C;;'f
