New Retiree Benefits Scam: "Insurance Arbitrage"

Squirrelly insurance deals are too good to be true.
December 10, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

Readers from 2008 will recall my reports in a previous column of Wisconsin school districts that were sold a bunch of junk securities to magically bail them out of their retiree medical (OPEB) deficits. Those deals went sour when the collateralized debt obligations lost value. As usual, the peddler's promise of "something for nothing" vaporized -- along with the schools' investments.

Now there is a new scam making the rounds in some parts of the country, as conniving salespeople try to convince public officials that they have discovered a new form of financial alchemy that can turn lead into gold. This time, it's an "insurance arbitrage" scheme.

The pitch goes like this: The municipality or public agency responsible for funding its retiree medical plan (known as OPEB for "other post-employment benefits) is induced to borrow money from a bank at a temporarily low interest rate usually tied to LIBOR. The municipality then buys a big fat juicy insurance policy that pays a fixed rate of interest, so that if interest rates remain at record-low levels for a decade, the municipality makes a hypothetical profit to pay off its OPEB liabilities. In some cases, the insurance peddler offers an "employer-owned life insurance policy" that pays the employer when its employees die and thus puts them in the position of profiting from early deaths of employees.

The latter scheme has been around for years, and is known as "janitors insurance" -- where employers make bets on how long their employees will live -- instead of promoting positive health habits, as most public officials would agree is the proper public policy. It's an offensive practice on its face and would embarrass any politician if the media were to uncover the policy features, which are typically approved by internal personnel as administrative actions, and not in a public meeting.

But the financial alchemy claims are what I want to focus on here. The idea that you can profit by borrowing from a bank at a low short-term rate and investing with an insurance company at a higher long-term rate is nothing new. Public agencies have borrowed short and invested long before, and they've inevitably blown themselves up. This happened in prominent California municipalities twice in the 1980s and 1990s. Experienced public financial professionals have already witnessed the dismal results of running a mis-matched book. The professional literature is chock full of advice to run fast when you are presented with these schemes.

Here are five questions to ask anyone who tries to pitch the OPEB insurance arbitrage scheme. Demand that the responses be in writing and signed by a registered principal of the company, not just the sales representative.

1. Please disclose in full detail all the investment risks of this strategy.

2. Please provide explicit examples of the investment results if the referenced interest rates return to 2007 levels in three years, four years and five years. Provide examples if interest rates return to 1980 levels over the same periods.

3. Please disclose the full amount of commission, bonuses, incentives and other compensation that the sales representative will be paid for this proposed transaction and the timing of such payments.

4. Will you and your firm assume fiduciary responsibility as an adviser in this transaction, since you are recommending the borrowing of money from a specific financial institution and the use of leverage?

5. Will you guarantee the investment profits you have presented?

There's another similar scheme floating around in OPEB-land that I might as well mention while we're on the topic: The OPEB-bond arbitrage trust.

Here, the promoter suggests that public agencies sell taxable term OPEB bonds (bullet maturities far in the future) and put part of the proceeds into a special escrow or trust account to pay back the bonds. The theory is that the future value of the investment fund will exceed the ultimate bond redemption costs, and the issuer can then use the rest of the money to pay off the retiree medical expenses as they come due. Again, it's presented as "free money" created from a hypothetical arbitrage.

As one might expect, the promoter expects to be paid a ridiculously high fee for setting up the flim-flam structure in these deals, even though any bond attorney in the industry could accomplish the same outcome with a proper sinking fund at a fraction of the cost. The Rube Goldberg legal and financial structures of these deals are unnecessarily complex and serve only one purpose, which is to confuse the investor into thinking that something special is happening here.

Of course, the promoter never discusses what happens if the escrow account or sinking fund fails to earn sufficient returns to pay off the bonds. If that occurs, which is a distinct possibility, then the employer and bond issuer must pony up more money to pay off the bonds, and potentially throw their credit rating into jeopardy. Not to mention burdening future taxpayers for the cost of such fiscal malpractice.

As I've written before, there is no magical way to sell taxable municipal bonds and invest in taxable bonds to make a profit to pay for pensions or OPEB expenses. The only realistic source of "benefits bonds arbitrage" is to sell taxable bonds and invest in a portfolio of stocks that investment professionals would expect to earn something like 10 percent over the next thirty years. I'm not opposed to benefits bonds in principle, but there is a time and place for them because of the obvious market risks, and they need to be structured properly using the insights of the market research I've shared in that column.

So, when you're presented with one of these schemes, ask the peddler to put everything he's presented to you orally in writing as well as the answers to my questions above, and send it to you for review, and I can pretty much guarantee you won't hear from them again.