The Insurance Exposure Problem

State and municipal deferred-compensation plans are at risk from the insurance-industry tumult. It's time for some due diligence.
April 9, 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.

Many months ago, when the gaping cracks in the banking system first attracted national attention, I received an e-mail from a small-town finance officer in California. She was asking about her city's 457 deferred compensation plan provider, which happened to be a major insurance company. At the time, I checked around and replied "not to worry" as long as it wasn't AIG, which was already skating on thin ice. Well, it turns out I was far too optimistic, as the market meltdown of the past eight months has now clobbered the capital base of the nation's leading life insurance companies. It's now time to revisit any insurance companies involved in your 457, 403(b) and 401(a) plans.

How we got here: When the governmental deferred-compensation industry first started in the 1970s, insurance companies stormed the market and grabbed the dominant market share. They had two competitive advantages. First, they could offer high-rate investment contracts as inflation was accelerating. Second, they had "hooks" on their contracts with deferred sales charges and punitive cancellation clauses on house products that were not well understood by public officials, and later regretted by some who bought them.

Today, many state and local governments have major exposure to the insurance industry through their 457 plan, and schools districts are littered with them in their 403(b) plans. A good number of the companies have moved away from the 1980s-style investment contracts and focus today on efficient recordkeeping systems -- without pushing their proprietary products. But there are several others that still operate on the old business model. Bundled arrangements with house products are most common with smaller and less-sophisticated plans, which intensifies their risk exposure in times like now.

As a result, a significant number of 457 and 403(b) plans hold insurance company contracts with firms that were highlighted in a March 12 Wall Street Journal article (subscription required) that portrayed several prominent firms in the industry as potential candidates for bailouts, as well as others who were unnamed but may have similar, related problems. A quick look at the industry's stock market index, which lost about 80 percent of its value before the recent market rally, tells us that Wall Street investors have shunned these companies. Their stocks have performed as badly as banks'. That is a strong reason for public officials with exposure to these companies to take a harder look at the nature of their risks.

Investment risk. Some insurance companies write investment contracts in their 457 plans that are unsecured general account liabilities, not unlike a bond or bank CD but without federal deposit insurance. Some dedicate reserves for these accounts, but you have to verify that. Likewise, a handful of states may provide individual investors in these contracts with full or partial principal guarantees up to $100,000 per person, which should likewise be verified and documented. A few also offer separate accounts that may include various forms of collateral to protect investors' interests. The terms of these investment contracts are typically lengthy and written by the insurance companies' lawyers in the interests of the insurance company. Very few public agencies actually demand investor-friendly terms in these agreements, so the first place to start if you hold one of these contracts is to dig out the document and re-read it very carefully.

A related concern for some employers may be the variable annuities underwritten by a handful of companies that guarantee investors a minimum or floor rate of return. With stock prices falling by nearly 50 percent, the ability of the weaker firms to meet these obligations should be ascertained. If any of these practices were too widespread in the firm's overall book of business, it could destabilize the entire company, even if the contracts are written in other markets outside of 457 deferred compensation plans. Again, those with conservative underwriting practices are not a source of worry here.

You may need to have an experienced and independent consultant assist you in this review. Make sure that the credit research group in that firm is more than just the person who visits your office or a one-man back office with limited access to industry financial information. Now is not the best time to use tiny firms if you face this challenge with a limping, big-name insurance company.

Service quality risks. Like other providers in the 457 industry, insurance companies face shrinking profit margins and sometimes, outright operating losses. You should ask about the number of layoffs they have ordered in the past 12 and 18 months, company-wide and specifically in the defined contribution business segment.

Going-concern and acquisition risks. Industry consolidation that results in mergers and sales of these business units could be a problem. An acquiring company may not provide the same level of attention to your plan that you had previously enjoyed, and their administrative platform may eventually require changes in the investment menu. So, do your due diligence ahead of market disruptions.

Strengthening your contracts? Some 457 plans have multi-year terms, but many of them have cancellation clauses for specific performance issues. Rarely do these clauses cover the kind of credit collapse we are now experiencing, which ought to be a lesson for everybody in the industry going forward. In some cases, plan sponsors may be able to negotiate better terms. Most important of these would be a requirement for the insurance company to collateralize its investment contracts if its capital ratios, credit ratings or stock price fall below certain predetermined levels. If possible, a service-provider contract cancellation clause based on similar downgrades or changes in control should be pursued.

Be deliberate, and don't panic. I detest fear-mongering. So let's keep our heads about this -- but let's not put those heads in the sand. Some of the major players in this industry have stronger balance sheets and operating margins, and one should never tar them with the same brush as the weaker companies. Likewise, those who have long-ago reformed their sales practices to eliminate deferred sales charges and "market value adjustments" on their investment contracts should not attract the same kind of anxiety as their other competitors. But the vast majority of 457 plans now have worried participants who are experiencing the worst investment losses of their lifetimes. Many are scared that they could lose their entire nest egg. For those in 401(a) defined contribution plans, it may in fact be their entire life savings. Plan officials are wise to perform a little extra due diligence in times like these.

So a special review of the insurance companies who represent significant risks to your plan may now be a timely exercise that could result in some plan-level adjustments. For those about to bid out their 457 and 403(b) plans, it's especially important to make sure your consultant has the analytical capacity to dig deeper than most. If you need suggestions for how to undertake this process, e-mail me.