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Gareth Morgan - The Big Game II |
The National Business Review – Part 2
October 20, 2006
Gareth Morgan continues his investigation of investment rorts
How the industry creates reserves with your savings and then takes them
Tricky Business
How companies access your savings via manipulating reserves:
- Rewording existing contracts to increase fees and charges (sometimes retrospectively);
- Rewording that introduces rights to alter terms and conditions under trust deeds and products in the future;
- Rewording that introduces rights to unlimited management fees over time;
- Creating reserves or provisions for predicted future risks or expenses such as tax sometimes on a fictitious basis often with the express knowledge the expenses or provisions may never be required (hidden reserves);
- Creating reserves for the purpose of smoothing returns in future weak years. Sometimes these reserves are never returned to the saver;
- Creating reserves to prop up “attractive returns” on “sales display products” that capture the market first, then a few years later start to degenerate or migrate into less than attractive offers as the reserves are artificially recovered again from the immense pool of capital captured; and
- Creating resilience reserves or expenses portended but that never arise.
The illicit changes over time to the wording of a savings contract to reduce the company’s liabilities described last week is just one technique deployed to take your money.
 The Big Game is to create reserves and then deploy a myriad of techniques to distance any relationship of ownership attributable to any party.
These reserves are then transformed into a surplus for the company which is distributed to shareholders or otherwise extracted for other purposes as soon as the funds are unaccountable and arguably not owned by anyone.
Let’s finish the story from the rewording example in the previous article (NBR, Oct 13). It proceeded as follows.
The reduced liability valuation arising from those contract changes allowed the company to increase free reserves – either in the form of funds set aside for no express purpose as reserves exceed actuarial estimates of what will be required, or funds set aside for some express purpose the company has identified that may or not occur.
This move alone starts clouding ownership away from any association of the funds being related in trust and equity to the saver.
The next step completes the separation of the savers from their money without them knowing.
The company sets up a service company on the side to siphon off the resulting free reserves (these were reserves no longer tagged to be returned) via charging uncapped management fees.
Once the company had removed as much of its savers property as it could through unauthorized policy rewording and a couple of other techniques, it then began to close the fund by turning it into a Zombie. (These “dead man walking” funds are the subject of the next article.)
The idea is that they get neglected (euphemistically the company declared they were too “uneconomic” to manage), the fund return diminishes and costs increase gradually.
As the fund diminishes (redemptions) with fewer and fewer investors, the costs and expenses continue to rise,
In some bad cases, the funds turn sour, and with no incentive to support the fund with reserves, it diminishes fast, and so does investors’ money.
But investors are thrown a life raft – “prudent” investment management on another level – so long as they switch to a new fund at a “once-in-a-life-time” concessionary cost.
Of course, everybody did and the Zombie fund was closed with the company taking all the reserves left behind.
So how can a life insurance company seize your savings?
At the core of the problem is a regulatory regime that has allowed insurers to migrate techniques that are relevant to management of life insurance contracts to the business of investing household savings.
The conventional arrangement for managing savings is transparent – fees are paid for the service with the client able to terminate the contract at any state.
At that point they could reasonably expect to get back their savings plus whatever compounded return net of fees had been earned.
When insurance companies get into this business the vanilla-style arrangement is relegated to the sidelines.
In the pure insurance business, the customer pays a premium and in return is recompensed should a specified event occur – death, injury, lost of property, whatever.
So the company collects premiums and once every so often has to pay out on claims.
This is where actuaries and reserves come into the picture. A successful company will collect more in premiums than it has to pay out in claims. One of the jobs of the actuary is to calibrate objectively the extent of that excess. From that analysis, reserves are created – these are the funds that the company has at its disposal over and above what’s reasonably expected to meet future claims.
The question of ownership of these reserves arises continually. Eventually, if the premiums keep rolling in and the claims each year continue to be less than the inflow of premium, these reserves get to a point where the actuary can reasonably declare they are surplus to predicted requirements.
In a conventional insurance contract, these excess or “free” reserves become the property of the insurance company and its shareholders. Before demutualization, the insurer either rebated the excess through lower premiums to policyholders (not common) or accumulated the funds on its balance sheet and spent them buying other assets or businesses.
Conceptually, at least, the free reserves remained the property of the current or next generation of policy holders. Past policyholders just kissed goodbye to any reserves set aside from their past premiums when they cancelled their policy.
With demutualization, the door is opened to a change of ownership of the reserves as soon as they are “freed” by the actuary. They can become the property of the company and its shareholders; no longer of the policyholders.
Naturally, the company wants to create free reserves as fast as possible, as this is how the net asset backing of the shares is lifted.
This is all very well for an insurance company where the customer is paying premiums for a service (insurance cover) but transposing this technique to the guardianship of people’s money has contaminated the savings and investment business.
Ever wondered why savings products offered by insurance companies always have a life insurance component attached? The answer is not the obvious one – that they want to sell two things as once.
Instead, the companies are able to deploy the old reserves manipulation trick and deprive you of not just your investment returns but much of your capital as well.
The law says an insurance company cannot accept or take in money from the public into its statutory life fund (a separate statutory trust fund pooling investors’ money) unless it relates to the business of life insurance; otherwise the funds must be treated separately.
As a result life insurance companies issue savings and superannuation schemes “dressed up” to appear life insurance products, but which in economic substance are ordinary savings and investments.
The law used to exempt life insurance from the Securities Act requirements.
That loophole has now been closed – life insurance companies must now comply with the Securities Act 1978 and regulations, the Securities Markets Act 1988, the Fair Trading Act 1986 and all other various consumer protection legislation.
The government repealed defined life insurance policies unit trusts and interests in superannuation schemes as securities.
But at the same time it let lapse the obligation of the company to adhere to the 1989 Code of Business Practices for Life Insurance Companies that stated a company must comply with the law relating to fiduciary duties.
A fiduciary duty obligates your interests to be protected ahead of that of the company. That’s been reversed and you are now an unsecured creditor with little to no rights or protection.
The common characteristic of these products is that people’s savings are “pooled” and aggregated into collective investment schemes where the insurance company is able to apply various unique and often undisclosed “industry and actuarial discretions” that other savings and investment institutions do not have.
This distinct advantage enables the industry to create, manipulate and ultimately own reserves that arise out of such “pooled” funds using various discretions so as to generate surpluses that are in effect “free capital” – theirs for the taking.
Life insurers deploy several techniques to access your savings via manipulating reserves (see separate box). This is about creating “free reserves” or “inherited estate” – which arise when the policyholders have all but gone and the company inherits all it has managed to siphon off into reserves as well as the expenses charged.
Investors eventually give up in disgust with the pool performance of their fund and surrender their policies, not knowing that much of what is rightfully theirs is left behind in the reserves that the company with then inherit.
In most industries loss of business is not acceptable. For insurers and super funds it is The Big Game.
The exit of clients releases reserves and so creates capital. The business in NOT about bottom line profit as in most industries; it’s about creating free capital.
To do that the company must capture market share first at any cost, then manage that captured generation of investors over time so as to create capital from the reserves set aside.
The next article will outline product churn and Zombie funds – the means by which life insurance companies get you to abandon ship and leave your money on board.
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