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Gareth Morgan - The Big Game III - Product churn, zombie funds and the renewal cycle | The Big Game III - Product churn, zombie funds and the renewal cycle | | investment - 13 November 2006 - 4882 views |  Printable version
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The National Business Review – Part 3
October 27, 2006
Gareth Morgan continues his investigation of investment rorts.
 Why do life insurance companies have so many savings products and unit trusts in the market, most of them without much money? Why do they always seem to be closing funds to new money and then some years later wind them up? Why do investment funds run by life insurance companies have poor track records?
These indicators of instability are not the result of inexpert management, stumbling about from one idea to the next. In fact they are the result of premeditated risk management. Sadly, it is not risk management of savings but rather risk management by the industry of its claim to your money – the notorious creation, manipulation and ultimate ownership of reserves outlined in the previous article.
This is how the industry churns products like this:
- First, the company markets and sends our its sales force to encourage you into their products;
- Then it invokes over subsequent years a number of discretions that create reserves in the fund from the savings to public have contributed;
- It ensures the surrender terms for your withdrawal are as horrendous as possible – sometimes done by retrospective policy wording changes;
- It closes the fund to new money. This is the day it becomes a Zombie – the walking dead of funds where performance no longer is a priority for the manager, as no new money will be attracted anyway;
- A few years later it announces your fund is no longer viable to manage – this is when the zombie starts to stagger;
- It incentivises you to transfer to a “new and better” fund with an offer you can’t refuse because it is slightly better than the horrendous surrender terms;
- It closes the zombie fund thus releasing all remaining reserves for transfer to the company’s balance sheet; and
- It closes the new fund to new monies after a few years, starting the cycle again.
What about why? The industry’s purpose is to build its own claim to the reserves.
The most important parameter is the length of the churn cycle. The faster it is then the greater the rate of creation of free reserves and thus the greater the value to be captured by the aggressive insurer/pension fund operator.
To achieve this, new products have to be designed and released; legacy ones have to be discontinued. The process is euphemistically marketed as “rationalization and consolidation of product mix.”
There are about $10 billion of life insurance-related savings products in the New Zealand market. New sales less redemptions or discontinuances total about $1 billion a year, redemption or discontinuance being about 80% of new sales. Together, these figures imply it takes about eight to 10 years for the products to be “churned out.”
So here we have so-called long-term savings products but with the promoters deliberately trying to get members to leave at a substantial cost to those members and benefit to the company.
Clearly it’s a balancing act – if too many leave and aren’t replaced then the company’s gravy train slows down. The evidence suggests a mature market with no overall growth. The most aggressive operators can cut the churn rate to five to seven years.
Investors who don’t leave a zombie fund are tempted to transfer to a “new improved” fund. This is commonly achieved by offering favourable terms to transfer – at least favourable compared to the horrendous surrender value discounts imposed.
For the investor it’s like the torturer has mercifully remembered compassion and is offering relief. But of course it’s a ruse – the way to get the last of the long-suffering investors out of the way before all the reserves and provisioning can be released into the company’s coffers.
The old fund is then terminated and the end of a successful round of expropriation completed.
Remember, this investigation is an international problem. KPMG (UK) recently published a study (July 2006) that makes a few interesting observations on product churn, but fails – because it is actuarially lightweight – to make the tackle on why this occurs.
For instance,
- “The UK life and pensions industry appears to have a serious problem with product persistency [how long a product lasts] and it seems to be getting worse;
- “in other words, significantly more than half of the money paid out by the industry related to surrenders of policies before they reached their expected maturity;
- “independent industry analysts {conclude} that much new business is being recycled from existing investments;
- “These findings indicate that pursuit of new business continues to be a more important behaviour driver than retention of existing business; and
- “We think the life and pensions industry has much more to do to address the serious challenges posed by deteriorating persistency… but we do not see much evidence that the industry is making a concerted effort to address the root cause of the problem which in out view is the relentless pursuit of ‘new’ business – almost at any cost.”
- The KPMG study notes the industry will stop at nothing to get this new business (which is mainly old business recycled) but the consultancy doesn’t have a clue as to why the insurers churn products as they do. Indeed, KPMG sees accelerated churn as “a problem” whereas the reality is that from the companies’ perspective it is a major achievement.
Here then we have one of the industry’s global advisers not even understanding The Big Game.
Finally, let’s consider how the business of product churn makes it so attractive for offshore firms to enter the New Zealand business and rationalize it. If a local life insurance company has been successful proliferating savings funds of the type we’re discussing, and has managed through its marketing expertise to line up hordes of sucker savers, then those pools of capital are the value of the business. They are after all, the fruit to be plucked by an expert operator.
One event that can trigger such widespread mayhem is when the life insurer is taken over. That provides the opportunity for the acquirer to rationalize products, close funds, and merge.
The closed funds of products generally do not breathe life again as they do not need to attract more customers. The remaining investors are normally trapped with exit penalties that make it expensive to escape, and so tend to put up over time with conservative to worsening returns and increasing fees.
There is no incentive for the fund manager to perform to attract new business, so this is just a goldfield for the company as it closed generations of products and funds in a cyclic process. This describes what we’ve seen in New Zealand – young aggressive life insurance companies pull in customers’ savings via all sorts of deals and attractive livery. They then sell out to the bigger insurers or banks and walk away with a payout far in excess of what any profit from savings management would imply.
What they’ve done is to sell their savers’ capital to the acquirer. All that remains is to see how much of that the acquirer can usurp.
NEXT WEEK:
The role of the actuary.
Zombie Watch
How to tell whether your fund is a zombie – the investor’s worst nightmare.
- The product contract normally has hefty penalties for terminating (worse still, hidden charges) to encourage the investors not to exit (unless they take a hit – which increases reserves immediately anyway)
- There are normally a spread of discretions that are silent in the contract
- The company or funds manager is not really interested in promoting the fund any more as it is closed to new investors
- There is no incentive to make sure the fund performs, so the investors get stuck in a conservative low-profile fund returning little to nothing over time
- As the same time the fund is usually “leached” on the side by uncapped management fee arrangements run out of a subsidiary management services company – which finds this closed fund with no performance requirements an easy process to manage and get paid for
- The leaching agreements are far and wide, and apparently so “commercially” sensitive that even the Securities Commission gives exemptions to prevent disclosure.
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