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Life Insurers Pump It Up

After the financial scandals of the past decade and the institutional meltdowns of the past year, you might think regulators would have gotten awfully fussy about companies that try to make themselves look stronger than they really are.

Think again.

In the world of life insurance, regulators across the country are allowing companies to issue debt — sometimes significant amounts of debt — without reporting this debt on their balance sheets. This inflates the companies’ equity, otherwise known as book value.

This debt that seems to be written with disappearing ink is called a “surplus note.” Joseph Belth, a professor emeritus of insurance at Indiana University who publishes The Insurance Forum newsletter, has called surplus notes “bizarre financial instrument[s],” which is putting it kindly. They are a deceptive fiction that regulators do not merely tolerate, but actually join in foisting on the uninformed public. (The notes are also known by other names, including surplus debentures in Texas and contribution certificates in California.)

The practice of issuing surplus notes began with mutual insurance companies. Mutual insurers are owned by their policy holders; they do not sell stock. This cuts them off from an important source of capital. A weakened company cannot sell stock to restore its financial strength, and a growing company cannot sell shares to support its expanding business.

Mutual companies can sell surplus notes instead. By buying the notes, investors give a cash infusion to the company. The investors expect to receive interest on their money and, eventually, to get their principal back, just like any other lender.

But the notes are not reported as debt on company financial statements. The justification for this is that the insurer is permitted to repay surplus notes only after all other creditors are paid, and only when it is financially stable enough to do so. In other words, surplus notes are a very junior sort of debt. But they are still debt. Insurance benefits should be paid from the insurer’s own capital, not from borrowed funds. Otherwise you do not have true insurance; you have a Ponzi scheme.

Most states require that companies obtain regulatory approval in order to issue, make interest payments on, or repay surplus notes. In some cases, regulators might suspend note payments while a company continues to pay policy benefits. But this just puts off the ultimate acknowledgement that a company in this position is a financial mess.

Policyholders and creditors alike should be able to see all of a company’s obligations when they look at its financial reports. Keeping surplus notes off a company’s balance sheet denies the reality of its obligations. Buyers of surplus notes expect their money back, just like other creditors. They are not making a gift to policy holders.

At first, surplus notes were used only as a way of surviving hard financial times, but, in 1993, Prudential became the first company to sell surplus notes at a time when it was financially sound. The practice caught on, and, by 1996 $8 billion of notes had been sold to investors by 24 companies. What was originally an (at least marginally) acceptable way of providing for emergency needs has become a habitual way of eliminating transparency from accounting.

Perhaps most galling is the fact that, while companies insist that surplus notes are equity for accounting purposes, they still want them to be debts for tax purposes. When surplus notes first appeared, the Internal Revenue Service said interest paid on surplus notes should be treated as the equivalent of dividends paid to stockholders, which are nondeductible, instead of being treated as deductible interest. But companies, which record the notes as equity, argued that, when it comes to taxes, the notes should not be treated as equity at all. The companies won, leading some stock companies to join mutual companies in issuing these miracle notes.

Financial miracles usually work only on paper. Buyer beware.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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