#48 | Sub(sidiary) Standard

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Most clients naturally assume that if they’re signing an illustration with the Principal name and logo on it, then they must be buying a life insurance policy from the same company that runs the TV ads with Eddie. They recognize the name and trust it. But chances are good that they’re actually buying a life insurance policy from Principal National Life Insurance Company, a small and fairly new subsidiary of the Principal Life Insurance Company. As it turns out, many life insurance companies write policies through subsidiaries and sometimes the primary name-bearing life insurers are subsidiaries themselves. If you take captives into account, it’s actually pretty difficult to figure out what contractual relation (if any) a particular policy has to the big, name-bearing life insurer. Do subsidiaries have the potential to negatively impact policyholders? I think it’s an open question that’s well worth exploring.

I was first introduced to this idea by the good folks at ALIRT, an independent firm that analyzes the strength of life insurance entities. Ratings agencies look at the entire corporate entity and apply ratings to subsidiaries under the rated holding company. The implicit assumption is that a life insurer is something like a stew – many inseparable parts that come together to make something that generally tastes good or bad. ALIRT looks at life insurers like a cafeteria tray by judging each subsidiary individually. The reason is because ALIRT says that the ties between parents and subsidiaries are usually not contractual. A carrier can dispose and acquire subsidiaries at will and without necessarily experiencing spillover effects at the corporate holding company level beyond reputational impacts. As you can imagine, ALIRT and the ratings agencies often come to different conclusions when dealing with subsidiaries. Ratings agencies assume that the parent and the subsidiary are effectively bound. ALIRT identifies risk in the system that could impact your policyholders if the parent company were to decide to drop the subsidiary.

From what I can tell in reading statutory filings, subsidiaries generally come in two flavors (but I’m sure I’m oversimplifying). The first is a true standalone entity that is bound to the parent primarily because of capital infusion, but might also involve some expense sharing and reinsurance arrangements. The former Aviva USA qualifies, as does John Hancock and ING. Standalones tend to be fairly large. The second is a shell entity that primarily exists to distribute product and reinsures the vast majority of its risk to the parent holding company or to other entities within the organization. Most of the management, product development and servicing is actually housed (with varying degrees) at the parent. I would put Principal National Life, Pruco of Arizona, Lincoln Benefit Life and Nationwide Life & Annuity in this category. There’s plenty of grey area (like MetLife Investors) but I think these two categories are broadly applicable. Subsidiaries themselves aren’t necessarily more or less risky than the parent, but they do present slightly different risks than brand-name parent entities. I see three primary risk factors that are either unique to or substantially magnified in subsidiaries – financial, product and administrative.

Financial risk in subsidiaries can be different than in the holding company because it’s more likely that a subsidiary becomes saddled with a particular type of risk. For example, a life insurer could set up a subsidiary that writes the bulk of the company’s Variable Annuity or Guaranteed UL products, which would create a concentrated risk profile in equity performance or interest rates. I’d argue that life insurers are actually incentivized to set up their businesses this way because it allows each subsidiary to manage to a particular type of risk, but compartmentalizing the risk also allows the carrier to exit the subsidiary through sale or runoff if the risk sours. Shell subsidiaries are particularly at risk because they tend to be much smaller and sell fewer lines of business than standalone subs. A shell can be readily unloaded because of its small size whereas a standalone would likely fight through or get more capital from the parent. As a result, subsidiaries are guilty until proven innocent. The parent typically looks healthier than the sub on a standalone basis.

Product risk is arguably a subset of financial risk, although the teeth aren’t as sharp. These days, most financial risk in life insurers comes from product rather than assets. Every product guarantee creates a corresponding risk on the carrier balance sheet. Product risk usually manifests itself in changing non-guaranteed policy elements. Products with lots of non-guaranteed pricing give carriers flexibility to push more risk back to policyholders. A carrier might want to unload a subsidiary with a book of business ripe for changes to non-guaranteed factors to another party to avoid reputational damage, but it’s unlikely that a book of business with non-guaranteed elements will cause so much financial strain that an insurer would need to unload it. As a result, I’m not sure there’s a strong case to be made that product risk in subsidiaries is necessarily any worse than in the holding company. Witness Lincoln’s decision two years ago to drop all crediting rates on all policies to the guaranteed minimum and eliminate all non-guaranteed interest bonuses. The real risk is writing policies with non-guaranteed elements in a subsidiary mostly writing products with toxic guarantees. The probability of a sale goes up and you can bet that the acquirer will look to the non-guaranteed elements to shore up profitability on the guarantees.

Administrative risk is probably the least discussed but most damaging of all of the risk. The reason is intuitive. All life insurance products are complex and require active administration. We’re finding out that Guaranteed UL products in particular need meticulous annual handholding to ensure that the guarantees stay fully funded. Most insurers have Flintstonian administration platforms, but they usually aren’t antagonistic during the administration process. They are still somewhat courting and maintaining agent customers through policyholder service. Runoff companies, on the other hand, have no such new business concerns. They actually have an incentive to provide poor support because policy lapses are usually profitable. I’ve bumped into this in real life when a particular reinsurer only allowed one type of in-force ledger and required eight weeks to run it. Administrative risk is more problematic than financial or product risk because it can’t be hedged or solved with a modification to the product and it lasts for many years beyond the agent’s retirement. An unchanged product written by a solvent company can still fail without proper administration.

So what to do? I think there are two steps to dealing with this issue. First, recognize when you’re writing a product through a sub and look at the ALIRT report to get a feel for its standalone financial strength. Second, diversify across companies and company type (sub, parent, foreign, domestic, etc). Writing through a subsidiary is usually not considered to add risk but I think it does. How much? I’m not sure. It varies based on the subsidiary and is difficult to quantify because most of the risk I discussed is binary. A company is part of a strong parent until it’s not. LBL was an AllState company until it wasn’t. As a result, holding all else constant, I prefer parents to subsidiaries. Holding all else constant, I prefer large subsidiaries to small ones. I’d like to see a subsidiary with its own systems and employees because I think it’s more likely that the company would be picked up by another insurer. But without perfect foresight, the best policy to manage this type of risk is simple diversification.

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