#308 | The New Ohio National

golden firework in night sky

Almost a year ago to the day, Ohio National announced that it had agreed to be acquired by Constellation, an insurance holding company backed by two Canadian pension plans and spearheaded by the former CEO of Prosperity Life. The response to the transaction has been, in a word, dismay. Ohio National was widely regarded as a high-quality, high-integrity life insurer that had painstakingly won the loyalty of its agents over decades of delivering competitive products. Now it was being snapped up by a de-novo company backed by institutional investors for a mere $500 million. How could things have gone so wrong?

Now we know. In a 200 pages prospectus that reads like an autopsy report, Ohio National painstakingly details the transaction and how it came to pass. I wrote in #268 | Constellation Buys Ohio National that the story behind Ohio National was a very simple one – the company sold too many GMIBs that were too rich, too flexible and too cheap. Sustainably priced GMIBs can offer one of those three things. Problematically priced GMIBs offer two of the three. GMIBs with all three are toxic sludge. And there is arguably no block more toxic than Ohio National’s. As early as 2017, Ohio National began to look for a way out.

The prospectus says that “in late 2017, Ohio National engaged a nationally recognized investment banking firm…to identify companies that might be interested in a strategic partnership with Ohio National…In early 2018, this firm identified six potential strategic partners…each of which entered in to an NDA…However, these discussions did not result in proposals that were acceptable…discussions with these parties effectively ended in May of 2018.”

Not long after, Ohio National was downgraded by S&P and Moody’s and the capital position of the company became increasingly precarious. In September of 2018, it “decided that we would no longer issue new variable annuity contracts” and executed a strategy to “[manage] our in-force variable annuity block, with a specific focus on reducing the retained [GMIB] rider block through multi-year exchanges, buyout and annualization programs, and through the establishment of a captive reinsurance subsidiary, Sunrise Re.”

Although it wasn’t mentioned in the prospectus, Ohio National also made the decision to cease paying trail compensation on its GMIB block in the same month, immediately resulting in a huge industry backlash that culminated in a series of lawsuits against Ohio National from some of its former distribution partners. In the eyes of the industry, Ohio National essentially burned the ships. Why? Because it seems as though they had to. Reducing trail compensation and establishing a captive don’t fundamentally change the economics. They are just strategies to buy more time. And time is what Ohio National needed.

A little over a year later, “in December of 2019, Constellation and its investors approached Ohio National to discuss several potential transaction structures.” The saga that follows is reminiscent of Barbarians at the Gate, the detailed account of the frenzied battle to buy RJR Nabisco in the 1980s. It makes for good reading – at least, the best reading you’ll ever get in a prospectus.

The long and short of it is that Ohio National entered into an exclusivity agreement with Constellation and an unnamed Party A in the depths of the COVID crisis, June of 2020, and Constellation overplayed their hand, offering zero compensation to Ohio National’s Members – effectively valuing the company at zero – and offering $500 million to shore up the capital position of the company. The reason why is explicitly spelled out in the prospectus when it says that “Constellation…ascribed a significant negative value to our block of variable annuity products.” The negative value of the GMIB block was presumably enough to completely wipe out the value of the company.

Ohio National, however, had leverage. A few months prior, reinsurance company (“Party B”) had approached Ohio National with a buyout offer but was rebuffed because of the exclusivity agreement with Constellation. Ohio National turned down Constellation’s offer and let the exclusivity period lapse, then reached back out to Party B to sign an NDA and submit a real offer. At the same time, Ohio National was pushing Constellation to also pony up $500 million to the Members of Ohio National and also reaching out to other mutual companies and mutual holding companies about a potential merger. Out of the numerous companies contacted, one large mutual holding company – Party C – was interested.

But in the end, Constellation prevailed as the highest bidder in an auction that it seems no one else wanted to win. Even Constellation’s original partner, Party A, backed out at the last minute, leaving the Canadian pension funds to increase their investment. Party B was interested, but only if the capital from the purchase was used to buy out and otherwise diminish the GMIB block, leaving essentially nothing for Members. Party C was willing to absorb Ohio National for no compensation, but hadn’t really dug into the books yet, a process that would take months and could culminate in nothing. Mutual company parties D through F also had conversations but passed. Add to that the 6 companies that kicked the tires back in 2018 and it seems as though everyone in the industry took a look at Ohio National and didn’t like what they saw. Except for Constellation.

The prospectus isn’t just an autopsy report of Ohio National. It’s also a roadmap, in broad terms, for what Constellation intends to do with Ohio National. It is readily apparent from the prospectus that the immediate goal is to strengthen the capital position of the company both in the form of the $500 million capital contribution and by creating a “more flexible capital structure.” In a strict sense, converting from a mutual holding company to a stock company enhances flexibility because it allows the company to raise money by selling stock. But in a broader sense, the transaction will also very likely entail block sales, reinsurance transactions and other plays to release capital, some of which may go to support the new company and some of which will likely be paid back in dividends to the new owners.

Constellation also sees Ohio National as a viable new business platform. The prospectus makes repeated references to enhancing new business competitiveness, not just because of a better corporate capital position but also because of “additional sources of capital to invest in distribution growth, technology and innovative products” and “investing in the future growth of the business.” The result, the prospectus says, is that the transaction “enhances Ohio National’s ability to seize growth opportunities and respond to varying market conditions, resulting in a stronger, more responsive and innovative company that is well positioned for the future.”

But probably most importantly for folks reading this newsletter, the prospectus also details exactly how Ohio National is going to calculate its Dividend Interest Rate going forward for the Open Block – and also how it came up with the calculation. According to the prospectus, “the Board convened [in September of 2020] and received a presentation from senior members of our management team. During this presentation the management team communicated that they were operating under the assumption that…dividends to Present Participating Policyholders might need to be materially reduced in 2021 and in future years.” It appears that Constellation had a similarly dim view because it originally proposed a “prompt and significant reduction framework” for dividends.

However, as economic conditions improved in early 2021, Ohio National asked for a better Open Block framework that the prospectus characterizes as “more favorable [for] our Present Participating Policyholders” and was ultimately approved as a part of the sale. That Open Block Life Dividend Framework is detailed in Exhibit C. The good news for Ohio National policyholders is that, as the prospectus says, “[Constellation] will have an obligation to pay a dividend that is calculated using the formula.” There’s no wiggle room for calculating the DIR. It is essentially creating a dividend framework that is analogous to what would have happened had the Open Block been designated a Closed Block.

So how does the Framework for the Open Block work? In broad strokes, it has two key elements – the Dividend Interest Rate (DIR) and the Economic Charge (EC). The DIR is a pretty simple formula:

Net Portfolio Yield – Pricing Spread = NIER

There are three catches to the formula. The first is that there is no definition for Net Portfolio Yield in the prospectus. That, in my view, is a real problem. If the NPY is the primary input for the DIR and it’s not clearly defined, then it leaves the door open for interpretation. The term “net,” for example, likely means net of investment expenses – what about if Constellation decides to charge an extremely high asset management fee for this block? Even the word “yield” is open for interpretation. For example, does it include capital gains? It’s not hard to imagine a scenario where Constellation can essentially funnel earnings that are above the line, if you will, so that they don’t even make it to the NPY formula.

Second, the Pricing Spread ranges from 0% if the NPY is below 3% to 1% if the NPY is above 4.2%. No other Whole Life company that I know of charges a pricing spread from the portfolio yield to determine the DIR. There are pricing spreads in Whole Life products, but they’re built into the products themselves as a part of the overall pricing package. Conceivably, an Ohio National Whole Life product might actually have two spreads, one above the NPY line and one below the DIR line in the product itself.

That leads us to the third catch – the DIR is only paid if the Net Portfolio Yield minus the Pricing Spread is greater than 3%. Otherwise, it’s 0%. Take a look at the DIR relative to the Net Portfolio Yield after accounting for both the cliff at 3% for the DIR and the Pricing Spread:

Looking quickly at this graph, it’s not hard to see what Constellation is doing with Open Block formula. They take a vig on both sides of the trade. On the upside, the Pricing Spread is, essentially, a success fee for Constellation. If they can generate sufficiently high Net Portfolio Yields, then they can pay themselves higher fees. But because of how the Spread is structured, the incentive to generate high NPYs essentially stops at 5.2%. After that point, the Spread remains constant at 1%.

The downside, in my interpretation, is even worse. Recall that a dividend in a Whole Life product is comprised of expense, mortality and interest components. The total dividend is the sum of the contributions of all three elements to the extent that actual experience is better than what’s priced into the guarantees. If the DIR is zeroed out below 3%, then that means the interest margin contributed by the DIR is going to be negative because the DIR will be lower than the guaranteed interest rate. That negative margin will very likely eat up any dividend margin generated by expenses and mortality, meaning that the actual paid dividend to policyholders will be zero.

When it comes to the Open Block formula for calculating DIR, Constellation employed classic private equity playbook – heads I win, tails you lose. That’s the deal that Ohio National Open Block Whole Life policyholders are stuck with from now on.

And, strange as it sounds, that deal is substantially better than what they’re going to get for the next 18 years. Over that period of time, Ohio National will also assess an Economic Charge that essentially functions as a reduction in the Dividend Interest Rate. The net result of the Economic Charge is that the DIR net of the Economic Charge will be equal to the average 10 year Treasury Yield for the previous year (2022-2027) or 3 years (2028-2039). On top of that, if the 10YT yield falls below 3%, the Economic Charge has an additional fee that scales up from 0% at 3% to 0.7% at 2% and remains there for any 10YT yield below 2%.

The upshot for policyholders is that, essentially, their best possible DIR until 2037, when the Economic Charge mercifully begins to burn off, is equal to 10 Year Treasuries. All of the extra yield earned by the portfolio is essentially going to Constellation. From what I can tell by triangulating data in the statutory statement, it looks like about $3 billion of Ohio National’s $4.4B in Whole Life reserves are in the Open Block (the remainder is in the Closed Block that was written before the company’s demutualization in 1998). Rough math would say that Constellation is going to be able to reap at least 2% per year in margin – and potentially much more – from the Economic Charge. They are, effectively, paying themselves back over time for the $500 million that was distributed to Members as compensation for the sale. The Economic Charge is proof that Ohio National was, in fact, worth almost nothing.

Perhaps the greatest understatement in the prospectus is when it says that “Ohio National cannot assure that Policyholders will not respond negatively to the Conversion [to a stock company owned by Constellation] by surrendering or declining to renew their Policies.” By paying existing policyholders up front and then essentially billing them back over the next 18 years, they are virtually guaranteeing that policyholders will “respond negatively” to the sale. In fact, they are incentivizing policyholders to take their cash and leave – and that’s exactly what’s going to happen. Producers everywhere are absolutely salivating at the prospect of exchanging Ohio National Whole Life policies that are flush with cash into other products. There is a $3 billion pot of gold up for the taking.

However, there’s a slight twist in the story. The Economic Charge actually has a temporary booster component that essentially hides the effect of the new formula on the DIR for the next 3 years by adding 3.2% in 2022, 1.8% in 2023 and 0.9% in 2024 to the 10 Year Treasury yield that would otherwise serve as the DIR. This is very, very clever. The Economic Charge formula references the average 10 Year Treasury for May, June and July of last year, which was about 1.5% in 2021. 1.5% plus 3.2% is 4.7%, the same DIR that Ohio National declared for dividends in 2021, which leads to an impression – and an illustration – that have actually remained stable as a result of the transaction. That’s not the case. It’s temporary relief that will very likely be illustrated as permanent for 2022. Don’t be fooled. The new DIR and Economic Charge formulas are real and have real teeth, regardless of what the illustration says.

From one vantage point, the future of Ohio National is bleak. The company is still saddled with massive GMIB liabilities, is about to experience a run on the books for its cash-rich Whole Life policies and has managed to infuriate its once-loyal agents who are purportedly exiting en masse to more stable companies. But from another vantage point, this is the process of Ohio National shedding its past and transforming itself into the cornerstone of a private equity-fueled acquisition, new business and reinsurance platform that will very likely target other mutual and mutual holding companies.

How do we know? Because they’re already doing it. Constellation snapped up Columbian Financial Group, a mutual company that sells boatloads of final expense Whole Life, in the middle of last year. The reality is that there are many mutuals and mutual holding companies small enough – and, in some cases, vulnerable enough – to be a target for Constellation for a “sponsored demutualization.” It’s hard to imagine that Constellation is going to stop with Ohio National and Columbian.