Before I wrote the headline above, I too thought the phrase actuarial hell-raiser was an oxymoron, out there with jumbo shrimp or teetotalling broker. But consider Bill Rudd, former chief actuary of Canada’s London Life, whose quixotic 13-year lawsuit against some of Canada’s leading corporate interests has paid off – big.
London Life is a leading Canadian outfit that was bought in 1997 by another insurer, Great-West Life, in a bit of a snatching of the bride at the altar. London Life’s parent had chosen another partner – Royal Bank – but then struck a deal with Great-West for $2.95 billion. Royal Bank got $70 million consolation, poor dears.
So you can see the money was flowing in this deal. One reason: Great-West figured it could use cash London Life was holding to help buy London Life itself. And that’s what got Rudd incensed.
Dealmaking like this was the heart of the original leveraged buyouts of the 80s – borrow some money short term, buy a company with said money, then take cash off the company you just bought to help pay off the loan. If you remember the original Wall Street, that was how Gordon Gekko was going to take over Bluestar Airlines. In real life, it’s how T. Boone Pickens became famous.
Canadian insurance regulations make that kind of transaction – well, difficult. Or as actuary Bill Rudd and others would assert – illegal.
The heart of the matter is a type of policy London Life (and many other companies) sold, a participating life insurance policy. These policies are priced assuming the policyholder will receive a dividend funded by the investment income thrown off by his original premium. (The set-up is described lucidly by another Canadian insurer here.)
To make sure the company doesn’t abuse that investment income, it is placed in a separate account, called the participating policies account. This account is segregated from the rest of the insurance company’s operations. It has separate asset accounts, liability accounts and surplus accounts. Think of it as a little company operating – wholly independently – inside a big company.
And the money is the policyholders’ money. It does not belong to the shareholders. Of course, the shareholders manage that money, and they are supposed to act in the policyholders’ interests, not their own. Actuary Rudd argued that’s not what happened in this deal.
London Life’s new owners peeled off $180 million from London Life’s policyholders. And it peeled off another $40 million from Great-West’s policyholders. The $220 million helped pay for the purchase of London Life.
- The merged company would have lower expenses.
- The participating policies account (read: the policyholders) would benefit from lower expenses.
- The policyholders should bear some of the cost of the merger, since it will benefit.
To share in the cost, Great-West took the policyholders’ money and left them with a prepaid expense account for the amount it took. The expense account would be paid off in time, with interest. It sounds a lot like a loan, but was not set up as one. In Canada the policyholders can’t lend money to the shareholders. (Remember the shareholders say what happens to the policyholders’ money, so a loan to themselves would be an obvious conflict of interest.)
It’s a little hard to follow, so I’ll spell it out step by step. The important thing here is to follow where the cash goes – the actual dollars and see where it is replaced by non-cash assets.
- Great-West needs cash to buy London Life.
- It takes $180 million cash from London Life’s policyholders and $40 million cash from Great-West’s – $220 million in all.
- To offset the accounting transaction, it sets up a Prepaid Expense Asset for both sets of policyholders. These are non-cash assets. (Now the shareholders hold the cash.)
- The non-cash Prepaid Expense Assets are designed to sit on the policyholders’ balance sheets for 25 years, when they will be paid off in cash (with interest).
- Great-West uses the $220 million cash to complete its purchase.
Summing up, Great-West used policyholder money to help buy London Life. It dropped an asset on the policyholders’ books. But the actuary, Bill Rudd, led a lawsuit against Great-West, asserting that this asset was a lousy deal for policyholders, in part because the policyholders wouldn’t see the cash for a quarter century.
The court agreed. Technically, it said the pre-paid expense asset was not a legitimate asset, thus the shareholders owed the policyholders:
- $220 million – the amount, uh, liberated from the policyholders.
- $172.7 million – the amount of investment income the policyholders would have made had they been able to keep the $220 million cash.
- $63 million to cover taxes on the investment income.
Naturally, Great-West plans to appeal. In the meantime, quoth the actuary, “We established a principle that you keep your cotton-picking hands off the policyholder funds.”
(h/t Claude Penland)