September 22, 2003

Reading: The Fall of First Executive Life

In 1974, when Fred Carr took the helm of First Executive Life, the life insurance industry was at the threshold of drastic change, and Carr was one of those who took it over that threshold. Reading Schulte, The Fall of First Executive: The House That Fred Carr Built provides an insider's view into how a financial services company can fall victim to the actions of a few individuals acting either from greed, hubris or both. Gary Schulte's inside account provides important lessons in regulation of financial services. (Read more ... )

Fred Carr took over the management of First Executive Life in 1974, at a time when it was near bankruptcy due to lack of capital. The life insurance industry was then a wealth creation machine that few outside of the industry understood, and which faced little competition, despite the hundreds of companies in the market. It was shaken up in 1978 with a FTC report that claimed that the savings component of life insurance produced a rate of return far below that of other safe investments available to the public. The press picked up on the report, shaking public confidence in life insurance as a savings vehicle.

Into this situation, ripe with opportunity for change, stepped Fred Carr, a stock broker who had earned a reputation as a "gunslinger" in the explosion of the mutual funds markets during the "Go-Go Sixties." His was the opening story in the 1972 book "The Young Millionaires" by Lawrence A. Armour.

Author Benjamin J. Stein included Carr among the ranks of what he called a network of junk bond financiers in his "License to Steal" (Simon & Schuster 1992). Besides Michael Milken and others the list also included Saul Steinberg of Reliance, which would eventually fail also, but not until after the disaster of 9/11/01.

First Executive pulled itself from the brink of bankruptcy through the sales of interest-sensitive life insurance products. Agents showed prospects projections of investment returns dramatically superior to competing products. Carr made the returns plausible by heavy investment in "high yield" or "junk bonds" bought from Michael Milken, and erroneous assumptions that high returns would continue indefinitely. First Executive provided Milken a ready market for his bonds, propelling both businesses into rapid growth, in a reciprocity strategy commented on by Forbes in a 1984 cover story.

Schulte criticizes Executive Life (and those that followed it into the hot money trance of the 1980's) for failing to consider the unknowns of the future, and for taking risks that were not its to take ... risking the long-term promise to the policyholder for short-term performance. Without old portfolios or existing policyholders to consider, Executive Life was able to offer products based upon an investment portfolio with yields as much as double those of the established companies with established portfolios invested in conservative bonds and mortgages.

He also saw Executive Life succumb to what he calls "psychomedia risk" -- "the risk that even though you do everything right, something unexpected will happen, which creates the perception of failure although the facts don't support it." Schulte, page 56.

One element of Carr's eventual downfall was his self-imposed isolation of First Executive from both the insurance establishment and the press. First Executive and its managers avoided participation in industry associations and the network of industry support. He operated the expanding company like a sole proprietorship, making all the decisions and sharing little information with his own executive staff.

His agents suffered similar isolation from the established industry network. By joining Executive Life and aggressively converting old-line policies, they rejected the rest of the industry and put other agents on the defensive about their products. Other agents looked upon Executive Life agents as pariahs, associated with junk bonds, junk policies and junk agency practices.

What made Executive Life grow so fast, was the competitive advantage from the exceptionally high yield of its portfolio of junk bonds. According to Schulte, by 1987, First Executive Life had the largest portfolio of junk bonds in the world. In 1990, he was called before Congressman Dingell's subcommittee investigating problems in the insurance industry and defended his portfolio strategy. Those hearings resulted in a report "Failed Promises: Insurance Company Insolvencies" which was critical of state insurance regulation. As junk bonds and the Milken activities began to break down and come under increasing criticism from the media and commentators such as Benjamin Stein and Joseph Belth's Insurance Forum, he declined to respond.

What undid the company was its eventual inability to raise sufficient capital to support the rapidly expanding volume of business. The nature of the life insurance business is that due to heavy up-front expenses (mostly for agent's commissions), policies do not become profitable until several years of renewals. In the early years, every dollar of new premium is an actual drain on capital. Fast growing companies need more and more capital, and Carr took greater and greater risks to raise that capital, while projecting the continuation of high yields into the indefinite future.

Of course, the future turned out to be quite different than the projections.

When the junk bond market collapsed and policyholders became frightened for their investments, redemptions of his policies began and the company was forced to announce a dramatic writedown in 1990, increasing the policyholder panic.

His competitors and the press had been predicting the downfall of Carr's practices for some time, and in light of the new revelations, fed the collapse of confidence in the company. Carr found himself without allies or friends in the industry or media. Agents converted the company's policies to other writers, and in a very short time, Executive Life went from a fast growing business to a company in liquidation, a victim of the "psychomedia risk" and its lack of support and allies within the industry and media.

As the crisis deepened, Carr's pattern of centralized, autocratic management resulted in paralysis as he was buried in defensive issues. As organizational scholars such as Columbia Professor Duncan Watts would later predict, without a network of informed executives within the company and sympathetic allies outside the company, he was unable to effectively respond to the rapid change and challenges.

Although the base company reserves were sufficient to cover the remaining liabilities, they were seized by the insurance departments and placed into liquidation, and the holding company was forced into bankruptcy on May 13, 1991. The policyholders were covered, eventually, but the shareholders who had not cashed out early (as did Peter Lynch) lost their investments.

Stories like this are invaluable studies, because cases like those of First Executive continue to play out today. Such as those told in the February 2002 issue of The Actuary, "Deja Vu All Over Again - a roundtable discussion of insurance solvency and insurance fraud."

DougSimpson.com/blog

Posted by dougsimpson at September 22, 2003 03:31 PM | TrackBack
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