"The Fall of First Executive"

Twenty years after entering rehabilitation, Executive Life of New York (ELNY) appears on the brink of liquidation with potential future losses resulting to structured settlement stakeholders including defendants and liability insurers who purchased structured settlement annuities as well as structured settlement recipients.

The most recent financial statements for ELNY (as of December 31. 2010) show assets of $905,945,200 compared with liabilities of $2,474,317,342 resulting in a negative surplus of $1,568,372,142.

On December 17, 2010, a New York State Supreme Court Judge ordered the Superintendent of the New York State Insurance Department to present the Court with a proposed order and plan of liquidation for ELNY on or before July 1, 2011. On June 23, 2011, the Superintendent moved to postpone the deadline from July 1 to August 10 "in order to present a comprehensive and consensual proposed Plan of Liquidation that maximizes the potential benefits for ELNY's structured settlement and other annuitants."

Because of the 20 year time lapse since ELNY sold the last of its nearly 8,000 structured settlement annuities many current structured settlement stakeholders have either forgotten or never directly experienced the meteoric rise and fall of First Executive Corporation (FEC) and its two life insurance subsidiaries, Executive Life of California (ELIC) and ELNY (also referred to herein together as "Executive Life")

For persons interested in the background story of the rise and fall of FEC, "The Fall of First Executive", written by Gary Schulte and published in 1992, provides a fascinating and educational history of the events that led to the largest insurance failure in history. Schulte, who served as Marketing Director for Executive Life, provides an insider's account in the immediate aftermath of the FEC and Executive Life debacle.

Schulte's story inevitably features FEC CEO Fred Carr, who first gained a national reputation as a financial "gunslinger" during the 1960 mutual fund "Go-Go" years when his company, the Enterprise Fund, first outperformed the mutual fund industry then tanked in 1968. Carr's subsequent experience with FEC and Executive Life had many parallels to his mutual fund career.

ELIC was founded in 1961 and subsequently borrowed $14.6 million from what is now Citibank to purchase ELNY. Because the New York insurance code is more restrictive than other states, many life insurance companies own separate New York affiliates.

When Carr first joined FEC in 1974, the company was already publicly traded and "a financial mess". FEC had $77 million of assets (355th among U.S. life insurers) of which $22 million represented policy loans. FEC's investment portfolio was $20 million under water. FEC was in default on its $14.6 million Citibank loan. Both the IRS and the New York Insurance Department were investigating ELNY. Touche Ross, FEC's auditors, refused to express an opinion on its financial statements.

At its zenith, under Carr's leadership in 1986-87, FEC had shareholders' equity of more than $1.5 billion, no debt, and total assets of $16.4 billion. The combined assets of the two Executive Life subsidiaries ranked 15th among U.S. life insurers. Both Executive Life companies held ratings of AAA and A+ from Standard & Poor's and A.M. Best's respectively. Executive Life was ranked #1 in employee productivity and sold the highest average per case premium in the life insurance industry.

FEC's stock price reached its all time high in June 1986 at $23 per share. FEC counted among its major shareholders some of the most respected investors in the United States including John Templeton of Templeton Funds (7.3%) and Peter Lynch of Fidelity Securities (11.4%). Here is what analysts had to say during 1986-87:

• "Executive Life's capital structure and, hence, operating leverage are substantially more conservative than virtually all its "AAA" rated counterparts" - Standard & Poor's November 3, 1986;
• "I'd rather have Fred Carr running my company than the people who run General Motors" - Peter Lynch, Magellan Fund, in Barron's, February 2, 1987;
• "First Executive Corportation is one of the strongest life insurers in the United States ... The company's strong financial position is a counter to potential criticisms of investment policy." Johnson, Lane Equity Research Report, February 23, 1987.

By the time it collapsed in 1991, however, FEC had lost $1 billion of its investment portfolio; its market value had declined 99% from $1.5 billion to $15 million; and its net worth had sunk from almost $2 billion to a negative $3 billion.

So what happened to explain this roller coaster ride? On the upside, Schulte attributes FEC's early success to the convergence of four crucial components:

• Superior investment performance - Fred Carr was an early advocate for and investor in "high yield securities" (junk bonds). He formed a strategic relationship with "junk bond king" Michael Milken. By 1987, FEC and Executive Life had accumulated the largest junk bond portfolio in the world. Unlike its competitors, Executive Life initially did not have old investment portfolios or many existing policyholders to service. FEC offered new money rates at a time when interest rates reached historic highs and new money was hot.
• Profitable, competitive, innovative products - FEC specialized in interest sensitive and single premium products. Unlike structured settlements, most of FEC's products, including single premium deferred annuities (SPDA) and guaranteed investment contracts (GICs) were transferable. Offering higher rates than its competitors, Executive Life initially benefited from product transfers (disintermediation) from more conservative life companies.
• National distribution system - Fred Carr entered the life insurance industry when the traditional and expensive captive agency system (agents representing one company) was morphing into an independent agency system (agents representing multiple companies). With virtually no development costs, FEC was able to cherry pick the best agents who had been trained by and had previously represented other companies. The Executive Life companies also sold their products through stockbrokers and offered top producers participation in an agent owned reinsurance company.
• Unlimited capital to fund growth - As one informal quid pro quo for purchasing junk bonds from Milken and his company Drexel Burnham Lambert, Fred Carr had a reciprocal outlet for selling FEC stock. In addition, FEC implemented a series of "innovative" surplus relief reinsurance agreements which initially accelerated FEC's growth.

To explain the downfall of FEC and Executive Life, Schulte highlights both specific developments and more fundamental problems. The specific developments:

• In 1986, the Ivan Boesky scandal erupted and junk bond prices began to fall. Also in 1986:
  • Michael Milken's problems began to surface as junk bonds increasingly were utilized to finance leveraged buyouts, many of which were underfunded. Although Milken, in 1986, was still considered by many "the most influential man in American finance since J.P. Morgan", the "junk bond king" eventually was jailed for securities fraud in 1991.
  • Financial analysts first noted that municipalities were not legally responsible for the performance of GIC-backed bonds. In a matter of months, Executive Life's extensive GIC market dried up.
  • The Tax Reform Act of 1986 restricted the flexibility of withdrawls from two additionally important Executive Life products: SPDAs and interest sensitive whole life insurance.
• In 1987, the New York Insurance Department disallowed a number of reserve credits for ELNY resulting from questionable reinsurance treaties. ELNY admitted to violating eight sections of the New York insurance code and agreed to pay a $250,000 fine. ELIC subsequently provided ELNY with a $151 million capital infusion requiring FEC to raise additional capital.
• Also in 1987, Joseph Belth, an Indiana University professor and publisher of "Insurance Forum", began writing negative reports about Executive Life. The mainstream financial press eventually echoed Belth's negative analysis questioning FEC's concentration of junk bonds. Executive Life's competitors promoted these negative press reports to convince Executive Life policyholders to surrender their SPDA contracts.
• To pay for contract surrenders, FEC was forced to sell junk bonds before their maturity at a loss in a plummeting and thinly traded market. During the first half of 1990 alone, Executive Life experienced $2 billion of SPDA surrenders which Schulte equates to a "run on the bank".
• Although Fred Carr invested in companies that were heavily indebted, he disliked debt and avoided using debt financing for FEC. Nevertheless, as financial pressures increased in 1988, Carr negotiated a $275 million loan for FEC from a consortium of Japanese banks.
• To raise capital in 1989, FEC announced the sale of ELNY but the sale fell apart in January of 1990. With the Japanese bank loan nearing default, FEC did complete a complex rights offering which raised $284 million in 1989 but also resulted in a 1990 investor lawsuit alleging fraud.
• In January 1990, Executive Life announced a write down that eventually totaled $776 million and A.M. Best's lowered Executive Life's ratings from A+ to A. Peter Lynch liquidated Fidelity's investment in FEC the same month after stating to Fred Carr: "Fred, I've been listening to you for an hour and you sound to me like someone who's shorting the FEC stock". In fact, FEC was the most shorted stock in the United States during 1990. From July 1989 to the end of 1990, FEC's stock fell from $16 per share to 16 cents per share as its net worth declined to a negative $3 billion.
• On April 11, 1991, newly elected California Insurance Commissioner John Garamendi obtained a court order seizing control of ELIC. New York's Insurance Commissioner Salvatore Curiale followed with ELNY on April 16. FEC filed for Chapter 11 bankruptcy on May 13. As Schulte points out: FEC was bankrupt when Fred Carr took it over in 1974, and it was bankrupt when he left seventeen years later.

More fundamental problems attributed by Schulte to Fred Carr, FEC and Executive Life:

• In mid-1980s, Executive Life was known for three things and two were bad: competitive, innovative products; junk bonds; and the poorest service to agents and policyholders in the industry.
• FEC and Executive Life overdosed on junk bonds. In a properly constructed portfolio, higher risk of default for high yield bonds may be compensated for by higher returns. Fred Carr, however, never said "no" to Michael Milken. He "bought in" on every Drexel Burnham Lambert junk bond deal. FEC did over $40 billion in trades with Drexel Burnam between 1982 and 1987 and accumulated the largest portfolio of junk bonds in world. Fred Carr underestimated the risks associated with the yields.
• Executive Life was also very aggressive with mortality assumptions reaching too far and promising more than it could deliver. Fred Carr took a short-term period during which exceptional yields were available and extrapolated those yields to long-term products.
• The lack of good operating systems caused serious servicing problems. Schulte characterizes FEC as a "Fortune 500 sole proprietorship". There was no budgeting or internal controls; no pension or profit sharing plan. FEC had an "addictive reliance" on outside consultants. Officers never attended Board meetings. Employee morale was always low. FEC and Executive Life hired young, single, poorly qualified, immigrants. In 1986, turnover in operations at FEC was 106 percent.
• Schulte also highlights how FEC and Carr greatly underestimated the "psychomedia risk". Once Executive Life was caught in the media cross-hairs, a crisis in confidence occurred creating an avalanche of policy surrenders. Of the $19 billion of assets Executive Life held on January 1, 1990, $11 billion were subject to surrender by policy holders.

When FEC and Executive Life collapsed in 1991, the combined companies stranded more than 500,000 policyholders, annuitants, investors, employees and agents. The annuitants included 13,500 structured settlement recipients. Despite payment delays, almost all of the ELIC structured settlement payees eventually received, and continue to receive, their payments in full. ELNY, operating under the control of the New York Liquidation Bureau since 1991, has met all of its structured settlement payment obligations to date despite its deteriorating financial condition.

The ultimate fate of ELNY's structured settlement payees and purchasers remains uncertain pending the results of its anticipated liquidation. As Schulte concludes in his 1992 book: "the proverbial fat lady in the First Executive Opera has yet to sing. Her song could put a different complexion on [the Executive Life story]."

For additional and continuing reporting and analysis about Executive Life, see:

• S2KM's structured settlement wiki;
• Sections 3.05 and 5.04 of "Structured Settlements and Periodic Payment Judgments" (S2P2J).