With leverage transactions investors are regularly deceived to yield and risk
Effortless wealth: the sales lie “over 12% yield”
The Regional Court of Bamberg sentenced a British life insurer in several cases, whose agent had referred to past values “of more than 12%” yield to insurance customers. From this, the intermediary had then presented ‘a conservatively assumed performance of at least 8,5 %’ as realistic. One of the insurer’s tricks: it brought into circulation returns from another type of life insurance policy that was not even available to investors in Germany. The actual return on investment was only 3,2 % and minus 8,8 % in 2000 and 2001 respectively.
Organizational Fault: Liability for outdated data and loan financing
Advertising with out-of-date data, under the eyes of the insurer, leads to fault liability of the institutions with the insurer. The insurer still claimed at the trial that it had not known about the financing to the extent of 80% of the single premium paid. The financing banks always had the surrender value assigned to them by the customer before the loan was paid out to the insurer, and requested a reconfirmation from the insurer for the credit file. The insurer must adhere to the practice of “single premium, ongoing repayment and assignment of security to the bank”. incidentally, some brokers claim that this insurer also specifically trained its brokers “on leverage transactions,” but that was not the issue at all in the lawsuit.
Incorrect information on return and risk: insurer liable for its intermediaries
Only accurate information on past returns can form the basis for the independent decision of insurance customers: without correct bases, no investor can calculate correctly or weigh up the risk correctly. The breach of duty on the part of the insurer or the intermediary, for which the insurer is liable, is so serious that contributory negligence on the part of the customer is out of the question in the case of such interest differential transactions.
Hundreds of thousands of customers affected: Insurers from England, Germany, Liechtenstein
The method used in sales, not only by British insurers, was “five to fifteen times commission”, because a small amount of equity capital was supplemented by a much higher amount on a loan basis. Of course, each bank also still pays a commission for the loan brokerage. Yes, the model paid off so “favourably” on paper that many a client could not believe his luck and even paid the intermediary an additional five- or six-figure fee out of his own pocket. Unfortunately, it later became apparent that the interest rates on loans were permanently higher than the returns: The destruction of money was pre-programmed.
Smoothing is not a miracle cure for high returns
British life insurers advertised high and at the same time stable returns in so-called unitised-with-profits (UWP) policies – in some cases still to this day. Strong returns result from the high proportion of equities. On average, equities deliver higher returns. But they also involve an increased risk, which British insurers are trying to mitigate through a special process that most outsiders don’t even begin to understand. Indeed, the stability of returns is attributed to a smoothing process peculiar to UK life insurers, which is designed to smooth out fluctuations in the capital market. In good times, the (unsmoothed) value increases generated are only partially passed on to customers. This means that the maturity bonus can be maintained or even increased in the event of a short-term moderate stock market decline – an effect of smoothing. But as the stock market continued to fall, the value of the shares also had to be reduced: the maturity bonuses gradually fell sharply. The effect of smoothing can only be seen in a slightly delayed decline in maturity bonuses compared with the stock market trend. The smoothing process therefore only has a gradual and short-term effect here.
Value of the units is not guaranteed
It would be a mistake to confuse the value of the units – i.e. including maturity bonuses – with the guaranteed values; only the latter cannot fall if the investment is held until the scheduled maturity date. This is because even these guarantees no longer apply if the shares are sold prematurely. However, these guarantees are significantly lower than would correspond to the development of the stock market. The guarantees are only determined for one year in advance in each case – as an interest rate on the guaranteed value of the units achieved to date. There is no guarantee that interest will continue to accrue in subsequent years. In principle, therefore, the guaranteed value of the shares once achieved could also remain unchanged until expiry – only it may not fall. And because this guaranteed value of the units only applies at scheduled expiration, it should not be confused with an actual today’s value of the insurance: In the event of an early sale, it can be significantly undercut.
Financial strength through risk shifting to the customer
Even just to guarantee the declared capital gains, UK insurers need substantial collateral capital or a great deal of flexibility in their commitments. This security capital consists to a large extent of the funds already generated, which, not yet definitively guaranteed, have been passed on to the customer. This also includes the maturity bonuses included in the value of the units, which are not guaranteed. With this part of the unit value, the customer is also “liable” for the development of the capital markets or unsmoothed increases in value until the expiry of the contract. It is only this “financial strength” that makes it possible to take a high risk when investing capital – a large investment in shares. Conversely, this riskier investment policy – which tends to generate higher returns – also requires greater financial strength, i.e. lower guarantees. In the case of larger guarantees, a possible decline in stock market prices could no longer be absorbed: The consequence would be insolvency, which would then also jeopardise the guarantees given.
What principles are used to determine the level of performance for UK insurers?
Anyone expecting a formula here will be disappointed. The basic idea of the British in determining performance (guarantees and maturity bonuses) is to treat all policyholders fairly. It is impossible to determine in advance exactly what this will be in view of the never predictable concrete development of the capital markets. Rather, the procedure is institutionalized: First of all, it is necessary to start from the financial possibilities. As part of the state’s oversight and the advice of the actuary responsible for it, the current bonus policy is then regularly set by a committee whose job is to ensure that policyholders as a whole are treated fairly. There is no mechanical bonus allocation, but some discretion in determining bonus levels. Only when this has been determined can the values for the individual customer be calculated.
How transparent are opportunities and risks for the investor?
An investment in a UK life insurance policy participates – to an extent not previously specified – in the performance of the underlying capital market funds. However, there is no prospect of a result corresponding to the investment performance of these funds themselves. This makes the guarantees possible, but they only include a portion of the funds’ performance. The extent to which the customer participates in the actual performance of the funds is determined by the UK insurer itself, with only a general promise of “fair treatment”. What fairness to the totality of all customers means for the individual case remains open. However, this means that the costs of the guarantees given are completely non-transparent in advance. This is because the guarantee costs are only known at the end of the contract, when the more or less high maturity bonuses are paid out. Then the overall result can be above or below the performance of the funds – namely as a result of “smoothing”. However, the extent to which capital market developments will be mitigated by smoothing cannot be determined in advance. But in the case of premature redemption of units, there are usually no guarantees at all – the capital market then takes full effect.
Reverse leverage effect
In the case of regular withdrawals – e.g. to pay instalments on leverage loans – guarantees usually do not apply; instead, the shares are valued and paid out with a so-called market price adjustment when the stock market is weak. When the stock market is weak, many shares must be sold, and when the stock market is good, fewer shares must be sold. What is known as a useful yield-increasing leverage effect in the opposite case when buying fund shares, has the opposite effect here – an additional weakening of yield – a reverse leverage effect. Unfortunately, such damaging fluctuations were not mentioned in the advertising brochures at all – here one shone rather with an always evenly increasing performance. Criminally, this was then also included in the forecast calculations of the leverage models – far removed from any expected reality and the actual contractual agreements.
by Dr. Johannes Fiala and Dipl.-Math. Peter A. Schramm
by courtesy of
www.experten.de (published in Expert Report 03/2009, 56-57)
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About the author
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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