Number-crunchers Caught Out By Keyman Policies
Sydney Morning Herald
Wednesday November 27, 1991
Eighty Ernst and Young partners are out of pocket after participating in boom-time insurance policies designed to protect people with high incomes.
The embarrassing troubles with keyman insurance contracts sold by the AMP Society could lead each partner to forking out an average $25,000 - a total of almost $2 million to keep up the commitments on the policies.
The Ernst and Young saga involves the enthusiastic sale of high-premium, high-commission, whole-of-life policies with $1 million death cover for each partner, with the payout rising to a projected value of $11.5 million after 40 years, in a climate of tumbling policy bonus rates and high interest rates.
One main selling feature of the scheme was the policies were to be mainly self-funding, with premiums paid for at first by an ANZ loan and then by borrowings from the AMP Society using the policies' cash value as security.
But the assumed earning rates on the policies were not fulfilled.
As a result, Ernst and Young partners and their wives - several of whom took out policies on their husband's lives - have found themselves having to find additional cash to finance the hefty premiums.
A similar situation is facing a large number of other individual policy holders who took out large business insurance and keyman policies -essentially whole-of-life policies with big premiums - with the AMP, National Mutual Life and Prudential.
All three life offices viewed business insurance as having high growth potential three years ago and set about aggressively carving out market share among perceived (or potential) high net worth individuals.
Some of the policy holders now ruthlessly reviewing their business insurance policies are former high-flying agents who fell for their own sales pitch and were often helped into financing such policies with generous interest-free or low-interest "agency development" loans provided by life companies to entice them away from a competitor.
In the case of keyman or split-dollar policies, where the favourable arithmetic hinged on tax deductible borrowings to pay premiums, a tax office crackdown in the past 18 months has rendered them unviable. The Ernst and Young policies are not split-dollar policies and are not affected by any tax rulings.
Now that the life companies are demanding their so-called development loans be repaid in a hurry, agents have had to refinance the loans used to pay the premiums.
Some are finding it difficult to justify the high premiums payable on these policies when market interest rates have remained fairly firm but the bonuses paid by life offices on the policies have plummeted.
Indeed, market loan interest rates are tending to dwarf the earning rates on the policies by a substantial margin - 5 percentage points is not unusual.
This can leave the policy holder a difficult choice. To discontinue the policies within two years of its purchase means all premiums paid are forfeited.
And to discontinue them after two years means their cash value is minimal due to the high commissions paid up-front to the agents who sold the policies
Changed economic circumstances and growing consumer resistance to hidden commissions have forced life companies to review their product range. Many high-commission policies have been replaced with products that pay lower commissions or spread commissions over a five-year period instead of two years or one. This delivers higher returns to policy holders who elect to discontinue policies early.
But the sheer size of the Ernst and Young policies, which were written under the old rules, the way the arithmetic fell apart very quickly and the complicating issue of Ernst and Young being the AMP's auditor, has given the dispute a special piquancy.
These policy holders are not a group of car mechanics who had difficulty grasping the mathematics of what they were buying, but highly skilled numbers people making a very good living understanding complex issues and adding up columns of figures, then analysing them for holes and discounting them for inflation.
Ernst and Young's senior partner Mr Ric Turner strongly denied the audit has been mentioned in the context of the dispute. "The AMP have not said they are unhappy. It has never been a threat to the audit." Mr Turner acknowledged, however, it could be a sensitive issue if it received publicity.
"AMP did not pressure us to take out the policies. It was done totally outside the consideration of the audit," he said.
"At the time it stacked up as a reasonable deal. I think it is not attractive now.
"It is a bad investment. It did not do what it was supposed to do. A number of them (partners) are going to cancel and not pursue the policy."
One Ernst and Young partner aged about 44, and who asked not to be identified, told the Herald : "It is not a very good deal at all."
He took out one of the policies two years ago. "As a profession we spend more time on our client's affairs than on our own. It (policy renewal) is in my briefcase and I have to focus on it."
He added: "It is not appropriate today. I might have to make a decision soon. My gut feeling is that I probably won't carry it on. But I'm not sure when this policy clicks out in terms of surrender value."
The initial death cover on each partner's life is $1 million and the annual premiums for the partners ranged from $15,300 for the youngest partner to$37,000 for the older partners. Even with the hefty discounts provided by the agent, which saved the partners an average of $4,000 a year in premiums, the total premium figure involved in the package was about $1.5 million each year
Insurance sources contend the policy was one of thd largest group policies ever sold by an Australian underwriter. The same sources estimate the commission payments to the agency group, Chancellor Investment Group Pty Ltd, should have been about $3 million.
Chancellor Group is based in Albury and has a paid up capital of $4.7 million. Among its shareholders is the AMP Society with 3.8 million shares.
According to documents filed with the Australian Securities Commission the AMP has a charge of $774,000 over the assets under its loan agreement with the Chancellor group.
It is understood a driving force within Ernst and Young was Mr Gabriel Szondy, an insurance expert with the firm.
To sweeten the deal, the AMP discounted premiums, with bonus rates remaining the same thereby giving the Ernst and Young policy holders a greater advantage than was available to other holders of the same AMP policy. The partners paid a $2,000 fee for investment advice to the agents - a fee which would normally be tax deductible.
In return, Chancellor Group forfeited its commission and thereby beat several other tenderers to the punch.
The arithmetic underpinning the deal was this: the projected bonus rate on the policies was assumed to be 12.1 per cent in the first year, dropping to 10.7 per cent in each of the next 10 years.
The loan rate to pay for the first two years' premium was to be 16 per cent, with a 14 per cent rate applicable to borrowings from the AMP in subsequent years using the policy as security.
As the loan interest was not deductible, it is hard to see the policy being a good deal under these assumptions. It is possible policy holders were told the bonus rates would be higher and loan interest rates would drop, but neither Ernst and Young nor AMP would confirm this. Or it could be the premium discount was the factor making it viable.
© 1991 Sydney Morning Herald