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Confederation Life made the fatal error of concentrating its assets in the real estate market at a time when real estate prices were inflated.
In order to make a profit in the increasingly competitive insurance industry, Confederation Life invested heavily in real estate throughout the 1980s and early 1990s. By 1993, 71% of the company's assets were in real estate. The performance of the real estate market appeared to be too good to be true - and it was. The losses began to hit hard in the early 1990s.
Between 1990 and 1993, appraised values fell from an average of $208 per square foot to $129 per square foot (based on properties held over the entire period), and a $200 million portfolio Confederation had assembled for various pension funds lost 34% of its value during the same time period. The company's problems were compounded by poor management in its business practices. Among these were lax application standards for loan applicants, and company employees who bought condominium units from the company, then sold them back at a considerable profit a short time later.
Ultimately, federal officials, fearing investor panic, stepped in and shut the company down. KPMG, the liquidators, estimated losses at $1.3 billion. |
In late 1993, Confederation Life Insurance Company ranked fourth among Canadian life insurance companies with 273,000 policyholders, 4425 employees, and $19 billion in assets. A.M. Best Co., a leading ratings service for insurance companies, rated Confederation as "A (excellent)", the third-best of 15 possible ratings.
Executives at competing insurance companies have said that they knew Confederation was having some problems at that time, but nothing that couldn't be resolved - or so they thought. The problems stemmed from economic conditions in the early 1980's. At that time, competitiveness in the Canadian insurance industry was increasing, as insurance companies battled not only each other, but also mutual funds, banks, and trust companies for consumers' money.
This led to decreasing profit margins, which, coupled with rising inflation rates, meant that pension fund managers had to be on their toes in order to provide customers with the returns they expected and still turn a profit for themselves. Patrick Burns, Confederation's CEO at that time, decided that the best strategies were:
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To increase volume to achieve economies of scale;
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To establish new ventures; and
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To invest as much as possible in the real estate market, which was yielding impressive
returns at that time.
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In 1982, Confederation had a mere $119,000 invested in property, but thanks to aggressive real estate investment, this sum had grown to $1.1 billion by August 1994. Likewise, Confederation's mortgage portfolio grew from $1.2 billion in 1982 to $8.5 billion in 1993. The company had 71% of its assets, far more than any of its rivals, invested in real estate, either through direct ownership or through mortgages on properties ranging from houses to condominiums to office buildings and shopping malls.
In addition to the risks associated with having such a large proportion of the portfolio concentrated in one market, Confederation arguably couldn't have picked a worse time to make its foray into real estate. The real estate market was inflated, and the amazing returns could not continue forever. The losses hit hard in the early 1990's: between 1990 and 1993 appraised values fell from an average of $208 per square foot to $129 per square foot (based on properties held over entire period). A $200 million portfolio that Confederation had assembled for various pension funds lost 34% of its value during the same time period.
If this lack of diversification and broad exposure to market risk weren't enough, Confederation also was plagued by poor management in its business practices. Perhaps the biggest liability in this respect was the Confederation Trust Company, which was set up in 1987 to provide loans to condominium promoters. Through partnerships with other companies, such as the Reemark Group in Southern Ontario and British Columbia, the company quickly grew its mortgage portfolio. For example, Confederation financed loans made through Reemark to the tune of about $350 million.
Unfortunately, neither Confederation nor Reemark was thoroughly checking where these loans were going. In fact, many were going to buyers of apartments who were not planning to live there and had no chance of even breaking even unless rents and values rose - but they were granted large mortgages with down payments of as little as $1,000 per unit.
By 1989, the trust company had $906 million in mortgages. Over the next three years, it lost $89 million, mostly due to defaults on loans, and received $70 million in capital from Confederation Life. Ultimately, Confederation Trust had to be shut down.
Confederation reported impressive profits of over $100 million per year in 1989 and 1990. But problems were starting to become apparent by 1992, with the company reporting a mere $1.9 million in profits for that year. In the fall of 1993, Confederation announced that it needed help and opened its books to competitors who might be interested in a merger, take-over, business alliance, asset purchase, or almost about any other kind of financial assistance.
Great-West Life Assurance Co. of Winnipeg expressed interest in the company in October, and in December agreed to try to work out a deal to save or absorb Confederation, on the condition that Confederation stop talking to all other companies. Confederation agreed. However, the proposed deal never materialised.
In July 1994, Great-West announced that it would not be able to act alone. Great-West stated that Confederation needed $600-million in funds, and that Great-West would put up no more than $75 million. On July 23, Canada's six leading life insurers began planning a joint rescue of Confederation. The insurers had an incentive to help, since if Confederation failed, they would pay the costs of compensating Confederation's policyholders, via the industry fund that existed for this purpose. However, the negotiations between the rival insurers stalled, and on August 11 the Canadian government stepped in to shut down Confederation, fearing that public anxiety would lead Confederation customers to initiate massive withdrawals and cancellations, a similar process to "a run on a bank".
Confederation's individual life insurance policyholders will fare relatively well, since death benefits up to $200,000 are guaranteed by the Canadian Life and Health Insurance Compensation Corp., an industry-sponsored fund. About 90% of Confederation's policies are fully covered by this limit. Larger policies will be paid out at a somewhat reduced rate, but CompCorp is optimistic that the reduction will be as little as 10%. Deferred annuities and accumulated cash values that customers can claim when they cancel their coverage are insured only up to $60,000, and so may present a stickier situation. Ultimately, all policyholders will likely experience increased costs passed down to them from the remaining insurers, who must cover Confederation's debts through contributions to the CompCorp fund. Counterparties to Confederation's interest rate and foreign exchange derivatives transactions also felt the pain; it is estimated that these aborted contracts ran into hundreds of millions of dollars. |
Early 1980s: Confederation decides to aggressively purchase real estate to be able to provide competitive returns in the life insurance business.
1987: Confederation Trust is established to provide mortgages on condominiums.
1989, 1990: Confederation reports profits exceeding $100 million in each of these years.
1992: Confederation reports an annual profit of $1.9 million.
Third quarter 1993: Confederation announces that it needs financial help.
December 1993: Great-West undertakes to work out a deal to save or absorb the company, and begins a review of Confederation's books to further evaluate the situation.
23 July 1994: Major Canadian life insurers band together to attempt a joint rescue of Confederation with a $600 million loan, but talks stall.
11 August 1994: Federal officials, fearing that public apprehension will lead to a surge in withdrawals and cancellations, decide to shut down Confederation.
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Lessons to be learned:
Set limits and establish a balance
The concentration of 71% of the company's assets in real estate was a major factor in the company's dissolution. It does not appear that the company planned any strategy for diversifying or otherwise limiting its risk in the real estate market.
Apply checks and balances on the activities of those in positions of power
Chairman Patrick Burns' determination to concentrate vast amounts of assets in real estate went virtually unopposed. Michael Mackenzie, Canada's former superintendent of financial institutions, provides insight into the danger this poses:
"I have been trying to train people that this is an early warning sign of trouble anywhere, it doesn't matter what the company, what the industry: When you see a CEO, a strong-minded CEO, who brooks no opposition inside, watch out. . . If he doesn't create an open working atmosphere where people can say, 'Pat, for Christ's sake, this doesn't make any sense,' [the company courts disaster] because if they're not going to say it at the operating level, they're also not going to say it at the board level." (The Globe and Mail, 12/22/94).
Understand the business:
The cyclical nature of the real estate industry was apparently completely ignored. Mortgages were given out indiscriminately to some borrowers who probably would not have qualified under a normal application process.
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