A confluence of recent events has brought the entire subject of rebating and inducements into the public eye, for (1) philosophical debate over the merits of the rules themselves; (2) technical analysis with respect to acts, structures or service provisions that constitute rebates under prevailing current law and (3) practical counsel, given the extraordinary amount of rebating that has occurred during the past 5 years or so to find (a) what and who should be the subject of enforcement actions, (b) who should initiate them, (c) what should the framework for appropriate penalties be given the history of enforcement dealing with rebates. The first signal of serious reflection may be found in the issuance of New York State Department of Insurance (NYSID) Circular Letter No. 9 (2009) dated March 3, 2009. Signal 2 was the publication of IRS Revenue Rulings 2009-13 and 2009-14 which, although not dealing strictly with rebates, are raising the alarm bells and drumbeats in the distance. This was followed by the appearance in the Insurance Advocate magazine several weeks ago of source selected information.

To begin our analysis, the most recent era of rebating is unlike any that has preceded it! This episode is thoroughly unique (and potentially worthy of Armstrong II) in terms of its (a) scale and scope, (b) its participants and promoters, (c) the extraordinary damage that has been done to customers (primarily senior citizens), (d) the defrauding of insurance carriers that was involved with respect to certain honorable insurance companies, (e) the extraordinary hypocrisy that was exhibited by  other carriers (or select senior personnel). The carriers issued fearsome letters to their respective sales forces in suspicious proximity to each other and then subsequently and highly questionably accepted massive amounts of business from favored distributional outlets initiating a storm of protest throughout the historically loyal agency and brokerage system.

Second, the most recent storm of rebating was a critical constituent component of the Stranger Owned Life insurance (“STOLI”) phenomenon. Third, this recent historical anomaly introduced into the critical mass of “actors” an essential ingredient to the sizing parameters that so overwhelmed the industry’s historical norms:

(1) the investment bankers, (2) the major law and accounting firms and their pedigreed letterheads, (3) the hedge fund managers,( 4) the asset advisors (family offices, endowments, foreign sovereign wealth funds, (5) the new group of specialists – actuarial firms, life expectancy providers etc. whose Cassandra prophecies achieved overnight stamps of international approval and (6) the shadowy transitory “characters” who seem to migrate to wherever new under regulated pockets of financial activity surface. The entry into the business, whether licensed or not (another matter for intense examination) terminally modified the historic and comfortable industry paradigm that found financial giants (Met Life, New York Life etc.) distributing their products by relatively small firms while the giants retained customary and corresponding control. Under the new paradigm, distribution and client control was migrating toward other financial giants (Merrill Lynch, Goldman Sachs etc.). The expression “ordinary life distribution” does not envision an equality of financial and other resource power and the concentration risk that this entails. It does refer to the pre-existing situation where the carriers were so overwhelming in their asymmetrical relationships that letters like the ones issued to their sales forces in the spring of 2005 achieved much of their desired objective – as their own appointees, at least in the beginning, including normal non-agency brokerage distributional lines, were sufficiently frightened to stop, decelerate or hide their participation in STOLI business. However, those in the world they inhabited did not feel intimidated and did not withdraw and “play nicely with others”. Many ignored licensing requirements altogether on the tenuous premise that they were simple wholesalers of capital with no responsibility to the life insurance industry or those who are empowered to regulate industry activities. This qualitative shift in who was supplying the capital also rotated the rebate and inducements from fairly straightforward direct rebates to eminently more sophisticated indirect rebates often connoting secrecy and stealth, i.e., the implication of “something to hide”.

A Rebate and inducement – Direct, Indirect and Upside Down
The essence of rebating is simplicity itself. The thrust of life insurance law and the thrust of securities law have often been compared by stating that the primary objective of (1) is non-discrimination and of (2) is full disclosure. Ad hoc, un-filed rebates, by their very nature, turns this objective principle on its head as it mandates that some policyholders will eventually have a different financial arrangement than others. This difference may develop exclusively by serendipity or may be part of a focused marketing campaign. Either way, it violates the core principle for which the life insurance law operates. While a policy is indeed a contract (as every CLU candidate learns early in his conversion to professional status), it is a very special contract- one that is sacrosanct, one of adhesion and one of dramatic asymmetry in the specialized knowledge necessary to truly understand what one is getting into. An insurer (and its massive representational base) is not a fair counterparty to negotiate a contract with an occasional acquirer of its contracts. This is why the statutory schemes interpose a Department of Insurance, with more than comparable experts and an institutional memory to neutralize the insurance carriers and their distribution forces for the protection of the public.

Circular 9 (2009) and the Predecessor Cautionary Carrier Letters
Recently, carriers received from the NYSID and redistributed to their agents, a Circular Letter. The letter, Circular 9, is titled innocuously enough: “Permissible Services of insurance agents and brokers; rebating and inducements.” However, the dry sounding name masks a much more potent message. The senior Insurance Department in the US, the Department to which many look to as they would to the SEC in securities related matters at the federal level, is serving up a stern warning that rebating has become a hot topic (the kind that finds its way from a collection or album of General Counsel Memoranda (GCMs, somewhat lower level authority in the hierarchy of departmental authority) and will not be tolerated. It is quite interesting to ponder the manner by which the Departmental author decided to transmit the message to those of us who practice in this field on a regular basis. Since we believe that the Department is concerned a good deal more about the hundreds of millions of dollars of surreptitious transfers or laundering of funds through the system than the discount of services in exchange for receiving the green light for a singular piece of business, why would the Circular Letter focus primarily on the latter rather than the former. One can conclude that the Department believed that if they could finally communicate to their wider audience that, if they take minor infractions seriously, it stands to reason that they are going to assert themselves with full force and effect in the event, not of a single accidental transgression, but rather of a secret, conspiratorial cabal of wrongdoers who defraud the public, the state, the state’s apparatus for regulating this commercially essential business. Let’s remember that insurance is one of the few major enterprises remaining that are dependent on state level (or multi-state cooperative level) and not federal level authority for tracking a mammoth enterprise without which both commerce and family life as we know it would not exist. Further, they do this without recourse to their departmental overseers, federal quality power, and the state legislative committee’s ability to print money or run massive deficits to “green light” any rationally determined need to add staffs to target dangerous “end runs” around central principles that are being violated on a basis even when the scale may be frighteningly massive. In banking parlance, unsafe and unsound practices are becoming fundamental components in the markets where the sponsors and their facilitators are collaborating to book profits today at the expense of the public interest tomorrow.
Principled Participation

My firm attempted to participate in the market, that is the Non-Recourse Loan and Premium Finance Market, in an ethical and honorable manner and believe that we succeeded. In the inquiries and investigations and examinations that will follow this phenomenon, we will wish to understand why, when our firm did its due diligence and visited major carriers etc. and explained our program in depth, received formal approval and encouragement, wrote business with full disclosure in each case, we found our licenses terminated two years later.
The reason tendered: our involvement in non-recourse premium finance- the very field that they encouraged. This is no longer a collaborative effort between issuers and marketers. This kind of conduct does not encourage open and frank and honest interchange. We will wish to know why carriers issued the most threatening sets of letters I have read in my thirty years in the business to their sales forces. These letters warned agents that the mere accepting of an application that could consist of STOLI could cause disciplinary action, including the dreaded Termination for Cause and then continued to accept applications from certain other distribution outlets for months offering others only excuses when it is widely believed that some other motive was at work in this anomalous distributional mystery.
As a separate matter, why has no concerted action been taken to protect the identities (the insureds) of those who, rightly or wrongly, entered into these arrangements and having been divested of their policies, are frightened that they may become targets of “actuarial self correcting modalities”?

Circular 9 through the LOOKING Glass
The fundamental tenet of the antirebating and anti-inducement provisions of the law are that no benefit can be offered or delivered to a prospective or in-force policyholder that is not described in the policy itself, as filed with the appropriate regulator, and no part of the insurance premium, or commission, can be used to finance such a benefit. Circular 9 leads with the point that affording a client a service that such client requires, at a price which represents a discount from market, is impermissible. This seems so logical as to hardly need to be articulated in the face of the plain language of the anti-rebate/inducement statutes. Yet, I can tell you without fear, that the vast majority of interlocutors with whom I have debated this subject have concluded that they have discovered the silver bullet that allows them, and sometimes claim smugly that it allows only them, to modify the intended, filed and approved allocation of premium funding of an insurance plan without creating a rebate or inducement. The rule is fundamental. No under compensated (or, of course, uncompensated value transfer may occur) unless such transfer is filed and approved in the policy form as filed with the applicable state authority. The rule is immutable. In the history of New York’s GCMs, the queried techniques are sufficiently varied as to have left no doubt of the “spiritual” meaning of the rule as well as the technical meaning. Yet, I have had no shortage of individuals wishing to debate the issue on non-fundamental grounds. The attached Q&A presents a sampling of thinking on this score:

(Q)(1)- While I understand why one cannot simply write a check to the proposed policyholder, I do not understand why I cannot make an indirect transfer of value especially if the client is not aware of the transfer since it would not then constitute an inducement. Please explain?

(A)(1)- The general rule in life, business and law is that one should not be able to accomplish indirectly that which he/she cannot accomplish directly. With the special situation of California (mentioned earlier) virtually all of the statutory schemes use the language making it plain that either direct or indirect avoidance are treated equally.

(Q)(2)- What are the basic indirect rebate classifications?

(A)(2)- There are essentially two types of indirect rebate types. The first is highlighted in Circular 9 and describes the value transfer or “kickback” of some of the premium dollars through services provision in areas other than through the insurance policy itself. Examples abound. A split funded qualified pension firm provides actuarial services including the filing of all requisite 5500 Series Forms and the filing of Schedule B, the Enrolled Actuary’s Statement with the Labor Department. For an uninsured plan, the provider charges $2500 for a particularly sized plan but if insurance is purchased then the fee is to be reduced to $1500. It is self evident that this is the moral and economic equivalent of charging and receiving $2500 in both cases but in the situation where insurance was purchased thus producing an insurance commission the service provider will return $1000 in cash. The seemingly close example on page 3 involves only insurance information necessary to fill out a return and does not involve actuarial services that would be required whether insurance was purchased or not.

(Q)(3)-What is the second kind of indirect rebate?

(A)(3)- The second kind of indirect rebate involves a third party provider which primarily distinguishes this transaction structure from Q&A 2 in that it is possible to broaden the type of services (and/or products to be offered) or more intriguingly to disguise the existence of the rebate, inducement or discount from the purchaser, the insurer and the agent. The major distinction: the recipient may not be a willing participant in the scheme since he/she was unaware of the benefit being conferred. However, although this should certainly constitute a defense to the purchaser for conspiracy to participate in the unlawful act, the Internal Revenue Service would still take the position that such an individual (or his trust) received taxable income and will expect to have it reported as such.

(Q)(4) There is little authority or law written regarding indirect rebates. Is this true?

(A)(4) Quite the contrary. The letter and the spirit of the law is to prevent a rebate from being permitted in one form when it is not permitted in a more fundamental form.

(Q)(5) Since premium loans come in a wide variety of modalities, with differing pricing and terms and conditions, how can one be certain that a particular arrangement is really a rebate at all?

(A)(5) In commercial relationships, the starting point for any analysis is the profit motive and the search for value. Therefore, if one party is prepared to pay millions of dollars to a second party, it is virtually definitional that the transfer is being made to acquire something that the market is not otherwise offering for nothing. For no rational businessman (premium financier) would pay Bank Wholesaler A a share of his commissions if he/she could obtain the same exact loan from Morgan Chase without paying millions of dollars of “voluntary” payments.

(Q)(6) The payments being made were not gross commission sharing, they were permissible allocations of net profits. According to NYSID GSM this is a legal arrangement. Why then is this a prohibited transaction?

(A)(6) Because these are sham arrangements designed to appear to comply with the NYSID GCM which indeed permits the legitimate sharing of net profits of an insurance brokerage. In the absence of such a sensible rule, there would be no way for a Marsh & McClennan or AON to share brokerage profits with their legitimate risk taking shareholders. The example oftentimes quoted from the GCMS of NYSID Legal Counsel involves two LLCs or Limited Liability Companies entering into a joint operating agreement with one side perhaps investing a little capital, making business introductions etc. in return for a percentage of the net business profits. The flaw in each one of these infuriating structures is that the operating expenses are a defined level percentage of operating revenues thus effectively guaranteeing or replicating the arrangement based on gross profits. If, for example, the expenses are agreed upon to represent 65% of all revenues then the profit to be earned by the enterprise (or the share of the profit deemed to be earned by the wholesale lender in the enterprise is 35% without regard to whether there are any real profits at all. Assume a situation where there is only one large policy sold in a year generating a gross commission of $1 million. Most likely, after all real expenses including reasonable compensation to the operators and payment of the share of the gross commission to the originating agent is 50% there will be a real operating loss in the entity. However, based upon their artificially imported formula the Net Profit, as defined for the purpose, will still be 35% (100% gross commission minus 65% assumed levelized expenses). I have had some of the most famous insurance lawyers try to persuade me that this is a perfectly valid commercial manner of arranging a transaction. When I offered to participate in such an arrangement if they could produce a single client who would honor such a preposterous scheme each failed to deliver a true counterparty.

(Q)(10) It is only the basic commission that is subject to the rules concerning rebating. Expense allowances do not count in their formulation and can be transferred as one pleases?

(A)(10) I have discussed this with attorney, regulators and have researched the question exhaustively. I am unable to find any distinction between the two components of compensation (sometimes there are multiple layers of compensation segmentation).

(Q)(11) It is the licensing of the recipient that is the major problem in these cases. If the recipient is licensed, then the payment is simply a commission share and not a rebate.

(A)(11) If the payment causes an item of value, discount or in any way transfers commissions to the purchaser of the policy (or his/her agent) it is unlawful. The fundamental rule is present for a reason and while many may disagree, in our society, we do not get to choose which laws to obey and when they are convenient to our endeavors to obey them.
The Commercial Philosophy of Rebates

I am often asked why I exhibit a level of anger at the development and peddling of these end run schemes designed to give the appearance of compliance but in fact do not even approach proximate compliance with the law. In terms of whether rebates should be permitted this is a much more transcendent question and California has answered it differently than has, for example, Minnesota or New York. I am often fascinated by brokers of long standing (who should know their own economics much better) as they lobby with me that their particular scheme is valid and thus allows them to seriously diminish their own compensation. Imagine Alex Rodriguez and his manager bragging about finding a loophole that would allow them to permit the Yankees to cut their compensation by 50%. What would be his motive?
In the world of life insurance brokerage, it is generally assumed that life insurance agents receive commissions, are exempt from expenses and thus, alone among all commercial market participants, have net profits that are co-equal to their Gross Revenues. So naturally I am incensed at this continuation of disrespect directed at the life insurance brokerage community for the past 30 years. It is this self derogation and accumulated years of pejorative placement in the scheme of the financial hierarchy that will lead off the next Part (Part 11) of this Introspective.