Expensive Mistakes: Operational Risk in Life Insurance

• DOI: http://doi.org/10.1111/j.1540-6296.2012.01221.x
• Date: 01 September 2012
• Author: Shauna Ferris
• Published date: 01 September 2012

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2012, Vol.15, No. 2, 263-288

DOI: 10.1111/j.1540-6296.2012.01221.x

EDUCATIONAL INSIGHTS

EXPENSIVE MISTAKES:OPERATIONAL RISK IN

LIFE INSURANCE

Shauna Ferris

ABSTRACT

Although insurers have developed sophisticated techniques for measuring and

managing mortality risks, asset–liability mismatch, and interest rate risks, they

may underestimate the potential cost of operational risks. This is a case study

of an Australian life insurer, which made a series of very expensive mistakes.

"Frankly this is a story of incompetence from beginning to end. .. "

Report to the Chief Executive Officer of National Mutual in October 2000

INTRODUCTION

Sometimes, life insurers make quite small mistakes, which end up costing them a great

deal of money.Although life insurers have developed sophisticated techniques for mea-

suring and managing mortality and morbidity risks, asset–liability mismatch, and inter-

est rate risks, insurers may well underestimate the potential costs of operational risks.

According to a 2008 Towers Perrin study, management of operational risks is a weak

point for many insurers.1

The first step in managing any risk is to collect data about past experience. This has been

particularly difficult for operational risk, since corporations are often reluctant to reveal

any evidence of mismanagement. However, if the matter ends up in court, the facts will

inevitably be revealed.

The purpose of this article is to provide a case study of one rather serious example

of operational risk in life insurance. In 1999–2000, one of Australia’s largest and most

respected life insurers, National Mutual, sold hundreds of millions of dollars worth of

Prosperity Bonds. The results were disastrous. The insurersuffered losses of several mil-

lion dollars, which had a significant impact on the company’s profits in 2001. Disgrun-

tled policyholders sued National Mutual, demanding billions of dollars in damages.

Shauna Ferris works as a Senior Lecturer (and Fellow of the Institute of Actuaries of

Australia) in Department of Actuarial Studies, Macquarie University, New South Wales; e-mail:

Shauna.Ferris@mq.edu.au. This article was subject to double-blind peer review.

1TowersPerrin, 2008, Embedding ERM—A Tough Nut to Crack: An ERM Update on the Global Insur-

ance Industry, World Wide Web: http://www.towersperrin.com/tp/getwebcachedoc?webc =

GBR/2009/200901/2008_Global_ERM_Survey_12809.pdf.

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264 RISK MANAGEMENT AND INSURANCE REVIEW

The company became embroiled in a long-running dispute with these policyholders,

incurring substantial legal costs, as well as reputational damage.

So what went wrong? And how can insurers avoid such problems in the future?

The first section of this article provides a chronological summary of events, highlighting

the weaknesses in the company’s risk management processes. The second section deals

with damage control—how did the management deal with the problem? The third

section outlines the ethical and legal issues that arose during the dispute between the

insurer and policyholders. The final section discusses the lessons to be learned from this

case study.

Note: The insurer, National Mutual, was partly owned by AXA when these policies

were sold. In 1999, the name of the holding company was changed to AXA Asia Pacific

Holdings. We will refer to the company as National Mutual; however some of the

newspapers quoted below refer to the insurer as AXA.

WHAT WENT WRONG?

The following description of events is largely drawn from the evidence presented to

the court during various legal disputes between National Mutual and Prosperity Bond

Investors.2

Background: The Product

During the 1990s, National Mutual sold a unitized market-linked investment product

called a Prosperity Bond. Policyholders could pay premiums to buy units in a portfolio

of assets. The value of the units would rise or fall over time, in line with changes in the

market value of the investments held in that portfolio.

The policyholder could choose between different investment options. They could invest

in either a Cash Portfolio or a Secure Portfolio. The Secure Portfolio contained a mixture

of cash, fixed-interest securities, Australian shares, and international shares.

Policyholders could switch money from one portfolio to another at any time. They were

entitled to two free switches per annum, but a switching fee would be charged for any

subsequent switches.

The unit prices would normally be declared daily (although the contract specified that

the insurer had the option to declare prices more or less frequently). The unit price for

any day would normally be determined by working out the total value of assets at the

end of the previous day, and then dividing by the total number of units. This unit price

would apply to transactions made during the following day (a process known as historic

pricing).

2See ACN 074 971 109 (as Trustee for the Argot Unit Trust), Pegela Pty Ltd., Thomas Oates and

Paul Oates v.National Mutual Life Association of Australasia Limited [2006] VSC 507—we will

refer to this case as Pegela henceforth; ACN 074 971 109 (as Trustee for the Argot Unit Trust)

& Anor v.The National Mutual Life Association of Australasia Ltd. [2008] VSCA 247; (2008) 21

VR 351—we will refer to this case as Appeal henceforth; and ACN 074 971 109 (as Trustee for

the Argot Unit Trust) and Pegela Pty Ltd. v. National Mutual Life Association of Australasia

Ltd. (No. 2) [2009] VSCA 24.