The Atlantic’s Megan McArdle looks into the real reasons “Why Companies Fail.”  Using GM as a case study, she concludes: “the answer is often culture—the hardest thing of all to change.” I see The Hartford as a case in point.

Business failure is about mismanagement – corporate culture that results in business practices that fail to balance risk with reward and complacency with scale. While short term returns are maximized for the majority shareholders (private equity firms) then there is a strong anti innovation incentive. Rather than innovate, management tinkers to fine tune shareholder equity.

Shareholder-Compliant Culture vs. Sound Business Fundamentals

Private equity firms in the past have targeted 20% returns vs. a public average of 8 – 10%.  That extra margin of 10% return creates pressure on management to focus on rationalizing operations, rather than investing in growth. For The Hartford,  fund manager John Paulson was reportedly pressing for 40 – 60% when he insisted on breaking up The Hartford to maximize the share price.

Management had already been stretching itself thin, making a series of compromising business decisions to satisfy shareholders at the expense of sound business judgement.  Not rocking the shareholder boat had resulted in the abandonment of the fundamentals of running a business,exposing them to increased market risk that came unexpectedly during the market plunge of 2008.

By the fundamentals of running a business, I mean anticipating consumer trends and opportunities, and moving resolutely and soundly to profit from them – encouraging the risks of creativity and innovation, buttressed with proper actuarial assumptions.  But habitual capitulation to shareholder pressure can make it more likely that a company will pursue the production of high profit margin widgets (as with GM’s SUVs), and/or fight to dominate a familiar market niche,  shaving margins without adequate hedging, as Hartford did in its race to add costly, improperly hedged generous living benefits to its Variable Annuity products.

Actuarial and Claims Issues Parallel the ’97 DI Market

Top-down shareholder compliant strategies can result in a slippery slope to a highly leveraged position and extreme sensitivity to market fluctuations, which further erodes profit margins and investment in distribution.  As a result of the losses and potential losses owing to their Variable Annuity living benefit provisions during the 2008 market decline, The Hartford all but discontinued sales of variable annuities, a strategic mistake that resulted in the loss of a distribution system.

Actuarial losses in products that produce periodic claims typically result in companies withdrawing from the market as the result of adverse claims and declining profits. This is what happened with Noncancellable and Guaranteed Renewable Disability Income policies with Own Occupation definitions of disability in the mid 1990s.

The Own Occupation definition of disability was so generous that a surgeon could collect benefits for “gray area claims” –  conditions with self-reported symptoms for which little objective medical data was available to support, including Fibromyalgia, Epstein-Barr Syndrome, Chronic Fatigue Syndrome, Carpal Tunnel Syndrome, and various mental- and nervous disorder-type claims.  As long as they prevented the insured from performing the duties of his own occupation (for example, surgery) but allowed him to keep working (in general practice, for instance)  a specialist could claim full disability benefits equivalent to 70% of average monthly income while continuing to practice medicine. It was a windfall profit for savvy physicians who could effectively double their earnings, but a major loss for Disability Income Insurance (DI) providers. A difficult economy caused by reduced payments under managed care plans helped touch off a spate of claims that DI providers could not sustain.

In response to the financial crisis, many insurance companies exited the disability market, while others consolidated. Three of the nation’s largest – Provident Life and Accident Insurance Company of America, Paul Revere, and Unum Corp—are now one company, UnumProvident, which writes some 40 percent of disability insurance in the country, while a handful of companies now comprise the bulk of the market.

For remaining carriers, benefits were scaled back by tightening eligibility through stricter definitions of disability, and switching to Residual Income policies, which only paid percentage of income lost due to disability.

Synopsis of the Implosion of the DI Market

Here’s an excellent synopsis of the DI market shakeout by Physicians News Digest:

By the mid-1990s, disability insurance companies began to report a large increase in the overall number of disability claims, as well as an increase in the incidence of claims for conditions with self-reported symptoms for which little objective medical data was available to support, according to Tim Mitchell, national sales director for MetLife, which concentrates on group disability writing for large companies. Such “gray area” claims, which Mitchell says continue to escalate, include Fibromyalgia, Epstein-Barr Syndrome, Chronic Fatigue Syndrome, Carpal Tunnel Syndrome, and various mental- and nervous disorder-type claims. Aggravating the trend, Mitchell adds, was an older work force than in the past and the movement of the baby boomer population into the 45 to 55-year-old age bracket, which he says produces the highest incidence of disability claims. Although these claim trends were mirrored by other occupational groups such as attorneys, says Mitchell, insurers’ experience with physician claims was particularly negative during the onset of managed care, says Mitchell. “In the past,” he says, “physicians with disabilities were so dedicated to their occupation and making so much income that they were willing to work through their disability.” Managed care reduced physician income and increased bureaucratic hassle, he adds, leaving disabled physicians less willing to work through a disability. Perry notes that adverse physician claims experience was particularly acute in the California area, where managed care had a head start on the rest of the country. A less charitable assessment, made by some insurance companies and analysts during the crisis of the mid-1990s, was that managed care had eroded healthy physicians’ work ethic and that many found that they could earn a considerable income by cashing in their generously-written disability policies.

Hartford Suffers The Same Fate

The “quantitative myopia” of The Hartford caused them to build in generous product features that would kick in during a bear market. But it seems they failed to factor in the worst case scenario – that a bear market might actually arrive. The tipping point came in the form of the recent mortgage bubble collapse.

The ones who suffered from this were employees who faced layoffs, and today face massive layoffs since the situation has became so untenable that private equity shareholders have demanded units be spun off.  Paulson wants The Hartford to focus on its more profitable core business to increase shareholder returns 40% to 60%.

Problems of this magnitude often never come to light until the last minute because, as long as influential shareholders are getting a reliable return, they are content to allow the business to manage itself, while, within the organization, there is little incentive to rock the boat, fund innovation, and undertake creative risk tempered by sound risk management.

The Mistake That We are Condemned to Repeat

This is, unfortunately, an inherent flaw in our capitalist model, and one that is difficult to resolve from the inside. Outside in oversight can be established in the form of reserve requirements and such, and government has a role to play in this as the canary in the coal mine.  But government’s role is, of course, reactive rather than proactive, focusing on consumer protection and ethical trade, and the financial integrity of the institution.

The large banks are today fast approaching a point of insustainability that may require private equity firms to eventually break them up as well. But we know historically that if we wait that long, it’s already too late to undo tremendous damage to the broader economy.  At that point there are calls for government bail outs, and the endemic issues of corporate governance are left untouched.

Theodore Roosevelt took an activist approach to trust busting, to break up institutions that overreach, and laws like Glass Steagall were effective protections against the self-destructive cannibalistic policies that resulted from the merger of consumer banking with investment banking. Deregulation and failure to rigorously oversee business practices, including most prominently the trading of derivatives, resulted in a major financial setback resulting in a housing crisis, massive unemployment, ballooning public debt and increased income polarization.

Today, lacking real corporate governance, retail institutions like Walmart have forced suppliers to compete for the lowest possible unit costs, resulting in manufacturing being shipped to China and Bangladesh for 40 cents per hour wages, further eroding economic viability and lowering GDP. All we can do is throw up our hands and say that the answer is to just let the “free market” rein, drill for more oil and frack for gas, simplistic answers that ignore root issues.

You would think that business schools would have trained managers and congress to better understand the fundamentals of running a business.  It appears that government works in much the same way that the private sector does, with large shareholders dictating economic policy. Politicians are for the most part myopic lawyers who are largely ignorant of economic theory and trained to represent paying clients for billable hours (short term profit.) As in the corporate culture, the advice of trained economists is marginalized.

Quantitative myopia means running a business for shareholder gain rather than sustainability and long term profit.  This can be avoided through forward-looking, rigorous business practices that balance the needs of all stakeholders.

Snap principle of sound business management:

Invest in profitable lines of business and control for inevitable volatility.