the tragedy of corporate governance in america impacts and … · 2014-06-13 · corporate...
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The Tragedy of Corporate Governance in America
Impacts and Implications for the Insurance Industry
Casualty Actuarial Society of the Northeast
Uncasville, CTSeptember 30, 2002
Robert P. Hartwig, Ph.D., CPCU, Senior Vice President & Chief EconomistInsurance Information Institute ♦ 110 William Street ♦ New York, NY 10038
Tel: (212) 346-5520 ♦ Fax: (212) 732-1916 ♦ [email protected] ♦ www.iii.org
Serious Implications forFinancial Institutions
• Insurers exposed to a wide variety of risks:Investment risk (as institutional investors)
Insurance risk (surety, D&O, E&O, etc.)
Litigation risk (as both plaintiff & defendant)
Regulatory risk
Corporate Governance: Expensive and Hard-Learned Lessons
• Crisis of Confidence—skepticism is on the riseRatings agencies Analysts Regulators
Investors/Creditors Employees Lawmakers
• Regulatory/Legislative Fallout UnclearEnormous number of investigations under way
SEC, State Attorneys General, IRS, DoJ, etc.
Most new SEC cases are against large companies
Many competing reforms from Congress, SEC, A.G.’s., NYSE, NASDAQ, etc.
Collectively are likely to help, at least somewhat
• SEC, Administration & Congressional proposals vary
• Surge in shareholder suits well underway
Terrorism
Market Malaise
Weak ProfitPerformance
GeopoliticalInstability
Crisis inCorporate
Governance
Market Malaise
Houston…We Have a Problem
Source: Loss estimates from Morgan Stanley as Feb. 8, 2002; Insurance Information Institute.
Surety26%
Multiple7%
D&O1%
Fin. Guarantee2% Investment
64%
Total Exposure (Life & Non-Life): $3.796 BillionEnron is the biggest
bankruptcy in US history ($31B+)
Equity/debt widely-held as S&P 500 company
Biggest impact in institutional investors/creditors
11 Congressional investigations
56 suits against officers & directors
Will spark similar suits
WorldCom to WorldCon?Insurer Exposure
*As of 7/1/02; Includes $5.4B in debt assuming default, $100 mil D&O, $225 mil CDO (still collateralized). As of 7/1, WCOM debt trading at about $0.15 of par, stock trading at $0.08/share. Equity losses are indeterminant.
**Does not include disclosed but unquantified exposure to credit default swaps
Source: Insurance Information Institute based in from Moody’s, company announcements, III research.
D&O2%
Financial Guarantee**
4%
Investment94%
Total Exposure (Life & Non-Life): $5.725 Billion*WorldCom could
default on ($29B+) in debt.
Equity/debt widely-held as S&P 500 company
Biggest impact in institutional investors/creditors
SEC/Congressional investigations underway
Suits against officers & directors imminent
Who’s Who in theCorporate House of Ill-Repute
Corporate Hall of Shame
•FraudInappropriately accounted for $3.8B in expenses, inflated profits
•Guilty of obstruction of justice•Individual partners may be liable
Lax oversight of some client books, conflicts of interest, shredded documents
•Securities Fraud •Insider trading•Perjury
D&Os created complex outside partnerships that kept billions in losses of Enron’s balance sheet; Accused by CA of manipulating energy market
Potential ChargesProblemCompany
Corporate Hall of Shame
•Insider TradingEx-CEO Sam Waksalindicted June 12 for tipping off family & friends that FDA did not approval of cancer drug Erbitux
•Securities fraud•Insider trading
Bogus capacity swaps inflated revenues (Qwest did too); Dynegy = “round-tripping” to inflate revenue
•Tax evasion•Misuse of corporate funds•SEC accounting query
Ex-CEO Dennis Kozlowski indicted for tax evasion on art purchases
Potential ChargesProblemCompany
Corporate Hall of Shame
•Possible fraudComplex projects exaggerated cash flow; “Round-tripping” to inflate revenue
•Fraud•Possible insider trading
Questionable acctg. in sales of fiber optic capacity; Ex-CEO Nacchio under fire for excessive compensation & questionable stock sales
•Securities fraud•Misuse of corporate funds•SEC accounting query
$4.6B in undisclosed loans to founding Rigas family; Misc. unconventional transactions, questionable accounting
Potential ChargesProblemCompany
Martha Stewart Omnimedia fell by more than 50% after Imclone
insider trading scandal broke out
This sumptuous New England lobsterbake
is available at MarthaStewart.com
for just $250!
Cynicism is Running High
Cynicism is Running High
Living High Off the Company Hog
Bernie Ebbers, former CEO of WorldCom
Dennis Kozlowski, former Tyco CEO
Wall Street Conflicts of Interest Breed a Crisis of Confidence
Investment Risk
WorldCom: From $60/share in to6 Cents in Three Years
As of July 1, 2002
Source: Low trade for July 1, 2002.
Xerox: From $60/share in to$6.60 Cents in Three Years*
As of July 1, 2002
Source: Opening price, July 1, 2002.
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Jan-
90Ju
l-90
Jan-
91Ju
l-91
Jan-
92Ju
l-92
Jan-
93Ju
l-93
Jan-
94Ju
l-94
Jan-
95Ju
l-95
Jan-
96Ju
l-96
Jan-
97Ju
l-97
Jan-
98Ju
l-98
Jan-
99Ju
l-99
Jan-
00Ju
l-00
Jan-
01Ju
l-01
Jan-
02Ju
l-02
Yie
ld S
prea
d (p
oint
s)Risky Business: Yield Spread
Rising with Corporate Scandals*
*January 1990 through August 2002Source: Board of Governors, Federal Reserve System; Insurance Information Institute
Risk premium (2.46 points) reached all time high in Oct. 2001 (Enron problem surfaced)
Yield Spread Between Long-Term ‘aaa’ Corporates and 10-Year US Treasury Securities
Insurance Industry Stockand Bond Holdings, 2001
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
CorporateBonds
CorporateStocks
State/LocalBonds
U.S. Gov'tBonds
Life P/C
In B
illio
ns
Total $1531
Total $1120
Total $209
Total $438
Source: Federal Reserve Flow of Funds Report as of Dec. 31, 2001.
P/C $194Life $1,337
P/C $185Life $935
P/C $188Life $21
P/C $131Life $307
Total Industry Holdings = $3.3 Trillion
Institutional Investor Market in Corporate Equities
by Market Value of Holdings, as of December 31, 2001All Others
$459.56%
Insurers$1,120.4
15%
State & Local Gov't
Retirement Plans
$1,215.716% Private
Pension Funds$1,902.3
25%
Mutual Funds$2,836.8
38%
Source: Insurance Information Institute from Federal Reserve Flow of Funds Report
Total: $7,534.7 billion
We’re big enough: Should we cut our losses and run or
throw the bums out?
Institutional Investor Market in Corporate Equities
by Amounts Outstanding, as of December 31, 2001All Others
$459.56%
Insurers$1,120.4
15%
State & Local Gov't
Retirement Plans
$1,215.716% Private
Pension Funds$1,902.3
25%
Mutual Funds$2,836.8
38%
Source: Insurance Information Institute from Federal Reserve Flow of Funds Report
Total: $7,534.7 billion
Insurers are the 4th
largest holder of corporate stocks
Institutional Investor Market in Corporate Bonds*
By Amounts Outstanding, as of December 31, 2001
Banks, SIs, Trusts$515.214%
All Others$387.310%
Insurers$1,530.4
41%
State & Local Gov't
Retirement Plans$343.0
9%
Private Pension Funds
$345.510%
Mutual Funds$608.716%
*Includes foreign bonds. Source: Insurance Information Institute from Federal Reserve Flow of Funds Report
Total: $3,730.1 billion
Life = $1,336.5 (87%)
Non-Life = 193.9 (13%)
Insurers are the largest holder of corporate bonds
Insurance Industry:Corporate Equity Holdings, 1995-2001
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
1995 1996 1997 1998 1999 2000 2001
Life P/C
In B
illio
ns
Total $450B
Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.
P/C
$13
4L
ife $
315
P/C
$14
9L
ife $
414
P/C
$18
6L
ife $
559
P/C
$20
0L
ife $
733
P/C
$20
8L
ife $
965
P/C
$19
4L
ife $
941
P/C
$18
5L
ife $
935
$563B
$745B
$933B
$1,173B $1,135B $1,120B
Insurance Industry:Corporate Bonds Holdings, 1995-2001
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
1995 1996 1997 1998 1999 2000 2001
Life P/C
In B
illio
ns
Total $993B
Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.
P/C
$12
3L
ife $
870
P/C
$14
2L
ife $
949
P/C
$16
0L
ife $
1,04
6
P/C
$17
1L
ife $
1,13
0
P/C
$18
1L
ife $
1,17
3
P/C
$18
8L
ife $
1,22
2
P/C
$19
4L
ife $
1,33
7
$1,091B$1,206B
$1,301B $1,3543B$1,410B
$1,531B
Beginning of the End:Bursting of the Tech Bubble
4.4%3.5%
2.5%
5.7%
8.3%
4.8%5.6%
2.2%
1.0%
-0.6%-1.6%
-0.3%
5.0%
1.1%
2.3%3.2%2.7%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1998
1999
:I19
99:II
1999
:III19
99:IV
2000
:I20
00:II
2000
:III20
00:IV
2001
:I20
01:II
2001
:III20
01:IV
2002
:I20
02:II
2002
E20
03F
Real GDP Growth
Source: US Department of Commerce, Blue Economic Indicators 9/02, Insurance Information Institute.
Economy is experiencing sluggish growth following the
recession of 2001
(first recession since 1990/91)
Directors & Officers Coverage
The ABC’s of D&O3 Components of D&O Coverage
A. Personal Coverage: protects directors and officers against liability arising out of “wrongful acts”
B. Corporate Reimbursement Coverage: reimburses organization when legally required/permitted to indemnify D&Os for their “wrongful acts”
C. Entity Coverage: reimburses for claims made directly against the organization (including those that name no individual insureds)
• Today, about 90% have entity coverage today, compared to 30% 5 years ago. Sources: AICPCU, Tillinghast-Towers Perrin, Ins. Info. Inst.
The ABC’s of D&ODuties of Directors & Officers
1. Duty of Care:• D&Os must exercise “reasonable care”• Courts hold that D&Os are not guarantors of profitability• Directors not required to have special knowledge of business
2. Duty of Loyalty to Corporation:• Undivided loyalty required (should be no conflicts-of-interest)
3. Duty of Loyalty to Shareholder:• Prohibits insider trading, for example
4. Duty of Disclosure:• Officers must disclosure material facts to directors• Officers must disclosure material facts to regulators• Officers must disclosure material facts to creditors or potential creditors• Officers must disclosure material facts to stockholders, bond holders,
potential investors
Median Total D&O Limitsby Business Class ($ Millions)
Source: Tillinghast-Towers Perrin
$50
$32
$20 $20$15 $15
$10 $10 $10 $8$5 $5 $5 $5
1$0
$10
$20
$30
$40
$50
Utilitie
sBan
king
Durab
le M
fg.
Nondu
rable
Mfg.
Merc
handis
ing
Petro/M
ining
/Ag.
Health
Serv
ices
Person
al & B
usine
ss Serv
.
Trans
. & C
omm.
Non-B
ank F
inl.
Biotech
& Phar
m.
Constr
. & R
eal E
state
Educa
tion
Tech
Govt. &
NPOs
Mill
ions
Limits vary considerably by industry
Median Total D&O Premiumby Business Class
Source: Tillinghast-Towers Perrin
$215
,880
$170
,000
$154
,327
$153
,000
$150
,738
$139
,500
$116
,025
$90,
500
$90,
100
$80,
000
$66,
935
$58,
432
$30,
729
$19,
398
$3,4
50
$0
$50,000
$100,000
$150,000
$200,000
$250,000
Utilitie
sBan
king
Durab
le M
fg.
Petro/M
ining
/Ag.
Merc
handis
ing
Nondu
rable
Mfg.
Trans
. & C
omm.
Person
al & B
us. S
erv.
Biotech
& Phar
m.Tech
nology
Non-B
ank F
inl.
Health
Serv
ices
Educa
tion
Constr
. & R
eal E
state
Govt. &
NPOs
Premiums vary considerably by industry
D&O Broker Market Share(by Number of US Retail* Accts as Primary Broker)
Woodruff-Sawyer21%
ABD19%
Marsh8%
Other10%
W. Gallagher & Assoc.10%
Armfield, Harrison & Thomas
10%
Carpenter Moore12%
A.J. Gallagher5%
Aon5%
Source: Tillinghast –Towers Perrin*Excludes wholsale brokerage activity; Based on sample of 1,976accounts
INDUSTRY FINANCIALS
Overview & Outlook
Highlights: Property/Casualty First-Half 2002 ($ Millions)
-2.3%289,649282,871Surplus*
111.1
2,789
18,749
(18,781)
129,301
162,8552001
-6.1 pts.105.0Combined Ratio
+66.34,639Net Income (a.t.)
-4.9%17,831Net Inv. Income
-39.9%(11,285)Net UW Gain (Loss)
+3.9%134,336Loss & LAE
+12.0%182,434Net Written Prem.Change2002
*Comparison with year-end 2001;
P/C Net Income After Taxes1991-2002 ($ Millions)
$14,178
$5,840
$19,316
$10,870
$20,598$24,404
$36,819
$30,773
$21,865$20,223
-$7,921
$9,278
-$10,000
-$5,000
$0
$5,000
$10,000
$15,000$20,000
$25,000
$30,000
$35,000
$40,000
91 92 93 94 95 96 97 98 99 00 01 02**I.I.I. estimate based on first half 2002 data.Sources: A.M. Best, ISO, Insurance Information Institute.
2001 was the first year ever with a full year net loss
2002 First Half ROE = 3.3%
P/C Net Income After Taxes vs.Net Operating Cash Flow ($ Billions)
$20.2
$9.5
-$7.9
$12.8
-$10
-$5
$0
$5
$10
$15
$20
$25
Net Income After Taxes* Net Operating Cash Flow**Sources: A.M. Best, Guy Carpenter estimates.
Cash flow accounting for insurers makes 2001 look good (+35%)Accrual method shows worst year-ever!For insurers, accrual gives much better picture of true state of
industry). This SAP is used for regulatory reportingReserves are a big part of the difference
2000
2001
20012000
*NIAT = Prem Earned – Exp Incurred + Inv Inc.**NOCF = Prem Coll – Exp Exp Pd + Inv Inc.
Change in P/C Loss Reserves1996-2001 ($ Billions)
$2.9
-$2.2
$1.7
-$3.4-$4.5
$15.9
-$5
$0
$5
$10
$15
$20
1996 1997 1998 1999 2000 2001
Sources: ISO
Accrual Accounting: Earmings/expenses recorded as they occur or incurred (SAP is a conservative variation of accrual method)
Cash Flow Accounting: Income recognized whenever cash “received,” expenses accounted for only when paid.
Fudging the timing of revenue and expense flows is behind virtually all of the recent earnings restatements
Financial Restatements Filed
116
160
215233
270
0
50
100
150
200
250
300
1997 1998* 1999* 2000 2001*ApproximateSources: Huron Consulting Group
The number of financial restatements is rising
even thought the number of publicly traded
companies is falling.
Market Share forPrimary D&O Coverage
2%
2%
3%
3%
3%
5%
5%
18%
20%
22%
2%
5%
5%
2%
2%
3%
3%
13%
14%
35%
0% 10% 20% 30% 40%
Hartford
AEGIS
Genesis
Special Program
C N A
Great American
Admirial
Chubb
Lloyd's
AIG
Policy Count Premium Volume
Source: Tillinghast-Towers Perrin
EPS Growth: Turning the Corner?
*Compared to 1st quarter 2001.Source: Company financial statements; Merrill Lynch
-9.0% -10.3%-16.5%
46.1%
26.7%
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
1999 2000 2001 2002E 2003E
Annual % Increase in Operating Earnings per Share
1st Quarter 2002 Summary*Operating EPS: +83.3%NPW: +37.0%Loss Ratio: 66.0% (-3.7 pts)Expense Ratio: 27.6% (-1.4 pts)Combined Ratio: 93.8% (-5.1 pts)ROE: 11.9% (+3.3 pts)
0%
5%
10%
15%
20%
25%
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
*Estimate based on first half 2002 results.Source: A.M. Best, Insurance Information Institute
Growth in Net Premiums Written (All P/C Lines)
2000: 5.1%
2001: 8.1%
2002: 12.0(est.)
The underwriting cycle went AWOL in the 1990s.
It’s Back!
95
100
105
110
115
120
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00
02**
P/C Industry Combined Ratio
2001 = 115.7
2002E = 105.0
Combined Ratios
1970s: 100.31980s: 109.21990s: 107.72000s: 110.4
Sources: A.M. Best; III
* Based on III 2002 Groundhog Forecast
110.
5
105.
0 113.
6 119.
2
104.
8
100.
8
100.
5
114.
3
106.
5
117.
4
108.
8 115.
8
106.
9
108.
5
106.
5
105.
8
101.
6
105.
6
107.
7
110.
0 115.
7
105.
0
126.
5
162.
5
90
100
110
120
130
140
150
160
170
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002*
Reinsurance All Lines Combined Ratio
Combined Ratio:Reinsurance vs. P/C Industry
*First Quarter 2002 figures.Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute
2001’s combined ratio was the worst-ever for reinsurers
($60)
($50)
($40)
($30)
($20)
($10)
$0
$1019
7519
7619
7719
7819
7919
8019
8119
8219
8319
8419
8519
8619
8719
8819
8919
9019
9119
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
02
Underwriting Gain (Loss)1975-2002*
*Annualized estimate based on first half 2002 data.Source: A.M. Best, Insurance Information Institute
$ B
illio
ns
P-C insurers paid $53 billion more in claims & expenses than they collected in premiums
in 2001
-5%
0%
5%
10%
15%
20%
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
*
US P/C Insurers All US Industries
ROE: P/C vs. All Industries 1987–2002*
*2002 figures are estimates; p/c figure based on first-half 2002 data.Source: Insurance Information Institute; Fortune
$0
$50
$100
$150
$200
$250
$300
$350
75 77 79 81 83 85 87 89 91 93 95 97 99 01
Policyholder Surplus: 1975-2002*
*As of 1st quarter 2002Source: A.M. Best, Insurance Information Institute
Bill
ions
(US$
)
Surplus Peaked at $336.3 Billion in 1999
•Surplus decreased 8.7% in 2001 to $289.6 Billion.
•Surplus rose 1.9% in the 1st quarter of 2002
•Surplus is now lower than at year-end 1997.
“Surplus” is a measure of underwriting capacity. It is analogous to “Owners Equity” or “Net Worth” in non-insurance organizations
Insurer Stocks:Outperforming the S&P 500
-30.43%
-8.30%
-15.42%
-8.16%
-16.21%
-27.14%
-35% -30% -25% -20% -15% -10% -5% 0%
S&P 500
Life/Health
P/C
All
Brokers
Multiline
Source: SNL Securities, Insurance Information Institute
Total Return 2002 YTD Through September 27, 2002
Insurer Stocks:Outperforming the S&P 500
-30.43%
-8.30%
-15.42%
-8.16%
-16.21%
-27.14%
-35% -30% -25% -20% -15% -10% -5% 0%
S&P 500
Life/Health
P/C
All
Brokers
Multiline
Source: SNL Securities, Insurance Information Institute
Total Return 2002 YTD Through September 27, 2002
Abuse of the Tort System
Average Jury Awards1994 vs. 2000
419759
187 333
1,140 1,1851,744
1,1681,727
269698
3,482 3,566
6,817
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
Overall BusinessNegligence
VehicularLiability*
PremisesLiability
MedicalMalpractice
WrongfulDeath
ProductsLiability
($00
0)
1994 2000
Source: Jury Verdict Research; Insurance Information Institute.
Cost of U.S. Tort System($ Billions)
Source: Tillinghast-Towers Perrin; Insurance Information Institute estimates for 2001/2002 assume tort costs equal to 2% of GDP. 2005 forecasts from Tillinghast.
$129 $130 $141 $144 $148 $159 $156 $156 $167 $169 $179$198 $204
$298
$0
$50
$100
$150
$200
$250
$300
$350
90 91 92 93 94 95 96 97 98 99 00 01* 02E* 05F
Tort costs consumed 2.0% of GDP annually on average since 1990, expected to rise to 2.4% of GDP by 2005!
Tort costs equaled $636 per person in 2000!
Expected to rise to $1,000 by 2005
Corporate Governance
Accounting Problems are Getting Many Companies into Trouble
•Enron was tip of an iceberg
•Major implications for insurers (p/c and life)
Shareholder Class Action Lawsuits*
*Securities fraud suits filed in U.S. federal courts; 2002 figure is through June 14, 2002**Suits of $100 million or more.Source: Stanford University School of Law;Woodruff-Sawyer & Co.; Insurance Information Institute
164202
163
231188
110
178
236209 216
487
110
0
100
200
300
400
500
600
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
*Shareholders typically recover just 2.56% of amount lost; 1/3 of that
goes to lawyers & expenses**
Insurance Information Institute On-Line
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