the tragedy of corporate governance in america impacts and implications for the insurance industry
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The Tragedy of Corporate Governance in America Impacts and Implications for the Insurance Industry. Casualty Actuarial Society Risk & Capital Management Seminar Toronto, ON, Canada July 8, 2002. Robert P. Hartwig, Ph.D., Senior Vice President & Chief Economist - PowerPoint PPT PresentationTRANSCRIPT
The Tragedy of Corporate Governance in America
Impacts and Implications for the Insurance Industry
Casualty Actuarial SocietyRisk & Capital Management Seminar
Toronto, ON, CanadaJuly 8, 2002
Robert P. Hartwig, Ph.D., 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 for Insurers
• 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)
Accounting Risk
Regulatory risk
Corporate Governance: Expensive and Hard-Learned Lessons
• Crisis of Confidence—skepticism/cynicism is high
Ratings agencies Analysts Regulators
Investors/Creditors Employees Lawmakers
• Regulatory/Legislative Fallout Unclear
SEC opening record number of investigations
SEC, NYSE reforms; unclear what (if any) action Congress will take
States will take own legal action (e.g., NY)
• Surge in shareholder suits has already begun
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.
Cynicism is Epidemic
-Palm Beach Post, June 2002.
Mistrust Runs Deeper
-The Economist, June 8, 2002.-BusinessWeek,, May 13, 2002.
Terrorism
Market Malaise
Weak Profit Performance
Geopolitical Instability
Crisis in Corporate
Governance
Market Malaise
-30%
-20%
-10%
0%
10%
20%
30%
40%
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
*
Large Company Stocks*As of July 5, 2002.Source: Ibbotson Associates, Insurance Information Institute
Total Returns for Large Company Stocks: 1970-2002*
Could be headed for 3rd consecutive year of decline for stocks
Last happened 1939-1941
Who’s Who in the Corporate House of Ill-Repute
Accounting Problems are Getting Many Companies into Trouble
•Enron was tip of an iceberg
•Major implications for insurers (p/c and life)
Corporate Hall of Shame
Company Problem Potential ChargesD&Os created complex outside partnerships that kept billions in losses of Enron’s balance sheet; Accused by CA of manipulating energy market
•Securities Fraud
•Insider trading
•Perjury
Lax oversight of some client books, conflicts of interest, shredded documents
•Guilty of obstruction of justice
•Individual partners may be liable
Inappropriately accounted for $3.8B in expenses, inflated profits
•Fraud
Corporate Hall of Shame
Company Problem Potential ChargesEx-CEO Dennis Kozlowski indicted for tax evasion on art purchases
•Tax evasion
•Misuse of corporate funds
•SEC accounting query
Bogus capacity swaps inflated revenues (Qwest did too); Dynegy = “round-tripping” to inflate revenue
•Securities fraud
•Insider trading
Ex-CEO Sam Waksal indicted June 12 for tipping off family & friends that FDA did not approval of cancer drug Erbitux
•Insider Trading
Corporate Hall of Shame
Company Problem Potential Charges$4.6B in undisclosed loans to founding Rigas family; Misc. unconventional transactions, questionable accounting
•Securities fraud
•Misuse of corporate funds
•SEC accounting query
Questionable acctg. in sales of fiber optic capacity; Ex-CEO Nacchio under fire for excessive compensation & questionable stock sales
•Fraud
•Possible insider trading
Complex projects exaggerated cash flow; “Round-tripping” to inflate revenue
•Possible fraud
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!
Risk Assessment:
Enron vs. WorldCom
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
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.
How Much Investment Risk Do Insurers Have?
• Industry Financials: Overview/Outlook
• Cost Driver Summary
Terrorism
Mold
Tort Abuse
Medical Cost Inflation
Investment Performance
Catastrophes
Corporate Governance
Insurance Industry Stock and 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
illi
ons
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 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
illi
ons
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
illi
ons
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
$1,0
46
P/C
$17
1L
ife
$1,1
30
P/C
$18
1L
ife
$1,1
73
P/C
$18
8L
ife
$1,2
22
P/C
$19
4L
ife
$1,3
37
$1,091B$1,206B
$1,301B $1,3543B$1,410B
$1,531B
Beginning of the End:Bursting of the Tech Bubble
Directors & Officers Coverage
The ABC’s of D&O
3 Components of D&O Coverage
A. Personal Coverage: protects directors and officers against
liability arising out of “wrongful acts”
B. Corporate Reimbursement Coverage: reimburses organization
when legally required/permitted to indemnify D&Os for their
“wrongful acts”
C. Entity Coverage: reimburses for claims made directly against
the organization (including those that name no individual
insureds)
• Today, about 90% have entity coverage today, compared to 30% 5
years ago.
Sources: AICPCU, Tillinghast-Towers Perrin, Ins. Info. Inst.
The ABC’s of D&ODuties of Directors & Officers
1. Duty of Care: • D&Os must exercise “reasonable care”• Courts hold that D&Os are not guarantors of profitability• Directors not required to have special knowledge of business
2. Duty of Loyalty to Corporation:• Undivided loyalty required (should be no conflicts-of-interest)
3. Duty of Loyalty to Shareholder:• Prohibits insider trading, for example
4. Duty of Disclosure:• Officers must disclosure material facts to directors• Officers must disclosure material facts to regulators• Officers must disclosure material facts to creditors or potential creditors• Officers must disclosure material facts to stockholders, bond holders, potential
investors
Median Total D&O Limits by Business Class ($ 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
Utiliti
es
Banki
ng
Durab
le M
fg.
Nondu
rabl
e Mfg
.
Mer
chan
disin
g
Petro/
Min
ing/
Ag.
Hea
lth S
ervi
ces
Perso
nal &
Bus
ines
s Ser
v.
Trans
. & C
omm
.
Non-B
ank
Finl.
Biotec
h &
Phar
m.
Constr
. & R
eal E
state
Educa
tion
Tech
Gov
t. &
NPOs
Mil
lion
s
Limits vary considerably by industry
Median Total D&O Premium by 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
Utiliti
es
Banki
ng
Durab
le M
fg.
Petro/
Min
ing/
Ag.
Mer
chan
disin
g
Nondu
rabl
e Mfg
.
Trans
. & C
omm
.
Perso
nal &
Bus
. Ser
v.
Biotec
h &
Phar
m.
Techn
ology
Non-B
ank
Finl.
Hea
lth S
ervi
ces
Educa
tion
Constr
. & R
eal E
state
Gov
t. &
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
Litigation Risk
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
Shareholders typically recover just 2.56% of amount lost; 1/3 of that
goes to lawyers & expenses**
Average Jury Awards1994 vs. 2000
419759
187 333
1,140 1,185
1,744
1,168
1,727
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.
Surety
Insurer Vulnerabilities
Insurer Vulnerabilities• Insurers by and large have solid reporting practices
Report under GAAP
Duel reporting under more conservative SAP makes insurer financial
statements uniquely transparent
• Setting of reserves are biggest issue for insurerAlways tricky, esp. for longer-tailed lines, since uncertainty increases with time
(e.g., investment performance, med infl.)
Some areas (WC, Asbestos) have big deficiencies
Less cause for concern than might seem since liabilities paid over many years,
possibility of favorable legislation (asbestos)
Remember Unicover?
• Unicover was a group of pools that reinsured workers comp
• Unicover priced policies at 30% - 40% below expected losses, then passed most of the “carve out” med/health component to reinsurers
• Reinsurers in turn lowered prices to attract retrocessionaires
• Spiral continued• Ultimate cost: Estimated at $2 billion• Life reinsurers stuck with much of it
Unicover:“Passing the Trash”
Primary Insurers
Reinsurance Brokers
Fronting Companies
Unicover Pool
Reinsurance Brokers
Reinsurers
Why Did Unicover Happen?3 Possibilities Have Been Proposed
Greed Strong incentive to accept premium, ceding fees Accusations that risks were misrepresented
Complexity/Ignorance Didn’t understand “carve-out” business (life reinsurers took on
medical portion of risk) Higher-ups thought it was ordinary A&H Regulators asleep at the switch
Economic Weak premium growth in WC, competition, overcap. Rate on line falling; preserve revenue stream Insufficient premium & wrong bet on fundamentals (combineds
>200%!!??)
Remember Reliance?• 200 year old company wiped out by one bad owner
Now being liquidated by PA Insurance DepartmentProducing large hits on guarantee fundsassessmentsUnderpricing, underresserving part of the problem
• Very different from Enron/WorldComSteinberg was holdover from the last era generation of corporate scandals:
LBOs, hostile takevers and corporate raiders like Michael Milken, Ivan Boesky. If happened today, would probably be more focus on insurers than currently
exist
• Congress has called for GAO investigation of pricing and reserving practices of med mal insurers
Warning Signs & Red Flags
Red Flags & Warning Signs• Company grows rapidly through acquisition
• Overdosing on risk
• Dysfunctional board
• Excessive CEO salaries (relative to performance)
• Company pursues strategy du jour
• Excessive emphasis on pro forma earnings
• Company consistently meets earnings targets to the penny
• Employees fear management more than competition
Source: Fortune; Insurance Information Institute
Solutions
New York Stock Exchange:Proposed Reforms
• Independent directors must make up board majority2 yrs to implement (most other provisions 1 yr.)
• Non-management directors must meet regularly without management
• Independent directors defined as those with no material relationship
with the company
• 5-yr “cooling off” period before former employees or auditors can sit
on board
• Only independent directors can sit on audit, nomination and
compensation committees
Securities & Exchange Commission:New Requirements
• Beginning with 3rd quarter 2002 10-Q filings, CEOs
and CFOs must swear under oath the following:Company’s financial statements do not contain any untrue
statements of material fact
Company’s financial statements do not omit a material fact
that results in such statements being misleading
Company’s financial statements have been (or not been)
reviewed by its audit (or equivalent) committee
Securities & Exchange Commission:Rationale for New Requirements
• “In light of recent reports of accounting irregularities at public
companies, the purpose of the commission’s investigation is to provide
greater assurance to the Commission and to investors that the persons
have not violated, or are not currently violating, the federal securities laws
governing corporate issuers’ financial reporting and accounting practices,
and to aid the Commission in assessing whether it is necessary or
appropriate in the public interest or for the protection of investors for the
Commission to adopt or amend rules and regulations governing corporate
issuers’ reporting and accounting practices and/or for the Commission to
recommend legislation to Congress concerning these matters.”
Source: SEC
Securities & Exchange Commission:New Requirements (cont’d)
• New SEC requirement pertains to companies with revenues
exceeding $1.2 billionSEC’s “Final 1000” list contains 954 companies
Visit http://www.sec.gov/rules/other/4-460list.htm for complete list
• 20 Non-life companies (or their parents) listedAIG, Allstate, American Financial, Aon, Berkshire Hathaway
(GeneralCologne Re, GEICO), Citigroup (Travelers), Chubb, Cincinnati
Financial, GE (Employers Re), Hartford Financial, Loew’s Corp. (C N A),
Markel, Marsh & McClennan, Mercury General, Ohio Casualty, Old
Republic, Progressive, Safeco, St. Paul, W.R. Berkley
Securities & Exchange Commission:New Requirements (cont’d)
• Insurers (apparently) excluded are:Companies with revenues under $1.2 billion
All mutuals (irrespective of size) or any other form of non-publicly traded insurer
Bermuda companies (e.g., Ace, XL, Willis, Partner Re, Everest Re)
Public subsidiaries of publicly-traded companies (Travelers, GE Global,
Transatlantic Holdings, C N A)
• ALSO LIKELY SOON: Banishment of Ebitda (Earnings before interest,
taxes, debt and amortization)Excludes too many transactions that affect cash flow
P/C Net Income After Taxes vs.Net Operating Cash Flow ($ Billions)
$20.2
$9.5
-$7.9
$12.8
-$10
-$5
$0
$5
$10
$15
$20
$25
Net Income After Taxes* Net Operating Cash Flow**
Sources: A.M. Best, Guy Carpenter estimates.
Cash flow accounting for insurers makes 2001 look good (+35%)
Accrual method shows worst year-ever!
For insurers, accrual gives much better picture of true state of industry). This SAP is used for regulatory reporting
Reserves are a big part of the difference
2000
2001
20012000
*NIAT = Prem Earned – Exp Incurred + Inv Inc.**NOCF = Prem Coll – Exp Exp Pd + Inv Inc.
Change in P/C Loss Reserves1996-2001 ($ 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
Insurance Information Institute On-Line
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