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 bobh@iii.org 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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