Insurance under scrutiny - Cover Story

What a tough year it's been for management and company boards of directors. Not long after the misdeeds of Enron's executives came to light, up step other corporate giants to face harsher public scrutiny for alleged wrongdoings. Corporate malfeasance has since been headline fodder across the world and scrutiny is growing as more companies and their accounting practices face examination. In fact, any restatement of earnings is enough to send a company's stock plummeting.

The situation has industries sitting up and taking notice. The Conference Board, an international, independent membership organization based in New York, at this writing has nearly completed its first report on the group's work on best-practices guidelines. Some of the issues the Board will address include what control processes an organization should take to ensure its role in overseeing governance and what constitutes a red flag within an organization's governing body. The best-practices guidelines are expected to be completed at year's end.

Insurance companies are not escaping the same inspection. But the industry, just as it did after the last year's terrorist attack, is stepping up to do the right thing. Some insurers are reviewing their internal checks and balances and coming forward to assure shareholders and policyholders that their financial statements are sound. They are dusting off their codes of conduct and putting teeth into them.

Standard & Poor's plans to hold seminars on corporate governance and accounting standards at its upcoming conference. Indeed, the industry is putting itself under a microscope.

Aon Corp., for example, was able to quickly resolve questions the SEC had about restated earnings for its special purpose entities. Willis Group voluntarily certified its SEC filings and, along with Max Re, has decided to expense employee stock options. AIG also has decided to expense employee stock options, though a company press release expresses concern about the cost of such a move.

"We've had voluntary changes adopted by individual publicly traded companies, and we've had changes that have been forced upon these companies," says Robert Hartwig, chief economist at Insurance Information Institute, New York. "Some companies have decided to expense options, for instance. That's a voluntary measure. On the other hand, the federal government requires that CEOs now provide a guarantee that the results they certify be true and correct."

Still, it only takes a few lapses in a company's governance structure to erode shareholder value and public confidence. While the insurance industry generally is conservative and transparent in nature, the current climate requires extra vigilance on the part of all companies.

Experts agree that tougher scrutiny is going to change the shape of boardrooms across the country. They also agree that the changes, while seemingly severe, are for the better. But in the meantime, the tougher scrutiny is expected to affect the ability to recruit directors. In fact, an estimate by executive recruiter Christian & Timbers says that Fortune 1000 companies can expect to see director turnover of as much as 50 percent over the next year. Insurance products are even being developed to address the personal risks directors now face. AIG in September introduced a stand-alone insurance policy to provide independent board members with protection for their personal assets in the event corporate wrongdoing prevents them being covered by traditional directors' and officers' liability insurance.

"Corporate governance is the way a company is organized, managed and includes how it controls itself and its relations with shareholders and the transparency the provides to stakeholders," says Thomas Hodler, corporate secretary and executive team member at Swiss Re.

Those controls, if not managed properly, can cost a company dearly. Consider Royal & SunAlliance. The company received a record fine for failing to identify people who were wrongly sold pension policies in Britain. The Financial Services Authority fined the company [pounds sterling]1.35 million ($2.1 million) for the oversight.

A company spokesperson said, "This is a situation that the U.K. life industry has dealt with over the last 12 to 14 years. A large number of fines have been levied. This was an error of judgment stretching back quite some years that was just picked up in 2000 and immediately we corrected it. It's a very complex issue, deciding who's been mis-sold a pension. The decision that was wrong was deciding which groups of people were likely to have been mis-sold and therefore should be sent a questionnaire to establish whether they'd been mis-sold. It was that error of commission at an early stage which made the wrong judgment on who should be contacted. Agreed entirely by the FSA that it was unintentional and that everything was done to set it right as soon as possible. I think it has to be put into context of the whole of the industry and of the time scale we're talking about."

A Royal & SunAlliance press release quoted Duncan Boyle, the U.K. CEO as saying, "Once the process problems were uncovered in 2000, we took urgent action including allocating substantial additional resources to ensure the issues raised were resolved."

Northwestern Mutual faces a lawsuit filed by 10 policyholders alleging that the company used fraudulent sales practices. The suit alleges that the company's sales training materials were fraudulent. "The allegations made are essentially a rehash of claims made in a previous case. That previous case has been dismissed and is in binding, private arbitration," says a Northwestern Mutual spokesperson. "We're confident that the allegations in the lawsuit will be proven baseless, absolutely baseless."

Government Intervention

In July, President Bush signed into law the Sarbanes-Oxley Act of 2002, the most comprehensive corporate governance legislation in decades. The Act creates tougher provisions for prevention and punishment of corporate and accounting fraud. The Act calls for the creation of the Public Company Accounting Oversight Board, designed to enforce the new standards. Also, the Act increases penalties for corporate corruption and misdeeds and makes CEOs and CFOs personally responsible for company disclosures.

"When you look at Sarbanes, which has to be the most comprehensive securities legislation since the 1930s, you see some extremely strict changes that address responsibilities and qualifications for the audit committee," says Markus Dietehlm, chief legal officer and head of group public affairs, Swiss Re, New York. "The general discussion in the marketplace will have people reviewing whether their internal checks and balances are appropriate under increased public scrutiny in these uncertain market environments."

The law, however, is not necessarily a change, but a formalization of accepted practices, says Bruce Zaccanti, national practice director with Ernst & Young, Chicago. "These processes and procedures have always been there. The law has elevated awareness of them. SarbanesOxley is important not only from a corporate perspective, but also from shareholder and financial markets perspective. If I'm going to invest in a company, I want to see something from that company that talks about process management, responsibility, ownership, communication, and commitment to integrity."

Yet, as Holder points out, "you have to differentiate between legal accountability and the perception of accountability. The chief executive officers and the chief financial officers are accountable without any duty of signing any annual reports. In tenns of accountability, there has been growing pressure from the public. It is also mirrored in our behavior insofar as we've added a focus on governance to one of our board meetings."

Governance in Insurance

That focus is being given serious attention by insurers, says one expert. When Sarbanes-Oxley Act was passed, insurers were faced with one more issue on top of a growing pile of issues, according to Zaccanti. "We are now taking more risk because of the pricing components, all of the effects of September 11, effects of the telecommunications issues and the energy issues. Insurance companies are being impacted greatly."

Dietehlm recalls seeing the industry first face the idea of outside forces managing the daily business. "Post-September 11, I traveled to Washington to speak to all the concerned politicians about terrorism cover, or as was the case the lack thereof going forward. Quite a number commented on how no one ever had to think about reinsurance. It had never been an industry that had come up to the federal level as an industry that was required to be bailed out. Therefore, managing its own business without any federal support or concern or any other public issue was unnoticed throughout its history."

Peter Forstmoser, chairman of the board of directors at Swiss Re, says that the public perception of governance has caused changes in business as usual. "You certainly can see a highly increased awareness in the public, which caused us to have now in our annual report a specific section on governance. It's not new information, but the fact that you collect this information is showing a strong sign for the raising importance of the issue.

As boards reshape and governance comes to the forefront of business practices, companies are going to find it a much harder task to recruit new blood into the governing body.

"The executive search firms are reporting that it's a very difficult job now to find the caliber of person you need on a board," says Hartwig. "There are several reasons. The job isn't as glorious and pretty as it once was. There's a real chance of lawsuits being lodged against you. Many outside directors are actually officers with other companies. The boards of directors at those other companies are discouraging their participation in other boards."

What will happen to the shape of the board? Some say it's an unanswered question. Others think the changes can only be positive. Says Zaccanti, "Corporations are going through a metamorphosis. They want trust between themselves and their shareholders and business partners. They want to understand who has responsibility, who is peer reviewing what's being done, who is involved in making these decisions, and how these decisions are communicated throughout the organization. Now, everybody's responsible."

Risk Management's Role

Shaking out the boardroom causes plenty of dust to settle in the vicinity of the risk manager. While a risk manger's main function is to quantify risk, many say that up to this point, risk management had little to do with the boardroom decision-making process. Some say that the responsibility is not the risk manager's. "It falls on the board, the C-level executives across the organization to help the risk manager understand what the risk tolerances are, what the insurable and non-insurable risks are, what processes and procedures are in place," says Zaccanti. "Enterprise risk management and steering committees have gained much more visibility in organizations now.

"The risk manager's position is one of coming to the organization having senior management doing what the risk manager had previously done," he says. "There's a much higher level of pressure."

Many believe that the legacy of Enron, WorldCom and their ilk is unlikely to occur in the insurance industry. As Hartwig explains, insurers report their business under two books-the general accounting principles (GAP) and the statutory accounting principles. "This adds an extra measure of confidence to the insurance industry that you don't have elsewhere," he says. With statutory accounting, he adds, there is an immediate realization of expenses. "That creates a conservative estimate of income and profitability and net worth. You don't have this anywhere else." Insurers, he says, are often conservatively managed entities.

What adds to the confidence level is that the revenue that insurers report is not pumped up. With a hard market, those numbers are relatively high.

"There's no swapping, trading, or fooling around with the amortization schedules like Enron was doing," Hartwig says.

"The revenue gains in this industry are probably better than any other industry out there today. On the books, the number is only realized as it's earned. It's one more safeguard."

Lori Widmer can be reached at lwidmer@lrp.com.

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