Casualty Actuarial Society
Risk & Capital Management Seminar
Toronto, ON, Canada
July 8, 2002
Robert P. Hartwig, Ph.D., Senior Vice President & Chief Economist
Insurance Information Institute

110 William Street

New York, NY 10038
Tel: (212) 346-5520

Fax: (212) 732-1916
 bobh@iii.org
 www.iii.org

•
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

•
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
300
250
200
150
100
The number of financial restatements is rising even thought the number of publicly traded companies is falling.
116
160
50
0
1997 1998*
*Approximate
Sources: Huron Consulting Group
215
1999*
233
2000
270
2001

-Palm Beach Post, June 2002.

-BusinessWeek,, May 13, 2002.
-The Economist, June 8, 2002.

Terrorism
Market Malaise
Crisis in
Corporate
Governance
Market Malaise
Weak Profit
Performance
Geopolitical
Instability

40%
30%
20%
10%
0%
-10%
-20%
-30%

Could be headed for 3 rd consecutive year of decline for stocks

Last happened 1939-1941
Large Company Stocks
*As of July 5, 2002.
Source: Ibbotson Associates, Insurance Information Institute

Accounting Problems are Getting
Many Companies into Trouble
• Enron was tip of an iceberg
•
Major implications for insurers (p/c and life)

Company
Problem
D&Os created complex outside partnerships that kept billions in losses of
Enron’s balance sheet;
Accused by CA of manipulating energy market
Lax oversight of some client books, conflicts of interest, shredded documents
Potential Charges
• Securities Fraud
• Insider trading
• Perjury
• Guilty of obstruction of justice
• Individual partners may be liable
• Fraud Inappropriately accounted for $3.8B in expenses, inflated profits

Company
Problem
Ex-CEO Dennis Kozlowski indicted for tax evasion on art purchases
Bogus capacity swaps inflated revenues (Qwest did too); Dynegy = “roundtripping” to inflate revenue
Potential Charges
• Tax evasion
• Misuse of corporate funds
• SEC accounting query
• Securities fraud
•
Insider trading
• Insider Trading Ex-CEO Sam Waksal indicted June 12 for tipping off family & friends that
FDA did not approval of cancer drug Erbitux

Company
Problem
$4.6B in undisclosed loans to founding Rigas family;
Misc. unconventional transactions, questionable accounting
Potential Charges
• 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
• Possible fraud Complex projects exaggerated cash flow;
“Round-tripping” to inflate revenue

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!

Total Exposure (Life & Non-Life): $3.796 Billion
Multiple
7%
 Enron is the biggest bankruptcy in US history ($31B+)
Surety
26%

Equity/debt widely-held as S&P
500 company

Biggest impact in institutional investors/creditors
Fin. Guarantee
2%
D&O
1%
 11 Congressional investigations
 56 suits against officers & directors
 Will spark similar suits
Investment
64%
Source: Loss estimates from Morgan Stanley as Feb. 8, 2002; Insurance Information Institute.

Total Exposure (Life & Non-Life): $5.725 Billion*
Financial
Guarantee**
4%
D&O
2%
Investment
94%
 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
*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.

WorldCom: From $60/share in to
6 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

$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
Total Industry Holdings = $3.3 Trillion
Total $1531
P/C $194
Life $1,337
Total $1120
P/C $185
Life $935
Corporate
Bonds
Corporate
Stocks
Source: Federal Reserve Flow of Funds Report as of Dec. 31, 2001.
Life P/C
Total $209
P/C $188
Life $21
Total $438
P/C $131
Life $307
State/Local
Bonds
U.S. Gov't
Bonds

by Amounts Outstanding, as of December 31, 2001
Insurers
$1,120.4
15%
All Others
$459.5
6%
Total: $7,534.7 billion
Mutual Funds
$2,836.8
38%
State & Local
Gov't
Retirement
Plans
$1,215.7
16%
Private
Pension Funds
$1,902.3
25%
Insurers are the 4 th largest holder of corporate stocks
Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

By Amounts Outstanding, as of December 31, 2001
Total: $3,730.1 billion
All Others
$387.3
10%
Banks, SIs,
Trusts
$515.2
14%
Insurers
$1,530.4
41% Life = $1,336.5 (87%)
Non-Life = 193.9 (13%)
Mutual Funds
$608.7
16%
Private
Pension Funds
$345.5
10%
State & Local
Gov't
Retirement
Plans
$343.0
9%
Insurers are the largest holder of corporate bonds
*Includes foreign bonds.
Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

1995-2001
$1,400
$1,200
$1,000
$800
$600
Total $450B
$563B
$400
$200
$0
1995 1996
$745B
1997
Life P/C
$1,173B
$1,135B
$1,120B
$933B
1998 1999 2000 2001
Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

1995-2001
$1,800
$1,600
$1,400
$1,200
$1,000
Total $993B
$1,091B
$800
$600
$400
$200
$0
1995 1996
$1,206B
1997
Life P/C
$1,301B
$1,3543B
$1,410B
$1,531B
1998 1999 2000 2001
Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

Beginning of the End:
Bursting of the Tech Bubble

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.

Duties 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)
$50
Limits vary considerably by industry
$50
$40
$32
$30
$20 $20
$20 $15 $15
$10
$10 $10 $10
$8
$5 $5 $5 $5
$0
U til iti es
B an
D ki ng ab le ur
N on
M fg
.
du ra bl e
M fg
.
M er ch an di
Source: Tillinghast-Towers Perrin
Pe tr sin g in in o/
M
H g/
A ea
Pe rs on lth al g.
S er
&
B vi ce s us in es s S
T ra ns er v.
. &
C om
N on m
.
k
Fi nl
.
-B an
B io te ch
C on
& st
P ha rm r.
&
R ea
.
l E st at e
E du ca tio n
G
T ov ec h t.
&
N
PO s
1

Median Total D&O Premium by Business Class
Premiums vary considerably by industry
$250,000
$200,000
$150,000
$100,000
$50,000
$0
U til iti es
B an ki ng ab
D ur
Pe tr le
M fg
.
o/
M in in g/
A g.
M er ch an
N on di sin
T g du ra bl ra ns
Source: Tillinghast-Towers Perrin e
M fg
.
. &
Pe rs on m
.
C om al
&
B us
. S
B io te ch er v.
&
P ha rm
T
.
ec hn
N ol og on y
-B an k
Fi nl
.
S er vi ce
E s du
H ea lth
C on st ca tio n r.
&
R ea l E st at e
G ov t.
&
N
PO s

D&O Broker Market Share
(by Number of US Retail* Accts as Primary Broker)
Aon
5%
Marsh
8%
A.J. Gallagher
5%
Other
10%
W. Gallagher &
Assoc.
10%
Armfield, Harrison
& Thomas
10%
Source: Tillinghast –Towers Perrin
Woodruff-Sawyer
21%
ABD
19%
Carpenter Moore
12%
*Excludes wholsale brokerage activity;
Based on sample of 1,976accounts

Shareholder Class Action Lawsuits*
600
500
400
300
200
100
0
Shareholders typically recover just
2.56% of amount lost; 1/3 of that goes to lawyers & expenses**
164
202
163
231
188
110
178
236
209
216
487
110
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002*
*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

Average Jury Awards
1994 vs. 2000
$7,000
$6,000
1994 2000
6,817
$5,000
$4,000
3,482 3,566
$3,000
$2,000
$1,000
419
1,168
759
1,727
187
269 333
698
1,140 1,185
$0
Overall Business
Negligence
Vehicular
Liability*
Premises
Liability
Medical
Malpractice
Wrongful
Death
Source: Jury Verdict Research; Insurance Information Institute.
1,744
Products
Liability

•
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 insurer
 Always 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)

• 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

Primary Insurers
Reinsurance Brokers
Fronting Companies
Unicover Pool
Reinsurance Brokers
Reinsurers

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%!!??)

• 200 year old company wiped out by one bad owner

Now being liquidated by PA Insurance Department

Producing large hits on guarantee funds
 assessments
 Underpricing, underresserving part of the problem
• Very different from Enron/WorldCom

Steinberg 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

•
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

•
Independent directors must make up board majority

2 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

•
Beginning with 3 rd 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

• “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

•
New SEC requirement pertains to companies with revenues exceeding $1.2 billion
 SEC’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) listed

AIG, 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

•
Insurers (apparently) excluded are:

Companies with revenues under $1.2 billion
 All mutuals (irrespective of size) or any other form of nonpublicly 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

$25
$20
$15
P/C Net Income After Taxes vs.
Net Operating Cash Flow ($ Billions)
$20.2

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
$12.8
$9.5
$10
$5
2001
$0
2000
-$5
-$10 -$7.9
Net Income After Taxes*
Sources: A.M. Best, Guy
Carpenter estimates.
2000 2001
Net Operating Cash Flow**
*NIAT = Prem Earned – Exp Incurred + Inv Inc.
**NOCF = Prem Coll – Exp Exp Pd + Inv Inc.

$20
$15
$10
$5
$0
-$5
1996
Sources: ISO
$2.9
Change in P/C Loss Reserves
1996-2001 ($ Billions)

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
$15.9
$1.7
-$2.2
1997 1998
-$3.4
1999
-$4.5
2000 2001

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