the tragedy of corporate governance in america impacts and implications for the insurance industry...

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 for Financial 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 rise Ratings agencies Analysts Regulators

Investors/Creditors Employees Lawmakers

• Regulatory/Legislative Fallout Unclear Enormous 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 Profit Performance

Geopolitical Instability

Crisis in Corporate

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 the Corporate House of Ill-Repute

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


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


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!

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

Yie

ld S

pread

(p

oin

ts)

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 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 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


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


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

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%

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&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


$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

INDUSTRY FINANCIALS

Overview & Outlook

Highlights: Property/Casualty First-Half 2002 ($ Millions)

2002 2001 Change

Net Written Prem. 182,434 162,855 +12.0%

Loss & LAE 134,336 129,301 +3.9%

Net UW Gain (Loss) (11,285) (18,781) -39.9%

Net Inv. Income 17,831 18,749 -4.9%

Net Income (a.t.) 4,639 2,789 +66.3

Surplus* 282,871 289,649 -2.3%

Combined Ratio 105.0 111.1 -6.1 pts.

*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 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

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


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%

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

*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: 100.3

1980s: 109.2

1990s: 107.7

2000s: 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

$101

97

51

97

61

97

71

97

81

97

91

98

01

98

11

98

21

98

31

98

41

98

51

98

61

98

71

98

81

98

91

99

01

99

11

99

21

99

31

99

41

99

51

99

61

99

71

99

81

99

92

00

02

00

12

00

2

Underwriting Gain (Loss)1975-2002*

*Annualized estimate based on first half 2002 data.Source: A.M. Best, Insurance Information Institute

$ B

illi

ons

P-C insurers paid $53 billion more in claims & expenses than they collected in premiums

in 2001

-5%

0%

5%

10%

15%

20%

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

Bil

lion

s

(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

Abuse of the Tort System

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.

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

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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the tragedy of corporate governance in america impacts and implications for the insurance industry...

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