The Tragedy of Corporate Governance in America Impacts and Implications for the Insurance Industry
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Transcript of 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
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!
Living High Off the Company Hog
Bernie Ebbers, former CEO of WorldCom
Dennis Kozlowski, former Tyco CEO
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
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
$1,531B
4.4%3.5%
2.5%
5.7%
8.3%
4.8%5.6%
2.2%
1.0%
-0.6%
-1.6%
-0.3%
5.0%
1.1%
2.3%3.2%2.7%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Real GDP Growth
Source: US Department of Commerce, Blue Economic Indicators 9/02, Insurance Information Institute.
Economy is experiencing sluggish growth following the
recession of 2001
(first recession since 1990/91)
The ABC’s of D&O
3 Components of D&O Coverage
A. Personal Coverage: protects directors and officers against
liability arising out of “wrongful acts”
B. Corporate Reimbursement Coverage: reimburses organization
when legally required/permitted to indemnify D&Os for their
“wrongful acts”
C. Entity Coverage: reimburses for claims made directly against
the organization (including those that name no individual
insureds)
• Today, about 90% have entity coverage today, compared to 30% 5
years ago.
Sources: AICPCU, Tillinghast-Towers Perrin, Ins. Info. Inst.
The ABC’s of D&ODuties of Directors & Officers
1. Duty of Care: • D&Os must exercise “reasonable care”• Courts hold that D&Os are not guarantors of profitability• Directors not required to have special knowledge of business
2. Duty of Loyalty to Corporation:• Undivided loyalty required (should be no conflicts-of-interest)
3. Duty of Loyalty to Shareholder:• Prohibits insider trading, for example
4. Duty of Disclosure:• Officers must disclosure material facts to directors• Officers must disclosure material facts to regulators• Officers must disclosure material facts to creditors or potential creditors• Officers must disclosure material facts to stockholders, bond holders, potential investors
Median Total D&O Limits by Business Class ($ 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
$250,000
Utiliti
es
Banki
ng
Durab
le M
fg.
Petro/
Min
ing/
Ag.
Mer
chan
disin
g
Nondu
rabl
e Mfg
.
Trans
. & C
omm
.
Perso
nal &
Bus
. Ser
v.
Biotec
h &
Phar
m.
Techn
ology
Non-B
ank
Finl.
Hea
lth S
ervi
ces
Educa
tion
Constr
. & R
eal E
state
Gov
t. &
NPOs
Premiums vary considerably by industry
D&O Broker Market Share(by Number of US Retail* Accts as Primary Broker)
Woodruff-Sawyer21%
ABD19%
Marsh8%
Other10%
W. Gallagher & Assoc.10%
Armfield, Harrison & Thomas
10%
Carpenter Moore12%
A.J. Gallagher5%
Aon5%
Source: Tillinghast –Towers Perrin
*Excludes wholsale brokerage activity; Based on sample of 1,976accounts
Highlights: Property/Casualty First-Half 2002 ($ 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
Source: Tillinghast-Towers Perrin
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
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
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
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**