Ronald Gift Mullins examines the heightened interest in the corporate governance of the US re/insurance sector.

Following the all-too-often disclosures of unbridled fraud, greed and deception within corporate America, there has been a rush to mend legislatively the tattered status of corporate governance and repair investors' loss of confidence. This heightened interest in governance provides re/insurers with more detailed, pertinent information to make underwriting decisions, helps protect their own considerable investments in securities and also exposes how well re/insurers themselves abide by sound governance practices.

Generally, corporate governance is defined as how the management of a company provides shareholders and creditors with credible information concerning the welfare of the business. Prior to 2000, governance was more discussed outside boardrooms than practiced within them, leading to explosions of misleading information from such giants as Enron, WorldCom, Tyco, Global Crossing, Adelphia, ImClone Systems and Qwest. These ruinous revelations sparked a sudden and severe eroding of investor confidence in publicly traded securities.

"Our confidence in the world of finance and business has been shaken, but every experience, even if it is negative, teaches us something," said Markus E Straubinger, senior underwriter, credit & surety, Converium Ltd. "Following a phase of exaggerated emphasis on the short-term maximisation of profit, the pendulum has now swung in the opposite direction. It saw the transformation of apparently large and sound companies into gigantic financial risks. We will thus in future be well advised to be more careful in our assessments and to give adequate consideration to the question of the ethics and morality of a risk or a transaction."

Massive D&O claims

As economic losses began to mount from the collapse of these huge corporations, there was a swelling of investor lawsuits against corporations and their management. This has exposed re/insurers to massive claims from directors' and officers' (D&O) policies covering these tarnished companies. A study by Tillinghast-Towers Perrin showed a levelling off of the frequency of D&O claims in 2001, but an increase in their severity, as indicated by the rise in median and average payments and defence costs.

Among closed claims overall - excluding those closed with no payment - US participants paid an average of $5.65m to claimants, up more than 75% from the 2000 survey. The average indemnity paid to shareholder claimants was at an all-time high of $17.18m in 2001, compared with $9.62m in 2000. The average indemnity payment in 2001 among closed employee claims was $250,000, up slightly from $240,000 in the year before.

Defence costs for closed claims overall increased to $540,000 from $490,000 in the 2000 survey. The study noted that nearly one-third of all claims filed in 2001 against US companies were class actions, which are typically expensive to defend and often result in very large payments. D&O claims, the study said, were more than twice as likely against companies with a history of merger and acquisition activity, and publicly traded companies were more than twice as likely to experience a claim than their private counterparts.

Figuring that something had to be done to improve the image of corporations, the Sarbanes-Oxley Act became law in late July 2002. It promised to be a comprehensive approach to improve accounting oversight and strengthen corporate governance. The Act establishes new corporate governance standards, enhances financial disclosure requirements, creates new federal crimes and increases the maximum penalties of existing crimes. It sets up a Public Company Accounting Oversight Board to regulate and oversee audits of public companies by registered accounting firms, and directs the Securities and Exchange Commission (SEC) to address conflicts of interest by securities analysts.

"Companies, investors and markets are increasingly coming back to appreciate something we have known all along: that credibility and high governance standards are essential factors in a company's efforts to attract and retain investors in global capital markets," said Leo C O'Neill, president of rating agency Standard & Poor's (S&P).

In addition, new rules for corporate governance have been issued for companies listed on the New York Stock Exchange (NYSE) and NASDAQ. The new regulations require corporations to post very specific information regarding governance on their websites.

Surveys by Blunn & Co done immediately after the NYSE issued its new corporate governance rules in June 2002 found that of the 135 prominent companies surveyed, 84% did not have a section devoted to corporate governance on their sites. Only 14% published their corporate governance policies prominently and less than one quarter published a corporate code of ethics. "Clearly," the report said, "even the world's leading businesses have a lot of catching up to do to meet the new standards adopted by the big US exchanges."

Re/insurers not immune

This Sarbanes-Oxley Act and other measures are intended to calm investor alarm and return confidence to the securities markets by mandating that corporations provide more disclosure and offer greater transparency of a range of financial and operational functions. Re/insurance companies are not immune from these new rules and are taking steps to reveal more about their financial procedures, dealings, internal checks and balances to assure shareholders and policyholders that their financial statements are sound.

"Analysts have always had a certain level of discomfort with insurance because of its unique regulatory status, accounting practices and business language," wrote Patricia L Guinn, managing director, Tillinghast-Towers Perrin, in a paper on the need for greater transparency. Increased transparency brings a number of benefits to re/insurers. "At the industry level," she wrote, "improved financial reporting would likely have a positive impact on insurance company pricing. If companies have to account to their shareholders more quickly and accurately, they are less likely to focus purely on top-line results and engage in `irrational' pricing activities, for example, pegging prices against market leaders and shaving off a few points."

William Coyner, research analyst at SNL Financial, said that the insurance industry legitimately has to `fudge' some figures. "The insurance industry is always working off estimates," he said. "They have to estimate what their liabilities are, based on past loss experience and early investigations into claims and re-evaluating old claims. They are always playing in grey areas, always making adjustments, adding to reserves, drawing down reserves. The insurance industry is not a black-and-white industry as far as accounting strictly and permanently for profit and loss. Unlike manufacturers, where revenues and expenses are set figures, with insurance there has to be legal adjustments; it is the way of doing business."

Expensing stock options

Along with the required changes enforced by the Sarbanes-Oxley Act, such as requiring CEOs and CFOs to certify that their companies' results are true and correct, some corporations - including certain re/insurers - are making voluntary changes, such as deciding to expense stock options and bearing the additional cost to their bottom lines.

Max Re Capital Ltd of Bermuda announced it would expense the fair value of employee stock options starting 1 January 2003. It estimates that this will reduce 2003 net income by approximately $1m. The expense will increase annually over the next four to five years as the cost is phased in. In 2001, Max Re had a net profit of $2.6m. Through the first nine months of 2002, the company had a net loss of $16,738.

The Chubb Corp said it will start expensing the fair value of all stock options granted from 2003. If options had been expensed in 2001, Chubb's net income would have been reduced by $0.26 per share. Chubb estimates 2002 earnings will be lowered by approximately $0.11 per share.

Grudgingly, Maurice (Hank) Greenberg, CEO of American International Group, said the company will expense stock option costs beginning in 2003. The cost in 2003 is estimated to be less than $0.01 per share, and about $0.05 per share by 2008. Mr. Greenberg noted that treating stock options as an expense is not an economic issue for AIG because it has never granted an excessive number of options. He grumbled that there is a legitimate concern that expensing options is "economically punitive because it causes a company to pay two times - once through the expense and again through dilution."

A major reason AIG has never granted "an excessive number of stock options" to employees can be traced to 1969 when the insurer went public. At that time, Mr Greenberg and other senior officers set up a separate company in Bermuda with more than $100m in stock. The revenue from that fund is used to reward the top officers of the company. This incentive is on top of the compensation received from corporate AIG.

As a result of expensing stock options, Willis Re of London reported a net loss for the 2002 second quarter of $7m, or $0.05 per diluted share, compared with net income of $17m, or $0.12 per diluted share, for the 2001 second quarter.

Bulking up 10-Ks

As part of improving transparency for investors and analysts, companies can voluntarily provide more data than is legally required. Ms Guinn of Tillinghast said that a review of 2001 10-Ks filed with the SEC revealed most companies were disclosing more information that they have in the past. But she cautioned that "merely increasing the amount of the information provided does not necessarily increase the transparency of the reporting if the most essential facts become lost in a sea of details."

She observed that AIG increased the number of pages in its 10-K from 16 in 2000 to 150 in 2001. MetLife increased its 10-K from 61 pages in 2000 to 365 in 2001. Companies that are under intense scrutiny by analysts or the financial press are more likely to increase the depth of the reporting, she noted.

Mr Coyner of SNL Financial said that the 10-K filings were loaded with figures and charts and tables, which "is wonderful for number junkies." The 10-K filings are done using Statutory Account Principles (SAP), as compared with Generally Accepted Accounting Principles (GAAP). Statutory accounting takes a cash approach. "Regulators want to make sure the insurer has enough cash on hand to pay a large loss," Mr Coyner said. "GAAP can be used to fudge the figures just a bit for a certain time period, but not with SAP."

Governance for hire

With governance a hot item for most corporations, a number of organisations have recently announced programmes that will evaluate a company's governance strategy. S&P has developed what it calls a `Corporate Governance Score'. Moody's Investors Service is starting to train its analysts to scrutinise corporate governance practices more closely and plans to introduce a corporate governance section in research reports next year. Institutional Shareholder Services has begun offering a `Corporate Governance Quotient'. In addition, The Corporate Library and GovernanceMetrics International plan to release their governance metric in late 2002.

Corporate Diagnostics LLC, chaired by former Cabinet Secretary Jack Kemp, will collaborate with Marsh Inc, FTI Consulting and the law firms of Patton Boggs LLP and others to "assure the board and senior management of client companies that their record keeping and governance meet the standards necessary to maintain the confidence of investors."

A study done by S&P ranked how well the annual reports of companies in its S&P 500 fared for global transparency and disclosure. Among the 500 were 17 to 20 (depending on the major focus of the company) re/insurers, among them ACE Ltd, Aetna Inc, Allstate Corp, AIG, AON, Chubb, Marsh & McLennan Cos and XL Capital Inc. Ranked on 98 attributes, on a scale of 0 to 10 (the best), most re/insurers had scores of 4 or 5 and better, except Allstate which scored a 2.

George S Dallas, managing director and global practice leader, governance services at S&P, said the study did not detect any significant differences between the re/insurance industry and others, though the high tech and health care sectors fared somewhat less favourably than others.

In a wide-ranging and detailed report, the Conference Board observed that US institutional investments dominate those of all other countries. The type of corporate governance activism now evolving in the US, the report noted, could eventually influence the management of investments around the world.

Just say no

Certainly, the renewed and amplified concern for governance will improve the degree and kind of information available to investors, but this opening of closed compartments will also benefit re/insurers. Clients seeking coverage, particularly D&O, errors and omissions and employment practices liability, will need to become more forthcoming with details and data to persuade underwriters to accept the risk.

Mr Straubinger of Converium Ltd said, "The presentation of a transaction is very important to us because it gives us a clear indication of how well our client has studied his risk and how he wants to `sell' it to us reinsurers so that we will be persuaded to share it.

"I realise that people are always in a hurry and that business has to be placed," he continued, "but speed can be dangerous... We must take the time to examine our risks very carefully and to ask additional questions whenever we feel uneasy, where the facts are not clear or where discrepancies arise. And we must above all have the courage to say `No' if we are not 100% sure about a transaction and the risk, even if this means that we lose premiums and thus business."

By Ronald Gift Mullins

Ronald Gift Mullins is an insurance journalist based in New York City.