The threat of downgrades, investigations and perturbed investors means the decision to restate financial results can no longer be taken lightly, says Ronald Gift Mullins.
The Restatement of financial results or loss estimates can have devastating results for some reinsurers yet only slight consequences for others. The degree of influence from a restatement depends greatly on how seriously the financials will be affected and how that plays out against the company's share price as well as its credit and claims paying ratings, which can swiftly impinge on its relationship with clients. Given the unsettling reaction that a restatement usually brings to investors, rating agencies and customers, companies usually only resort to this action when compelled by a federal or state government agency's investigation or legal action, following a troubling internal or external accounting audit, and rarely from outright fraudulent activities.
"Companies in every industry restate earnings," says Clint Harris of Conning Research & Consulting. "But the unusually intense scrutiny of the insurance and reinsurance industry in 2004 and 2005 might make it appear unjust that the industry has had a higher number of restatements than other industries. There are many internally and externally-generated reasons that result in restatements. Often companies are compelled by the Securities and Exchange Commission (SEC), perhaps indirectly, to restate earnings. These actions arise from the need to make company operations transparent and to make results comparable over multiple years." He observed that while many companies never find it necessary to restate their results, there have been cases where companies have restated their results twice in one year.
Within the reinsurance industry, a common reason for restatements is the reinterpretations of finite insurance and reinsurance agreements. Like the insurance industry in general, these agreements have come under more intense scrutiny in recent years from the SEC and state attorneys general. Further, the Sarbanes-Oxley Act may be increasing the pressure to ensure accounting treatments are above misinterpretation. "Another issue is that the development of financial products often has outpaced development of accounting to address reporting of these products," Harris points out. "Not only do changes in rules sometimes affect prior accounting periods, but also evolving interpretations of prior rules affect prior earnings." Damien Magarelli, a Standard & Poor's director, said restatements are not frequent, but they do happen for a few companies: "Basically a restatement reflects the numbers that were reported and have been re-evaluated with new criteria from auditors with explanations of why the restatement is necessary."
Reinterpretations of finite insurance
Assuming that a specific restatement resulted in a decrease in earnings over a previous period, an important question is what influence will the restatement have on future earnings? Uncertainty causes investors to react negatively. But if the restatement only results in a slight decrease in earnings, and a sound explanation is provided for the restatement, investors and rating agencies tend to either ignore the restatement or react positively.
Bermuda-based ACE is one example of a reinsurer/insurer that enjoyed almost no impact on its share price, volume of business or ratings, despite announcing a restatement. On 21 July 2005, ACE announced it was restating its financial results for the years 2000 through 2004, as well as its results for each of the quarters in the years 2003 and 2004, and for the first quarter of 2005. "The primary purpose of the restatement is to correct the accounting treatment for eight transactions in the non-traditional products or 'finite risk' category," the company explained in a statement. The estimated cumulative impact of the restatement through the first quarter of 2005 was an increase in shareholders' equity of approximately $1m. In addition, ACE admitted it had received numerous subpoenas, interrogatories and civil investigative demands in connection with the ongoing industry-wide investigations of insurance business practices and non-traditional or loss mitigation insurance products, often referred to as finite risk reinsurance. An independent investigation into these products did not identify any instances of inappropriate conduct by current senior management of the company or by members of the board of directors. Evan Greenberg, president and CEO of ACE, said at the time, "We have found accounting problems on a number of transactions and we regret that. We are fixing those problems. We have also put in place strict procedures to ensure that this does not happen again."
The share price of ACE Ltd on the New York Stock Exchange on 20 July 2005 was $46.60; and on 22 July, the price was $46.51. In early June 2006, the price had risen to a little over $50. On 12 September 2005, ACE said it would not know exact losses with certainty for some time from Hurricane Katrina, but preliminary estimates indicated that total net losses would be approximately $450m to $550m after tax. In October 2005, ACE sold 28.6 million ordinary shares to raise more than $1bn dollars to use for growth opportunities in global insurance and reinsurance markets. None of the rating agencies took any action following the restatement of earnings or the estimate of losses from Hurricane Katrina. Little business appears to have been lost too. Net premiums written for ACE property casualty units for the third quarter of 2004 were $2.8bn, edging down to $2.1bn for the third quarter of 2005, and $2.6bn for the forth quarter of 2005 but jumping up to $3.2bn for the first quarter of 2006. Standard & Poor's and AM Best both give ACE Group an "A+" financial strength rating with a stable outlook.
Converium, a Swiss-based reinsurer, announced in December 2005 that its restatement would increase shareholder equity by $69.3m as of 30 June 2005, and result in a third quarter deficit of $6.9m due to hurricane losses. The restatement was from an internal review of the way that the group had accounted for certain complex finite reinsurance transactions. But it didn't rule out further restatements: "Although the internal review was extensive, the ongoing governmental inquiries, or other developments, could result in further restatements of Converium's financial results in the future," the company said. Even with the possibility of further adjustments to earnings, "the restatement did not have a big impact on our various audiences," said Esther Gerster, a spokesperson for Converium. "The rating has not changed so far. With regards to clients, we have renewed 97% of our business as per 1 January 2006, and 99.5% as per 1 April. So no significant impact there either. There might be a few clients who have not renewed due to the restatement, but there is usually more than one important reason for a client's final decision."
"Customers of insurers and reinsurers tend to have a longer-term view of their business partners," commented Conning's Harris. "A restatement of earnings that does not reduce the insurer's or reinsurer's overall financial condition is unlikely to have a profound affect on relationships. That is, if there are no additional complications, such as a finding of fraud or an unusual delay in announcing an increase in losses causing a substantial reduction in surplus."
Restatements of losses
Harris noted that loss reserve changes are a related but different issue than earnings restatements: "Unfavourable case loss and IBNR development can negatively affect the insurer or reinsurer that announces the loss reserve increase. This action can also assail other insurers or reinsurers that may have similar underwriting exposures, but have not yet quantified the charge on their reserves. Reserve changes may follow major catastrophes as well as settlement of major litigation and developing trends in jury awards."
Consider PXRE, a Bermuda reinsurer. The slow but steady descent into near oblivion for PXRE began on 11 September 2005 when it announced its preliminary estimate of its net loss from Hurricane Katrina of approximately $235m. Eight days later, it raised its maximum net loss from Katrina to $300m. On September 28, it said its preliminary estimate of the net loss from Hurricane Rita would be between $30m and $40m. The company said determining true estimates of its net losses from Hurricane Rita and Hurricane Katrina was subject to high levels of uncertainty and that the company's results might therefore differ substantially from the current estimates. On 30 September, AM Best downgraded the financial strength rating of PXRE to "A-" from "A". The rating agency said the "downgrades reflect the deterioration in PXRE's risk-adjusted capital position due to the group sustaining net losses from hurricanes Katrina and Rita in the $265m to $340m range."
Jeffrey Radke, president and CEO of PXRE, on 21 December 2005, said that PXRE had raised over $1bn of additional risk capital in the fourth quarter of 2005 "to support our underwriting and allow PXRE to take advantage of the current favourable underwriting environment in our core lines of business." On 16 February 2006, PXRE increased its estimates of the net pre-tax impact of hurricanes Katrina, Rita and Wilma by between $281m to $311m, bringing its total gross loss estimate to between $758m-$788m. Previously, the estimates had been $462m to $477m. Radke observed that in light of the potential negative impact that adverse rating actions would have on the company's future business, "PXRE has decided to explore strategic alternatives for the company." Immediately, AM Best downgraded PXRE's financial strength rating to "B " from "A-". On 24 February 2006, it further downgraded the rating to "B+". Lawsuits against PXRE began to appear in May, alleging the reinsurer had misled investors about the losses from the hurricanes. Finally, along with its first quarter 2006 results, PXRE reported it had lost two-thirds of its business. Rumours began to circulate that the reinsurer would be put into runoff if a buyer could not be found. Its stock, which had sold as high as $25.50 in late July 2005, toppled from $11.89 on 16 February 2006 to $4.05 the next day. It was selling for about $3.60 in early June.
"Yes, a restatement or re-evaluation of losses by a reinsurer has a very real effect on its clients," said an insurance company executive who asked to remain unnamed. "It means something has been done that is not legal or is a serious breach of prudent decision-making by management. When a company starts re-estimating and increasing its losses, the rating downgrades begin and once it goes below an "A", then its clients bail out if they can."
Usually, unless it is written into a reinsurance treaty, an insurer can't move from a reinsurer it has signed a contract with until the end of the contract. "But we," the executive continued, "in the last few years, along with other insurers, have put a clause in our treaties with reinsurers that gives us the right to terminate unilaterally if the reinsurer loses its "A" rating, or if its surplus takes a big hit. If we don't leave the reinsurer at the first sign of difficulty we could be left with a greater net retention."
- Ronald Gift Mullins is an insurance journalist based in New York City.
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