"Managing Insurer Asbestos Risks"

InsurancedigestAmericas edition • June 2004

Sharing insights on key industry issues*

The Americas Insurance digest is published three times a year, to address the key issues driving the insurance industry. If you wouldlike to discuss any of the issuesraised in more detail, please contactthe individual authors or the Editor-in-chief, whose details arelisted at the end of each article.

We would also welcome yourfeedback and comments onInsurance digest, and as such, we enclose a Feedback Fax Replyform. Your feedback will help us toensure that our publications areaddressing the issues that you feelmost strongly about.

Contents

Editor’s Comment 2John S. Scheid

Corporate governance and Sarbanes-Oxley – Boon or bust for D&O insurers? 4Leslie J. HawkesIn the wake of the recent corporate scandals, insurers providing directors and officers liability insurance have seen the number of D&O claims increase at an accelerating rate and the loss costs for these claims skyrocket. Will a renewed focus on corporategovernance and the introduction of the Sarbanes-Oxley Act 2002 actually improve insurers’ profit potential for this line of business,or will it set the standards so unrealistically high that lawsuits and loss costs will only continue to increase and cut into profits?

International Financial Reporting Standards continue to progress 10David Scheinerman and William GoldsteinIFRS preparers will be required to adopt IAS 32 Revised and IAS 39 Revised for financial statements covering annual periodsbeginning on or after January 1, 2005. The scope of the revised standards is very wide, and the revisions provide further definitionand modified guidance in key areas. This article provides an overview of the provisions of the revised standards, highlightingsignificant changes and notable differences from US GAAP.

Managing insurer asbestos risks 18Claire A. LouisThe financial implications of asbestos for the insurance industry, with losses estimated to be in the billions, are significant. This article examines how the industry has managed its asbestos exposure in the past and how insurers are leveraging lessonslearned to address current asbestos challenges. It also looks at efforts to legislate asbestos reform at the federal and state leveland considers the potential impact of the Sarbanes-Oxley Act of 2002 on insurer financial statement disclosures relative toasbestos liabilities and the monitoring of the controls environment surrounding insurers asbestos claims management.

Managing General Agents and the implications of Sarbanes-Oxley – 26

Legislating good business practicesKey Coleman, Steven Sumner and Anthony GrazianoThe Managing General Agent continues to be an excellent vehicle for the distribution of products and services of its insurerpartners. However, the Sarbanes-Oxley Act of 2002 ‘raises the bar’ in terms of corporate oversight, controllership and controls over the financial reporting process for those insurers that do business with them.

Supervision in insurance-affiliated broker dealers: 34

Yesterday’s leading practices are today’s expected practicesEllen Walsh and Stephen KoslowVital insurance companies constantly change over time with new product offerings, target markets, distribution channels andoperating platforms. With these changes come increased risks that require enhancements to your NASD-required supervisorystructure. This article provides suggestions on maintaining an effective compliance program for your insurance-affiliatedbroker/dealer.

Americas edition • June 2004

2 Insurance digest • PricewaterhouseCoopers

Welcome to theJune 2004 editionof AmericasInsurance Digest.

With the first fourmonths of 2004now in therecord books,many companies

are seeing evidence of a growing global andregional economy. True there still remainsuncertainty; however, most companies arelooking ahead to key challenges. It is someof these challenges that form the content ofthis edition of Insurance Digest.

Clearly, corporate governance reformfollowing the Sarbanes-Oxley legislation is a focus area for many insurers. Our firstarticle, authored by Leslie Hawkes, looks atrecent trends in directors and officers liabilityinsurance. With increased corporateresponsibility for financial reporting andinternal controls, will the D&O insurers bebetter able to assess the underwriting risksand offer better coverage? Today more than

ever, insurers will need to better understandthe risks they are insuring, and one wouldthink that with the greater transparency in financial reporting and independentassurance on controls, D&O writers will bebetter equipped to underwrite this risk.

Our second article continues our focus onInternational Financial Reporting Standards(IFRS) with a discussion of progress towardsadoption by some for financial statementscovering annual periods beginning on or after January 1, 2005. This article, co-authored by David Scheinerman and Bill Goldstein, discusses the revised standardson financial instruments. IAS 32R and IAS39R offer opportunities to reassess assetclassifications and address derivative/hedgeaccounting effectiveness testing to namejust a few. These revised standards representa significant change from the initial standardsand therefore IFRS preparers will benefitfrom a detailed review of the new provisions.For many, continued uncertainty over manytechnical provisions within IFRS is makingconversion more difficult. The requiredchanges in accounting for financial

Editor’s Comment

JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP

Welcome to theJune 2004 edition

of AmericasInsurance Digest.

3Insurance digest • PricewaterhouseCoopers

instruments will undoubtedly require changeto procedures, processes and systems.Although the scale of change will vary fromcompany to company, we have yet to find acompany whose detailed analysis has indicatedthat the impact will be less than first thought.

For several insurers asbestos litigation has been an increasingly difficult challengesince the mid-1980s. Claire Louis examineshow the insurance industry has managed its asbestos exposure over the years andconsiders some lessons learned whenaddressing today’s challenges of increasingasbestos insurance coverage disputes,reinsurance reimbursement and fine-tuningclaims practices and processes. Clairediscusses the evolution of asbestos litigationtogether with national and state initiatives to attempt some asbestos litigation reform.Based on our work with insurers, there doesseem to be good results from strong claimsmanagement practices, processes andclinical procedures coupled with a thoroughinternal control environment to furthermitigate financial, operational and regulatoryrisk in this area.

Key Coleman, Steve Sumner and Anthony Graziano discuss the critical need for insurers who work with Managing GeneralAgents (MGAs) to focus on controls intendedto manage all processes outsourced toMGAs. Sarbanes-Oxley is mandating a levelof formalized control and documentation of all processes affecting the financial reportingprocess that has not typically been done ineither the insurer or MGA. Our authors identifyten critical success factors for insurers andMGAs to consider. Use of MGAs offersinsurers some good benefits but only if strongcommunication and all risk/controlconsiderations are addressed.

Today’s demands for corporate responsibilityand the ever-increasing regulatory expectationscan be considered yet another burden to befaced. Insurance companies offering generalsecurities, investment advisory services and banking/trust products have increasedthe range of their supervisory risks andresponsibilities. As a result, several insurershave thoroughly re-evaluated their supervisorysystem. Ellen Walsh and Steve Koslowdiscuss key considerations for supervision

in insurance-affiliated broker dealers.Maintaining a reasonable supervisory structureis essential in managing both financial andoperational risk. It also helps to protect thereputation that all insurers have worked hardto maintain.

I hope you find this edition of InsuranceDigest interesting. Please do continue toprovide us with feedback on the topics youwould like to see addressed in future issues.Copies of this publication and the Asia-Pacificand European editions are available on ourwebsite (www.pwc.com/financialservices).

John S. ScheidEditor-in-chief

Tel: 1 646 471 [email protected]

Corporate governance and Sarbanes-Oxley – Boon or bust for D&O insurers?

AUTHOR: LESLIE J. HAWKES


Sarbanes-Oxley and other legislation require insurers to betterunderstand the risks they accept and to tighten underwriting standards.

The Sarbanes-Oxley Act (SOA),corporate governance, enterprise-wide risk management, internalcontrols – all are terms that havebeen in the forefront of the newsrecently. However, the notions of corporate governance, riskmanagement, and internalcontrols are not new concepts.These are the responsibilities to which directors and officers of corporations supposedly havebeen regularly attending in theirroles as directors and officerssince the beginning of time. Yet whenever the topic turns to recent corporate scandals and accounting misstatements,these terms are bandied aboutquite regularly as new andimproved tactics that must be implemented in order toreverse the current trend towardcorporate malfeasance.

Partially as a result of the recentcorporate scandals, insurers thatprovide directors and officersliability insurance have seen thenumber of D&O claims increase at an accelerating rate and theloss costs for these claimsskyrocket. Recent awards in response to shareholders’litigation in cases such asCendant and Waste Managementhave boggled the mind.

D&O insurers, investors, and regulators alike are leftwondering if this legislation,regulation, and renewed attentionto corporate governance will have

a positive effect on the operationof the nation’s corporations ingeneral. Will all this attention to improved controls really ensurethat our corporations are beingrun by directors and officers whoare truly responsible and forthrightindividuals faithfully and honestlylooking out for the shareholders’best interests? Given theextremely complex organizationalstructure of most of today’s largercorporations, is it realistic toexpect that a single small group at the top can provide the level ofcontrol and oversight now expectedas a result of new legislation andthe renewed concern withcorporate governance?

But the $64,000 question (or should it be the $64 billionquestion?) that D&O insurersreally want answered is: Will all ofthis attention to the requirementsof the SOA, corporategovernance, and internal controlsactually improve insurers’ profitpotential for this line of business,or will it set the standards sounrealistically high that lawsuitsand loss costs will only continueto increase and to cut into profits?

Recent Trends in Directors andOfficers Liability Insurance

D&O insurance has been aroundfor many years, but never beforehas it received the level ofrecognition experienced in themost recent times. D&O claimsare on the rise. So, too, are themagnitude of D&O litigation

settlement amounts and thepremium levels insurers arecharging for this coverage.

In 1995, in an attempt to stem the tide of certain security class-action lawsuits, Congresspassed the Private SecuritiesLitigation Reform Act (PSLRA).This legislation was intended todecrease the number of ‘frivolous’lawsuits by making it more difficultto file such suits. At the time ofthe passage of this legislation, we were experiencing anextremely soft insurance cycle. In the property and casualtymarket, capacity was abundantand insurers were competing for business by offering morecoverage for lower prices. Insurers offering D&O insurancebegan increasing coverage limits,decreasing retentions, providingbroader coverage, and loweringprices to attract more business.Certain insurers began widelyproviding entity coverage, also known as Side C coverage,that covers the corporation itselfin the event of a shareholderclaim. Insurers were also attachingliberal severability provisions.Severability provisions aredesigned for the protection ofinnocent directors and officers in the event of misdeeds by otherdirectors or officers. One exampleof the applicability of theseverability provision is thatmaterial misstatements by certaindirectors or officers on the originalapplication for coverage without

D&O insurancehas been aroundfor many years,but never beforehas it receivedthe level ofrecognitionexperienced in the most recent times.

CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS?


knowledge of innocent directorsand officers could lead to aninsurer nullifying coverage. The severability provision wouldprovide coverage for theinnocent directors or officerswhile nullifying it for thoseresponsible for themisstatements. In anticipation ofdecreased numbers of lawsuitsas a result of PSLRA, insurerswere willingly decreasingdeductibles, retentions, andcoinsurance amounts in additionto charging much lower rates.

Unfortunately, the intendedconsequences of the 1995legislation were not realized, and in reality, the direct oppositeoccurred. In the three years thatfollowed the passage of PSLRA,the number of securities class-action lawsuits that were filedincreased by 75 percent.1

In 1998, the Securities LitigationUniform Standards Act waspassed and did appear to stemthe tide, at least for a couple ofyears, but now the number ofsuits is again rising.

It was not too long ago that onlythe largest and most notablecorporations purchased D&Oinsurance as a regular practice.Today, directors and officers ofvirtually all types oforganizations, particularlypublicly traded companies andSecurities and ExchangeCommission (SEC) registrants,are fully aware that they simplycannot afford to take thepersonal risk associated withserving in the capacity of

a director or officer without the protection provided by D&O coverage.

The corporate and accountingscandals of 2001 and 2002 wereextreme eye-openers to D&Oinsurers, yet in terms of loss-generating incidents, they weremore akin to the proverbial strawthat broke the camel’s back thanan epiphany-creating event. The aforementioned softeninginsurance market of the 1990s,combined with the dot-com bustof the few years leading up to2001 and 2002, had alreadybegun to take a significant toll on D&O insurers’ profitability asthe loss experience of the D&Oinsurance line significantlyworsened during this period. The most notable of thecorporate scandals – Enron,WorldCom, and Tyco – havesubsequently had a markedimpact on the D&O marketplace.However, it will take literally yearsbefore all of the actual impactcreated by these events will befully known and understood.Many of the D&O insurersinvolved with these corporationsare attempting to invoke certainpolicy provisions, such as theregulatory exclusion2 or thesecurity law violation exclusion3,to exclude coverage for some ofthese scandals. Some insurersare attempting to rescindcoverage altogether by allegingthat the insured corporationacquired the coverage throughmisrepresentation and, had theseD&O insurers known the fullpicture when they first entered

into the contract to provide thecoverage, they never would haveagreed to write D&O insurance inthe first place.4

Since the full impact of the pastfew years will remain unknownfor several years to come, D&Oinsurers have become muchmore conservative in providingcoverage. In addition to chargingmuch higher premiums for D&Oinsurance, insurers skilled atproviding this type of coverageare being much more selectiveabout which businesses they are willing to insure and whatcoverage grants they are willingto provide. Over the past twoyears, some insureds have seentheir rates skyrocket, and, ingeneral, rates are increasinganywhere from 30 percent to 300 percent, depending upon the type of organization and needfor limits and coverage. Insurersclearly are cutting back on entitycoverage and severability and areseverely increasing retentionsand deductibles.

Enter Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002was enacted in direct response tocorporate scandals in an attemptto bring investor confidence backto the capital markets and tocreate oversight for the accountingprofession. Two key outcomes ofthe SOA were, first, the creationof a public accounting oversightentity, the Public CompanyAccounting Oversight Board(PCAOB), which is designed to oversee the public accountingprofession; and second,

the restriction of variousconsulting services beingprovided by public accountingfirms that are also providingaccounting and audit services toan SEC registrant. One might askwhat these outcomes have to dowith D&O insurance. It is notthese provisions, but rather twoother significant areas of theSOA that will have the greatestimpact on the D&O exposuresfaced by SEC registrants subjectto the SOA.

Sections 302 and 404 of TheSarbanes-Oxley Act of 2002

Section 302 of the SOAessentially requires companiessubject to the SOA to develop,implement, and institutionalize a set of comprehensive internalcontrols over all aspects of theirfinancial reporting to ensure thatreported financial statements arefree from any materialmisstatements that wouldmislead investors or regulators.Section 404 of the SOA requiresthat the company’s externalauditors review and test thesecontrols and attest to theeffectiveness of the controls.

The essence of the SOA,particularly Sections 302 and404, is the requirement that allcorporate directors and officersexercise a much higher degree of control, take a much morecomprehensive view of allinternal controls, and fully assess how these controls affectall aspects of the organization. A summary of Sections 302 and 404 of the SOA follows5:

CORPORATE GOVERNANCE AND SARBANES-OXLEY – BOON OR BUST FOR D&O INSURERS? continued


1. PricewaterhouseCoopers LLP Securities Litigation Study (2002).2. The regulatory exclusion is included in most D&O contracts and excludes coverage for proceedings brought by regulatory agencies.3. Some D&O policies exclude coverage for losses which emanate from violations of security laws.4. ‘Enron and the D&O Aftermath – Tips and Traps for the Unwary.’ See http://www.iwancray.com/articles.htm.5. Summary of the Sarbanes-Oxley Act of 2002 located at http://www.aicpa.org/info/sarbanes_oxley_summary.htm.

Section 302: Corporate Responsibility for Financial Reports

• The CEO and CFO of eachissuer shall prepare astatement to accompany the audit report to certify the ‘appropriateness of thefinancial statements anddisclosures contained in theperiodic report, and that thosefinancial statements anddisclosures fairly present, in all material respects, theoperations and financialcondition of the issuer.’ A violation of this section mustbe knowing and intentional togive rise to liability.

Section 404: Management Assessment of Internal Controls

• Requires each annual report of an issuer to containan ‘internal control report,’which shall:

(1) state the responsibility of management forestablishing andmaintaining an adequateinternal control structureand procedures forfinancial reporting; and

(2) contain an assessment, as of the end of the issuer’s fiscal year, of theeffectiveness of the internalcontrol structure andprocedures of the issuer for financial reporting.

Each issuer’s auditor shallattest to, and report on,

the assessment made by themanagement of the issuer. An attestation made underthis section shall be inaccordance with standards for attestation engagementsissued or adopted by theBoard (PCAOB).

• Directs the SEC to requireeach issuer to disclosewhether it has adopted a codeof ethics for its senior financialofficers and the contents ofthat code.

• Directs the SEC to revise itsregulations concerning promptdisclosure on Form 8-K torequire immediate disclosure‘of any change in, or waiverof,’ an issuer’s code of ethics.

With the full implementation ofthe SOA (being phased in forcertain size companies in 2004and 2005), no longer will the CEOof an entity be able to say that heor she was unaware that the CFOwas misstating financial results tobolster share prices. The SOAwill require that all corporateofficers and directors understandthe controls in place to ensureintegrity over financial reportingand that they attest to theeffectiveness of those controls.

Like other legislation before it,the full effects of the SOA willtake quite some time to shakeout. There are still many morequestions being asked thanbeing answered, and it will not be until well into 2004 before some of these questionsare answered.

Directors & Officers LiabilityInsurance and Sarbanes-Oxley: What Happens Next?

Before we can know what futurelies ahead for the D&O insurancemarket, we first have to ask howthis legislation and increasedattention to corporate controlswill affect the way ourcorporations will actually be rungoing forward. Will the SOA reallyhelp to clean up the perceptionthat many investors have ofcorporate United States: thatcorporations are being poorly run(or worse yet, being deceptivelyrun) and that lawsuits are theway to recoup monies lost inmaking bad investments?

There are those who believe thatthis new legislation and attentionto corporate governance will donothing more than add layers ofbureaucracy at the corporationlevel and layers of regulation atthe government level. However,others hope and believe thatputting the spotlight and theonus on all members of the ‘C’suite will prove to be very fruitfulin decreasing the opportunity forcorporate greed to go undetected.As time progresses, the recenttrend of corporate scandals willbecome a footnote to a processwhereby all investors stand onequal footing and, with theproper amount of research, havethe ability to be treated fairly bythe capital markets.

So what will be the effect of thislegislation and the other trendstoward increased corporategovernance and scrutiny on thefuture of directors and officers

insurance? It depends uponwhom you ask.

Some insurers believe that theSOA will set the standards so high that it will be nearlyimpossible to meet them.Similarly, the rules andregulations set forth by the SOAwill be sufficiently complicatedand complex that missing one ortwo requirements will open thedoors to increased shareholderlitigation. John W. Keogh, thepresident and chief executiveofficer of National Union FireInsurance Co., a Pittsburghsubsidiary of AIG, one of thenation’s largest D&O insurers, quoted in the October 9, 2003issue of American Banker puts it this way, ‘God forbid you onlydid 999 of the 1,000 things youneed to do for Sarbanes-Oxley.’This insurer believes that‘Sarbanes-Oxley creates aroadmap for plantiffs.’6

Still others believe that theincreased transparency infinancial reporting and the actualneed for corporations todocument, implement, andinstitutionalize controls overfinancial reporting will help D&Oinsurers separate the wheat fromthe chaff when it comes todetermining which organizationsare good D&O risks and whichare not worthy of their time,attention, and capital.

Clearly, insurers will need to do a much more thorough job tobetter understand the risk theyare insuring. This will requireincreased specialization in



6. Gjertsen, Lee Ann, ‘Scandal Responses Seen Multiplying D&O Risks,’ American Banker, 168, no. 195 (October 2003).

underwriting for a line of businessthat is already one of the mostspecialized in the market today.D&O underwriters will have to doa much more diligent review ofthe more transparent financialstatements and disclosures.Underwriters will have to be ableto review the level of controlsimplemented and understandhow they permeate theorganization. If D&O underwritersdo this, however, they willimprove the quality of theirunderwriting of the corporationsto whom they provide coverage.They will be willing to providecoverage only to those entitiesthat have adequate controls inplace. This, in turn, will makecoverage for noncompliantorganizations prohibitivelyexpensive or nonexistent. Those organizations that cannotfind or afford D&O insurance willbe unable to attract qualitydirectors and officers and soonwill cease to exist.

Summary

These clearly are tumultuoustimes for both the buyers and thesellers of directors and officersliability insurance. Assimilating allof the recent changes into theunderwriting of D&O coveragewill be an essential step ininsurers’ attempts to improvetheir profitability in this line ofbusiness. The Sarbanes-OxleyAct and a renewed attention tocorporate governance shouldhelp D&O insurers improve thequality of their books of businessand, subsequently, their profitpotential for this line of business.Will this actually prove to be thecase? Only time will tell.

Leslie Hawkes is a manager in the Actuarial & InsuranceManagement Solutions (AIMS)practice of PricewaterhouseCoopersLLP. She has over 23 years ofexperience in the property-casualty insurance industry.



The preceding article was originally printed in ‘The John LinerReview’, Vol. 17, No. 4 (Winter 2004) and is reprinted here withpermission from The Standard Publishing Corporation.

AUTHOR

Leslie J. HawkesManager, Actuarial and Insurance Management SolutionsTel: 1 646 471 [email protected]



International Financial ReportingStandards continue to progress

AUTHORS: DAVID SCHEINERMAN AND WILLIAM GOLDSTEIN


IAS 32 Revised, Financial Instruments: Disclosure and Presentationand IAS 39 Revised: Recognition and Measurement were publishedin December 2003 and amended in April 2004.

Introduction

Preparers of InternationalFinancial Reporting Standards(IFRS) will be required to adoptIAS 32 Revised and IAS 39Revised for financial statementscovering annual periods beginningon or after January 1, 2005. The revised standards on financialinstruments, IAS 32R and IAS39R, were issued in December2003 clarifying principles makingthe standards easier to apply.These standards affect companiesin all industries, not just financialservices. Among other changes,the revised standards are likely to change the way all IFRS

preparers, particularly first-timeadopters, account for financialinstruments, and provide anopportunity to reassess their asset classifications.

For those companies currentlypreparing US-GAAP financialstatements, the revised standardsembody much of what is includedin SFAS 115, ‘Accounting for Debtand Equity Securities,’ SFAS 133,‘Accounting for DeclarativeInstruments’ and SFAS 140‘Accounting for Transfer andSecurity of Financial Assets andExtinguishments of Liabilities’.

The scope of the revised standardsis very broad, and the revisionsprovide further definition andmodified guidance in key areassuch as:

• Scope – certain financialguarantee contracts and loancommitments are excluded;

• Classification of financialassets and liabilities – on initialrecognition, may choose tomeasure any financial asset or liability at fair value throughthe profit and loss account;purchased loans that are notquoted in an active market maybe carried at amortized cost;

The scope of therevised standardsis very broad...

INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS


Scope of revised standards overviewFIGURE 1

Source: PricewaterhouseCoopers

Within Scope of Revised IAS 32 and IAS 39

Out of ScopeWithin Scope of Revised IAS 32 Only

Debt and equity instruments, and cash and cash equivalents

Investments in subsidiaries,associates and joint ventures

Loans and receivables Lease receivables and payables(subject to derecognition, impairment,and embedded derivative provisions)

Derivatives, including embeddedderivatives and on subsidiaries,related parties, and joint ventures

Own use commodity contractsFinancial guarantees based onloss incurred by holder

Derivatives on entity’sown shares

Own debt Tax balancesEmployee benefits

Own equity

Insurance contractsWeather derivatives

Loan commitments held for trading,unless cannot be net settled and othercriteria (required by 12/03 revisions)

Other loan commitments

• Hedge accounting – hedging of firm commitments are nowtreated as fair value hedges;

• The ‘derecognition’ model –substantially rewritten, but retains the concepts of rewards and control todetermine inclusion within the financial statements;

• Fair value determination –guidance changed andaugmented; and

• Certain disclosure requirementsmoved from IAS 39 to IAS 32.

This article provides an overviewof the provisions of the revisedstandards, highlighting significantDecember 2003 changes andnotable differences from US GAAP.

Scope

Generally, anything that meetsthe definition of a financialinstrument is within the scope of IAS 32 and IAS 39, unlessspecifically exempted. (Figure 1provides an overview of what is included in the scope of therevised standards).

Debt/Equity classification

Revised IAS 32 establishesprinciples for distinguishingbetween a liability and equity.The substance of a financialinstrument, rather than its legalform, governs its classification.The critical feature in identifying a liability is the existence of anobligation to pay cash (or toexchange another financialinstrument) under conditions thatare potentially unfavorable to the issuer.

A financial instrument isclassified as equity when itrepresents a residual interest in the net assets of the issuer.Liabilities and equity componentsof compound financialinstruments are accounted forseparately. Derivatives on ownshares are classified as equity if they only result in delivery of a fixed number of an entity’sshares or cash; otherwise, they are treated as derivatives,accounted for under IAS 39.

The treatment of interest,dividends, gains and losses in the income statement followsthe classification of the relatedfinancial instrument.

Figure 2 provides a framework fordistinguishing between a financialliability or equity instrument.

Initial recognition andclassification

IFRS, through revised IAS 39,and US GAAP require an entity to recognize a financial asset or liability on its balance sheetwhen, and only when, it becomesparty to the contractualprovisions of the financialinstrument. Initial measurementof the financial instrument at fairvalue, which will usually be thesame as the fair value of theconsideration given or received.If a financial instrument is valuedby reference to a more favorablemarket than the one in which thetransaction occurred, an initialprofit is recognized. Transactioncosts are included in the initialcarrying value of the financialinstrument unless the instrumentis carried at fair value throughprofit or loss.

INTERNATIONAL FINANCIAL REPORTING STANDARDS CONTINUE TO PROGRESS continued


Instrument Cash obligation for principle

Cash obligation for coupon/ dividends

Settlement in fixed number of shares

Classification

Ordinary stock n/a n/a n/a Equity

Redeemable preferredstock, with 5% fixeddividend subject todistributable profits

✓ ✓ n/a Liability

Redeemable preferredstock with discretionarydividends

✓ n/a n/a Liability for principal Equity for dividends

Convertible bond intofixed number of shares

✓ ✓ ✓ Liability for bond andequity for conversionoption

Convertible bond intoshares equal to value of the liability

✓ ✓ n/a Liability

Financial liability and equity instruments frameworkFIGURE 2


Financial liabilities are classifiedeither as ‘financial liabilities at fair value through profit or loss’or as ‘other financial liabilities’.Liabilities at fair value throughprofit or loss may be classified as held for trading or designatedto this category at inception. If adopted, a proposedamendment to IAS 39 wouldrestrict the application of fairvalue for liabilities to situationssatisfying certain strict criteria.

Reclassification of assets betweencategories will likely be relativelyuncommon under revised IAS 39and is prohibited into and out ofthe fair value through profit or losscriteria. Reclassification from held-to-maturity as a result of a changeof intent or ability are treated assales and generally result in thewhole category being ‘tainted’ andremeasured at fair value, with anygain or loss recognized in equity.

This is consistent with SFAS 115and US GAAP accounting.

Embedded derivatives

Revised IAS 39 maintains thedefinition of a derivative as afinancial instrument with all of the following characteristics:

• Its value changes in responseto changes in an ‘underlying’price or index;

• It requires no or a smallerinitial investment than requiredto purchase the underlyingfinancial instrument; and

• It is settled at a future date(note: there is not arequirement for netsettlement, as required by US GAAP FAS 133).

Derivatives embedded within a host contract are separately



Financial assets at fairvalue through profit orloss (previously‘trading’ assets)

Similar to IFRS frequent buying and sellingusually indicates a trading instrument.

No option to designate, the classification isbased on prescribed classification definitions.

• Assets acquired or originated principally for generating short-term profitsfrom trading

• Derivatives

• Any financial asset designated at initial recognition; may not be reclassified

Asset Classification US GAAP ProvisionsIFRS Provisions

Held-to-maturity (HTM)investments

• Financial assets with fixed or determinable payments and fixed maturitythat an entity has positive intent and ability to hold to maturity (assessedat each balance sheet date)

• Excludes originated loans and equity securities

• If an entity sells more than an insignificant amount of HTM securities, theentity will generally be prohibited from using the HTM classification forany financial assets for 2 years and must reclassify existing HTMinstruments as available for sale

Loans and receivablesoriginated by the entity

• Non-derivative financial assets with fixed or determinable payments thatare not quoted on an active market

• Includes loans acquired as a participation in a loan from another entity orpurchased by the entity (provided for by revised IAS 32)

• Must recover all of its initial investment from the financial asset (otherthan due to credit deterioration) to be classified as a loan or receivable(provided by revised IAS 32)

• May be classified and accounted for as held-to-maturity, ‘fair valuethrough profit or loss’, or available for sale

Available-for-salefinancial assets

• All financial assets not classified in another category are classified asavailable for sale

• Includes equity securities other than those classified as at fair valuethrough income

Similar to IFRS.

All debts receivable that are not securities arerecognized at amortized cost.

Similar to IFRS. Changes in fair value reported inother comprehensive income.

Figure 3 lists the four classification categories of financial assets and their key provisions under IFRS and US GAAP are:

Financial asset classifications under IFRS and US GAAPFIGURE 3


recognized (bifurcated) andaccounted for separately if:

• The economics of theembedded derivative are not‘closely related’ to those ofthe host contract;

• The embedded derivativewould meet the definition of a derivative on a stand-alonebasis; and

• The entire contract is notcarried at fair value.

Derecognition

Derecognition is the term usedfor removal of an asset or liabilityfrom the balance sheet. RevisedIAS 39 sets out the criteria forderecognition of financial assetsor liabilities and the resultingaccounting treatment.

Under US GAAP, derecognition isbased on control. Legal isolationof assets even in bankruptcy isnecessary for derecognition.

Generally, a financial asset (or part of an asset) isderecognized when:

• The rights to the cashflowsfrom the asset expire;

• The rights to the cashflowsand substantially all the risksand rewards of ownership ofthe asset are transferred;

• An obligation to transfer thecashflows from the asset isassumed and substantially allthe risks and rewards aretransferred; and

• Control of the asset istransferred, even if substantiallyall the risks and rewards areneither transferred nor retained,in which case the asset isrecognized to the extent of theentity’s continuing involvement.

The revisions to IAS 39 clarifythat derecognition is to beinitially assessed based on

transfer of substantially all therisks and rewards; control is thenapplied as a secondary test.

A financial liability is removedfrom the balance sheet onlywhen it is extinguished.Extinguishment occurs when theobligation in the contract isdischarged, cancelled, orexpired. A transaction isaccounted for as a collateralizedborrowing if the transfer does notsatisfy the conditions forderecognition.

On derecognition of a financialasset in its entirety, the differencebetween the carrying amountand the consideration received is included in the incomestatement. If only part of afinancial asset is derecognized,the carrying value of the financialinstrument is allocated based on relative fair value at the dateof transfer and the gain or lossaccounted for on thederecognized part.

Similarly, under US GAAP, in thetransfers of financial assets,each entity that is a party to thetransaction recognizes only theassets it controls and liabilities ithas incurred. In addition, a partycan only derecognize assetswhen control has beensurrendered, and derecognizeliabilities only when they havebeen extinguished.

Subsequent measurement, fair values, and impairment

The classification of a financialasset determines the subsequentmeasurement of the asset.Figure 4 summarizes theprinciples:

Financial assets categorized asthose at fair value through profitor loss (including trading assets)are measured at fair value, withchanges in fair value included inthe net profit or loss for theperiod. All other (non-trading)financial assets are carried atamortized cost.

The carrying amount of afinancial instrument carried at amortized cost is computedas the amount to be paid atmaturity adjusted for anyunamortized original premium or discount, net of anyorigination fees or transactioncosts and any principalrepayments. The financialinstrument is amortized using the effective interest method,which uses the rate of interestnecessary to discount thecashflows through expectedmaturity or derecognition date in order to equal the amount atinitial recognition.



Financial Assets Measurement Changes in Impairment testcarrying amount (if objective evidence)

Financial assets at fair Fair value Income statement No*value through profit or loss

Loans and receivables Amortized cost Income statement No**

Held-to-maturity Amortized cost Income statement Yes*investments

Available-for-sale Fair value Equity Yes*financial assets

* This is consistent with the accounting under US GAAP;** SFAS 114 and 118 requires companies to evaluate loans for impairment.

Summary of principles of financial assetsFIGURE 4


Fair value is ‘the amount forwhich an asset could beexchanged, or a liability settled,between knowledgeable, willingparties in an arm’s lengthtransaction.’ Revised IAS 39provides a hierarchy to be usedin determining a financialinstrument’s fair value:

1. If there is an active market,the quoted market price is to be used.

2. If no active market, valuationtechniques, incorporating allfactors that marketparticipants would consider in setting a price, consistentwith the economics andmethodologies for pricingfinancial instruments.

3. If there is no active market foran equity instrument and therange of reasonable fair valueestimates is significant and no reliable estimate can bemade, an entity is permittedto measure the equityinstrument at cost lessimpairment as a last resort.

Similar to US GAAP, realization ofgains on initial recognition of afinancial instrument are expectedto be rare.

Impairment losses are incurred if, and only if, there is objectiveevidence of impairment as aresult of a past event thatoccurred subsequent to the initialrecognition of the asset.Expected losses as a result offuture events, no matter howlikely, are not recognized.

Both IFRS and US GAAP havesimilar requirements for theimpairment of financial assets.

IFRS requires an entity toconsider impairment when thereis an indicator of impairment,such as: the deterioration in thecreditworthiness of acounterparty; an actual breach of contract; a high probability ofbankruptcy; or the disappearanceof an active market for an asset.

Generally US GAAP requires thewrite-down of financial assetswhen an entity considers adecline in fair value to be ‘otherthan temporary’. Indicators ofimpairment are: the financialhealth of the counterparty;whether the investor intends tohold the security for a sufficientperiod to permit recovery invalue; the duration and extentthat the market value has beenbelow cost; and the prospects ofa forecasted market price recovery.

Hedge accounting

IAS 39 allows for hedgeaccounting, subject to strictrequirements, including theexistence of formaldocumentation and theachievement of effectivenesstests. Their documentation must include the entity’s riskmanagement objective andstrategy for undertaking the hedge.

All derivatives that involve anexternal party may be designatedas hedging instruments (exceptcertain written options). An external non-derivativeinstrument may only bedesignated as a hedginginstrument of foreign currencyrisk. The fundamental principle isthat the hedged item creates anexposure to risk that could affectthe income statement.

Hedge accounting can beapplied to three types of hedging relationships:

1. Fair value hedges, for whichthe gain or loss from thehedging instrument isrecognized immediately in theincome statement, and thecarrying amount of the hedgeditem is adjusted for the gain orloss attributable to the hedgedrisk (and the change is alsorecognized immediately in theincome statement);

2. Cash flow hedges, includinghedges of foreign currencyrisk associated with firmcommitments, for which thegain or loss from the hedginginstrument is recognizeddirectly in equity. The gain orloss is ‘recycled’ to the incomestatement when the hedgedcash flows affect income; and

3. Hedges of a net investment ina foreign operation, for whichthe gain or loss on the hedging

instrument is recognizeddirectly in equity.

US GAAP is similar to IFRS in theaccounting for hedging of financialinstruments except as follows:

1. US GAAP does not consider a basis adjustment on cashflow hedges of forecastedtransactions;

2. When measuring hedges offoreign entity investments,ineffectiveness is recognized in the income statement.

If the hedging relationship comes to an end (e.g., thehedging instrument is sold), one of the hedge criteria is nolonger met (e.g., the hedge doesnot pass effectiveness tests) or the hedging relationship isrevoked, then hedge accountingmust be discontinued. Hedgeeffectiveness requires twoseparate tests which must beapplied prospectively andretrospectively:



• Prospective effectivenesstesting must be performed at inception of the hedge and at each reporting dateduring the life of the hedge.This test requires the entity to demonstrate that it expectschanges in the fair value orcash flows of the hedged item to be almost fully offset(i.e., nearly 100%) by thechange in fair value of thehedging instrument.

• Retrospective effectivenesstesting is performed at eachreporting date throughout thelife of the hedge inaccordance with the hedgedocumentation methodology.

Similar to US GAAPrequirements for hedgeeffectiveness, the objective isto show that the actual resultsof the hedge are within therange of 80-125%.

Based on the recently issuedamended IAS 39, most portfoliohedges of interest rate risk(sometimes referred to as‘macro’ hedges) will qualify forfair value hedge accounting.

Conclusion

IFRS continues to evolve and willhave significant impact on thefinancial statements of IFRSpreparers, as evidenced by therecent revised IAS 32 and IAS 39.The revised standards are asignificant change from the initialstandards and have essentiallyrewritten the rules for derecognition.

IFRS preparers and those entitiesconsidering adopting/convertingtheir accounting policies to IFRS will benefit from a detailedassessment of the provisions of the revised standards, given the potential requiredchanges in the way entitiesaccount for financial instruments,which may therefore requiresubstantial changes to systems,processes, and documentation.As IFRS is in a period ofsignificant change, it’s essentialthat IFRS preparers continue to monitor the developments and proposed changes andevaluate their potential impact to their business.



AUTHORS

David ScheinermanPrincipal Consultant, Actuarial InsuranceManagement SolutionsTel: 1 860 240 [email protected]

William GoldsteinSenior Manager, Assurance ServicesTel: 1 646 471 [email protected]



Managing insurer asbestos risks

AUTHOR: CLAIRE A. LOUIS


The mounting costs of asbestos litigation continue to take their toll on insurers.Increasingly, smaller, regional, and specialty insurers are being drawn into the fray. These companies may be especially vulnerable because they lack the knowledge,experience, infrastructure, processes, and resources of insurers for which themanagement of asbestos liabilities is a mature enterprise. If they are to maintain theconfidence of shareholders and rating agencies, insurers must practice a sound riskmanagement strategy, which is aligned with the ever shifting nature of asbestos litigation.

Introduction

Despite the general introduction of the asbestos exclusion intogeneral liability policies in the mid-1980s, the insurance industryin 2004 continues to try to cometo grips with its historicalasbestos liabilities. Analysts andrating agencies alike identifyasbestos as one of the majorfactors impeding insuranceindustry growth. This article willdiscuss insurers’ attempts tomanage asbestos liabilities andthe financial implications ofasbestos for insurers.

Rating agencies, including Fitchand A.M. Best, estimate that US insurance industry asbestoslosses may reach $65 billion1.According to Morgan Stanley, US insurers increased asbestosreserves by close to 70%between 1998 and 2003. In 2003 alone, US insurersstrengthened asbestos reservesby $5.204 billion2. Despite thesesignificant actions, the projectedshortfall between the insuranceindustry’s estimated $39 billion infuture asbestos-related costs andexisting reserves is $20 billion3.

We will examine how the industrymanaged its asbestos exposure in the past and how insurers areleveraging lessons learned toaddress current asbestoschallenges: the significant increasein unimpaired asbestos claim filings

since the late 1990s; the surge in policyholder bankruptcies and related ‘pre-packs’; casemanagement efficiencies thatfavor plaintiffs, force defendantsand insurers into unfavorablesettlements, and encourage thefiling of more claims; skyrocketingjury awards; non-products-relatedexposures; the recent emergenceof ‘mixed dust’ (asbestos and silica)claims; and increasing reinsurancedisputes. We will discuss effortsto legislate asbestos reform at thefederal and state levels.

We will consider the potentialimpact of the Sarbanes-Oxley Act of 2002 on insurers’ financialstatement disclosures relative to asbestos liabilities and relatedreinsurance recoverables and the monitoring of the controlsenvironment surrounding insurerasbestos claims management.The quality of insurer reporting of asbestos liabilities variesconsiderably. Not all insurers haverobust, formalized processes andcontrols for collecting andappropriately analyzing relevant,accurate, and complete asbestosclaim data and managing theirasbestos exposures. Sarbanes-Oxley provides the impetus forinsurers to enhance their asbestosclaims processes and controlsand, in so doing, reduceuncertainty on the balance sheetand realize new opportunities tolimit their liabilities.

With the increase in reinsurancedisputes related to asbestosliabilities, Sarbanes-Oxley providesmore reason than ever for insurersto reassess the reasonableness of their provisions for reinsurancerecoverables. Past assumptionsregarding the expected level ofpayments from reinsurers may no longer be valid. As such, it ispossible that insurers may findthemselves having to adjust thelevel of their provisions.

Increased regulatory and ratingsagency scrutiny, reduced profits,potential ratings downgrades,impaired reinsurance recoveries,shareholder actions, and eveninsolvency are some of the perilsfaced by insurers with asbestosliabilities. Those insurers thatrecognize and mitigate these risksthrough a consistent, disciplinedprogram of asbestos portfoliomanagement, which includesconservative reserve provisioning;aggressive claims management;and consistency, accuracy, andthoroughness in loss presentationto reinsurers stand the bestchance of weathering this ‘PerfectStorm,’ which asbestos litigationhas become. Indeed, legislativerelief from asbestos liabilities atthe federal level in the near term is far from certain as there is alack of complete stakeholderconsensus. As with tort reform so far, insurers’ greatest hope formeaningful change in the existing

In 2003 alone, US insurersstrengthenedasbestos reservesby $5.204 billion.

MANAGING INSURER ASBESTOS RISKS


1. Jardine Lloyd Thompson, ‘Insurance Market Overview,’ December 2003, citing AM Best report October 2003, p. 22.2. This PricewaterhouseCoopers estimate is based on a review of insurer data reported through mid-January 2004.3. A.M. Best, 2003.

system for compensatingasbestos claimants may very well lie with the states and localjudiciary. Inactive dockets inseveral states, includingMassachusetts and Baltimore,have experienced some successin prioritizing compensation for those claimants who arefunctionally impaired. Texas, Ohio, and Michigan are among the states that arepondering whether to establishinactive dockets for unimpairedasbestos claims.

Given the high stakes ofasbestos litigation, it is no smallwonder that insurers anddefendant policyholders areavailing themselves of everyreasonable means to limit theirasbestos exposure. Inventorysettlements with plaintiffs, salesof operations or business lineswith asbestos liabilities, and so-called ‘pre-pack’ reorganizationplans are strategies used byasbestos defendants to achievethis end. Defendants in formerlyrobust traditional industries such as building products,petrochemical, andmanufacturing, who are nowfighting for their very survival,often have nowhere to turn but to their historical insuranceprograms to fund the asbestosliability-related initiatives thatmay mean the differencebetween life or death. This hasincreased the level of asbestosinsurance coverage disputes,which has ultimately led to a number of recent majorsettlements between defendantsand insurers. Western MacArthur,

PPG, and, most recently, Equitas’$575 million settlement withHalliburton are notable examples.

In turn, settling insurers look totheir reinsurers forreimbursement of asbestos claimcosts. In the past insurers couldusually rely on reinsurers topromptly pay asbestos losseswith few, if any, questions asked.Although reinsurers continue topay valid asbestos losses,reinsurance disputes arebecoming more common asreinsurers, experiencing evergreater pain from their ownasbestos liabilities and increasingscrutiny from their ownreinsurers, are fine tuning theirclaims practices, processes, andcontrols to minimize any possiblerisk associated with the vetting ofcedant asbestos losses.Increasingly, arbitration panelsand the courts are demonstratinggreater willingness to lend asympathetic ear to reasonablereinsurer arguments that perhapsthey should not be obliged tofollow the fortunes of theircedants, whose loss presentationappears to be arbitrary and doesnot mirror the terms andprovisions of the policy contractor reinsurance contract wordings.Continuing reinsurer insolvenciesthreaten to further slow downand impair the level ofreinsurance collections forasbestos losses.

Evolution of asbestos litigation

The first asbestos injury lawsuitwas filed in 1966 in Beaumont,Texas4; the case was tried to a

defense verdict. The first plaintiffverdict in an asbestos injurylawsuit – Borel v. FiberboardCorporation – was returned in1973, also in Beaumont.

By 1974, asbestos lawsuits hadbeen filed in many jurisdictions.By the early 1980s, more than20,000 asbestos claims hadbeen filed. Asbestos claim filingsdecreased in the early 1990s, but sharply increased in the late1990s following several failedattempts to reach globalasbestos settlements5. The 2002Rand report estimated that morethan 600,000 asbestos injuryclaims had been filed by 20006.The majority of new asbestosclaim filings involve claimantswho have no functionalimpairment7.

Figures 1 and 2 depict theevolution of asbestos litigationfrom the 1970s through thepresent. Defense strategies andcase management procedureswhich appeared to be efficientand cost-effective in the earlydays of asbestos litigationultimately led to an exponentialgrowth in asbestos claim filingsand claim costs. The resultingincrease in defendant liabilitieshas triggered nearly 90bankruptcy filings with thelikelihood of more to follow. More than 6,000 companies havebeen sued in asbestos injurylawsuits8. The magnitude ofdefendant liabilities has not beenlost on insurers (and theirreinsurers) who have steadilyincreased reserves to cover theirshare of asbestos losses.

MANAGING INSURER ASBESTOS RISKS continued


Those insurers thatrecognize and

mitigate their risksthrough a consistent,

disciplined programof asbestos portfoliomanagement... stand

the best chance ofweathering this

‘Perfect Storm,’ whichasbestos litigation

has become.

4. Stephen J. Carroll, et al., Asbestos Litigation Costs and Compensation: An Interim Report (2002), Rand Institute for Civil Justice, at 6.5. Carroll, at 27.6. Carroll, at 51.7. Carroll, at 41.8. Carroll, at 49.



Asbestos injury litigation through the late 1990sFIGURE 1

• Initially, defendants and their insurers aggressively litigatedasbestos lawsuits;

• Litigation procedures were streamlined to create efficiencies and reduce costs;

• Court decisions resolved most coverage disputes betweeninsurers and defendants;

• The Wellington Agreement, which created the Asbestos ClaimsFacility (later the Center for Claims Resolution), was executed by selected defendants and certain of their insurers in 1985. The mission of the ACF was to ‘evaluate, settle, defend or payasbestos injury claims on behalf of defendants.’ The ACF wasdissolved in 1988; the CCR was dissolved in 2001. TheWellington Agreement, which governs how asbestos claims arepaid and funded, is perpetual;

• In most circumstances, defendants no longer contested liability;

• Matrix settlement agreements where claims are paid based on limited exposure and medical information according to adisease-based schedule became the favored means to resolveasbestos injury claims;

• Plaintiffs conducted mass screenings of asbestos workers;

• Pleural registries or inactive dockets were established in severaljurisdictions; and

• Failure of global settlement attempts: Amchem Products v.Windsor, 521 US 591 (1997) and Ortiz v. Fibreboard, 527 US 815 (1999).

Current developments in asbestos litigationFIGURE 2

• Some legacy matrix settlement agreements remain in place, but few new ones are being negotiated;

• Defense is increasingly aggressive with an increase in trials;

• Growth in claim costs, i.e., average settlements and jury awards;

• Insurers and defendants strengthen asbestos injury claimeligibility criteria, i.e., the Equitas policyholder DocumentationRequirements (introduced in June 2001) and cedantDocumentation Requirements (introduced in November 2001);

• Continuing defendant bankruptcies; attempts to create 524(g)asbestos claim trusts;

• Targeting of peripheral defendants with increasingly tenuousconnections with asbestos;

• Policyholder attempts to reclassify asbestos claims fromproducts to premises or completed operations, potentiallytriggering insurer obligations under comprehensive generalliability policies;

• Plaintiffs’ attorneys conduct mass screenings to identifyindividuals exposed to silica; a surge in silica claims in 2002 and 2003; many silica claimants are also asbestos claimants;more recent comprehensive general liability policies, withoutsilica exclusions, may be required to defend these ‘mixed dust’(asbestos and silica) claims;

• Decelerating and impaired reinsurance recoveries; more frequentreinsurance disputes, introducing greater uncertainty for cedantsrelative to recovery;

• Consolidations and mass trials (West Virginia and Virginia);

• Mega-settlements between defendants and plaintiffs,defendants and insurers; and

• The expansion of pleural registries, inactive dockets, and similardocket control mechanisms into more jurisdictions reduces the burden of the courts and costs for defendants, insurers, and reinsurers.



Current asbestos risks

Defendant Bankruptcies

Close to 90 asbestos defendants,including W.R.Grace, ArmstrongWorld Industries, Inc., andBabcock and Wilcox, have filedfor protection under Chapter 11of the Bankruptcy Reform Act of1978. Johns-Manville’sbankruptcy filing in USBankruptcy Court for theSouthern District of New York in1982 was the first attempt by acorporation to obtain relief fromits asbestos liabilities.

A significant feature of a numberof these asbestos bankruptcies,including ABB, Ltd. (CombustionEngineering, Inc.), and certaindivisions of Halliburton, is thepre-packaged reorganization plan(pre-pack) pursuant to 11 U.S.C.§§ 524(g) and (h). The pre-packincludes a pre-petition trust tocompensate the clients of certainplaintiffs’ lawyers.

Congress adopted §§ 524(g) and(h) in 1994 to assist companieswith significant asbestosliabilities to reorganize. Theseprovisions allow asbestosdefendants in Chapter 11 to bedischarged from present andfuture personal injury andproperty damage claims.

Insurers contend that the pre-petition trust is fundamentallyunfair because it favors knownclaimants, many of themunimpaired, over future claimantswho may someday developdebilitating malignant asbestos-related disease. Insurers havechallenged pre-packs in the ABBand AC&S bankruptcies. OnJanuary 26, 2004, the judge inthe US Bankruptcy Court for theNorthern District of California in

Oakland presiding over the AC&Sbankruptcy proceedings agreedwith insurers, blocking AC&S’proposed pre-pack. A federalbankruptcy judge in Pittsburghpresiding over bankruptcyproceedings involving eightHalliburton subsidiaries took an opposing view, ruling onFebruary 11, 2004, that insurersof Halliburton and its subsidiarieshad no standing to object to a proposed pre-negotiatedsettlement of all of thecompanies’ existing and future asbestos liabilities for$4.17 billion in cash and stock.

Pre-packs significantly raise thestakes for insurers. If pre-packsbecome an accepted way tobring closure to a bankruptasbestos defendant’s liabilities,not only might they increaseinsurers’ asbestos liabilities but they also might accelerateinsurers’ obligations, requiringunexpected cash payments. This would reduce the assets ofinsurers available for investmentand potential investment income.

Such is the specter raised bycourt rulings in connection withbankruptcy proceedings involvingFuller-Austin Insulation Company.Fuller-Austin filed a pre-packbankruptcy plan in September1998 with the US District Courtfor the District of Delaware.Although the court approved theplan, Fuller-Austin’s insurers, who were denied standing in thebankruptcy, refused to indemnifyFuller-Austin for its current andprojected asbestos liabilities.Following a jury trial on breach of contract and bad faith, Fuller-Austin was awardedapproximately $200 million in remaining liability insurance

limits. Insurers are appealing the award. A number of insurerspreviously settled with the Fuller-Austin pre-petition for $190 million.

Actions against insurers

In Ohio and Texas, insurers havebeen named as defendants inlawsuits which allege thatinsurers concealed or negligentlyfailed to disclose to appropriatepublic health and safetyauthorities the hazards ofasbestos in their policyholders’products. In two separate classactions in West Virginia andMassachusetts, insurers areaccused of deceptive defenseson the basis that asbestosdefendants purportedly did notknow of the dangers of asbestosuntil the 1960s. It is furtheralleged that as a result ofinsurers’ defensive strategy,compensation to plaintiffs wasdenied or reduced.

In each instance, insurers aredisputing the merits of theallegations. Plaintiff wins couldfurther expand the scope ofinsurers’ asbestos liabilities.

Reinsurance recoveries and disputes

As insurer asbestos-related risksgrow, reinsurers are refining theirprocesses for validating cedantasbestos losses. Three issues thatfrequently give rise to reinsurancedisputes related to asbestoslosses are number of occurrences,loss allocation, and prompt notice.The following are summaries ofrecent court decisions that dealwith these issues:

The US District for the District of Massachusetts in CommercialUnion Insurance Company v.

Swiss Reinsurance AmericaCorporation, 2003 WL 1786863(D. Mass. March 30, 2003) ruledthat the cedant, in connectionwith its underlying settlementwith insured, W.R. Grace, couldnot impose annualized limits onthe reinsurer in excess of the peroccurrence and aggregate limitsstated in the facultativecertificate at issue.

A federal court in Connecticutrecently held that Gerling Global,one of Travelers’ reinsurers, wasnot obliged to follow the fortunesbased on Travelers’ single-occurrence allocation of itssettlement of asbestos andenvironmental claims with itspolicyholder, which represented a departure from Travelers’original coverage position. The underlying settlementagreement did not specify howthe settlement was to beallocated against the Travelers’policies. Travelers Cas. & SuretyCo. v. Gerling Global Reins. Corp.of America, 285 F. Supp. 2d 200(D. Conn. 2003)

In Gerling Global ReinsuranceCorporation v. Ace Property andCasualty Insurance Company,No. 01 CIV 7825 (S.D. N.Y. May 16, 2003), a federal jury in Manhattan found that thecedant’s failure to promptlydisclose its policyholder’sasbestos exposures warrantedrescission of various facultativecertificates. The underlyingclaims involved a $40 millionpayment made by the cedantpursuant to the WellingtonAgreement to resolve asbestosinjury claims presented againstA.P. Green RefractoriesCompany, a former division of US Gypsum.



These three decisionsunderscore the increased riskfaced by insurers relative to theirability to recover from theirreinsurers for asbestos losses.The prudent insurer mayeffectively mitigate this risk byensuring that reinsurer notice istimely, loss presentations arereasonable, thorough andconsistent from loss to loss, and responses to reinsurerenquiries are prompt andcomprehensive. As the pace ofasbestos settlements betweeninsurers and policyholdersquickens, insurers should takecare to avoid any inconsistenciesbetween the loss presentationand reinsurance contractwording, irrespective of thenature of the settlement whichmay have been reached with the policyholder in the underlyingsettlement. In these ways,insurers may demonstrate therequisite good faith which mayform a solid foundation forprompt resolution of complex,high-exposure cessions on termswhich are at least acceptable, if not favorable, to the insurer.

National and state asbestos initiatives

The impetus for the Fairness inAsbestos Resolution Act of 2003(SB 1125), which Senate majorityleader Bill Frist (R-Tenn.) hastargeted for a floor vote in early2004, came from the AsbestosAlliance. The Alliance is acoalition of employers, insurers,and certain plaintiffs’ lawyers.

The proposed legislation hadbeen stalled in the SenateJudiciary Committee since

October 2003 when keystakeholders were unable toreach consensus on severalfundamental issues, including the level of compensation forclaimants suffering from the mostserious asbestos diseases andthe size of the trust fund to becreated to pay asbestos claims.Lawmakers continue to modifythe bill.

The goals of the FAIR Act are: to replace the current fault-basedsystem for compensatingindividuals injured by exposure to asbestos with an equitable,uniform no-fault approach;relieve the administrative burden

on the state and federal courts;reduce/extinguish the threat ofinsolvency to businessesexposed to asbestos liability;achieve certainty and finality forthese entities and the insuranceindustry as respects theirasbestos liabilities and relatedcosts; and ban the import andmanufacture of asbestos andasbestos-containing productsexcept where the use ofasbestos would present ‘nounreasonable risk to health.9’

The FAIR Act would create anational trust fund (the Fund) of about $115 billion to payasbestos claim awards.

Individuals with occupationalasbestos exposure as well aspersons with ‘take-home’asbestos exposure, i.e.,individuals exposed to asbestosfrom the work clothes of a familymember who worked withasbestos, and residents of Libby, Montana, the site of aformer vermiculite mining andmilling operation, would beeligible to seek compensationfrom the Fund.

The Fund would be financedthrough contributions fromdefendants, insurers, reinsurers,and asbestos bankruptcy trusts.Under an agreement between



9. 108th Congress, Senate, The Fairness in Asbestos Injury Resolution Act of 2003: Report Together With Additional and Minority Views. (Washington, DC, July 30, 2003): 41.

insurers and defendants in mid-October 2003, insurerswould contribute approximately$46 billion to the Fund, whiledefendants would be responsiblefor $57 billion and up to $10 billion in future shortfallcontributions in the event theFund is unable to meet itsobligations under its originalfunding mandate. This fundingagreement is contingent on theincorporation of certain insuranceindustry requirements into thefinal version of the bill. Theserequirements include holdingnon-US insurers and reinsurersresponsible on the same basis asdomestic insurers and reinsurersand no insurer/reinsurerresponsibility for financing anypotential Fund shortfalls.

US Senate Bill 413 (the FederalAsbestos Act), introduced inFebruary 2003, requires aclaimant to provide evidence of physical impairment to which asbestos was ‘asubstantial contributing factor10’as a prerequisite to filing anasbestos claim or lawsuit. The Act identifies specificobjective medical criteria by which a determination ofphysical injury would be made.The House of Representatives’counterpart of this bill, the Asbestos CompensationFairness Act of 2003 (HB 158),similarly seeks to prioritize theasbestos claims of thoseclaimants who can demonstrateactual physical injury related toasbestos exposure.

The framework for asbestosclaims administration proposedunder the bills resembles aninactive docket, which exists in anumber of jurisdictions. However,unlike the inactive docket, whichwe discuss below, theadministrative system proposedunder the bills would not requirea claimant to file a claim in orderto toll the statute of limitations.

Inactive asbestos dockets maybe the best chance formeaningful asbestos litigationreform, at least in the short term.The rules and proceduresgoverning inactive dockets varyby jurisdiction. In general, oncean asbestos claim is filed in ajurisdiction with an inactivedocket, the claim remains on theinactive docket until the claimantpresents evidence of asbestos-related physical injury. At thispoint, the claim would betransferred to the active docket.

The longest-established inactivedockets are Boston (1986),Chicago (1991), and Baltimore(1992). These jurisdictions haveenjoyed relative success inprioritizing payment to claimantswho are physically injured. New York City and Seattleimplemented inactive asbestosdockets in late 2002. Severalstates, including Texas, Ohio,and Michigan, are consideringestablishing state-wide inactive dockets.

The Coalition for AsbestosJustice (CAJ), Inc. was formed in 2000 as a nonprofitassociation ‘to address and

improve the asbestos litigationenvironment.’ Established byproperty and casualty insurers,CAJ’s mission is ‘to encouragefair and prompt compensation to deserving current and futureasbestos claimants by seeking to reduce or eliminate the abusesand inequities in the civil justicesystem.’ CAJ accomplishes itsgoals through litigation, judicialeducation, public relations, and legislative efforts.

Comprising of insurers,defendants, trade associations,and others, the Asbestos Allianceis another non-profit organizationseeking a legislative solution toasbestos litigation. The Alliancehas been active in promotingpassage of the FAIR Act of 2003.

The American InsuranceAssociation (AIA) and theReinsurance Association ofAmerica (RAA) are active onbehalf of their members to helpbring about asbestos reform atthe federal and state levels.

Maintaining shareholderconfidence

The Sarbanes-Oxley Act of 2002

Sarbanes-Oxley, which applies to public companies only,establishes new, enhancedstandards for financial reporting,while better definingresponsibilities for establishingthe controls environment.Company officers must certifythe company’s financialstatements and, along with thecompany’s external auditors,verify the adequacy of the

company’s internal controlsprocedures for financialreporting. The company mustalso exercise continuousmonitoring and testing of internalcontrols, implementingappropriate improvements.

To support decisions relative todisclosures about their asbestosliabilities and establishment ofreserves, insurers may wish toconsider enhancing the quality of claim, litigation, and insuranceprogram data collected forindividual asbestos accounts.This may include, but would notnecessarily be limited to,historical data on asbestos claimseverity, frequency, filing rates,and disease mix along withinformed insights into potentialfuture asbestos claim trends andlitigation as well as legislativeand judicial developments. Data sources may includedefense counsel, policyholders,coverage counsel, and publiclyavailable information. Insurersmay use the data in connectionwith appropriately constructedmodels to refine their projectionsof asbestos liabilities.

The potential benefits to insurersof an enhanced approach toasbestos data collection andanalysis include:

• More informed decisionsabout settlement and litigation strategies;

• Greater insight into claimdrivers, claim costs, andpotential future claims; and



10. Section 4.b. of the Federal Asbestos Act provides as follows:(b) Prima Facie Evidence of Physical Impairment –

(1) In General – No person shall bring or maintain a civil action alleging a nonmalignant asbestos claim in the absence of a prima facie showing of physical impairment as a result of a medicalcondition to which exposure to asbestos was a substantial contributing factor.

• Opportunities to leverage thisgreater knowledge to containor reduce asbestos liabilities.

Based on our work with a numberof insurers with asbestosliabilities, we believe there is astrong correlation betweeninsurer reliance on the followingasbestos claims managementpractices, processes,procedures, and resources and a robust internal controlsenvironment, which minimizesfinancial, operational, andregulatory risk:

• Adequate numbers ofcompetent claim managersand staff who are experiencedin managing complexasbestos defense andinsurance coverage issues;

• A consistent, coordinatedapproach to asbestoscoverage issues;

• To the extent feasible, a consistent approach to asbestos defense, including the development of medical defenses, asappropriate; local and nationalcounsel may be used to gaininsight into jurisdictionalissues, while at the same timeensuring uniformity inpleadings, documentproduction, and testimony;

• Joint asbestos defensearrangements where feasible;

• Internal task forces to monitorand advise senior claimsmanagement on emergingasbestos litigation trends;

• Account-based ground-upanalysis of accurate andcomplete claim, policy, and other appropriate data to support the estimation of asbestos liabilities;

• Implementation of Cost-Sharing Agreements withother insurers and thepolicyholder, as appropriate;

• Where appropriate, early,aggressive resolution ofasbestos account liabilitieswith the capping of insurerliability through Coverage-In-Place agreements,structured/annuity-typesettlements, or other similarsettlement facilities;

• Prompt identification ofapplicable reinsurance andtimely loss notification;

• Collaborative partnershipbetween Claims and Actuarialto promote the continuoussharing of claim data andother relevant informationnecessary to establishreserves for asbestosliabilities; and

• Active participation ininsurance industry efforts toeffect asbestos reforms at thenational and state levels.

Despite the proliferation in insurerasbestos reserve actions duringthe past several years, analystsand rating agencies continue tonegatively view the insuranceindustry’s exposure to asbestoslosses. Not only are thereconcerns that insurers still have

not fully owned up to theirasbestos liabilities, but also thatreinsurers have not kept pacewith cedant reservestrengthening and may be under-reserved.

Insurer reserve actions do notalways result in a positiveresponse from the ratingagencies. A company that hasincreased its asbestos reservesmay be placed on a ‘RatingsWatch’ with negative implicationsor even downgraded if the ratingagency does not believe that thereserve action fully addresses theinsurer’s asbestos exposure.

A ratings downgrade mayimpede an insurer’s access tocapital. Moreover, the insurermay no longer meet the financialstrength requirements of currentand prospective policyholders,which may reduce the insurer’scash flow.

Conclusion

While no immediate relief fromasbestos liabilities appears to be in the offing for insurers, a combination of thoughtfullegislative and judicial reforms;collaboration among keyasbestos stakeholders;coordinated insurance industryinitiatives to educate the judiciaryand the public on asbestos

issues along with well-designed,effective asbestos claimsmanagement practices,processes, procedures, andinternal controls and aconservative approach toreserving for asbestos liabilitiesshould serve insurers well in thequest to limit their asbestos-related risks.



AUTHOR

Claire A. LouisSenior Manager, Actuarial and InsuranceManagement SolutionsTel: 1 973 236 [email protected]

Managing General Agents and theimplications of Sarbanes-Oxley –Legislating good business practices

AUTHORS: KEY COLEMAN, STEVEN SUMNER AND ANTHONY GRAZIANO


The Managing General Agent continues to act as an effective vehicle for thedistribution of products and services of its insurer partners. Yet the introductionof the Sarbanes-Oxley Act of 2002 has created significant requirements forinsurers to consider in their oversight of MGA relationships. In responding to the requirements of Sarbanes-Oxley, insurers should pay added attention to the MGA control environment without losing sight of what makes the MGArelationship work in the first place.

Introduction and background

Managing General Agents (MGAs)continue to operate as an efficientdelivery system of insuranceproducts and services for manyinsurers. MGAs are agencies thatact as outside administrators ofunderwriting and/or claimsservices for the insurancecompanies that they represent1.As administrator, marketer,underwriter and claims adjuster,the MGA performs the services of an insurance company withoutthe regulatory requirements ofadmitted insurers. When theMGA/insurer relationship works

best, it operates as a virtual‘partnership’ where each partnershares information and operatesfor the partnership’s collectivebest interests. (Figure 1 summarizesthe benefits of the MGA distributionsystem). It is when this partnershipbreaks down that problems are aptto arise. The Sarbanes-Oxley Actof 2002 (‘Sarbanes-Oxley’) hascreated significant requirementsfor insurers to consider in theiroversight of MGA relationships.

Sarbanes-Oxley expands the levelof management responsibility,accountability, controllership andoversight of a publicly traded

company (including the company’soutside vendors and administratorsas they affect financial reporting).It necessitates publicly tradedinsurers formalize their oversightof the activities of their MGAs.

The MGA business model dictatesthat an insurer entrust some, or insome cases, essentially allbusiness processes to an outsideadministrator. While many suchrelationships have functionedsmoothly for years, Sarbanes-Oxleymandates a level of formalizedcontrol, as it affects financialreporting, that has not beencustomary in the industry.

Managing GeneralAgents (MGAs)continue tooperate as anefficient deliverysystem ofinsurance productsand services...

MANAGING GENERAL AGENTS AND THE IMPLICATIONS OF SARBANES-OXLEY – LEGISLATING GOOD BUSINESS PRACTICES


1. MGAs are actually defined under the NAIC MGA Model Law. It should be noted, however, that many agencies and program managers are commonlyreferred to as MGAs but do not meet all of the NAIC criteria. According to Bernie Heinze, Executive Director of the American Association of ManagingGeneral Agents (AAMGA), even some AAMGA members do not meet all of the criteria (although they undergo scrutiny to become members, which isperhaps more relevant to insurers).

Insurers

• Immediate access to MGAs’marketing network;

• Expertise, skill and knowledgefrom the MGA;

• Rapid premium growth;

• Variable expense structure(fees and commissions) basedon premiums;

• Rapid exodus if insurer’sbusiness focus changes; and

• Fixed costs that are minimalsince most staffingconsiderations are with the MGA.

MGAs/Sub-producers

• Ability to seize underwritingopportunities without a large capital commitment;

• MGAs can build expertise incertain insurance productsand services;

• Sub-producers given accessto markets and products thatthey may not normally haveaccess to.

Consumers

• Insurance knowledge andexpertise that their agent maynot possess;

• More competitive pricing andbroader coverage offerings;

• Safety programs that aretailored to the specific industrysegment; and

• Dedicated claims and claimsexpertise in the industry.

Who benefits from the MGA distribution system?FIGURE 1


Critical success factors forSarbanes-Oxley complianceand a successful MGArelationship

The ideal MGA relationship hasalways depended upon trust and communication. According toBernie Heinze, members of theAmerican Association of ManagingGeneral Agents (AAMGA, whichcomprises roughly 25% of USMGAs), actually welcome anyenhanced communication withinsurers, even if it means morefrequent audits. It is possibleSarbanes-Oxley will be viewed asa pivotal opportunity to enhancethe MGA/insurer relationship byimproving the quality ofcommunication and clarification of expectations. It should also be viewed as an opportunity toenforce and practice the basicfundamentals of good business.

Publicized situations fromUnicover to Fortress Redemonstrate that the risks ofpoor selection and controllershipof MGAs can be enormous. The following 10 critical successfactors should be considered byinsurers and MGAs alike in orderto establish and strengthen theMGA relationship and therebyincrease the sustainability of aneffective control environment:

1. MGA due diligence and selection

• A comprehensive duediligence process with crossfunctional teams (finance,operations, actuarial and tax).

• A due diligence check listexpanded to includeconsideration for the level of internal controls over thefinancial reporting process.

• The process should allow the insurer to conclude thatbusiness relationships arecompliant with management’sdocumented diligence criteria.

2. Contract terms andconditions

• Carefully monitored andcrafted contractualagreements and underwritingguidelines between the MGAand insurer are essential.

• Specific service standards,consistent with those of theinsurers, should becontractually agreed.

3. Controllership

• Increasingly, insurers arerequired to demonstrate ahigh degree of controllershipover the MGA; MGAs shouldembrace this closer relationshipas an opportunity to workseamlessly with the insurer.

• The appropriate levels ofcontrol and authority based on skills and expertise shouldbe instituted and must bedocumented.

• Controllership includesfrequent company and MGAmeetings, periodic companyaudits, good communications,effective correspondence andMGA letters of authority.

• MGA implementation of self-assessment and qualityassurance programs.

4. Expertise

• On behalf of the insurer,MGAs must be experts in theirparticular niche and they mustpossess the requisite skill sets

in underwriting, marketing andsales in order to be successful.

• On behalf of the retail agent,MGAs must be able to offer a level of service, productknowledge and technicalexpertise that is otherwisefound in an insurance company.

5. Track record

• Thriving MGAs have a recordof past performance that isevidenced in both the profitsthey generate for insurers andthe relationships they buildwith retail agents.

6. Management information

• The ability to monitor financialperformance, track premiumcollections and claims activity,and even remotely auditunderwriting files and financialinformation will improve thelevel of controllership andoversight capabilities of the insurers.

7. Technology

• Increasing the connectivitybetween the MGA, TPA and the insurer will help to improve the level ofcontrollership and theexchange of critical informationwhile simultaneously reducingthe paper flow, and increasingthe level of data quality.

8. Communications

• As fundamental as it sounds,communications between theMGA and the insurer may bethe most important successfactor in the relationship.

9. Documentation ofprocedures

• MGAs and insurers generate agreat deal of paper incommunicating with insureds,agents and each other.Procedures that are poorlydocumented and adhered tocan lead to miscommunicationand potentially constitute anerrors and omissions exposure.

• Maintaining a successfulinsurer/MGA relationship as well as compliance withSarbanes-Oxley requires gooddocumentation of all significantprocesses and controls at theMGA level. Documentationand effectiveness of controlsshould also be validated by theinsurer or MGA managementprior to the audit by theinsurer’s external auditors.

• Some MGAs have gone as faras to document their internalcontrols and processes andhave received specialrecognition in the form of ISO 9000 certification.

10. Appropriate profitabilitymeasurement

• All parties must understandhow profitability will bemeasured.

• Sliding Scale commissionsallow MGAs to share in theprofitability of the businessthey write while giving theinsurer comfort that the MGAis also vested in any losses.Some insurers now requirethat any deposit commissionin excess of the minimum beplaced into escrow or backedby a letter of credit.

MANAGING GENERAL AGENTS AND THE IMPLICATIONS OF SARBANES-OXLEY – LEGISLATING GOOD BUSINESS PRACTICES continued


• Profits go beyond thecommission rate in thecontract, and include bothexpress and implied duties.

Practices prior to Sarbanes-Oxley

In order to understand today’senvironment, it is necessary tounderstand the environment justprior to Sarbanes-Oxley.Monitoring the controlenvironment at MGAs is notnecessarily a new concept withthe advent of Sarbanes-Oxley. In recent years, many insuranceentities have increased theirfocus on MGA relationships for various reasons such assafeguarding of economicinterests, obtaining moreaccurate and timely financial and actuarial data, and to ensurepreservation of reputation. Many insurers and reinsurershave self-imposed processesaround all aspects of the MGArelationship ranging from duediligence, contract negotiation,risk assessment, monitoring andon-site reviews, culminating with termination of the MGArelationship. Although manyinsurers possess robustprocesses over MGAs, there aremany that have less rigorous,informal controls.

Prior to Sarbanes-Oxley, an auditor’s consideration ofcontrols relative to outsourcedoperations and controlenvironments required the auditorto assess such control risk byobtaining evidential matter in oneof the following ways:

1. Tests of the company’scontrols over such information(i.e., test of data sent to thecompany by the MGA),

2. Review of an MGA’s report onits own controls (rarely existsin practice), and/or

3. Tests performed by thecompany being audited, but performed at the MGA.

In practice, auditor tests aredesigned and executed in amanner that is consistent withthe financial statement audit riskassessment. The audit of controlrisks and activities associatedwith MGAs is typically treatedwith due reverence, as auditorsare quite aware that MGA’s short-term incentives may be in conflictwith the interests of the insurer.Absent from the formerenvironment is a requirement forpublicly traded insurers toexplicitly address the risks andassociated controls relative tofinancial reporting.Management’s requirement to evaluate the design andoperating effectiveness ofinternal controls now extends to relevant activities that supportsignificant financial statementaccounts, even if such activitiesoccur outside of the insuranceorganization for all entitiessubject to Section 404 ofSarbanes-Oxley.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002is largely in response to anumber of major corporate and

accounting scandals involvingsome of the most prominentcompanies in the world.Sarbanes-Oxley establishes newand enhanced standards forcorporate reporting, while betterdefining responsibilities forestablishing the controlenvironment itself. The legislationcontains 11 titles, ranging fromadditional responsibilities foraudit committees, to toughercriminal penalties for white-collarcrimes such as securities fraud.Title III, Section 302 – CorporateResponsibility for FinancialReports and Title IV, Section 404– Enhanced FinancialDisclosures, ManagementAssessment of Internal Controls,each have specific implicationsfor insurers that use MGAs.

The requirements of Sarbanes-Oxley can be felt on the entirecorporate reporting supply chain.In particular, the following areasmay be the most significantlyimpacted by this new legislation:

• Company executivesThe CEO and CFO carryprimary responsibility for acompany’s reports filed withthe SEC. Section 302 requiresthe issuer to maintain andregularly evaluate theeffectiveness of its disclosurecontrols and procedures. In turn, the principal executiveand financial officers mustcertify that they areresponsible for establishing,maintaining and evaluating theeffectiveness of internalcontrols. Section 404 requiresthat these same officers

report on the completenessand accuracy of theinformation contained in thereports as well as to report on the effectiveness of internal controls.

• Board of directors and audit committeesThe Act stipulates that thereare new responsibilities for the Audit Committee and thatthe external auditor nowreports into the Committee. It also stipulates that the Audit Committee must pre-approve all services providedby the external auditor,regardless of their nature, and that at least one memberof the Audit Committee mustbe a financial expert.

• External auditorThe external auditor is stillrequired to report on thefairness of the presentation of the company’s financialstatements in accordance with Generally AcceptedAccounting Principles (GAAP)and the Act reaffirms theauditor independencerequirements. Furthermore,the auditor’s reportingresponsibility is expanded to an attestation of the newlyrequired managementassertion on internal controls.



Section 404 requirements

In its simplest interpretation,Section 404 stipulates thatmanagement must assert to theeffectiveness of internal controlsannually and that the internalcontrol report must state:

• Management’s responsibility(written assertion) for establishing andmaintaining internal controlover financial reporting;

• The framework used bymanagement to evaluate the effectiveness of internalcontrol2; and

• Management’s assessment of the effectiveness of the internal control overfinancial reporting.

• Lastly, the company’s externalauditors must attest tomanagement’s assertions ofeffective internal control overfinancial reporting.

Compliance under Section 404

Compliance under Section 404goes beyond managementmerely asserting that the controlsare in place. It requires that theassertions by management beauditable by its external auditor;but in order for these assertionsto be attested to by the auditor,they must first be documented.Documentation is required inareas such as:

• The design of controls overrelevant assertions related to ALL significant accountsand disclosures in thefinancial statements;

• Information about howsignificant transactions areinitiated, recorded, processedand reported;

• Enough information about the flow of transactions toidentify where materialmisstatements due to error or fraud could occur;

• Controls designed to preventor detect fraud, including whoperforms the controls and therelated segregation of duties;

• Controls over the period-endfinancial reporting process;

• Controls over safeguarding of assets; and

• The results of management’stesting and evaluation.

Implications on the MGAbusiness model

The intent of this article is topoint out the potentialimplications of Sarbanes-Oxleyon insurers that utilize MGAs andnot to single out MGAs forgreater scrutiny. While it isimportant not to overlook MGAs as they relate to the Act,the ramifications of the Act onthe insurance industry go farbeyond MGAs.

In keeping with this theme,insurers need to explore the risk and control considerationsthat MGA relationships pose to the organization.Illustrative considerations areincluded (see Figure 2), mappedto relevant components of theCOSO framework.



2. For example, the Committee of Sponsoring Organizations (COSO) of the Treadway Commission’s report, Internal Control-Integrated Framework (the COSO criteria), provides suitable criteria againstwhich management may evaluate and report on the effectiveness of the entity’s internal control.



Control environmentSets the tone of the organization andestablishes the foundation for all otherelements on internal control byproviding discipline and structure.

What is the composition of the control environment at the MGA?

• Board of Directors/Audit Committee

• Management’s Philosophy and Operating Style

• Organizational Structure

• Ethics/Code of Conduct

• HR Policies and Procedures

Is the control environment and tone consistent between the Insurer and its MGA?

COSO Component MGA Control Considerations

Risk AssessmentInvolves the identification and analysis by management of relevant risks toachieving pre-determined objectives,forming a basis for determining how those risks are managed.

What is the relevance of MGA operations to initiating, processing and recordingtransactions that affect financial reporting?

Are insurance company and MGA level risk assessments performed which considerexternal and internal factors that could impact the achievement of objectives?

What are the risks and controls in place in regard to safeguarding of assets andfraud relative to significant MGA relationships?

Control ActivitiesRefers to the policies and proceduresto ensure management objectives areachieved and risk mitigation strategiesare carried out.

What are the process level internal controls at the MGA?

Are activities such as approvals, authorizations, verifications, reconciliations, reviewsof operating performance, security of assets and segregation of duties considered?

Information & CommunicationSupports all other control componentsby communicating control responsibilitiesto employees and providing informationin a form and time frame that allowspeople to carry out their duties.

Are reports available for individuals to make decisions and take appropriate action whichinclude adequate detail and summarize pertinent information?

Does internal communication and training occur at the MGA level? Are MGA employeesmade aware of insurer compliance and training requirements that affecttransacting/financial reporting?

Do formal job descriptions including roles and responsibilities exist?

Does effective communication occur up, down and across the insurer, MGA relationship?

MonitoringCovers the oversight of internal controlsby management or other parties outsidethe process or the application ofindependent methodologies such ascustomized procedures, standard checklists by employees within a process.

What are the monitoring controls in place at the MGA and insurance company level?

Does the MGA review exception reports, overall production results, and financialresults to ensure internal controls are operating as designed?

How are the internal controls designed and how does the insurer know that theyoperate effectively?

COSO Component and MGA Control ConsiderationsFIGURE 2


MGA processes and control activities

Insurers and MGAs shouldidentify each cycle in their ownsupply chain and assess therelative materiality of each cycleas a component of

management’s scoping process.To the extent that an activityperformed by an MGA is integralto effective control over financialreporting for the insurer, such anactivity will be in scope formanagement evaluation ofdesign and tests of operatingeffectiveness. Effectivelydesigned controls will likelyinclude controls in place at boththe MGA processing level as wellas the insurer level in the form ofmonitoring controls. As anexample, control activities maybe in place at an MGAtransaction level that aredesigned to prevent financialstatement errors. Such controlstypically include segregation ofduties, safeguarding of assetssuch as premium receipts, andautomated or manual controls to ensure complete and accurateapplication of receipts toinsurance polices or treaties.Reconciliation controls may alsobe in place at the MGA level toensure that the insuranceadministration system completelyand accurately feeds the ledgerfor financial reporting. At theinsurer level, controls over the

MGA transaction levelinformation would includemonitoring of receipt andprocessing of MGA-derived dataand funds in the insurer’s generalledger as well as analyticalprocedures over businessproduced by MGAs (volume,profitability, class) to ensure thatresults are in accordance withexpectations. Failure to ensurean appropriate level of preventiveand detective controls at boththe MGA and the insurer levelcan result in control deficienciesrelated to either design oroperating effectiveness. Such control deficiencies mayaffect financial balances such as premiums or the actuarialreserving process, as actuariesrely on a certain level of premiumexposure information in thereserving process.

Prior to Sarbanes-Oxley, the failure to ensure documentedand tested controls for relevantprocess presented a risk of acontrol breakdown that mightmanifest itself through cash orfinancial errors. In today’senvironment, design or operating

control deficiencies relative toMGA activities that are significantto the insurer’s operations mayaffect management assertionsover effective internal control and the auditor attestation ifsuch control deficiencies are not remediated.

Conclusion

Sarbanes-Oxley has come at a critical time for insurers whowork with MGAs. For years,MGAs have complained of out-of-touch insurers that wereonly interested in premiumvolume. On the other hand,insurers have complained thatMGAs’ procedures were oftenshrouded, causing bad practicesto be discovered, only too late.Sarbanes-Oxley affords agenuine opportunity to get itright. With the renewed attentionon controls, however, there is a danger that blind reliance onprocedure could be seen as the cure itself. It is, instead, a communicative insurer/MGArelationship that is the foundationof a proper MGA controlenvironment.



MGA controls are typicallyintended to manage certainprocesses or ‘cycles.’ The most relevant MGA cyclesthat affect financial reportinginclude the following:

Underwriting

Premiums

Claims

Commissions

Ceded Reinsurance

Policy Administration

Treasury

Financial Reporting

General Computer Controls

AUTHORS

Key ColemanDirector, Insurance Advisory ServicesTel: 1 312 298 [email protected]

Steven SumnerSenior Manager, Actuarial and InsuranceManagement ServicesTel: 1 646 471 [email protected]

Anthony GrazianoSenior Manager, Insurance Systems and ProcessAssurance ServicesTel: 1 646 471 [email protected]



Supervision in insurance-affiliatedbroker dealers: Yesterday’s leadingpractices are today’s expected practices

AUTHORS: ELLEN WALSH AND STEPHEN KOSLOW


A finding of ‘failure to supervise’ has become the modern equivalent of the‘scarlet letter.’ Imposed by the National Association of Securities Dealers (NASD),the securities industry’s self-regulatory organization, it remains a permanent partof the record, possibly affecting more than how the investing community viewsyour management abilities. This finding could very well tarnish the reputation andraise questions regarding the governance of your entire company.

It has been five years since the NASD released its Notice to Members (NTM) 99-45, which specifically addressedinsurance-affiliated broker dealers.This critical notice providescomprehensive guidance forNASD Rule 3010, whichestablishes the regulatoryexpectations surrounding the supervision of registeredrepresentatives. After its release five years ago, mostbroker/dealers developedcomprehensive supervisoryprograms to address 99-45.However, since that time, many companies havesignificantly modified theirproducts and services, their targetmarkets, their distributionstrategy, and their supportingoperational structure. Often thishas occurred through mergersand acquisitions of product lines,agencies or, in certain cases,entire companies, resulting in bothsubstantive and cultural changes.With these changes have comenew risks. Insurance companiesnow offering general securities,investment advisory services and banking products have anincreased range of supervisoryrisks and responsibilities.

If this applies to your insurancecompany, and if you have not completed a thorough re-evaluation of your supervisorysystem since just after the releaseof NTM 99-45, then there is a highprobability that your supervisory

system, while adequate severalyears ago, may be outdated andin need of a comprehensiveoverhaul to make certain you havereasonable controls in place.

Just as it is important to lookback and make certain you arestill in compliance with existingregulatory expectations, it is also prudent to look forward with anticipation to pending new regulatory requirements. This past June, the NASD issuedSpecial Notice to Members NTM 03-29, discussing aproposed amendment to NASDRule 3010. If enacted, this rule willrequire that each member’s ChiefCompliance Officer and ChiefExecutive Officer certify annuallythat the firm has reasonable andeffective compliance andsupervisory controls in place.

Before going further, it isimportant to re-establish the baseguidelines regarding the conceptof ‘reasonableness.’ Rule 3010specifies that a firm’s supervisorysystem be ‘reasonably designedto achieve compliance withapplicable securities laws andregulations’. According toguidance provided in NTM 99-45,this means that supervisorycontrols should be the ‘product of sound thinking and within the bounds of common sense,taking into consideration thefactors that are unique to themember’s business’ and that‘reasonableness is determined

in light of the particular facts and circumstances’.

Consequently, an evaluation ofwhether your supervisory controlsare reasonable is not a static, one time event. Rather, it is a fluidstandard requiring a continualanalysis of your company’ssupervisory program. It is importantto make certain that key controlsremain suitably designed andeffectively implemented givenyour company’s changing productlines, distribution channels andorganizational structure. In addition,this examination requires anexternal analysis of compliancecontrols being implementedthroughout the industry. Controls considered to bereasonable by industry standardsevolve over time as changing riskscreate the need for increasedcontrols. It is a well-known axiomin the insurance industry thatyesterday’s leading practices are today’s expected practices.Consequently, your companyneeds to assess how the industryat large, and your peers inparticular, design and implementessential supervisory controls.This assessment will helpdetermine whether your supervisorysystem is reasonable relative togeneral industry standards.

While growth-related change to your company’s products,services, structure and distributionwill affect most aspects of yoursupervisory system, there are

With thesechanges havecome new risks.

SUPERVISION IN INSURANCE-AFFILIATED BROKER DEALERS


certain areas that requireparticular attention. Based onrecent findings by the SEC andNASD, as well as our experiencein this area, it appears that manyinsurance-affiliated broker/dealerswould be well served to carefullyconsider the following:

1. Assign supervisoryresponsibility to individualswho possess sufficientknowledge, experience andauthority to adequatelyexercise their discretion

NASD Rule 3010 clearly statesthat each member shouldestablish a supervisory structurethat assigns each representativeto a supervisory principal whonot only has the knowledge and experience to perform thissupervision, but also theauthority to carry out thissupervision. Too often, aninsurance-affiliatedbroker/dealer’s supervisory

plan contains lofty supervisoryobjectives only to have theseobjectives assigned to individualswho do not possess theappropriate knowledge andexperience to sufficientlyexercise this responsibility. It is not uncommon for branchmanagers who are onlyexperienced in supervising thesale of variable products to begiven the responsibility forsupervising representativesselling general securities, orinvestment advisory services.These principals usually have farless knowledge and experiencein these areas than theindividuals they are supervising.Consequently, these principals areunable to adequately evaluate thesales approach being used or thesuitability of the recommendationsbeing offered.

While the above is problematic, a short-sighted fix may be worse.

It is not effective to hireregistered principals with therequisite knowledge andexperience and then fail to vestthese individuals with theauthority to adequately exercisetheir supervisory discretion.Often these individuals occupyfairly low-paid positions and arehoused in a branch or regionaloffice with reporting responsibilityup to the sales line supervisor. It is imperative for fieldcompliance personnel to begiven full authority to take actionwhen needed to uphold the firm’ssupervisory obligations.

In addition, many broker/dealersfail to institute a supervisorychain that provides for sufficientoversight of the registeredprincipals. Where the registeredprincipal is a high-profile branchmanager there may be aninsufficient review of theprincipal’s supervisory decisions.

SUPERVISION IN INSURANCE-AFFILIATED BROKER DEALERS continued


Key recommendations:

• Establish clear roles and responsibilities:Map out, in writing, the specific registered principal assigned to supervise each registeredrepresentative. Where more than one principal is assigned supervisory responsibility over arepresentative, identify the specific areas (products, services, etc.) of responsibility. At no timeshould there be any ambiguity as to which principal has primary responsibility for the supervisionover a particular activity of the representative.

• Empower registered principals with sufficient authority:Registered principals who are operationally subordinate to branch managers should have analternative means for communicating the results of their supervision. Examination reports should bereviewed by individuals who are completely outside of the operational chain of command.

• Institute a supervisory hierarchy of oversight for principal decisions:Key decisions by a registered principal should be reviewed by senior level members of the firm. This oversight should be a formal and rigorous part of the firm’s written supervisory program.

A firm shall take ‘reasonableefforts to determine that all

supervisory personnel arequalified by virtue of experience

or training to carry out theirassigned responsibilities.’

NASD Rule 3010 (a) (6)

‘A supervisor with a qualificationlimited to investment company

products and variable contractscannot supervise a registered

person conducting generalsecurities activities.’

NASD NTM 99-45

‘Passing the appropriatelicensing examination does

not, in and of itself, qualify a supervisor.’

NASD NTM 99-45

‘Having the requisite authority ...means that the person charged

with the responsibilities canexercise power to affect theconduct of a person whose

behavior is at issue.’

NASD NTM 99-45

‘It is essential that advisersimplement policies reasonably

designed... to detect and preventviolations of the federal securities

law by even their mostexperienced employees.’

In Re Robert T. Little andWilfred Meckel, Exchange

Release No. 2203/(December 15, 2003).

2. Institute robust andmeaningful reviews of your branch anddetached offices

Branch and detached officereviews continue to be one of thekey supervisory tools in helpingfirms maintain compliance.However, there remains acontinuing challenge to supervisethe operations of branch anddetached offices that have, astheir primary focus, the sale of

insurance products and services.With an increasing number ofinsurance companies seekinggrowth through the acquisition of existing agencies and clustersof experienced agents, thischallenge is only becoming moredifficult. Existing complianceresources are being thinlystretched and many detachedoffice reviews are being handled,if at all, by peer agents who alsohappen to be registered principals.

In addition, the branch anddetached office review programsbeing used by manybroker/dealers are insufficient in detecting potentially non-compliant activity. Mostprograms rely heavily on broad,open-ended questionnaires thatare not ‘refreshed’ periodically toaddress timely high-risk issues.



‘Each member shall conduct a review... reasonably designedto assist in detecting andpreventing violations of andachieving compliance withapplicable securities laws andregulations and with the Rules of this Association.’

NASD Rule 3010 (c).

‘In determining the inspectioncycle for a branch office, amember must consider thenature and complexity of thesecurities activity for which thebranch office is responsible...’

NTM 99-45

With regard to unregistereddetached offices, ‘supervisionmust be designed to monitorsecurities-related activities andto detect and prevent regulatoryand compliance programs.’

NTM 99-45


• Take a risk-based approach to detached office reviews:Regular, periodic visits should be the minimum schedule for office reviews. Companies should,however, maintain a list of indicators that will trigger more frequent reviews. Some indicators thatmay warrant an interim review might include:

– A significant change in volume or type of business;

– Change in management personnel;

– Red flags – e.g. complaints, unusual blotter activity;

– Newly acquired experienced agents;

– Unusual replacement activity;

– An inherently risky target market (e.g. seniors); or

– A high volume producer working alone.

• Complete unannounced visits:The rationale for pre-announcing all reviews is that geographically dispersed representatives areoften out of their offices on sales calls. Unfortunately, notwithstanding the logic, the NASD made it clear in NTM 99-45 that ‘unannounced visits may be appropriate.’ Even when the representativemay be out of the office, files, advertising material and associated persons should be available for inspection.

• Interview associated persons:When completing a branch and detached office visit, spend time talking to individuals providingsupport to the representative. Verify that these individuals are not engaged in activities that requireregistration and use the time to help educate the associated person in what activities are and arenot allowed.

• Implement a tailored and specific inquiry:It is important to tailor the review to the business being conducted by that branch or detachedoffice. Many small offices target niche markets with specialized products that have unique andinherent risks (e.g. investment advisory services). An appropriate review will seek information that is relevant to that office’s business model.

3. Recognize and respond to ‘Red Flags’

Over the past five years, theNASD has made it clear thateffective supervisory programsneed to recognize and respond to ‘red flag’ situations. There arecountless situations that could,and should, raise a flag warrantingcloser inspection and scrutiny. For example, your firm mighthave a single representative whocontinually pushes the suitabilityenvelope or an entire office with

an unacceptably high level of complaints.

In addition, surveillance focusedon the marketing and sale ofinsurance related products will notpick up red flags associated withthe marketing and sale of generalsecurities and advisory services.Many insurance companies thathave expanded their products andservices beyond life and annuityproducts have not expanded theirformal analysis of correspondingred flags.

Finally, even where companiesidentify and recognize a red flagsituation there is a challenge inadequately responding to thesituation. Many companies havefailed to institute a formalescalation and review processthat results in identifiedindividuals and offices beingsubject to higher scrutiny orenhanced supervision.




• Use effective surveillance to identify ‘Red Flags’:While most companies compile a significant amount of data on their representatives’ activities, there are still many companies that fail to turn this data into meaningful information. For example,replacements, blotters, lapse, and ‘not takens’ need to be tracked, by representative and office, so that unusual trends can be identified long before questionable activity turns into complaints or regulatory investigations.

• Establish a process for responding to ‘Red Flags’:Supervisory programs need to establish a formal process for responding to identified red flags. This should include enhanced scrutiny or heightened supervision, and an escalation process thatelevates the supervision of representatives, and possibly the immediate supervising principal, to amore senior level principal who is not in the direct line of operation and would not be financiallyaffected by any adverse actions that may need to be taken.

The supervisor ‘failed toinvestigate adequately red flags

raised by the numerous switchesof variable annuities and, thus,

failed to detect and prevent hisfraudulent conduct’

In Re Donna N. Morehead, SEC Release No. 46121

(June 26, 2002).

Supervisors must respond notonly when they are ‘explicitlyinformed of an illegal act’ but

also when they are ‘aware onlyof ‘red flags’ or ‘suggestion’

of irregularity.’), Ibid, citing

In re John H. Gutfreund,Exchange Act Release No.

31554 (Dec. 3, 1992).

4. Put ‘teeth’ into yoursupervisory program

Clearly, an effective supervisoryprogram must have meaningfulenforcement. Many supervisoryprograms have exemplary writtenprocedures, supervision beingperformed by individuals withadequate knowledge andexperience, and a clear means ofidentifying red flags, only to havethe program fail because thebroker/dealer does not have a

strong enforcement function.While this is linked to theconcept of imbuing supervisorypersonnel with sufficientauthority, it generally goes wellbeyond the individualsperforming supervisory functions,beginning and ending with theculture of the broker/dealer.

It is important for thebroker/dealer to look back overthe past five years and honestly

assess whether individuals whohave failed to fully follow andenforce the policies andprocedures of the supervisoryprogram have faced appropriateconsequences. If your firmfunctions on a ‘case-by-case’basis, with a liberal granting of exceptions and meaningless‘slaps’ on the wrist, it is time to overhaul your disciplinarypolicies and procedures.

Maintaining a reasonable supervisory system is an essential element in managing the risks associated with a growing and evolving insurance operation. This requires a continual assessment of your controlenvironment with particular focus on those key areas that may need significant modification due to theintroduction of new product offerings, target markets, distribution channels and operating platforms.Staying abreast of how these changes may result in a need for modified controls will help in avoiding a ‘failure to supervise’ finding.



‘Each member shall establish,maintain, and enforce writtenprocedures to supervise thetypes of business in which it engages...’

NASD Rule 3010 (b).

The firm ‘was often unable or unwilling to take effectivesupervisory action in the face of red flags indicatingabusive sales practices by the registered representatives.’

Metropolitan InvestmentSecurities, NASD News Release (Dec. 12, 2003).


• Track and trend disciplinary procedures:When a high producing representative engages in questionable activity that falls within the ‘grey’area between legal and unethical, it is often easy to excuse the activity as an aberration.Unfortunately this is a dangerous slippery slope. Companies should carefully track whichrepresentatives continually fall into this area and whether the company deals with these situations ona consistent and comprehensive basis.

• Establish a clear escalation of consequences:Companies serious about enforcing ethical conduct should establish clear disciplinary guidelinesthat contain escalating consequences for both the representative as well as the principal.

• Require consultation on disciplinary actions:It is tempting for a principal who is close to the representative to find reasons to excusequestionable behavior. As such, the disciplinary guidelines should require mandatory consultationwith a more senior principal for certain identified activities.

AUTHORS

Ellen WalshPartner, Insurance Regulatory and Compliance SolutionsTel: 1 646 471 [email protected]

Stephen KoslowSenior Manager, Insurance Regulatory andCompliance SolutionsTel: 1 312 298 [email protected]

Further information

Insurance digest

For further information about PricewaterhouseCoopers Americas Insurance Group, please call your usual contact atPricewaterhouseCoopers or one of the following:

Global Insurance Group

John S. Scheid*Global Insurance Assurance and Business Advisory Services Leader and Chairman, Americas Insurance GroupTel: 1 646 471 5350 E-mail: [email protected]

Bermuda

Richard Patching*Bermuda Insurance LeaderTel: 1 441 299 7131 E-mail: [email protected]

Canada

Bill BawdenCanadian Insurance LeaderTel: 1 416 947 8970 E-mail: [email protected]

South America

Leslie HemerySouth Americas Insurance LeaderTel: 56 2 940 0065 E-mail: [email protected]

US Insurance Group

James Scanlan*US Insurance Leader, Philadelphia, PATel: 1 267 330 2110 E-mail: [email protected]

J. Timothy Kelly*Tax Services, New York, NYTel: 1 646 471 8184 E-mail: [email protected]

Michael MarkmanFinancial Advisory Services, Chicago, ILTel: 1 312 298 2858 E-mail: [email protected]

Paul L. Horgan*Audit Business and Advisory Services, New York, NYTel: 1 646 471 8880 E-mail: [email protected]

Richard I. FeinActuarial and Insurance Management Solutions, New York, NYTel: 1 646 471 8150 E-mail: [email protected]

* Member of the Global Insurance Leadership Team

Insurance digest

As part of our insurance publications portfolio, we also publish an Asia Pacific and a European edition of Insurance digest. If you would like to receive copies of one or more of these editions,please contact one of the following, or alternatively visit us on-line atwww.pwc.com for electronic copies.

Americas Insurance digest

Pauline Wilson1 646 471 [email protected]

Asia Pacific Insurance digest

Irene Cai86 21 6386 [email protected]

European Insurance digest

Alpa Patel44 20 7212 [email protected]

PricewaterhouseCoopers (www.pwc.com) is the world’s largest professional servicesorganization. Drawing on the knowledge and skills of more than 120,000 people in 139countries, we help our clients solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an Internet-enabled world.

The Americas Insurance digest is produced by experts in their particular field atPricewaterhouseCoopers, to address important issues affecting the insurance industry. It is not intended to provide specific advice on any matter, nor is it intended to be comprehensive. If specific advice is required, or if you wish to receive further information on any mattersreferred to in this publication, please speak to your usual contact at PricewaterhouseCoopersor those listed in this publication.

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