The Tragedy of Corporate Governance in America Impacts and Implications for the Insurance Industry

1. The Tragedy of Corporate Governance in AmericaImpacts and Implications for the Insurance Industry Casualty Actuarial Society Risk & Capital Management Seminar Toronto, ON, Canada July 8, 2002 Robert P. Hartwig, Ph.D., Senior Vice President & Chief Economist Insurance Information Institute 110 William Street New York, NY 10038 Tel: (212) 346-5520 Fax: (212) 732-1916 bobh@iii.org  www.iii.org

2. Serious Implications for Insurers • Insurers exposed to a wide variety of risks: • Investment risk (as institutional investors) • Insurance risk (surety, D&O, E&O, etc.) • Litigation risk (as both plaintiff & defendant) • Accounting Risk • Regulatory risk

3. Corporate Governance: Expensive and Hard-Learned Lessons • Crisis of Confidence—skepticism/cynicism is high • Ratings agencies Analysts Regulators • Investors/Creditors Employees Lawmakers • Regulatory/Legislative Fallout Unclear • SEC opening record number of investigations • SEC, NYSE reforms; unclear what (if any) action Congress will take • States will take own legal action (e.g., NY) • Surge in shareholder suits has already begun

4. Financial Restatements Filed The number of financial restatements is rising even thought the number of publicly traded companies is falling. *Approximate Sources: Huron Consulting Group

5. Cynicism is Epidemic -Palm Beach Post, June 2002.

6. Mistrust Runs Deeper -The Economist, June 8, 2002. -BusinessWeek,, May 13, 2002.

7. Crisis in Corporate Governance Market Malaise Terrorism Weak Profit Performance Market Malaise Geopolitical Instability

8. Total Returns for Large Company Stocks: 1970-2002* • Could be headed for 3rd consecutive year of decline for stocks • Last happened 1939-1941 *As of July 5, 2002. Source: Ibbotson Associates, Insurance Information Institute

9. Who’s Who in the Corporate House of Ill-Repute

10. Accounting Problems are Getting Many Companies into Trouble • Enron was tip of an iceberg • Major implications for insurers (p/c and life)

11. Corporate Hall of Shame

12. Corporate Hall of Shame ???

13. Corporate Hall of Shame

14. Martha Stewart Omnimedia fell by more than 50% after Imclone insider trading scandal broke out This sumptuous New England lobsterbake is available at MarthaStewart.com for just $250!

15. Risk Assessment:Enron vs. WorldCom

16. Houston…We Have a Problem Total Exposure (Life & Non-Life): $3.796 Billion • Enron is the biggest bankruptcy in US history ($31B+) • Equity/debt widely-held as S&P 500 company • Biggest impact in institutional investors/creditors • 11 Congressional investigations • 56 suits against officers & directors • Will spark similar suits Source: Loss estimates from Morgan Stanley as Feb. 8, 2002; Insurance Information Institute.

17. WorldCom to WorldCon?Insurer Exposure Total Exposure (Life & Non-Life): $5.725 Billion* • WorldCom could default on ($29B+) in debt. • Equity/debt widely-held as S&P 500 company • Biggest impact in institutional investors/creditors • SEC/Congressional investigations underway • Suits against officers & directors imminent *As of 7/1/02; Includes $5.4B in debt assuming default, $100 mil D&O, $225 mil CDO (still collateralized). As of 7/1, WCOM debt trading at about $0.15 of par, stock trading at $0.08/share. Equity losses are indeterminant. **Does not include disclosed but unquantified exposure to credit default swaps Source: Insurance Information Institute based in from Moody’s, company announcements, III research.

18. Investment Risk

19. WorldCom: From $60/share in to6 Cents in Three Years As of July 1, 2002 Source: Low trade for July 1, 2002.

20. Xerox: From $60/share in to$6.60 Cents in Three Years* As of July 1, 2002 Source: Opening price, July 1, 2002.

21. How Much Investment Risk Do Insurers Have? • Industry Financials: Overview/Outlook • Cost Driver Summary • Terrorism • Mold • Tort Abuse • Medical Cost Inflation • Investment Performance • Catastrophes • Corporate Governance

22. Insurance Industry Stock and Bond Holdings, 2001 Total Industry Holdings = $3.3 Trillion Total $1531 In Billions P/C $194Life $1,337 Total $1120 P/C $185Life $935 Total $438 P/C $131Life $307 Total $209 P/C $188Life $21 Source: Federal Reserve Flow of Funds Report as of Dec. 31, 2001.

23. Institutional Investor Market in Corporate Equities by Amounts Outstanding, as of December 31, 2001 Total: $7,534.7 billion Insurers are the 4th largest holder of corporate stocks Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

24. Institutional Investor Market in Corporate Bonds* By Amounts Outstanding, as of December 31, 2001 Total: $3,730.1 billion Insurers are the largest holder of corporate bonds Life = $1,336.5 (87%) Non-Life = 193.9 (13%) *Includes foreign bonds. Source: Insurance Information Institute from Federal Reserve Flow of Funds Report

25. Insurance Industry: Corporate Equity Holdings, 1995-2001 $1,173B $1,135B In Billions $1,120B $933B $745B $563B Total $450B P/C $186Life $559 P/C $200Life $733 P/C $208Life $965 P/C $185Life $935 P/C $149Life $414 P/C $194Life $941 P/C $134Life $315 Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

26. Insurance Industry: Corporate Bonds Holdings, 1995-2001 $1,531B In Billions $1,410B $1,3543B $1,301B $1,206B $1,091B Total $993B P/C $160Life $1,046 P/C $171Life $1,130 P/C $181 Life $1,173 P/C $194Life $1,337 P/C $188Life $1,222 P/C $142 Life $949 P/C $123Life $870 Source: Federal Reserve, Flow of Funds Report as of Dec. 31, 2001.

27. Beginning of the End:Bursting of the Tech Bubble

28. Directors & Officers Coverage

29. The ABC’s of D&O • 3 Components of D&O Coverage • Personal Coverage: protects directors and officers against liability arising out of “wrongful acts” • Corporate Reimbursement Coverage: reimburses organization when legally required/permitted to indemnify D&Os for their “wrongful acts” • Entity Coverage: reimburses for claims made directly against the organization (including those that name no individual insureds) • Today, about 90% have entity coverage today, compared to 30% 5 years ago. Sources: AICPCU, Tillinghast-Towers Perrin, Ins. Info. Inst.

30. The ABC’s of D&O • Duties of Directors & Officers • Duty of Care: • D&Os must exercise “reasonable care” • Courts hold that D&Os are not guarantors of profitability • Directors not required to have special knowledge of business • Duty of Loyalty to Corporation: • Undivided loyalty required (should be no conflicts-of-interest) • Duty of Loyalty to Shareholder: • Prohibits insider trading, for example • Duty of Disclosure: • Officers must disclosure material facts to directors • Officers must disclosure material facts to regulators • Officers must disclosure material facts to creditors or potential creditors • Officers must disclosure material facts to stockholders, bond holders, potential investors

31. Median Total D&O Limits by Business Class ($ Millions) Limits vary considerably by industry Source: Tillinghast-Towers Perrin

32. Median Total D&O Premium by Business Class Premiums vary considerably by industry Source: Tillinghast-Towers Perrin

33. D&O Broker Market Share(by Number of US Retail* Accts as Primary Broker) *Excludes wholsale brokerage activity; Based on sample of 1,976accounts Source: Tillinghast –Towers Perrin

34. Litigation Risk

35. Shareholder Class Action Lawsuits* Shareholders typically recover just 2.56% of amount lost; 1/3 of that goes to lawyers & expenses** *Securities fraud suits filed in U.S. federal courts; 2002 figure is through June 14, 2002 **Suits of $100 million or more. Source: Stanford University School of Law;Woodruff-Sawyer & Co.; Insurance Information Institute

36. Average Jury Awards1994 vs. 2000 Source: Jury Verdict Research; Insurance Information Institute.

37. Surety

38. Insurer Vulnerabilities

39. Insurer Vulnerabilities • Insurers by and large have solid reporting practices • Report under GAAP • Duel reporting under more conservative SAP makes insurer financial statements uniquely transparent • Setting of reserves are biggest issue for insurer • Always tricky, esp. for longer-tailed lines, since uncertainty increases with time (e.g., investment performance, med infl.) • Some areas (WC, Asbestos) have big deficiencies • Less cause for concern than might seem since liabilities paid over many years, possibility of favorable legislation (asbestos)

40. Remember Unicover? • Unicover was a group of pools that reinsured workers comp • Unicover priced policies at 30% - 40% below expected losses, then passed most of the “carve out” med/health component to reinsurers • Reinsurers in turn lowered prices to attract retrocessionaires • Spiral continued • Ultimate cost: Estimated at $2 billion • Life reinsurers stuck with much of it

41. Primary Insurers Reinsurance Brokers Fronting Companies Unicover Pool Reinsurance Brokers Reinsurers Unicover:“Passing the Trash”

42. Why Did Unicover Happen? • 3 Possibilities Have Been Proposed • Greed • Strong incentive to accept premium, ceding fees • Accusations that risks were misrepresented • Complexity/Ignorance • Didn’t understand “carve-out” business (life reinsurers took on medical portion of risk) • Higher-ups thought it was ordinary A&H • Regulators asleep at the switch • Economic • Weak premium growth in WC, competition, overcap. • Rate on line falling; preserve revenue stream • Insufficient premium & wrong bet on fundamentals (combineds >200%!!??)

43. Remember Reliance? • 200 year old company wiped out by one bad owner • Now being liquidated by PA Insurance Department • Producing large hits on guarantee fundsassessments • Underpricing, underresserving part of the problem • Very different from Enron/WorldCom • Steinberg was holdover from the last era generation of corporate scandals: LBOs, hostile takevers and corporate raiders like Michael Milken, Ivan Boesky. • If happened today, would probably be more focus on insurers than currently exist • Congress has called for GAO investigation of pricing and reserving practices of med mal insurers

44. Warning Signs & Red Flags

45. Red Flags & Warning Signs • Company grows rapidly through acquisition • Overdosing on risk • Dysfunctional board • Excessive CEO salaries (relative to performance) • Company pursues strategy du jour • Excessive emphasis on pro forma earnings • Company consistently meets earnings targets to the penny • Employees fear management more than competition Source: Fortune; Insurance Information Institute

46. Solutions

47. New York Stock Exchange:Proposed Reforms • Independent directors must make up board majority • 2 yrs to implement (most other provisions 1 yr.) • Non-management directors must meet regularly without management • Independent directors defined as those with no material relationship with the company • 5-yr “cooling off” period before former employees or auditors can sit on board • Only independent directors can sit on audit, nomination and compensation committees

48. Securities & Exchange Commission:New Requirements • Beginning with 3rd quarter 2002 10-Q filings, CEOs and CFOs must swear under oath the following: • Company’s financial statements do not contain any untrue statements of material fact • Company’s financial statements do not omit a material fact that results in such statements being misleading • Company’s financial statements have been (or not been) reviewed by its audit (or equivalent) committee

49. Securities & Exchange Commission:Rationale for New Requirements • “In light of recent reports of accounting irregularities at public companies, the purpose of the commission’s investigation is to provide greater assurance to the Commission and to investors that the persons have not violated, or are not currently violating, the federal securities laws governing corporate issuers’ financial reporting and accounting practices, and to aid the Commission in assessing whether it is necessary or appropriate in the public interest or for the protection of investors for the Commission to adopt or amend rules and regulations governing corporate issuers’ reporting and accounting practices and/or for the Commission to recommend legislation to Congress concerning these matters.” Source: SEC

50. Securities & Exchange Commission:New Requirements (cont’d) • New SEC requirement pertains to companies with revenues exceeding $1.2 billion • SEC’s “Final 1000” list contains 954 companies • Visit http://www.sec.gov/rules/other/4-460list.htm for complete list • 20 Non-life companies (or their parents) listed • AIG, Allstate, American Financial, Aon, Berkshire Hathaway (GeneralCologne Re, GEICO), Citigroup (Travelers), Chubb, Cincinnati Financial, GE (Employers Re), Hartford Financial, Loew’s Corp. (C N A), Markel, Marsh & McClennan, Mercury General, Ohio Casualty, Old Republic, Progressive, Safeco, St. Paul, W.R. Berkley