From Resource, April 2003 
Copyright by LOMA

Doing The Right Thing

Integrity is making a comeback as insurers cope with equity and bond losses, implement SarbOx and TRIA provisions, await pension reform, and debate a dual regulatory system.

By Jennifer C. Rankin

Just remember something. A man looks into the abyss. There’s nothing staring back at him. At that moment, a man finds his character. And that’s what keeps him out of the abyss."

It’s hard to believe that so many forgot the excesses of the 80s so quickly. Some—like the experienced and honorable executive who gave this advice to young broker Bud Fox, who was about to be arrested for insider trading in the movie Wall Street—never bought into the go-go game. Unfortunately, many did. And a whole new cast of characters played the game in the 90s.

During the past two years, the repercussions of their actions have reverberated through the industry, the country, and the world, which have been shaken by a series of improbable and disastrous events.

The first of these was the collapse of the Internet bubble two years ago. The September 11 terrorist attacks followed six months later. Not caused, of course, by corporate America, they certainly were, in large part, an attack on the capitalist system at the pinnacle of which the country stands. The Enron debacle, rumblings of which began to surface in November 2001, sent another set of shock waves through the country. By April of last year, America’s longest-running bull market ground to a halt.

Today, industry executives are coping with the fallout from the sudden—and lingering—decline of the equity markets as well as a string of large corporate frauds and failures, which have shaken investor confidence and created a deep lack of trust in financial institutions. Adding to the uncertainty is the war with Iraq, launched on March 19.

Let’s start with the current economic climate and its effect on insurance and other financial services companies.

The past year has caused considerable damage, according to Ernst & Young’s most recent state of the industry report. The lack of investment gains, coupled with rising credit losses, has pummeled many companies’ earnings. In addition, the long market slide has stripped insurers, banks and asset managers of fee income and has slashed earnings from equity-based products.

According to Ernst & Young, the 30-month decline in the equity markets has slashed the wealth of America by US$ 7 trillion.

"For financial institutions," says the consulting powerhouse, "perhaps the most powerful effect of the market collapse is the shattering of the idea that investors should be fully invested in equities, since markets will always go up.

"More specifically, most financial institutions developed products, built distribution channels, and invested in technology and other infrastructure to pursue the vast savings market—especially the high-net-worth markets. But the vigor, vitality, and the earnings from this business come principally from equity investing. The distribution of investment assets recently shifted from equity to bond and money market funds. Without a continuation of substantial cash flows into equity-based products, business models will be seriously challenged."

Declining stock values and a lack of confidence in equities can have a profound affect on life insurers. Writers of variable annuity products experience a decline in fee income. Writers of all product lines experience a decline in the value of their investment portfolios, which affects earnings, reserves, and overall profitability. Finally, many insurers were considering the Citigroup model of the highly diversified financial institution that offers insurance products, banking services, and investments. This model is much less attractive in a bear market and much less trusted by the average consumer in the current climate.

The particulars are grim:

• During the past two years, life insurers experienced a steep drop in net income as a result of realized capital losses, shrinking annuity assets, and reduced fee-based income

• Analysts say the life industry will take a US$ 24 billion hit from corporate bond defaults at WorldCom, Qwest, Enron, Tyco, Global Crossing and Adelphia

• Profit spreads are narrowing in both fixed and variable products due to a combination of decreasing investment returns, embedded guarantees, and ineffective hedging

• Several major life insurers wrote off deferred acquisition costs (DAC) for equity-based products (variable annuities and variable life insurance) in late 2002, and DAC write-offs, which are serious business, are expected to continue throughout 2003

• As a result, Standard & Poor’s has revised its outlook on the U.S. life insurance sector to negative from stable and has downgraded a number of individual companies as well. In fact, about one-third of the U.S. life insurers the agency rates now either have a negative outlook or are on credit watch with negative implications.
• One of the biggest challenges at the moment is getting investors back in the market. What will it take to regain their trust? In a word, lots. To that end, the current administration has signed off on landmark legislation designed to improve corporate governance.

Corporate Governance

Named for sponsors Sen. Paul Sarbanes (D-Md.) and Rep. Mike Oxley (R-Ohio), H.R. 3763, the Sarbanes-Oxley Act of 2002, is a sweeping new law designed to clean up corporate America in response to recent scandals. Signed into law by President Bush on July 30, the Act has been called the biggest overhaul of corporate rules since the Great Depression. The new rules take effect this spring. SarbOx:

• Creates a new oversight board for accountants of publicly-traded companies
• Quadruples penalties for accounting fraud
• Bans insider loans—that is, companies lending money to their executives
• Calls for executive certification of financial results at 947 companies, 75 of which are insurance companies
• Establishes a new crime of securities fraud
• Increases corporate disclosures
• Separates investment analysts from investment bankers

Predictably, corporate lawyers and lobbyists say various parts of the Act are confusing. The insurance industry is especially concerned about the effect insider loan provisions might have on split-dollar products. More specifically, does the ban on company loans to its executives include the split-dollar life insurance that many executives get from their companies as perks? The ACLI defends the practice, saying split-dollar is not an insider loan.

Because CEOs and CFOs now must certify the accuracy of company reports, many predict the sales of directors’ and officers’ liability (D&O) products will soar.

Just as predictably, reform activists say SarbOx doesn’t go far enough, especially with respect to the accounting treatment of stock options, the use of derivatives, and the allocation of initial public offerings (IPOs). Many senators feel that the biggest omission from SarbOx was its failure to require companies to treat stock options as an expense.

Some states are worried as well, including Ohio, Colorado, North Carolina and New York. In a recent Reuters e-briefing, analyst Karen Pierog notes they are pushing for stiffer corporate fraud penalties, beefing up state oversight of companies, and looking for ways to address situations that might fall through the cracks of SarbOx. Ohio, for instance, wants to include companies that aren’t covered by SarbOx—that is, those not listed on U.S. stock exchanges, have less than 500 shareholders, and aren’t required to report to the Securities and Exchange Commission (SEC).

A vindicated Warren Buffet, the billionaire investor and CEO of diversified holding company Berkshire Hathaway, who was generally considered to be "out of it" during the go-go 90s, weighed in on corporate reform during his annual letter to shareholders in March.

Buffet believes the most flagrant deceptions in corporate America today involve stock options, pension accounting and derivatives. In an op-ed piece in the New York Times, he said the misrepresentations in these areas "dwarfs the lies of Enron and Worldcom." Buffet want companies to expense stock options, stop recording pension fund income as profit, and desist from using derivatives, which he calls "financial weapons of mass destruction, carrying out dangers that while now latent are potentially lethal." Derivatives are contracts based on underlying cash securities or "things" like interest rates, currencies, energy or the weather. They allow investors to both buy protection and make leveraged bets.

Corporations across America are scrambling to meet SarbOx requirements and there are lots of folks lining up to help them, including law firms, consulting firms, and M&A experts, who have experienced a sharp decline in business in recent months.

What’s new is a proliferation of new rating systems that gauge corporate governance practices at public U.S. companies. Purveyors of governance ratings include Standard & Poor’s, Institutional Shareholder Services, GovernanceMetrics, and the Investor Responsibility Research Center.

In the meantime, many major corporations are working hard to do the right things.

Citigroup is one company that has seen the light. Under fire for its ties to Enron and allegedly biased stock research, the financial services giant has taken a leadership role on the corporate governance front (see A Higher Standard).

"There is a higher standard than the law," says Sanford I. Weill, chairman and CEO. "It’s called doing the right thing." Speaking to executives at the October 2002 Fortune Boardroom Forum, Weill said there were three qualities Citigroup must demonstrate to the public in order to win back their confidence.

"The first and most fundamental," says Weill, "is integrity. This means we must be honest in how we treat our customers, partners and investors. It also means, in some instances, saying no to profitable business opportunities. The second quality is independence. When we are giving advice and telling clients we are acting in their interests, we must be truly objective and impartial. The third quality is accountability. We need to create the structures and framework that permit us to practice business with integrity and independence.

"And while we’re demonstrating those three qualities externally, for everyone to see, we also need to change the way we think about doing business, within our own hearts and our minds. No matter what we believe the rules or laws may allow us to do—and regardless of what may be accepted as common practice in our respective industries—we need to ask ourselves what the man or woman in the street might think, and then do right by them."

Pension Reform

Nowhere was the difference between right and wrong more evident than the Enron debacle, during which Enron employees lost about US$ 1 billion in 401(k) savings when the value of Enron common stock collapsed after the company reported that it had wildly overstated prior earnings. Enron matched employee salary deferrals only in company stock and barred employees from selling that stock until they turned 50.

This wasn’t the first debacle in corporate history, nor will it be the last. The difference is that it didn’t affect a handful of high rollers. Enron and its aftermath have devastated the savings of the American public. This fact is not lost on the country’s CEO-like president who early on, in a February 2002 address to a conference on retirement savings, said, "Every American deserves to be an owner of the American Dream. That dream includes a sound pension plan and adequate private savings."

"Over the past 20 years," says analyst Peter Szekely in an April 11 KPMG e-briefing, "employers have gradually replaced so-called defined benefit plans that assure life-long pensions with defined contribution plans, like 401(k) accounts, that are managed by employees themselves instead of professionals. Of the 70 million American workers with $3.6 trillion in assets in retirement plans, 42 million with $1.8 trillion were in 401(k) accounts at the end of 2000."

During the recent spate of corporate failures, Congress has worked diligently to make things right, especially with respect to pension plans. To that end, it has proposed numerous bills, including the:

n Retirement Security Advice Act (H.R. 2269). Proposed in November 2001 by Rep. John Boehner (R-Ohio) and 58 sponsors.

• Employee Retirement Savings Bill (H.R. 3669). Passed by the House Ways & Means Committee in March 2002.
• Pension Security Act (H.R. 3762). President Bush’s plan for pension reform. Passed by the House of Representatives in April 2002.

• National Employee Savings and Trust Equity Guarantee Act (S. 1971). Nicknamed NESTEG and passed by the Senate Committee on Financial Services in July 2002.
• n Pension Protection and Expansion Act (S. 9). Introduced by Sen. Tom Daschle (D-S.D.) in January 2003.

On February 28, House Education and the Workforce Committee Chairman Rep. John Boehner (R-Ohio) and Employer-Employee Relations Chairman Rep. Sam Johnson (R-Texas) reintroduced the Pension Security Act, which now carries the number H.R. 1000.

"In order to prevent more massive losses to 401(k) accounts in the aftermath of an Enron-like collapse, Congress’ first priority must be providing workers with new pension protections," says Boehner. "Workers around the country are waiting for us to act on these long-overdue reforms. Expanding worker access to professional investment advice and giving workers new rights to diversify their 401(k) portfolios are key components of our retirement security agenda (see Long Overdue).

After defeating various amendments proposed by panel Democrats, the House Education and Labor Committee passed H.R. 1000 by a vote of 29-19 on March 6 and sent it to the House floor. The Democrats wanted to require employee representation on pension plan boards of trustees. Another Democratic amendment would have required employers that convert their traditional defined benefit plans to so-called cash balance plans to give plan participants the option not to convert.

Now that Republicans control the Senate, the likelihood of congressional action on the legislation has improved greatly. President Bush has reaffirmed his support for H.R. 1001 in his 2004 budget request and has indicated he will sign it into law when it reaches his desk.

Another wrinkle on the retirement front are new White House proposals for three new savings accounts, which caught the insurance industry totally off guard.

At present, Americans can rely on three sources of retirement income—pensions, Social Security, and personal savings. President Bush favors replacing these with lifetime savings accounts, retirement savings accounts, and employer retirement savings accounts. His 2004 budget, currently in the works, takes these new accounts into consideration:

• Lifetime savings accounts (LSAs). No matter what their income, taxpayers could contribute up to US$ 7,500 per year in these accounts, earn interest on a tax-free basis, and withdraw money at any time for any reason without any tax consequence.

• Retirement savings accounts (RSAs). No matter what their income, taxpayers could contribute up to US$ 7,500 per year in these accounts, earn tax-free interest, and withdraw money at age 58 or later.

• Employer retirement savings accounts (RRSAs). These would replace existing defined contribution plans such as 401(k)s. Taxpayers could contribute up to US$ 12,000 per year through 2005 and up to US$ 15,000 per year thereafter. Taxpayers aged 50 or older also could make additional catch-up contributions of US$ 2,000 per year through 2005 and up to US$ 5,000 per year thereafter. Unlike 401(k) plans, RRSAs would not have to pass top-heavy, non-discrimination, or other tests.
• Both lifetime savings accounts and retirement savings accounts would be indexed for inflation. Taxpayers could contribute to all three accounts simultaneously. They also could convert existing IRAs into RSAs.

If passed into law, what effect would these accounts have on the insurance industry? While analysts are unsure and the ACLI is mum on the topic (for now, anyway), they almost certainly would discourage employers from offering retirement plans and taxpayers from buying annuity products.

Terrorism Reinsurance

Sarbanes-Oxley and pension reform are just two pieces of legislation with which insurers must comply. Another is the Terrorism Risk Insurance Act of 2002 (TRIA), which President Bush signed on November 26, 2002. Under the law, the Federal government shares the risk of loss from future terrorist attacks with the insurance industry.

Terrorism reinsurance is not just a property/casualty issue. Uncertainty about who would pay for what if terrorists struck again has affected the entire financial services sector as well as the U.S. economy. Late last year, for instance, Moody’s downgraded US$ 4.5 billion worth of commercial mortgage-backed securities due to a lack of terrorism insurance coverage, unsettling an already nervous economy and rattling the investment portfolios of life insurers.

Designed to protect the nation’s economy, the new legislation was a long time coming. Two months after the September 11 terrorist attacks, the House passed H.R. 3210, a temporary terrorism reinsurance backstop. During the next 11 months, the government issued a findings report, the Senate authored its own bill (S. 2600), and the House and Senate created a conference committee to study both H.R. 3210 and S. 2600.

Bipartisan legislation was not a possibility, largely because of tort reform, on which neither side would budge. More specifically, the Senate bill did not shield businesses from punitive damages, while the House version did. In addition, the Senate bill did not require insurers to pay back claims paid by the government, while the House bill did.

In October, an irritated President Bush told Congress to come up with a compromise solution, which it did with TRIA the following month. Key provisions of the new law, which, in effect, is a federal reinsurance plan, are a:

• Three-year backstop of funds that is effective from November 2002 to year-end 2004 and that may be extended until year-end 2005.

• Payment arrangement under which federal funds will cover 90 percent of damages after US$10 billion in damages has been incurred (first year),US$12.5 billion in damages has been incurred (second year), and US$15 billion in damages has been incurred (third year).

• Combined aggregate program limit of US$100 billion annually.

• Requirement that insurance companies pay back funds if the uncompensated losses are less than the insurance marketplace aggregate retention

• Deductible insurance companies must pay that is based on each company’s individual premium and that is capped at seven percent of premiums paid (first year), 10 percent of premiums paid (second year), and 15 percent of premiums paid (third year).
• n Right to sue for punitive damages, but only in federal court

According to a briefing from AON Risk Services, all insurers—direct, surplus lines and alien—that write primary and/or excess property/casualty insurance for U.S. risks will be required to participate in the program, to make coverage available for terrorism losses in all of their property/casualty coverages, and to offer coverage in a manner that does not differ materially from coverage offered for acts other than terrorism. The Act excludes reinsurers from coverage.

Finally, TRIA includes a built-in mechanism that allows its provisions to extend into other areas of insurance. By the end of August, for instance, appointed industry experts must study the effects of terrorism on life insurance and other insurance lines to determine whether such coverage should be included in the federal program.

The ACLI and the Financial Services Roundtable want to include group life in the TRIA, sending a formal request to the Treasury Department in January.

At present, the government is developing guidelines to help insurers and policyholders understand the new law as well as fashioning a government structure within the Treasury Department for accounting and repayment purposes should the federal backstop ever be necessary.

Federal Charter

What else is on the horizon for insurers?

The debate over an optional federal charter continues. The addition of such a charter to the insurance industry’s existing state-based system of regulation essentially would create a dual regulatory system much like that under which banks operate.

In April 2002, Resource covered this issue in great detail (see A Turning Point). When we left the discussion, three ideas were on the table—the ACLI draft proposal of November 2001, the unnumbered bill sponsored by Sen. Charles Schumer (D-N.Y.) in December 2001, and the unnumbered bill sponsored by Rep. John LaFalce (D-N.Y.) in February 2002.

What has happened since then? Not much.

In May 2002, the House Financial Services Committee decided to delay the debate until sometime that summer.

On June 4, 11 and 18, the House Financial Services Committee’s subcommittee on capital markets, insurance and government-sponsored enterprises held hearings on insurance regulation, including the federal insurance charter option.

In September, industry representatives gathered again before a Congressional panel to discuss insurance regulation. In October, it was a topic of great debate at the fall ACLI meeting. In December, Rep. Richard Baker (R-La.), second-ranking member of the House Financial Services Committee, denied he planned to introduce legislation that would give a federal charter option to only life insurers.

Generally speaking, large insurance companies and banks favor the optional federal charter for a couple of reasons. Many products sold by life insurers have evolved into investment products, which places insurers in direct competition with banks and securities firms. These competitors have a real advantage, because they can sell one product nationally, without the expense of meeting different requirements in different states. Many large companies also believe an optional federal charter will allow them to compete more effectively in the global arena.

Both the American Bankers Insurance Association (ABIA) and the American Council of Life Insurers (ACLI) are enthusiastic proponents of the concept.

"The life insurance industry is an increasingly significant part of the nation’s economy," said Joseph J. Gasper, president and COO of Nationwide Financial Services and then-chairman of the ACLI, during the June hearings. "Life insurers, along with the banking and securities industries, are the triumvirate of essential financial services providers. And yet, despite the striking parallels between the three in terms of their products and their importance to the financial health of the nation, there is no federal mechanism to address insurance issues on a broad scale."

Gasper and other proponents of the federal charter say it will streamline the product filing process, resulting in cost savings for insurers and more product choices for consumers, as well as enable insurers to compete effectively in an increasingly tough and global economy.

Opponents include the National Association of Insurance Commissioners (NAIC), the Alliance of American Insurers (AAI), the National Association of Mutual Insurance Companies (NAMIC), the Independent Insurance Agents and Brokers of America (IIABA), and the National Association of Independent Insurers (NAII). They and other opponents worry that a federal charter may foster regulatory arbitrage, decrease state premium tax revenues, and infringe on states’ rights.

Where does this leave the states? Some would say in quite a pickle.

According to the National Association of Insurance Commissioners (NAIC), state insurance regulators recognize the financial services industry is changing and have worked diligently over the past two years to identify the issues in this area and to come up with possible solutions to reflect the new market realities.

To that end, the NAIC established the Interstate Compact Working Group in March 2002. Its goal? To create a national, state-based system of insurance regulation that would provide for uniform standards and a single point of filing. The group’s proposed Interstate Compact would include life insurance, annuities, disability income and possibly long-term care products. To make the goal a reality, state insurance regulators are working extensively with their legislative counterparts at the National Conference of State Legislators (NCSL) and the National Conference of Insurance Legislators (NCOIL).

Through cooperation among the compacting states, the proposed Interstate Insurance Product Regulation Compact will:

• Promote and protect the interest of consumers of individual and group annuity, life insurance, disability income and long-term care insurance products
• Develop uniform standards for insurance products covered under the compact
• Establish a central clearinghouse to receive and provide prompt review of insurance products covered under the compact and, in certain cases, related advertisements, submitted by insurers authorized to do business in one or more compacting states

Give appropriate regulatory approval to those product filings and advertisements satisfying the applicable uniform standard

• Improve coordination of regulatory resources and expertise among state insurance departments regarding the setting of uniform standards and review of insurance products covered under the compact

• Create the Interstate Insurance Product Regulation Commission

• And perform these and such other related functions as may be consistent with the state regulation of the business of insurance.

Skeptics wonder if the states will be able to reform the state regulatory system. Don’t tell NAIC President and Iowa Commissioner Terri Vaughn that, however. She is confident it can be done and will be done in short order.

In November, commissioners elected not to finalize Vaughn’s March 2002 Compact proposal. On December 8, they changed course, adopting the proposal. The working group hopes to present a legislative model by the June NAIC meeting, with possible adoption by the fall meeting.

The proposed compact faces significant political opposition from consumer groups, the property/casualty industry, and state attorney generals, who have questioned the compact’s constitutionality.

As you can see, the financial services sector is in the midst of one of the most challenging business cycles ever. The truths that guided the past decade—blind faith in equities, the demise of the traditional business cycle, venture capital for everyone, unconscionable executive compensation packages, and more—in short, something for nothing—are gone. In its place we have corporate governance, pension security, a terrorism safety net, and more — that is, a commitment to doing the right thing.