No Assurance Of Good Governance: Observations On Corporate Governance In The U.S. Insurance Sector

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1 Special Comment October 2005 Contact Phone New York Mark Watson Kenneth Bertsch Sarah Hibler Joel Levine Robert Riegel Ted Collins No Assurance Of Good Governance: Observations On Corporate Governance In The U.S. Insurance Sector Summary Over the last few years, regulatory probes into U.S. insurers have focused attention on the quality of corporate governance within the insurance industry. The probes have raised questions in some new areas most pointedly, those on the use of finite insurance products and contingent commissions but the probes also have resurfaced old questions, or posed new ones, on insurance sales and brokerage practices, which has long been an area of concern. Moody s has continued to expand its corporate governance assessments within the industry, and we have identified some common strengths in U.S. insurers governance: The importance placed on an insurer s credit ratings acts as a constraint on boards and management teams. Insurance company boards tend to have good committee structures, staffed by independent directors. Given the regulatory framework, Moody s believes that insurance company boards of directors play a particularly critical role in ensuring strong oversight of risk management practices. Nevertheless, Moody s believes that insurers governance practices have several weaknesses: In some respects, insurance companies governance mechanisms operate with a less consistent safety net than do banks. Moody s believes that both the regulatory oversight of bank corporate governance and the perceived conflicts of interest appear stronger and more consistent than for the insurance industry, with its multistate regulatory system. That said, the fact that several prominent insurers have set aside reserves in anticipation of regulatory settlements, and some have received so-called Wells notices from the SEC. This highlights the increased intensity of regulatory oversight that the industry is currently facing on governance and related issues. We find that some boards would benefit from greater industry knowledge, which is a difficult challenge in director recruitment, given conflict of interest and competitive considerations. We also believe there is a growing debate about the independence of the chief actuary. Historically, some regulatory frameworks attempted to stress granular board-approval of investment decisions, which results in a risk of boards, going through a checkbox approach to their work, rather than a broader strategic approach. Setting executive pay with regard to long-tailed liabilities can be difficult, as can changing pay during demutulization. Shareholder rights may be more limited for offshore insurers, which could dilute accountability to shareholders. The mutual structure is prominent in the insurance industry and presents an analytical conundrum for Moody s. This is occurring in terms of evaluating the quality of corporate governance: the overall incentive structure favors creditor interests more than in a stock company structure, yet the mutual structure presents some distinct governance challenges for their boards and management teams.

2 Incorporating Corporate Governance Into Moody s Credit Analysis Moody s corporate governance analysis efforts have two goals. The first is to inform Moody s analysts and credit rating committees on the quality of governance at individual issuers so that this insight can be more explicitly factored into ratings. The second is to provide investors the targeted insights through our Corporate Governance Assessment reports. Moody s increased scrutiny of governance is one element of our Enhanced Analysis Initiative (EAI), which aims to improve the quality and transparency of our analysis. EAI provides detailed commentary on important credit-related issues such as liquidity, financial reporting, off-balance-sheet liabilities, and risk management as part of our suite of credit research on large corporate debt issuers. EAI represents our commitment to expand the scope and depth of our analytic activity, to strengthen the vigor with which we analyze companies and probe management, and to articulate more clearly the core factors that drive our rating decisions. Insurance-Sector Governance Strengths The importance placed on an insurer s credit ratings acts as a constraint on boards and management teams Moody s recognizes that, in reviewing the quality of corporate governance at insurers, a firm's governance primarily exists to protect its owners interests. Moody s attempts to evaluate the extent that shareholder interests and creditor interests diverge. In doing so, Moody s notes that a distinctive feature of the insurance industry is the degree to which an insurer s credit standing is essential to the franchise (particularly for life companies and reinsurers) and, ultimately, to the underlying value of the business. This creates a relatively high degree of alignment of shareholder and creditor interests at least when compared to other industries. An insurer s commitment to its credit rating and to the market perception of credit quality acts as a strong constraint on the board s and management s freedom to operate, which is a significant positive factor from a creditor s perspective. Boards tend to have good committee structures, staffed by independent directors For a number of years, insurers have had relatively well-structured committee oversight. Core committees audit, compensation and nominations have long been features of many insurers governance, as have investment or finance committees. Indeed, of the 18 insurers on which we have published corporate governance assessments, the average board has five committees. For most, committee meeting frequency has been relatively high over the last few years. Insurers have long been able to staff the core committees with independent directors (investment or finance committees, which typically include some executive directors). The average independence for 18 insurers, on which we have written governance assessments, is 74% compared to 72% of the first 300 companies Moody s reviewed. Although this figure is broadly in line with our overall average, we believe that board independence at insurers has been relatively high for some time; in contrast, in many other sectors, significant board changes have been required to improve independence. A number of insurers demonstrate strong oversight of their financial, actuarial, and investment risks Risk management and investment practices remain core disciplines within any insurer, particularly P&C companies. These disciplines determine how successfully an insurer can properly underwrite policies; can accurately assess claims; can pay actual losses and benefits; and can produce competitive returns. The board has a critical oversight role in these areas, particularly given the weak underwriting and investment results at some insurers in recent years. Typically detailed oversight takes place in board committees. Twelve of the 18 insurers that Moody s has reviewed have investment or finance committees. Many of these committees have been in place for a number of years. Board and committee risk and investment oversight depends heavily on the effectiveness of the management structures that have been adopted. Many of those insurers Moody s has reviewed have some form of centralized risk management oversight, and we have noted the appointment of a chief risk officer (CRO) in many insurers over the last couple of years. 2 Moody s Special Comment

3 The CROs report routinely to the relevant board committees and are generally supported by a range of risk committees at the management level. However, we believe there is significant room for improvement in the manner in which many insurers identify, quantify and mitigate risks at the enterprise level. Future efforts by insurers to develop economic capital models may facilitate a more informed discussion throughout the company on key risk exposures and appropriate risk limits, in our view. Independence of Actuary May Become a Key Issue Moody s believes that an area of increasing scrutiny by boards and perhaps regulators could be the level of independence within the actuarial function. Actuarial assumptions form the bedrock of reserve calculations, newproduct development, and pricing. Currently, chief actuaries are typically accountable solely to senior managers, with routine presentations made to finance and/or audit committees as required. New requirements for public company CEOs and CFOs to certify their financials on a routine basis have elevated the importance of an empowered chief actuary, in our view, as have the internal-controls checks mandated by Sarbanes-Oxley. We also assume that external auditors are even more focused on key actuarial assumptions around reserves than ever before. However, there is another argument: Given the actuary s critical role, the valuation actuary should more closely resemble the internal audit function that has developed in recent years; that is, with stronger links and, perhaps dotted line reporting responsibilities, to the board and its committees. A recent report on insurers governance by the Organization of Economic Cooperation and Development recommended such arrangements and even recommended that boards may wish to appoint independent thirdparties to review and comment upon management s actuarial assumptions and calculations.* Canadian insurers are already subject to three-year peer reviews, due to the Federal requirements. Moody s believes periodic independent assessments of an insurer s actuarial assumptions could be highly beneficial, particularly if the findings are communicated directly to the board and its audit committee. However, such reviews should not diminish the accountability of the chief actuary for the actuarial assumptions used by the insurer. * OECD Guidelines for Insurers Governance, April Insurance-Sector Governance Weaknesses Governance regulation becoming more important, but still behind banks In comparison with banks, insurance companies face less regulatory scrutiny, at least as it relates to the quality of corporate governance, risk management, and controls. Insurance regulation tends to focus more on governance during a change of control context, particularly through the course of demutalization. Insurers are governed by a system of state regulation and are not subject to an industry-specific Federal regulator. However, in recent years, the industry has faced a litany of regulatory investigations including the SEC, Department of Justice, state attorney generals, and state regulators. The FBI also appears to be increasing its focus on the insurance sector, raising the specter of possible criminal charges of companies or executives. 1 Some of the regulatory investigations appear to be coming to a head, with a number of rated companies, or their executives, recently receiving so-called Wells notices from the SEC. These notices significantly ratchet up regulatory pressure and potential negative outcomes to the issuer, including the possible loss of executives, especially where individuals receive such notices. (See Moody s Response To Rated Companies Receiving SEC Wells Notices, October 2005, #94627). The focus of regulatory investigations has included governance and controls, as well as conflicts of interest. The P&C sector has faced scrutiny, particularly on its reinsurance products. The life industry has faced investigations into management problems, particularly those associated with annuity sales practices and mutual fund trading. Insurance brokers have come under intense scrutiny for undisclosed commission practices and potential conflicts of interest. 1. In its May 2005 Financial Crimes Report to the Public, the Federal Bureau of Investigation noted the following: although corporate fraud is not unique to any particular industry, there has been a recent trend in involving insurance companies caught in the web of these schemes. Moody s Special Comment 3

4 During these regulatory probes, Moody s has focused heavily on the level of board involvement in shaping the response to control failures or regulatory missteps. The board plays a critical role in ensuring that management works openly with regulators in addressing control failures. The board also sets the tone. If the board is not vigilant, management may simply pass over failures and adopt a minimalist approach to rectifying the problems rather than unearthing the underlying causes and promptly taking immediate and corrective actions. Moody s has seen both approaches, and our analysts have acted accordingly, factoring the company s culture and style into our rating discussions. Some boards are better than others at considering the broader reputational issues that arise from control failures. Brand capital can be badly tarnished by control failures and more active, insightful boards recognize that the manner in which managements respond is crucial and can greatly influence the way the brand is perceived. Moody s also believes that a company s attitude in dealing with regulators is a key risk factor in the credit evaluation of insurance companies. A major challenge for Moody s in reviewing an issuer s regulatory problems is determining whether or not the issuer is under investigation directly or as part of a broader sector investigation that is actually focused on another company and also on the precise nature of the potential control problems that the investigation may unearth. Some Boards Are Too Involved In Approving Investment Decisions One area where existing regulation may have a negative effect is on the level of detail in which directors get involved in investment decisions, particularly for life companies. Every insurance company requires the board to gain a good understanding of management s investment approach and oversee the performance and composition of the investment portfolio. This is typically done in finance or investment committees, as noted above, in combination with discussion at the full board level. However, some insurers have adopted approval policies that Moody s believes draw boards or their committees into approving what appear to be relatively small investments, at least in the context of the size of the insurer s investment portfolios. Clearly, major investment decisions or investment policy changes should require board or committee approval. However, day-to-day investment decisions should be taken by management. Drawing directors into the approval process can blur lines of accountability and can impair the board s ability to provide independent, objective oversight. We note, as a positive, that some insurers are starting to revisit their approval processes to minimize the frequency of when board or risk committee approval is required. Staffing boards with industry-knowledgeable directors can be difficult; boards often too large Moody s looks for boards that are strongly independent in composition, highly knowledgeable, organized effectively to hold senior management accountable and act decisively and effectively. This is particularly important for insurance companies because of: Current regulatory probes of the industry Vulnerability of businesses to charges of conflicts of interest Critical importance of reputation to customers Complexity of the insurance business In this context, we have two concerns about the composition of insurance company boards: Financial service experience tends to be very low. To a great extent, limited financial services experience reflects a desire to avoid appointing directors who may have potential conflicts of interests associated with other financial service companies. Yet, insurance company directors have to be able to understand the industry, the key risks, different accounting standards (statutory and GAAP), and complex actuarial and investment issues. Clearly, having directors bring insights into the boardroom from other industries helps inform the discussion. However, in Moody s view, too few insurers have adopted the approach of appointing retired industry executives or advisers with industry experience, such as accountants or consultants. Boards are too large. Many insurers have large boards; although some have minimum size requirements established by state regulators. They average 14 members, compared with an average of 11 for companies that Moody s has evaluated outside of insurance. That said, few insurers have mega-boards, with 18 members or more. 2 Having a large number of directors helps in staffing committees, which is important. However, in Moody s view, smaller boards (of approximately 9-12 members) enhance active discussion, enable a more detailed review of key issues and also allow for the active participation of all directors. 2. Of the 18 insurers we have published corporate governance assessments, only one St. Paul Travelers, at 23 members has a board with 18 directors or more. 4 Moody s Special Comment

5 The death of insider boards? American International Group, Inc. (AIG) and Marsh & McLennan Companies Inc. were among the last U.S. holdouts among major public companies that had insisted on the value of large insider contingents on the board of directors. Such a board structure is generally designed with the view that it encourages executives to think both as executives and directors. It also provides direct access to key executives. Yet, control and governance problems at these companies have done much to discredit this approach, at least in the U.S. context. The difficulties at these two entities also validated the need for boards to be clearly independent of management, engaged, and willing to be aggressive. Setting executive pay with regard to long-tailed liabilities can be difficult, as can changing pay during demutulization Mutuals tend to have limited disclosure on executive pay. As such, given that four of the 10 largest insurers in each of the life and P&C segments are mutuals, it is difficult to accurately assess executive pay broadly across the industry or against other sectors. However, Moody s believes that average executive pay in the insurance industry is broadly comparable to other U.S. companies pay. 3 Insurance company boards face two distinct challenges in setting executive pay: Executive pay often becomes much more leveraged after demutualization. One of the oft-cited benefits of demutualization is the ability to use stock currency to attract and retain senior talent. However, in our view, the tendency to award significant stock option grants as part of the demutualization process can make pay more highly geared, at least compared to prior pay structures. Options can be an effective component of pay for management, but they can create pay structures that are, from a creditor s perspective, highly leveraged. To the extent that bondholder and shareholder interests diverge, such leverage could induce behaviors that are more short-term in nature or, at least, ones that are less creditor-friendly. Inherent challenges in this regard include structuring pay such that swaths of senior managers do not leave the firm relatively soon after their options vest. Another challenge is ensuring that change-of-control provisions do not make management pre-occupied with seeking out merger candidates, post-demutualization, in order to trigger significant payouts. The nature of the insurance liabilities creates real difficulties for each board s compensation committee in setting executive pay. Event risk can create significant anomalies in a company s financial performance. In addition, potential liabilities can stay on the books for decades. With this is mind, insurance boards face a difficult balancing act: on the one hand, pay should fall when management under-performs; but on the other hand, current management should not pay the price for past managements mistakes. Stock Options For Directors Can Encourage An Overly Short-term Focus We note that a few insurers continue to pay their directors with stock options. Moody s views this type of pay as inappropriate for directors as it can align their interests too closely with those of management and undermine their independence when reviewing strategy and financial decisions. When paid at high levels, it can encourage a relative short-term perspective, with a stronger focus on vesting schedules than on the company s long-term prosperity. Shareholder rights may be more limited for offshore insurers, which could undermine accountability to shareholders Several major insurers, particularly those in the reinsurance business, are incorporated off-shore for tax and regulatory purposes. Favorite places for incorporation include Bermuda and the Grand Caymans. These jurisdictions have been the focus of criticism by some major shareholders in the past because of the difficulties in enforcing shareholders rights. Many companies in these jurisdictions maintain that shareholders rights are not materially affected when compared with U.S. incorporation regulations. However, shareholders have argued that the legal systems in these jurisdictions are less predictable than those prevailing in the United States. Moody s considers this to be a negative rating factor to the extent that diluted shareholder-rights diminishes shareholders ability to hold management accountable. 3. Average 2004 CEO pay for 42 publicly traded insurers was $5.9 million, compared with $5.7 million for a broader universe of 1,043 U.S. companies. Moody s believes it is difficult to determine an accurate average for mutual company CEO pay, based on public disclosures. However, from what data we have, we believe the average for mutual insurance company CEOs is not likely to be materially higher than for public company insurance CEOs, if at all. Moody s Special Comment 5

6 Mutual Structure Creates Greater Alignment With Creditor Interests, But Governance Mechanisms Present Distinct Governance Challenges The mutual structure is prominent in the insurance sector. Four of the top 10 in each of life and P&C sectors are mutuals (or reciprocals). 4 In Moody s view, the mutual structure creates greater alignment between the core constituencies (both policyholders and creditors), particularly when compared with stock companies where the interests of shareholders and creditors can diverge. However, the governance mechanisms, and, in particular, the question of management accountability, are both more limited in the mutual structure; this is because the likelihood of collective action by the policyholders the owners of the mutual is much diminished compared to the ability of shareholders to act. Therefore, in a mutual structure, the board effectively becomes the only check on management s actions. The disconnect between ownership structure and corporate governance can be highlighted as follows: It can be a credit positive that the managers of mutual companies can sustain high (even "excess") levels of capital in the company. Typically, there is little pressure to actively deploy the capital as compared with a public stock company s focus on the appropriate return on equity to shareholders. Financial leverage also tends to be lower in mutual companies. Taken together, these features enhance the credit profile of a number of mutuals, and they account for the fact that mutuals tend to be more highly rated than some peer stock companies. In contrast, a mutual company s board and management team may be slow to take corrective action in the event of a strategic or financial misstep. Indeed, this inertia may help explain why several significant mutuals have failed through history. Further, policyholders are not motivated or empowered to act in the same way that public shareholders can. Public-company shareholders tend to force the board and management team to change more quickly. The lack of a performance culture within the organization can be a signal of future problems, for example, when boards and managers focus primarily on capital adequacy without an accompanying focus on capital efficiency and profitability. Of course, the relatively higher capital levels at mutuals, to some extent, protect them against the slow pace at which corrective action might be taken. In this context, Moody s assesses the quality of corporate governance within mutuals by the manner in which their boards handle several distinct challenges: 1. Determining the appropriate level of voluntary disclosure. One potential weakness of the mutual structure is the relatively limited disclosure, both on governance matters and financial performance. Governance disclosure. The most striking weakness is related to executive pay, where mutuals often only disclose total pay figures, and these figures may not incorporate all sources of pay. A breakdown of executive pay, highlighting all of the components of pay and key performance metrics, is rarely available, if at all. Further, with a number of mutuals, it is often difficult to get basic information, such as director profiles, board committee structures, meeting frequencies, among other information. Some mutuals have started to publish more information, but for the most part disclosure remains significantly below that of publicly traded stock company peers. Financial disclosure. Mutuals, in general, tend toward less disclosure than stock company peers. However, some mutuals have relatively good disclosure, particularly those undertaking a debt offering. 2. Determining the appropriate level of voluntary compliance with Sarbanes-Oxley/stock exchange governance requirements. Mutuals are able to avoid much of the governance requirements facing their stock company peers. Governance requirements. Increasingly, mutual boards have voluntarily adopted elements of those governance practices that are mandated for stock companies, including the appointment of lead directors, executive sessions of outside directors and direct-line reporting of the internal auditor to the audit committee. We believe, however, that significant room for improvement stills exists at many mutuals. Financial control and reporting processes. Most large mutuals have voluntarily adopted processes that ensure the CEO and CFO sign-off on the integrity of the financials on a quarterly and annual basis. These processes resemble those adopted by stock companies, which have to comply with section 302 of the Sarbanes- Oxley Act of 2002 that requires such certification. Significant differences remain, however, in terms of how mutuals will adhere to section 404 of the Act, which requires stock companies to implement robust evaluations of the internal controls surrounding financial reporting. At present, none of the mutuals Moody s 4. Similar to a mutual, a reciprocal is not a publicly traded company and its assets are owned by its policyholders (described as either members or subscribers). 6 Moody s Special Comment

7 rates is in full compliance with 404. Most mutuals are considering a voluntary 404-lite process, where internal controls would be documented and tested internally, but neither the management team nor the external auditor would attest to the effectiveness of the controls. This approach is better than no controls review, but, in Moody s view, the lack of attestation could diminish its usefulness. We know of several mutuals that are aiming to be fully compliant in 2006/7, including management and external auditor attestations, which we view positively. 3. Some boards have to oversee the additional challenges inherent in the mutual holding company structure. Within the mutual company universe, those insurers that have adopted a mutual holding company structure with a view toward demutualization may have a difficult time balancing between the mutual and stock world. These mutuals often act like stock companies in terms of strategic and financial decisions and growth expectations and are compensated to this effect, but they do not have shareholders to hold them accountable for mistakes. In addition, within the P&C industry, several mutual companies have adopted a structure whereby they own more than 50% of a publicly traded subsidiary. In our view, this holding company structure is complex, and the group could be challenged about managing issues pertaining to both shareholder demands for returns on equity and the interests of mutual policyholders. Moody s Special Comment 7

8 Appendix 1: List of Insurance Company CGAs Published As of October 14, ACE Limited Allstate Corporation (The) American International Group, Inc. Berkshire Hathaway Inc. Chubb Corporation, The Genworth Financial, Inc. Hartford Financial Services Group, Inc. (The) Lincoln National Corporation Massachusetts Mutual Life Insurance Company MetLife, Inc. Nationwide Financial Services, Inc. New York Life Insurance Company Pacific Life Insurance Company Principal Financial Group, Inc Protective Life Corporation Prudential Financial, Inc. St. Paul Travelers Companies, Inc. (The) XL Capital Ltd Related Research Rating Methodology: U.S. and Canadian Corporate Governance Assessment, July 2003 (78666) Special Comments: Moody s Findings on Corporate Governance in the United States and Canada, October 2004 (89113) CEO Compensation and Credit Risk, July 2005 (93592) Takeover Defenses and Credit Risk, December 2004 (89713) Don t Bank on Strong Governance: Observations on Corporate Governance in US Banks, August 2005 (93743) Observations of Governance in U.S. REITs - Some Weaknesses But Getting Better, September 2005 (94031) Moody s Response To Rated Companies Receiving SEC Wells Notices, October 2005 (94627) 5. Moody s has published over 350 corporate governance assessments on North American issuers. 8 Moody s Special Comment

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