Sharing insights on key industry issues*...Paul Horgan, Felix Sutter and Mark Train examine why. Claims management best practices – A practical guide for claims executives and managers

InsurancedigestAmericas edition • October 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

Life insurance secondary guarantees: A competitive offering or a financial crisis in the insurance industry? 4Larry RubinExposure to secondary guarantees in the insurance industryhas increased dramatically in recent years. To attract assets inan increasingly competitive financial services industry, insurershave increased the levels of guarantees and options in theirproducts. Just how aggressive are these assumptions and whatare the risks to insurance companies? Larry Rubin examinesthe effects of market uncertainty on cash value accumulationlife insurance, with special emphasis on the risks in secondaryguarantees or no-lapse premium-guarantee policies.

The evolving role of the chief complianceofficer: The impact of new regulatoryrequirements 8Ellen WalshThe rapid adoption of new regulatory requirements has had aprofound impact on the role of a company's chief complianceofficer. In fact, new and proposed rules from the SEC andNASD describe specific expectations of the chief complianceofficer and their position within the company and inconnection to the board. This article provides an overview ofthese requirements and guidance for practical implementationnot only for the chief compliance officer, but for the enhancedexpectations of business leaders throughout the enterprise.For insurance companies with divisions subject to these rules,this article will provide context and interpretation for businessexecutives and compliance professionals.

Dynamic and demanding flow of capital:What influence will this have on market cycles? 12Andrew Rothseid and Joan Lamm-TennantIn the weeks and months following the tragic events of September 11, 2001, a number of factors convergedexacerbating the capital shock to the property casualtyinsurance industry. Eventually the strain on capital gave wayto an unprecedented number of rating agencies downgrades.This article reflects on the momentous three year period sinceSeptember 11, and provides a review of the new capitalsources entering the insurance market while offering aninteresting perspective for the market’s future.

Embedding risk management into the DNA of the business 18Paul Horgan, Felix Sutter and Mark TrainEnterprise-wide risk management (ERM) is now firmly on the boardroom agenda. Yet, a far-reaching new study carriedout by PricewaterhouseCoopers has found that many insurersare still grappling with the practical challenges of developingeffective ERM capabilities. Paul Horgan, Felix Sutter and Mark Train examine why.

Claims management best practices – A practical guide for claims executives and managers 24Steven Kessler and Barbara MurrayClaims operations face increasing challenges in meeting the demands and expectations of all stakeholders of theirorganization and claims executives frequently face a range of very tough questions on a variety of topics resulting in asignificant focus on achieving best practices standards. Thisarticle provides a practical roadmap for claims executives tofollow which will assist them in responding to these and othertough questions. It also offers insight into processes that canbe implemented that will lead the claims operation towardestablishing best practices processes and controls.

Update on IFRS, XBRL and Sarbanes-Oxley Act – Section 404 32Marie Braverman, Francesco Nagari, Robert Lembach and John S. ScheidBrief updates on three current topics – IFRS, XBRL andSarbanes-Oxley. International Financial Reporting Standards(IFRS) No. 4 for insurance contracts has been released andmost North American insurers are reviewing the similaritiesand differences from US GAAP. Developments in XBRL and the SEC's/insurance industry’s increasing attention to this initiative focuses on developments in this area followedby a review of the implementation progress assessmenttogether with a view of the substantial implementation costsassociated with corporate governance reform followingSarbanes-Oxley legislation as many insurance companiesapproach the first implementation date of December 31, 2004,imposed by Section 404.

Americas edition • October 2004

2 Insurance digest • PricewaterhouseCoopers

Heading into thefinal quarter ofcalendar year2004 manycompanies arecontinuing towonder whetherthey will be ableto keep pacewith the steady

stream of challenges that they are facing.Some of these challenges will be addressedin this edition of Insurance digest.

Global bond yields have risen following theUS Federal Reserve action in mid-Augustand the expectation is that rate hikes willcontinue at a measured pace. Oil price risesretreated briefly in early September onslightly better news from the Middle East.Other central banks across Europe and Asiahave raised interest rates as well. On theglobal stock market front, most markets roseas the oil price rise slowed. Most marketshave significantly outperformed the US over the last year, especially in dollar terms.US consumer confidence has fallen off a bit over the summer months. US homesales softened during the July-August

timeframe. Clearly all eyes are watching thefinal stretch to the US Presidential election in November 2004.

With the market uncertainty and thehistorically low interest rates, policy creditingrates have also declined as most cash valueaccumulation products have a portfolio-based crediting strategy. Since lower interestrates over a relatively small number of yearsshould not significantly affect the premiumrequired to mature the contract, lapse ratesshouldn’t materially change due to the currentlow interest rate environment. However, ifrates were to remain near today’s low levelsfor a number of years, a fairly substantialadditional premium could be needed andpolicyholders may be reluctant to pay thisincrease, potentially resulting in higher lapsesthan originally priced for. Recently there havebeen numerous effects on cash valueaccumulation life insurance. Our first article,written by Larry Rubin, looks at some ofthese effects with special emphasis on therisks in secondary guarantees or no-lapsepremium-guarantee policies.

Change and rapid adoption of new regulatoryrequirements is the nature of our second

Editor’s Comment

JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP

Welcome to theOctober 2004

edition of AmericasInsurance digest.

3Insurance digest • PricewaterhouseCoopers

article. Ellen Walsh discusses ‘The evolvingrole of the chief compliance officer’ in light ofnew and proposed rules from key regulatorslike the SEC and the NASD. Because the newrequirements have wide reaching implications,we believe this article will be of interest farbeyond the compliance and law departmentsof your companies.

Our third article reflects on the momentousthree-year period since September 11, 2001and provides a review of the new capitalsources entering the insurance market.Andrew Rothseid and Joan Lamm-Tennantoffer an interesting perspective for the market’sfuture in their article entitled ‘Dynamic anddemanding flow of capital: What influence willthis have on market cycles?’

Paul Horgan, Felix Sutter and Mark Train havetaken some of the knowledge gained from ourglobal study on enterprise-wide riskmanagement and discuss the challengescompanies have faced in embedding solidrisk management practices deep into thefabric of their organizations in our fourtharticle. While it is clear from our authors’experience that there can be no one size fitsall solution, they have offered some key

drivers for success, which you should find of interest.

Today claims executives are facing increasingchallenges in appropriately addressing allstakeholder expectations. Steven Kessler and Barbara Murray, in our fifth article entitled‘Claims management best practices – A practical guide for claims executives andmangers,’ offer some interesting insights anddeveloping ideas worth your review.

The last section of digest offers three shortarticles on topics recently covered inInsurance digest where a brief update iswarranted. International Financial ReportingStandards (IFRS) No. 4 for insurancecontracts is out and most North Americaninsurers are reviewing the similarities anddifferences from US GAAP. There are anumber of complexities and the update fromMarie Braverman and Francesco Nagaridiscuss the key aspects for your focus.Robert Lembach gives us an update ondevelopments in XBRL and theSEC’s/insurance industry’s increasingattention to this initiative. Finally, corporategovernance reform following Sarbanes-Oxleylegislation has been a focus for many

insurers. As these companies approach thefirst implementation date of December 31,2004 imposed by Section 404 of theSarbanes-Oxley Act, we have attempted to gather an implementation progressassessment together with a view of the very substantial implementation cost.

I hope you find this edition of AmericasInsurance digest interesting. I welcome yourfeedback on topics you would like to seeaddressed in future issues. Copies of thispublication and the Asia-Pacific andEuropean editions are available on ourwebsite (www.pwc.com/financialservices).

John S. ScheidEditor-in-Chief

Tel: 1 646 772 [email protected]

Life insurance secondary guarantees:A competitive offering or a financialcrisis in the insurance industry?

AUTHOR: LARRY RUBIN


The Life insurance industry's exposure to secondary guarantees hasincreased dramatically in recent years. As insurers face increasedcompetition within the financial services industry, they have increasedthe levels of guarantees and options in their products.

Exposure to secondary guaranteesin the insurance industry hasincreased dramatically in recentyears. In an effort to attract assetsin an increasingly competitivefinancial services industry insurershave increased the levels ofguarantees and options in theirproducts. While basic assumptionsthat determine the account andcash surrender values for universallife are generally set at a fairlyconservative level, secondary orno-lapse guarantees may bepriced aggressively with mortalitylevels typically 30-40% of the1975-80 table, interest rates at ornear 7% and lapse rates around7-10%. The no-lapse guarantee is designed to give comfort to theinsured that so long as they pay a minimum annual premium, thedeath benefit will be paid.

Just how aggressive are theseassumptions and what are therisks to insurance companies? In a recent special comment,Moody’s expressed concernabout the aggressive pricingassumptions of universal life no-lapse guarantees. Recentevents give credence to Moody’sconcerns. A review of theassumptions, some of theeconomic and market forces thatare impacting these assumptions,as well as lessons from anotherrecent insurance product that hasgenerated losses due to insurersnot recognizing market dynamicsaround the same key assumptionshighlights Moody’s concerns.

Interest rates over the past fewyears have been at levels that are lower than most actuariespractising today have seen in their careers. As a result manyactuaries feel comfortable thatinterest rates will rise and revert to a historical mean.

Over the long term the level of nominal interest rates shouldbe related to economic activity.Risk-free rates should reflect acombination of inflation andgrowth. CPI inflation averagedclose to 8% in the 1970s, close to5% in the 1980s and slightly lessthan 3% in the 1990s. So far this decade CPI inflation hasaveraged less than 2%. The fall in interest rates since the 1970smirrors the fall in CPI inflationsince then. When recognizing thatFederal Reserve Policy has a highpriority on controlling inflation,whose credibility in the capitalmarkets has been earned over thepast three decades, it is reasonableto assume that the inflationpremium in interest rates will beconsiderably lower than it hasbeen in the past and one couldjustifiably argue it is unreasonableto assume otherwise.

While CPI has dramaticallyincreased over the past 35 years,real GDP growth has beenremarkably stable. According tothe Bureau of Economic Analysis,average annual real GDP growthin the 1970s was 3.2%, in the1980s was 3.2% and in the 1990s

was 3.2%. Assuming acontinuation of 3.2% real GDPgrowth and a 2% inflation ratewould result in an estimate oflong-term treasury rates for theforeseeable future of 5.2%.Adding to this risk-free rate thenet (after capital losses) creditspread produces an estimatedinterest rate of approximately 6%over the foreseeable future. Whileassumptions that interest rateswill rise is consistent with thiseconomic framework, assumingthey will rise to the levels seen in some of the products pricedtoday may be overly aggressive.

Further support for this interestassumption can be gathered bylooking at the future level of interestrates implied by the forward ratecurve. Historically, forward rateshave tended to over-estimate thefuture rate level. Today’s forwardrate curve implies future swap ratelevels between 6 – 6.5%.

The 1975-80 Inter-companymortality table continues to be thestandard most companies use forpricing insurance risk (althoughsome companies are beginning tomove to the newer 1990-95 table).Recent papers submitted to theNational Association of InsuranceCommissioners have pointed outthe inadequacy of this table forolder age mortality. These papersfocused on the inadequacy ofusing a discount of the 1975-80table at older ages when producingillustrations. The experience

…many actuariesfeel comfortablethat interest rateswill rise andrevert to ahistorical mean.

LIFE INSURANCE SECONDARY GUARANTEES


gathered in the development ofthe 2001 CSO table indicates asignificantly steeper slope to themortality curve than indicated bythe 1975-80 table.

The most critical assumption in the pricing of UL no-lapseguarantees is the lapse rate. The higher the lapse rate the lesslikely a policyholder will be in-force when their no-lapse optionis in the money. For example atan 8% lapse rate more then 70%of the policyholders will no longerbe in-force in 15 years. When apolicyholder lapses a UL contractthe difference between thereserve and the cash surrendervalue is released. When aproduct is priced assuming a level of lapse this excess isdistributed to policyholders whopersist. Since policyholders wholapse distribute their reserve topolicyholders who persist, higherlapses can have a multiplierimpact on the price.

The history of Long-Term Careinsurance demonstrates some of the changes in policyholderbehavior that can occur when a policyholder loses value due to lapse. Similar to a UL no-lapseguarantee, a policyholder thatlapsed their long-term carecoverage would have theirreserve distributed among those who persist. The cost tothe policyholder of lapsing (lossof their reserve) had a dramaticimpact on policyholder behavior.Policies that were originallypriced with ultimate lapse ratesof 5-7% experienced lapse ratesunder 2%. The difference inpremiums between a 5% lapserate and a 2% lapse rate for this

coverage was over 35% of premium.

In addition to policyholderbehavior being directly influencedby the no-lapse option, thegrowth of the senior settlementsmarket can dramatically impacton expected lapse assumptions.While this market is still in itsinfancy, and experience to date is minimal, the continued fundingof this market by investmentbanks and off-shore fundsdemonstrates a willingness of the capital markets to enablepolicyholders to monetize theiroptions. The senior settlementmarket looks to find lifeinsurance policies where thepresent value of future deathbenefits is greater than thepresent value of future premiumsplus the cash surrender value.Where premiums are priced witha lapse assumption and thesenior life settlement market isable to value the policies withoutlapses a natural arbitrage exists.Secondary guarantees pricedwith high lapse rates could leadto rapid growth in the seniorsettlements market.

Moody’s special commentdescribes the good, the bad andthe very, very ugly. What Moody’sdescribes as the good is ascenario of an investment yield of7%, a lapse rate of 6% andmortality equal to 100% ofexpected, assumptions thatseem somewhat aggressivebased on the discussion above.These assumptions produced apresent value of distributableprofits of slightly greater than$20,000 for a $1,000,000 faceamount policy. What Moody’s

describes as the bad scenario isan investment yield of 5%, lapserates of 4% and mortality 150%of expected. This ‘bad’ scenariois probably closer to expectedbased on the discussion above.This scenario resulted in apresent value of distributableprofits approximately equal to–$30,000. (In the very, very uglyscenario of an investment yield of 3%, a 2% lapse rate andmortality at 200% of expected,the present value of distributableprofits approximately equaled–$100,000. This analysis abovewould suggest that this scenariomay be overly conservative).

Regulators, reinsurers and capitalmarkets have all demonstrated awariness regarding UL secondaryguarantees. As a counter-part toActuarial Guideline XXX, theNAIC (National Association of Insurance Commissioners) has adopted guideline AXXX.Similar to Guideline XXX,Guideline AXXX requirescompanies selling no-lapseguarantees to determine reservesusing a mortality table andinterest rates considerably lowerthan pricing and using a zerolapse assumption. In order tomeet statutory reserverequirement for XXX reserves,insurance companies typicallyenter into a co-insuranceagreement with an off-shorereinsurer. The off-shore reinsurerobtains a letter of credit from abank that obligates the bank tobecome a reinsurer should theoff-shore reinsurer fail in itsobligations. While a similarsolution could be used for AXXXreserves, reinsurers have chosento use their scarce letter of credit

capacity in the XXX market ratherthen expose themselves to thelapse risks of UL no-lapseguarantees.

Over the past two years a number of capital marketsalternatives have been developedfor XXX reserves. These solutionshave demonstrated the capitalmarkets willingness to acceptadverse mortality experienceassociated with term insurance.To date a similar solution has not been developed for AXXXreserves as the capital marketshave been unwilling to accept the level of inefficient exercise of options as indicated by ULlapse rates.

The insurance industry differsfrom other financial intermediariesin its ability to transfer andabsorb risk. It offers thesebenefits to its policyholders by offering guarantees. No guarantee offered by theinsurance industry is moreimportant than its guarantee thatthe sum assured will be there toprotect the policyholder’s familyupon the death of thepolicyholder. In offering a guarantee that so long as a minimum premium is paid the benefits will be paid, theinsurance industry is fulfilling its historic mission as well as its unique status in the financialservices industry. However, justas important is for the industry to maintain its financial strengthto deliver on its guarantees. In order to deliver, the industrymust carefully evaluate thepricing of its guarantees in lightof economic evidence, trendsand other relevant experience.

LIFE INSURANCE SECONDARY GUARANTEES continued



LIFE INSURANCE SECONDARY GUARANTEES continued

AUTHOR

Larry RubinPartner, Actuarial Insurance Management SolutionsTel: 1 646 471 [email protected]

The evolving role of the chiefcompliance officer: The impact of new regulatory requirements

AUTHOR: ELLEN WALSH


The role of the chief compliance officer has been profoundly impactedby the rapid adoption of new regulatory requirements. As new andproposed rules from the SEC and NASD outline specific expectations ofthe chief compliance officer and their position within the company andin connection to the Board, many companies are critically evaluating thescope of this role.

The rapid adoption of newregulatory requirements has had a profound impact on the role of a company's chief complianceofficer. In fact, new and proposedrules from the SEC and NASDdescribe specific expectations ofthe chief compliance officer andtheir position within the companyand in connection to the Board.This article provides an overviewof these requirements andguidance for practicalimplementation not only for thechief compliance officer, but forthe enhanced expectations ofbusiness leaders throughout theenterprise. For insurancecompanies with divisions subjectto these rules, this article willprovide context and interpretationfor business executives andcompliance professionals.

The chief compliance officer rolein insurance companies that offera variety of financial servicesproducts has been a standardposition that virtually allcompanies have implementedover the last ten years, and formany companies, for much longer.The nature of this role, and thecompliance function for thatmatter, varies greatly fromcompany to company, includingthe scope of responsibilities,stature of the position and the

connectivity with everydaybusiness functions. In addition,now there is clearer articulation byregulators of the expectations forthis role. All of these factors havemany companies criticallyevaluating the scope of the chiefcompliance officer role, reportinglines across the enterprise, and insome circumstances, asking thehard question of whether the rightperson holds this position. Similarto the evolution of the CFO role as a result of Sarbanes-Oxley, the CCO role is experiencing acomparable ‘face-lift’, or in the caseof many companies, this changeis more akin to radical surgery.

At the heart of these challengesare the proposal and adoption ofnew regulations that providespecific expectations of thecompliance officer. While suchregulations apply to financialservices companies withinvestment companies,investment advisers and affiliatedbroker dealers, they apply directlyto insurance companies that offermutual funds, as well as variablelife insurance and variableannuities with registered separateaccounts. As background, theSecurities and ExchangeCommission (‘SEC’ or‘Commission’) recently adoptednew rule 38a-1 under the

Investment Company Act of 1940and new rule 206(4)-7 under theInvestment Advisors Act of 1940,setting forth requirements for thecompliance programs ofinvestment companies andinvestment advisors registeredwith the Commission (‘Final Rule’or ‘Compliance Programs ofInvestment Companies andInvestment Advisors’). At a highlevel, the three basic requirementsof the Final Rule are for relevantentities to:

1. Adopt and implement writtenpolicies and proceduresdesigned to reasonably assurecompliance with the federalsecurities laws (and any rulesrelated thereto);1

2. Review the adequacy andeffectiveness of the complianceprogram annually; and

3. Designate a chief complianceofficer responsible for theadministration of the policiesand procedures.

This last requirement is the heartof the new SEC rules, andsimilarly, the NASD’s proposedrule 3013, ‘Annual Certification of Compliance and SupervisoryProcesses’, calls for thedesignation of a chief compliance

…the CCO role isexperiencing asimilar ‘face-lift’,…

THE EVOLVING ROLE OF THE CHIEF COMPLIANCE OFFICER: THE IMPACT OF NEW REGULATORY REQUIREMENTS


1 For purposes of the new rules, ‘federal securities laws’ include: the Securities Act of 1933 (15 U.S.C. 77a-aa), the Securities Exchange Act of 1934 (15 U.S.C. 78a-mm), the Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)), the Investment Company Act of 1940 (15 U.S.C. 80a), the Investment Advisers Act of 1940 (15 U.S.C. 80b), Title V of the Gramm-Leach-Bliley Act (Pub. L. No. 106-102, 113 Stat. 1338 (1999)), any rulesadopted by the Commission under any of these statutes, the Bank Secrecy Act (31 U.S.C. 5311-5314; 5316-5332) as it applies to funds, and any rules adopted thereunder by the Commission or the Department of the Treasury.

officer. In fact, in the guidanceincluded with the latest version of this proposed rule, the NASDexplains that the rule is ‘intendedto indicate the unique andintegral role of the chiefcompliance officer both in thedischarge of certain complianceprocesses and reportingrequirements that are the subjectmatter of the certification’. While these recent rule adoptionsand proposals provide clearexpectations of the CCO, otherregulations in recent yearsrelated to privacy and anti-moneylaundering also call for thedesignation of a complianceofficer to be accountable forsuch activities.

Using these specific rules asbackground, it is clear whyfinancial services companiesand, specifically, insurancecompanies are stepping backand questioning whether they are well-positioned from acompliance perspective. The chief compliance officer is by no means a figurehead, but rather, a key member of thesenior management team of thecompany. In companies thathave not fully embraced theimportance of the chiefcompliance officer role, they haveattempted to keep this positionat more of a middle managementlevel that reports to an individualin office of general counsel, in the business lines or in someinstances, to internal audit. In some cases, this person is a ‘compliance manager’ or‘compliance director’ withoutsignificant seniority in thecompany. The rules clearlysuggest that the chiefcompliance officer should be asenior executive who serves as a

key advisor to the chief executiveofficer with reportingrequirements to the board. With these stipulations, onewould have to seriously questionwhether a manager or director isan appropriate level for this role.For companies that have treatedcompliance at such a level, it isimperative that they re-examinethis function and the stature thatit has within the governancestructure of the enterprise.

From a practical implementationperspective, however, chiefcompliance officers and theirsenior executives must questionwhether one person can truly be responsible for the design andeffectiveness of compliancepolicies and procedures for anentire organization. The answerto this is clearly no, and tosuggest that the compliancecontrol environment rests on theshoulders of one individual wouldbe foolish. Just as the chieffinancial officer must rely oncontrollers and operations stafffor the implementation andongoing monitoring of financialcontrols across the company, so too must the chief complianceofficer rely on leaders in thebusiness lines and operations to implement and embedcompliance controls into thebusiness processes for whichthey are responsible.

The typical means for distributingsuch accountability forcompliance requirements isthrough a periodic certificationrelated to compliance controlsthat are embedded into businessprocesses and also those thatare layered on as back-endcontrols to such processes.Defining the scope of a

compliance certification can be just as challenging, in someways, as a financial controlscertification because there is not always a clearly defined‘roadmap’ of compliance controlrequirements akin to line itemson financial statements. In orderfor a chief compliance officer touse certifications from otherswithin the organization, asignificant amount of legwork is required to determine whetherit is even reasonable to rely onsuch certifications in an effort torepresent to the chief executiveand/or board that compliancepolicies and procedures arereasonably designed andoperating effectively. This legworkincludes the following steps:

1. Define the scope ofapplicable regulatoryrequirements to thecompany’s business(es).Although this may sound quitebasic, the complexity of federalrules and regulations as wellas the complexity of companies’products and distributionsystems, requires upfrontconfirmation of the applicablerequirements to the business.

2. Assess where the mostsignificant risks exist from a regulatory complianceperspective. While the scopeof recent compliance programcertification rules includes ‘allapplicable federal securitieslaws’, compliance officersshould initially focus efforts onthose areas that pose thegreatest risk to the firm. Thesetopics may include those thatregulators have placedsignificant focus on in recentyears, for example, latetrading and market timing of

mutual funds and variableproducts, as well assupervisory concerns overregistered representatives’sales practices. The full scopeof requirements, of course,applies. However, chiefcompliance officers may bewell-served to prioritize theirefforts in terms of significantrisk areas.

3. Translate regulatoryrequirements into clearlyarticulated compliancecontrol objectives. To makecompliance requirementsunderstandable to keyindividuals across theenterprise (not just those whoare concentrated in legal andcompliance roles), it isimportant to translate suchrequirements into controlobjectives that clearly articulate,in behavioral terms, what thegoal is. From there, operationsand business personnel canmore easily apply therequirements to reasonably-designed operating andcontrol procedures.

4. Gather and review thewritten policies andprocedures related to thecompliance controlobjectives. Many of theemerging regulatorycompliance requirementsspecifically state thatcompliance policies andprocedures must bedocumented. In ourexperience, many companiesmay have reasonably designedpractices but they are notdocumented. Taking the timeto prepare completedocumentation, while resource-constraining, is essential.

THE EVOLVING ROLE OF THE CHIEF COMPLIANCE OFFICER: THE IMPACT OF NEW REGULATORY REQUIREMENTS continued


5. Determine whereresponsibility lies across theenterprise for these items,from a direct operatingperspective as well as acompliance monitoringperspective. As mentionedearlier, compliance is not justthe responsibility of the chiefcompliance officer. Rather,there is distributedresponsibility across theenterprise within operations,sales and marketing and fielddistribution, as well as amongservice providers. To know thatall requirements are covered,a mapping of responsibilitiesand where they reside isnecessary to facilitate anykind of certification process.

6. Articulate what controlprocedures exist withinbusiness functions andoperational processes.Compliance controls that areembedded within businessprocesses can be quiteeffective, rather than relyingon solely back-endcompliance monitoringcontrols. This may requireorganizations to articulatetheir compliance-relatedprocesses in the form ofprocess maps that highlightwhere compliance controlsexist. Alternatively, companiesmay opt to use a form ofcompliance control matrix thatdelineates the procedures andrelated controls.

7. Evaluate where control gapsexist or where existingcontrols are poorly designed.Remediate on deficiencies. In our experience, the oldadage of ‘the devil is in the

details’ certainly applies tocompliance-relatedprocedures. It is not untilcompliance officers obtain a reasonably detailedunderstanding of howcompliance controls arecarried out in the operationsof the company (e.g., NewBusiness processing ofapplications and relatedsuitability controls) that theycan feel reasonably compliant.

8. Test the design andeffectiveness of thecompliance controls. As directed in the new SECcompliance program rule andproposed NASD rule, testingof compliance policies andprocedures is expected atleast annually. To accomplishthis goal, chief complianceofficers should consider howtesting can be conductedperiodically throughout theyear, to allow time to remediateon deficiencies noted.

9. Develop a process for theongoing assessment ofcompliance controls and ameans for modifying suchcontrols as changes in thebusiness occur. As with anyprocess that involves riskassessment and review ofpolicies, procedures andcontrols, the chief complianceofficer should develop aformal program for howcontrol enhancements will be identified and howimplementation of changes willoccur across relevant businessunits and operations. Suchcontinuous assessment andimprovement is the foundationof these new requirements.

Finally, it is clear that the profileof the chief compliance officerand the regulatory expectationsof the individual who holds thisposition have been raised to awhole new level. In addition tohaving the right person in thisposition, he/she must be well-equipped with the appropriatelevel of management support,

adequate resources withincompliance and/or distributedacross the enterprise, and thetools and technology which willenable compliance controls.Ultimately, without thesecomponents, can the chiefcompliance officer adequatelyfulfil regulatory expectations?


THE EVOLVING ROLE OF THE CHIEF COMPLIANCE OFFICER: THE IMPACT OF NEW REGULATORY REQUIREMENTS continued

AUTHOR

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

Dynamic and demanding flowof capital: What influence willthis have on market cycles?

AUTHORS: ANDREW ROTHSEID AND JOAN LAMM-TENNANT


Following the tragic events of September 11, the convergence of a numberof factors intensified the strain on capital in the property casualty insuranceindustry. While these events converged to strain the quantity and quality of capital supporting the property casualty insurance industry, new capitalbegan to flow into the (re)insurance industry at an unprecedented pace.

In the weeks and months followingthe tragic events of September 11,a number of factors converged,exacerbating the capital shock tothe property casualty insuranceindustry – the recognition ofreserve deterioration on the priorunderwriting years, renewedconcern regarding the adequacyof asbestos reserves and theinvestment losses resulting fromexposure to credit and/or equityrisk. By 2002, the industry’s surpluscapacity fell $45 billion from itsmid-1999 high of $336 billion.

Eventually, the strain on capitalgave way to an unprecedentednumber of rating agenciesdowngrades. In the first ninemonths of 2003, more than 20%of the 450+ property casualtyinsurance companies rated byStandard & Poor’s weredowngraded with only 7upgraded.1 Of the insurancecompanies downgraded,approximately 1/3 weredowngraded multiple notches.2

Amongst reinsurers, rating agencyactivity was even more intense.Standard & Poor’s downgradedseventeen of the top 27reinsurers; and of the reinsurersdowngraded most were reducedmultiple notches.3 While reinsurercredit quality deteriorated, theinsurers’ dependency on

reinsurance recoverablesincreased. According to A M Best,as of December 2002 reinsurancerecoverables reported by the USinsurance industry exceeded 80%of surplus versus 50% of surplusin 1998.4

While these events converged to strain the quantity and qualityof capital supporting the propertycasualty insurance industry, new capital began to flow into the (re)insurance industry at anunprecedented pace. Within sixmonths of September 11, over$20 billion of new capital raisingactivities were completed withanother $9 billion pending.5

Of this new capital entering the insurance markets in 2001,approximately $9 billion flowedinto Bermuda to support globalreinsurance opportunities.6 Capitalraising activities continued in 2002with $15 billion of new capitalentering the US and Bermudamarkets; and another $14.7 billionin 2003.7

In addition to significant amountsof new capital flowing into themarkets post September 11, the speed in forming the newBermudians was also remarkable.Many were operational in time toparticipate in the January 1, 2002market renewals. This was

achieved via the involvement ofindustry brokers and by theappointment of well-known industrynames to manage the start-ups.Speed to market was furthered bythe stock of pent up capital sittingin venture capital bullpens.

Looking back, many areastonished at the amount andspeed by which capital enteredthe (re)insurance markets. Was theamount of new capital, along withthe speed of entry, an anomalyonly explained by the rareconvergence of events?Alternatively, can we concludethat the (re)insurance markets are healthy, dynamic marketscapable of sustaining capitalshocks without externalinterferences? Market participants,who believe that the influx ofcapital is merely an opportunisticplay, are suspicious of thesustainability of the capital.Furthermore, if the members ofthe ‘Bermuda Class of 2001’ are, in fact, opportunistic players,are legacy players foreverchanged, and capable of thedisciplined underwriting behaviorneeded to stabilize cycles? Whileonly time will tell, the followingparagraphs will further evaluatethe sequence of recent events inhopes of garnishing insights intofuture market consequences.

Looking back,many areastonished at theamount andspeed by whichcapital enteredthe (re)insurancemarkets.

DYNAMIC AND DEMANDING FLOW OF CAPITAL: WHAT INFLUENCE WILL THIS HAVE ON MARKET CYCLES?


1 Underlying data provided by Standard & Poor’s.2 Underlying data provided by Standard & Poor’s; e.g. Ten insurers were downgraded from AA- to A+ with another five going from AA- to A.3 Underlying data provided by Standard & Poor’s.4 A.M. Best, December 2002.5 Cited in ‘Insurance & Risk Briefing’, Morgan Stanley, March 28, 2002.6 Cited in ‘Global Reinsurance’, Moody’s Investors Services, September 2003.7 In 2003 Europe raised $16 billion primarily through rights issues.

New Bermuda companiesFIGURE 1

US $ amounts in millions

Company Initial Capital Date Formed Sponsor Other Capital ProvidersRaised

Axis Specialty Limited $ 1,600 November 2001 Marsh JP Morgan Partners, Thomas H. Lee Partners, The Blackstone Group and CSFB

Allied World Assurance $ 1,500 November 2001 AIG/Chubb/Goldman Sachs Swiss Re Capital Partners and other outside investors

Endurance Specialty $ 1,200 December 2001 Aon Capital Z Financial Services Partners, Thomas H. Lee Partners, Texas Pacific Group, Perry Capital, GIC Special Investments, GM Asset Management, Lightyear Capital, CSFB, Golden Gate Capital, Reservoir Capital and TIAA-CREF

Montpelier Re $ 1,100 November 2001 White Mountains/Benfield Cypress Associates, DLJMB, C.V., Gilbert Global Equity,Century Capital and Prospector Partners

Quanta $ 500 September 2003 Management/FBR Friedman, Billings, Ramsey & Co. (initial purchase andplacement agent for private offering)

Source: individual company press releases, annual reports and Benfield Group PLC ‘Old Money, New Money – A Review of the Bermuda Reinsurance Market dated March 2002.’

New capital sources and theirunique strategies

The Bermuda start-ups werebacked by venture capital thatwas ‘new’ to the insuranceindustry such as JP Morgan, The Blackstone Group andCapital Z Financial Services.(Figure 1 lists the more notablestart-ups, the initial capital raisedand the capital providers.) Theseventure capitalists recognized the opportunity to profit frompost-event rate increases andpredicted shortages in reinsurancecapacity. In addition, they wouldenter the market with acompetitive advantage relative to legacy players, since the new start-ups would beunencumbered from prior yearreserve deficiencies.

Unless the recent Bermudiancompanies initiate new foundedunderwriting, reserving andpricing disciplines, then time willbuild imbedded drags on theirbalance sheets similar to thosewhich legacy players bear today.To date the new Bermudianshave demonstrated the ability to maneuver the market sectorswith agility. The managementteams of the Bermuda start-upsinitially targeted property marketsbut, to their credit, severalexpanded into specialty andcasualty reinsurance lines andeven into primary insurance asproperty markets reachedcapacity. The new companies’willingness to adapt provideshope that these firms will deliversufficient pricing discipline toballast market swings allowing

them to meet the demands ofcapital providers. Neverthelessthis agile strategy does requireunderwriting, reserving andpricing expertise in manyspecialized markets as well asthe ability to anticipate and timemarket sector swings.

It is interesting to note that many (re)insurers whose originspre-date September 11 areemploying market strategiesdifferent from their newBermudian competitors. These companies are focusingon strategically core operationsto build pricing strength andrestored underwriting profitability.For example, primary companieswho operated assumedreinsurance divisions were exitingthe reinsurance market to focus

capital and resources on theircore insurance operations.Chubb Re remains the last manstanding of the four large primaryinsurers underwriting reinsurance,with St. Paul being the first toexit via the spin-off ofPlatinum/St Paul Re.

Growth and return targets

These ‘new’ investors enteringthe industry bring with themexpectations as to the level ofexpected return and the timeframe over which their capital willbe deployed. Annual reports fromthe new Bermuda companiesuniformly espouse long-termexpected RoE hurdles in the15% to 20% range. From ahistorical perspective, theindustry as a whole has not beenable to generate this level of

DYNAMIC AND DEMANDING FLOW OF CAPITAL: WHAT INFLUENCE WILL THIS HAVE ON MARKET CYCLES? continued


IPOs and secondary offeringsFIGURE 2

Source: Individual company press releases and annual reports Initial Public Offering Secondary Offering.

return on a sustained basis in thepast. Even within the Bermudacommunity that existed prior toSeptember 11, consistent, andfor that matter positive, RoEshave proved elusive.8

Commitment to the market

Given the inherent nature ofventure capital, exit strategiesgenerally are completed in shortorder. If market pricing has trulypeaked and maneuvering marketsectors falls short of expectations,then pressure to expedite the exitstrategy will increase. Thisexodus is already underway asFigure 2 illustrates. If the exoduscontinues and if the exodus isorderly, then perhaps the marketdynamics recently experiencedfollowing a capital shock will

become a new phenomenon.Alternatively, the absence of anorderly exodus may mark theserecent events as an anomaly withcapital contributors hesitant toreturn after the next crisis.9

Will historic problems be repeated?

Significant responsibility forbreaking the cyclical patterns of the industry has been focusedon senior management and thedirection it provides. The talkfrom both established marketsand new Bermuda start-ups is that they are RoE focused,with growth secondary to themaintenance of underwritingstandards. At the same time, the new Bermuda markets havemade significant inroads, with the

companies identified in Figure 1having written $1.6 billion and$2.9 billion of reinsurancebusiness in 2002 and 2003,respectively.

As previously noted, a number ofnew Bermudians haveconcentrated more resources oncasualty reinsurance to maintaingrowth as property has softened.Most have also opened, or areplanning to open, a Europeanoffice to support businessexpansion. In isolation these plansseem logical but given that thestrategy appears somewhatverbatim in four or five annualreports of the new Bermudianstart-ups, one questions ifmaneuvering market sectors will actually support the

expectations of the new capitalproviders.10

Yet there are some counterbalancessuggesting that discipline may bemaintained and expectationsmet. The increased use ofmodeling and analysis will helpprevent some of the ‘artistic’underwriting decisions of thepast. Management and externalauditors are cognizant of theheightened professional andpersonal risks involved in takingan ‘aggressive’ stance as regardsfinancial reporting. This mayprovide management with theadditional level of fortitudeneeded to sustain underwritingstandards through a softeningmarket regardless of growthimplications.



8 Benfield Group ‘Old Money, New Money: A Review of the Bermuda Market’ dated March 2002.9 Cited during the World Insurance Forum’s roundtable ‘What is the future of the trillion dollar plus global reinsurance market?’ which can be replayed on the internet by going to www.worldinsuranceforum.bm10 Individual company press releases and 2003 annual reports for Axis Specialty Limited, Allied World Assurance, Endurance Specialty, Montpelier Re and Quanta.

US $ amounts in millions

Initial Public Offering Secondary Offering

Company TKR Date Shares Amount Date Shares Amount toRaised Founders

Axis Specialty Limited AXS July 2003 13,400,000 $ 295 a April 2004 23,000,000 $ 640

Endurance Specialty ENH February 2003 9,600,000 $ 200 March 2004 9,800,000 $ 340 b

Montpelier Re MRH October 2002 10,950,000 $ 200 June 2003 8,000,000 $ 240 c

a 13.4 million shares issued by company ($295 million) and 8.0 million ($176 million) sold by investors.b 2 million shares ($65 million) also repurchased directly from founder, share repurchase program in place.c 1.2 million shares ($44 million) also repurchased from founder, share repurchase program in place.

Will alternate capital sourcesballast potential bermudianstart-ups withdrawal?

We have seen three market(re)emergences which mayprovide a ballast to capitalpressures should the newBermudian start-ups exit themarkets. First, an increase infinite reinsurance is evident,although rating agencies andauditors have begun to lookmore closely at the amount ofrisk that is actually beingtransferred to the reinsurers insuch arrangements. Second,Pooled Trust Preferred Securitieshave been developed as avehicle to allow smallercompanies to participate in thetrust preferred market even ifthey were too small to attractinvestors on their own. This‘hybrid’ capital source providesthe benefits of debt, with regardto the tax treatment onassociated capital costs, yet isthe more favorable capitaltreatment, of equity by ratingagencies.11 The more favorablecapital treatment and perceivedlower cost made these productsan attractive source of capital.Lastly we have seen an increasein the securitization ofcatastrophic risk and potentialinterest in securitizing other non-catastrophic exposures.

Meaning for the future of the market:

Pricing impact

To date it would appear that,generally, the new Bermudastart-ups have acted responsibly.The more difficult question iswhether the pricing strength is anillusion that will erode throughless observable factors such asexpanding terms and conditionsand potential loss volatility. Thepressure on loosening contractlanguage has begun, as cedantsare willing to trade pricingconcessions for ongoingbusiness. This will be of greaterconcern going forward,especially given market capacityand the pressure to retainbusiness. Furthermore, as buyerscontinue to search for innovativeand, perhaps, more streamlinedcapital sources/risk transfervehicles, pressure will build onthe reinsurance market to priceproducts more aggressively.

Length and breath of the cycle

Earlier this year, an industryanalyst predicted that 2005would be the RoE peak for theindustry as a whole and thatpublicly traded reinsurers wouldcap out at RoEs in the mid-teens.12 Discussion within thereinsurance community indicates

that property business hasalready softened and thatcasualty business will level off in 2004.

Cycles are likely to be repeated,even in the best of scenarios, butperhaps not as severely. In thepost-Enron world volatility ofindustry, results will likelyincrease as management ispressured to set reserves at morerealistic levels, be that positive ornegative. With a smaller ‘bank’ ofredundant reserves accumulatedduring hard markets, reinsurerswill find it more difficult to sustainreported earnings andprofitability through an extremesoft market, hopefully decreasingthe down cycle’s severity.

Unfortunately the entrance barrieris low, evidenced by the newBermudians’ entry to the market.While they have maintainedpricing discipline, they haveblunted the upside of the cycle;carving out slices of profitableprograms that otherwise wouldhave gone to existing marketsand contributing to the abundanceof capital once the ‘target price’is attained. Engineering asustained hard market willbecome increasingly difficult inthe future. One hope is that whilethe height of hard markets maynot reach levels experienced in

the past, perhaps the length willhave an offsetting effect.

Conclusion

Reinsurers that have participatedin the market over the past twoyears have enjoyed a clearopportunity to earn above marketreturns. It is encouraging to hearthe commitment to underwritingthat is universally professed.Given the market displacementthat has occurred and the impacton a number of managementteams, both on a professionaland personal level, one wouldlike to believe that thesecommitments can be sustainedis spite of the historical relapsesof the industry. That being said, a number of factors may make it difficult to fulfil the pledge toend the cyclicality of the industry.In this article, we have brieflytouched on the new investorsthat have participated in thecurrent round of financings andsome of the recent problems thatmay arise as a result. We hope to expand on these issues infuture articles and delve furtherinto new products that have been created.



11 9th Annual CEO Roundtable (hosted by American Re) – Managing Capital Strategies.12 Dowling & Partners IBNR Weekly #4, Vol. XI.

AUTHORS

Andrew RothseidManaging Director, Global Restructuring Services,PricewaterhouseCoopers LLPTel: 267 330 [email protected]

Joan Lamm-Tennant, Ph.DSenior Vice President, General Reinsurance CorporationTel: 203 328 [email protected]



Embedding risk management into the DNA of the business

AUTHORS: PAUL HORGAN, FELIX SUTTER AND MARK TRAIN


The most extensive study ever conducted into enterprise-wide riskmanagement (ERM) in the insurance industry has found that manycompanies are still struggling to get beyond the design and planningstage of ERM. Paul Horgan, Felix Sutter and Mark Train look at what the study reveals about the challenges facing insurers in developingeffective ERM capabilities.

Since the 1990s, many forward-thinking insurers have been lookingto develop a more holistic andsophisticated approach to riskmanagement. However, it is onlylately, in the wake of escalatingclaims, solvency scares andgovernance scandals, that ERMhas come to wider prominence.

ERM has long been seen as a valuable safeguard againstoperational risks, earningssurprises and reputationaldamage. Now, more and morecompanies are exploring howERM can enhance the basis fordecision-making through a betterunderstanding of the trade-offsbetween risk and reward, leadingto smarter capital allocation, a swifter response to marketmovements/opportunities and hence to more sustainableshareholder value creation.Indeed, a number of insurers arealready using their ERM data tochallenge their underwriting andinvestment assumptions andenhance their understanding ofrealistic risks, for example thoserisks associated with guaranteeddeath benefits.

Looking ahead, a fresh wave ofregulation including Solvency II andthe 8th EU Directive on StatutoryAudit, the European version of theUS Sarbanes-Oxley legislation(‘Euro-Sox’), is likely to provide afurther catalyst for the developmentof ERM. In particular, ERM canprovide an infrastructure of

information and control capable of strengthening governance and facilitating compliance withdifferent regulations across avariety of jurisdictions. Moreover,by providing a common platformfor regulatory observance, ERM can prove more robust,systematic and cost-effective than the often cumbersome and duplicating piecemealapproach to compliance.

In short, ERM helps break down the standalone silos of riskmanagement to create a commoncontrol network and ‘language’ ofrisk. Indeed, if today’s silos couldbe likened to a musician playingsolo, then ERM represents awhole orchestra through whichindividual musicians transcend the sum of their parts.

However, ERM is still an evolvingdiscipline and many companiesface significant challenges inimplementing and fine-tuning theirERM programmes. Earlier thisyear, PricewaterhouseCooperspublished Enterprise-wide RiskManagement for the InsuranceIndustry, one of the most detailedstudies of ERM ever conductedwithin insurance worldwide, aimed at pinpointing what makes ERM work in practice.

The study draws on an in-depthsurvey of 44 companies fromAsia, Australia, Europe and NorthAmerica. All the participants arerecognized as leaders in their

respective markets, with theturnover of 30 of the 44 beingmore than US$5 billion and 20 more than US$10 billion. Thequestions covered infrastructureand analytical issues includingorganization, governance, riskaggregation, capital allocation,data and systems. They alsolooked at specific risk categoriesincluding credit, investment andoperational risk, along with the issues facing particularindustry sectors includingproperty and casualty and life andhealth underwriting.

The survey confirms that riskmanagement is now a Board/CEOpriority, with the protection ofshareholder value emerging as the main benefit (see Figure 1overleaf). However, it alsorevealed a mixed picture ofattainments and expectationsfrom ERM programmes (seeFigure 2 overleaf). In particular,only 5% of respondents felt that ERM was fully integrated with strategic business decisions.Similarly, only one of thosesurveyed described theirorganization as proactive in ERM,which is arguably the essence ofeffective ERM. Significantly,almost all of the participantswould like to be proactive in ERMwithin five years.

Hurdles to overcome

Clearly, one of the key challengesis translating the boardroom visionof ERM into a programme that is

…ERM represents a whole orchestrathrough whichindividual musicianstranscend the sumof their parts.

EMBEDDING RISK MANAGEMENT INTO THE DNA OF THE BUSINESS


embedded and valuedthroughout the organization.However, as Figure 3 highlights,many respondents are finding itdifficult to make headway in ERMin the face of uncertain directionand understanding. Only two-thirds of participants felt that theroles and responsibilities drivingERM were understood within theorganization as a whole. Onlyaround 50% or less of thosesurveyed acknowledged that the strategy, processes, missionand objectives or tools andtechnologies underpinning ERMwere even partially understood.In short, if we see ERM as anorchestra, then many key players

are out of time or struggling withthe score.

A rich vein of consistent andcomprehensive data is thelifeblood of ERM. However, it isevident from the survey that thecommunication of riskinformation around the enterpriseis generally weak, with only oneparticipant describing riskreporting as very effective andless than 50% of those surveyedbelieving that it is quite effective.

On a portfolio level, theseshortcomings tend to stem fromgaps in systems capabilities anddata availability. Only a third of

respondents were either very orquite satisfied that their currentinformation technology systemscan meet the required frequencyof risk management reporting.Similarly, only a third of thosesurveyed rated their datastrategy as good.

Any technical and organizationalstumbling blocks will naturallyimpact on the performance ofERM. While most of thosesurveyed are making strenuousefforts to put risk controls inplace, only 39% feel that theirlimits and exceptions monitoringare quite strong and only twoparticipants very strong.

Similarly, systems hurdles andproblems in sourcing timely andreliable risk information meanthat most of those surveyed arestill struggling with the data andmodeling challenges of creatingeffective risk aggregation andrisk-based capital allocation.Only 6% of respondentsaggregate across all risk factorsand business lines. Thedifficulties in developing viablecapital allocation methodologiescan be seen in the fact that more than 40% of respondentsrequired between three and five years to implement theircurrent systems.

EMBEDDING RISK MANAGEMENT INTO THE DNA OF THE BUSINESS continued


0 20 40 60 80 100

Risk management is aboard/CEO priority

Clearly defined standardsexist for risk-taking activities

ERM programme is animportant part of our

interaction with regulators, rating agencies and investors

Common terminology andprocesses for all risks

are well understood

ERM is fully integratedwith strategic

business decisions

% of respondents who strongly or slightly agree that

5% 38%

8% 48%

9% 47%

16% 51%

19% 62%

77% 23%

Risk systems produceinformation that supports

risk management objectives

Strongly agree Slightly agree

Mixed ERM attainments and expectationsFIGURE 2

Source: PricewaterhouseCoopers Global ERM Survey, 2004

Main Second Third

14%

12%

5%

2%

7%

7%

8%

13%

17%

18%

20%

25%

35%

45%

64%

2%

0 2010 30 40 50 60 70

Balanced risk capabilities

Soundness of corporate management and stable growth and profits

Control breakdowns reduced

Too early to say

Complete/consistent operationalrisk information

Regulators satisfied

Process improvement facilitated

Reputation protected

Common risk language established

Strategy clarified

Losses reduced

Quality or service improved

Cross-enterprise risk identified

Awareness of enterprise risk increased

Improved capability to predictenterprise risk

Shareholder value protected

Main benefits of risk managementFIGURE 1


While data management is aproblem in all financial servicessectors, the difficulties faced byinsurers in sourcing the rightinformation are especially acute.In part, this stems from thecontinuing lack of investment inclaims systems, which not onlytends to make data hard tosource, but also difficult tocompare. Insurance datacurrently lacks the commonlanguage or ‘notation’ that couldmake risk integration far easier to achieve. The move to anXRBL coding language, ideallyacross all enterprises, would notonly speed up the disseminationof information, but also improve

comparison and aggregation.The banking industry has alreadypaved the way through its ORXsystem, which enablesinstitutions to pool, analyze andaggregate empirical data.

Important strides

While the survey highlights someof the difficulties to be overcome,it also demonstrates how manyinsurers are beginning to bringgreater clarity to their ERMmission and integrating theirprogrammes into the overallmanagement of the enterprise(see Figure 4 overleaf) – practiceis paying off.



0 10 20 30 40 50 60 70 80

Scope of each risk committee

Roles and responsibilities

Terminology (e.g. definition of risk)

Mission and objectives

Processes

Tools and technology

% of respondents who stated that certain aspects of their ERM programmes are understood throughout the organization

12% 48%

44%22%

12%

45%

43%

10%

5% 45%

2% 40%

26%

Strategy

Completely understood Understood

Firm-wide understanding of key components of the ERM programme

FIGURE 3


As they tackle the technical andorganizational challenges of ERMimplementation, they can marrytheir deeper understanding of the risks faced within theorganisation with new insightsinto the risks and opportunitiesfacing them in the externalenvironment. For example, oneparticularly advanced companyalready has procedures in place

to correlate ERM indicators andlosses and use these indicatorsfor predictive analysis. However,it should be stressed that nosingle participant, nor indeedparticular country or industrysector, was universally strong in all areas of ERM.

Key drivers for success

It is clear from our experiencethat there can be no ‘one size fits all’ solution for developingeffective ERM in such a diversebusiness as insurance. However,Enterprise-wide RiskManagement for the InsuranceIndustry identified a number ofguiding principles underpinning

successful ERM that haveemerged from both the recent survey andPricewaterhouseCooperscontinuing work and dialoguewith the insurance industry:

• Sound governance underpinsstable rewards and sustainableshareholder value creation.Senior management needs toensure that risk management isa priority and manage businessactivities in a way thatproduces consistent andpredictable returns;

• Senior management isresponsible for defining andcommunicating the company’srisk appetite including settingtargets for shareholder valuecreation and tolerances forearnings variance that are thencascaded down to individualbusiness units;

• Roles, responsibilities andaccountabilities should beclearly defined. Business unitsare responsible for identifying,taking and mitigating risks. The risk management functionis responsible for ensuring that appropriate limits, policiesand procedures are in placewithin the business units. The audit function verifies that controls are in place and operating effectively;

• Active management of risk isideally delegated to corporate riskcommittees, either at a portfoliolevel or relating to specific riskcategories as appropriate. Thesecan be supported by businessunit representation or furthercommittees at the business unit level;



0 10 20 30 40 50 60

All risk management processes and controls areevaluated according to frequency, completeness,

timeliness, consistency and sophistication

A risk management training programme isestablished and operating effectively

Correlations between indicators and losses areunderstood and leading indicators are utilized

for predictive analysis

The company utilizes an effective self-assessmentprocess annually as part of the strategic

planning process

Process improvements or mitigation basedon analysis of risk events are developed

and implemented

Escalation triggers are tiered from theCEO level down through the organization

A clear vision and goals have been established forERM and business units are involved in defining

the risk management initiative

Technology and process improvement are viewedas long-run business enablers and not as a cost

to be controlled

Service contracts are effective in transferringall appropriate risks to the third party

An enterprise risk committee is establishedand actively managing risks

The ERM unit is responsible for setting firm-wide standards for risk management

Internal audit and other oversight functions reviewrisk events based on predetermined criteria

Enterprise risk indicators are available tomanagement at any time during the month

Enterprise risk management practices that are in place and are operating effectively or have certain aspects that are not operating effectively

14%

2% 14%

9% 18%

2% 24%

5% 23%

2% 28%

5% 29%

8% 26%

7% 33%

33%7%

19%26%

28%21%

35%16%

Practice is in place and operating effectively

Practice is in place; however certain aspects are not operating effectively or as intended

At what level is your ERM programme operating?FIGURE 4


• It is critical to agree and applyclear policies and standardscovering risk identification,monitoring, analysis andreporting across all risk typesand business units;

• The measurement andaggregation of risk(s) across theenterprise needs to be basedon consistent methodologies.Companies will need to discernan appropriate balance betweenquantitative and qualitativeapproaches. They will alsoneed to capture all volatility and correlation variables;

• Companies need to be able to turn timely, reliable andcomprehensive data intodecisive management action.Some companies are nowdeveloping executive‘dashboards’ that combine key risk and performanceindicators; and

• Systems capabilities need toprovide the necessary quality,integrity and timeliness of data.Key applications include riskdetection, measurement,escalation and analysis of risks and returns.

Knowing the score

Many of the findings of thissurvey are echoed in the recently published Uncertaintytamed? The evolution of riskmanagement in the financialservices industry, the latest in our series of pan-financialservices briefings, carried out in partnership with the Economist Intelligence Unit. Both Uncertainty tamed? Theevolution of risk managementin the financial servicesindustry and Enterprise-wideRisk Management for theInsurance Industry highlight thevital importance, and thechallenges, of developing a morerigorous and coherent approachto risk management. However,once insurers begin to overcomethese hurdles and enhance theirability to measure, analyze andrespond to risk, ERM is likely to play an ever more proactiverole in identifying the strongestsources of earnings andstrengthening the execution of the strategic plan. Theeffectiveness of ERM is thereforelikely to emerge as a keycompetitive differentiator.

However, ERM is not an end initself, rather an integral part ofthe effective governance andmanagement of the business.Indeed, most of the key driversoutlined in Enterprise-wide RiskManagement for the InsuranceIndustry can be achieved bybreaking down the risk silos andimproving the co-ordination ofexisting capabilities rather thancreating an additional andpotentially redundant tier of riskmanagement. Nevertheless, tobe successful, people at all levelsof the organization need tounderstand their responsibilitiesand appreciate the true nature/extent of the risks they are taking.

We will begin work on a follow-up study later in 2005 and it willbe fascinating to see how theindustry has progressed. In themeantime, we would be pleasedto help companies to completethe questionnaire and provide a‘scorecard’ and comparativeanalysis of their progress in ERMcompared with the earlier surveyresults. We would also bepleased to help previousparticipants to update theirscores, either across all sectionsor in specific areas.

To download a copyof Enterprise-wideRisk Managementfor the InsuranceIndustry orUncertainty tamed?The evolution of riskmanagement in thefinancial servicesindustry, please visitwww.pwc.com/financialservices



AUTHORS

Paul HorganUS Insurance Advisory Practice LeaderTel: 1 646 471 [email protected]

Mark Train Partner, Actuarial Insurance Management SolutionsTel: 44 20 7804 [email protected]

Felix SutterLeader SPA (Systems and Process Assurance) Insurance, SwitzerlandTel: 41 1 630 [email protected]

Claims management bestpractices – A practical guide forclaims executives and managers

AUTHORS: STEVEN KESSLER AND BARBARA MURRAY


As claims operations confront the demands and expectations of allstakeholders of their organization, claims executives place significantfocus on achieving best practices standards.

Introduction

Today’s claims operations arefacing increased challenges inmeeting the demands andexpectations of all stakeholders of their organization. Claimsexecutives regularly face verytough questions on a range oftopics. How accurate are lossreserves? Are we paying toomuch for or even properlymanaging our outside servicesuppliers? Are subrogation andsalvage recoveries as robust asthey should be? Are our claimsprocesses and controls workingas they should? Are we compliantwith Sarbanes Oxley and 404requirements? As a result,significant focus is placed onachieving best practicesstandards. This article will providea practical roadmap for claimsexecutives to follow that will assist

them in responding to these andother tough questions and offerinsight into processes that can beimplemented that will lead theclaims operation towardestablishing best practicesprocesses and controls.

The desired state

Let’s start by taking a look at thehigh-level functional characteristicsof the ‘Desired State’ claimsorganization (see Figure 1).

The order of these characteristicsand the ability to deliveroutstanding results related tothese criteria in qualitative andquantitative measures are vital to the success of achieving anoperation that meets bestpractices standards. For example,without a well-balanced andtrained field staff with well-defined

goals and performancemeasurements and an ingrainedgood-faith claims handlingphilosophy, the rest of thecharacteristics will be difficult toimplement. We will now visit eachof these criteria in greater depth.

Developing a dedicated staff

The aspects to developing aqualified and disciplined team arefar too great to address in detailwithin this article. As such we willhighlight some of the basics thatclaims executives may find helpfulin this area in terms of trainingand performance goals andmeasurements. Training and on-going education are vital to thesuccess of the claims team. Thedecisions and actions taken byclaims and associated personnelare impacted by the externalenvironment. Changes in

Training and on-goingeducation arevital to thesuccess of theclaims team.

CLAIMS MANAGEMENT BEST PRACTICES – A PRACTICAL GUIDE FOR CLAIMS EXECUTIVES AND MANAGERS


Characteristics of a ‘Desired State’ claims organizationFIGURE 1

• A dedicated staff with the optimum blend of skillsand experiences to handle the current andanticipated workload, the loss exposures andplanned growth;

• Good-Faith claims handling principles;

• A ‘Learning’ organization;

• Aggressive pursuit of subrogation and otherrecovery opportunities;

• Sound management of engaged suppliers;

• Regularly scheduled reviews of claims files toconfirm file quality requirements are being met and opportunities for improvement recognized;

• A Claims system that supports and enhances theclaims handling function while tracking appropriatefinancial activity; and

• A system of performance indicators or benchmarksthat provide a means of targeting and measuringresults in qualitative and quantitative terms usedby management and stakeholders to measure thesuccess of the claims operation.

Source: PricewaterhouseCoopers

regulation, laws and the views of the public that make up juriesrequire a claims staff to be wellinformed in order to implementthe most appropriate solutions.

Claims departments, as well asall other functions of aninsurance or related organizationare also subject to their internalenvironment. Changes inorganizational structure, systemsor business objectives alsoimpact the claims operations andpersonnel. Organizations mustdetermine, based upon theirmeans, business goals andexposures which traininginitiatives will best allow them to stay in tune with theirenvironment and enable them toeffectively and efficiently meettheir goals and objectives.

In addition, performance goalsand measurements must beestablished in a way that theyreflect the mission of the overall

organization and the claimsfunction. Goals that are welldefined with stated expectationsand measurements, and thathave the buy-in of the team, aswell as management, have thebest chance for bringing aboutthe desired results. Thecommitment from the team toachieving the goals cannot beunderstated. Many leaders havefound that involving the team inthe process of establishing thegoals and performancemeasurements ensures itscommitment to its success. This, however, does require theleadership to ensure the team iswell informed and educated withrespect to the mission of theorganization and in tune withboth its external and internalenvironments.

Good Faith Claims Handling

Figure 2 lists the key elements ofGood Faith Claims Handling:

Good Faith Claims Handling isderived, interestingly enough,from the NAIC Model UnfairClaims Practices Act. If a claimsorganization knows what it takesto create ‘bad faith,’ it canengineer anti-bad faith or ‘Good Faith’ techniques into theorganization. All aspects of thehandling of losses andmeasurement of the claimsorganization’s success need tobe grounded in a ‘Good Faith’claims management philosophy.The operations, processes andcontrols, as well as the claimsfiles themselves, need to reflectthe efforts of the organization’scapabilities to operate underGood Faith practices.

Good Faith Claims Handling isgrounded in the notion that at theoutset of the investigation of anewly reported claim, theassigned adjuster and engagedconsultants investigate the claimwith an open mind about policy

liability. All benefits of the doubtregarding policy liability must beconstrued in favor of thepolicyholder. The policyholdershould not be surprised by theadjuster’s findings. An opendialogue should be maintainedthroughout the claims cycle. If this way of doing businessbecomes ingrained in the cultureof the claims organization,customer satisfaction measureswill usually be quite high andsustained over time.

This philosophy should not beequated with payment to thepolicyholder of more than what isdue. There will be instanceswhere the investigation leads tothe only possible conclusion thatliability has to be denied in wholeor in part. However, in thesesituations, if the policyholderknows through exquisitecommunications that the adjusterperformed a sound and thoroughinvestigation, construed allbenefits of the doubt in theirfavor, was kept up to date duringthe investigation and was treatedfairly and appropriately, thedenials will be met with less furorthan they otherwise would havebeen. Should a matter proceedto litigation despite everyone’sattempts to avoid it, the claimsexecutive and organization willbe in a better position to defendany alleged bad faith.

Specific states have clearlydefined regulations applicable toclaims operations dealings withits insured’s. In such cases,claims organizations should lookto these guidelines as the criteriafor their operations and ensurethat the claims team is educatedon the specifics of the

CLAIMS MANAGEMENT BEST PRACTICES – A PRACTICAL GUIDE FOR CLAIMS EXECUTIVES AND MANAGERS continued


Key elements of Good Faith Claims HandlingFIGURE 2

• Prompt, thorough investigation of thecircumstances of the claim without pre-conceived notions of liability in partnership withthe policyholder and their engaged consultants;

• Verbal and written advice to the policyholder ofall activities undertaken or to be undertakenduring the course of the investigation andadjustment of the claim;

• Timely response, both verbally and in writing,whenever the policyholder requests action fromthe claims organization;

• Policy liability and claims process issues areanticipated early on and ways are found to dealwith them promptly, professionally andeffectively. Then confirmed in writing;

• Payments are made in a ‘timely’ fashion in accordance with agreed policyholderexpectations;

• Payments of undisputed portions of the claimare made as soon as there is agreement on anamount owed even though other portions of theclaim may remain in dispute; and

• If, after a thorough investigation, liability for allor a portion of the claim does not exist, thepolicyholder should immediately be advisedboth verbally and in writing, citing specific,relevant policy language.

Source: PricewaterhouseCoopers

regulations that apply to them.With that said, in areas wherethere are no clearly definedprotocols offered by theregulating body, we offer thefollowing as guidelines as towhat constitutes ‘timely’ in thecontext of key elements of GoodFaith Claims Handling notedabove. Notice of loss should beacknowledged in writing withinten business days. Requests foraction by the policyholder shouldbe acknowledged in writingwithin ten business days.Coverage or lack thereof shouldbe confirmed in writing within ten days of the determination of liability. All denials of liabilityshould first be communicated inperson and then confirmed inwriting. If an investigation of thecircumstances of the claim isgoing to be protracted (generallytaking longer than 30 days on acomplex property claim) thepolicyholder should be advised inwriting when the investigation islikely to be concluded. Claimspayments should be made withinthe time parameters spelled outin the policy or as agreed uponwith the policyholder during theclaims process.

There are several ways tomeasure adherence to this keyprinciple. The second and thirdoption can be done alone or intandem with the first:

• Reviews of the claims files(claims management shouldparticipate in these reviews);

• A re-inspection process; and

• Holding focus groups with orinterviewing policyholders thatsuffered losses.

Baseline measurements can bemade and then incrementalimprovement targets establishedfor the year. Best in classmeasurement for this principlewould be near ‘zero-defect’ aslack of adherence to it can havedire consequences in terms ofbad faith exposure.

A learning organization

A learning organization is able toretain lessons learned derivedfrom past experiences and usethose lessons and experiencesas a means to improveoperations, enhance goalachievement possibilities andcontinually respond appropriatelyto its changing environment. The claims organization operateswith a unique perspective fromwhich it can observe whether thepolicy behaves as it wasintended by the underwriters,brokers and policyholders. It isalso in a position to observewhether the policyholder issatisfied with the product andservice it has purchased. This isall valuable information to feedback into the larger organization,particularly underwriting andsales, so it can be even moreresponsive to the needs of thepolicyholders. The benefit to theclaims organization will beimproved visibility within thelarger organization and a likelyincrease in internal andpolicyholder customer satisfaction.

A formal process needs to beestablished to make this happenautomatically. It should beinitiated by the claims executiveor Manager on behalf of the largerorganization when a triggeringevent occurs. The triggeringevent can be a loss of a certain

size (usually very large) or when asmaller loss occurs that couldhave been larger but for someexquisite underwriting, sales orclaims input. The latteropportunity will allow for thelarger organization to celebrateits teams’ successes. The formeropportunity tends to reflect theorganization’s weaknesses andwhen they’re exposed, can leadto defensive behavior by thevarious process constituents.This behavior needs to bediscouraged by executivemanagement so a free flow of learning can take place toprevent the shortcomings fromrepeating themselves (which is the real value gained from this process).

It is recognized that some of the triggering opportunities mayinvolve cases where holding thelearning lesson within 60-90 days(an ideal timeframe) might not be viable due to possible orpending legal issues. That’s OK.The session can be held when all constituents agree it is right to proceed.

A suggested form ofmeasurement for this processwould involve the following:

• All triggering events werefollowed by a learningsession; and

• Significant (the top three-four)lessons learned were repeated.

Aggressive pursuit ofsubrogation and otherrecovery opportunities

One way to help reduce theoverall cost of loss and toachieve high customer

satisfaction is to develop asystematic approach toidentifying all recoveryopportunities, successfullydeveloping/prosecuting thecases and promptly recoveringfunds from negligent third partiesand/or their insurers. Salvageand subrogation are the recoveryopportunities property insurersdeal with regularly. This paperwill deal only with subrogationrecoveries as salvage is typicallyhandled well by most propertyinsurers. A subrogation recoverydoes not become viable until the opportunity is identified. This may sound simple enough,but it is a factor critical to thesuccessful pursuit of any type of recovery. The simple way tomake sure all opportunities arediscovered is to ingrain in theperformance of your staffadjusters or independentadjusters the importance ofassuming one key principle:‘Subrogation potential exists in each and every claim until itcan definitively be ruled out.’Evidence of ruling it in or outmust be in writing in the firstreport to the file and becommented upon in subsequentreports until the matter is resolvedone way or the other. Thesetypes of file records make it quiteeasy to review for compliance.

Many insurers engage outsidesubrogation counsel automaticallyon all claims over a particularthreshold amount as soon as theclaims are reported. There isnothing wrong with this strategyas counsel is skilled at identifyingand pursuing valid cases. But thebest way to motivate the fieldstaff of adjusters to identifysubrogation is to give them



ownership of identifying thepotential and holding themaccountable for it. That meansrewarding them for ‘zero-defect’identification performance andsetting goals for improvementwhen performance falls short ofthis measure. Once a validsubrogation case is identified,then selectively engaging outsidecounsel makes sense.

Once subrogation potential isidentified, it needs to be pursuedvigorously to conclusion underthe direction and guidance of awritten Subrogation ManagementPlan. The policyholder is a keymember of the subrogation teamand needs to be consultedfrequently. Their cooperation is essential to the successfulprosecution of the case and, in addition, they may have asignificant uninsured interest theywish to pursue. They may alsohave a long standing relationshipwith the potential third partywrong-doer that needs to beconsidered. The plan elementsought to include at least:counsel’s statement of the casefacts, the law and likelihood ofsuccess (both in percentage andin money terms), key milestonesin the case, key strategiesincluding possible stumblingblocks (along with strategies forovercoming them), a budget andtime frames for reaching eachmilestone. The plan should bedynamic – not static. Asadditional information isuncovered along the way, theplan should be tweakedaccordingly. At each milestone,the team needs to considerwhether the facts supportcontinued pursuit. If the caseneeds to be shut down, so be it.

Learn from the experience andmove on to the next opportunityworthy of pursuit.

After you’ve become pretty goodat planning and succeeding, or if you believe you’ve alreadyarrived at Nirvana, interestingand valuable measures ofprocess success might include:

• Percentage of gross recoveryto current year’s incurred loss(our experience suggests thatif this % exceeds five you’redoing OK – if it reaches tenyou’re likely to be havingextraordinary success in yoursubrogation efforts and yourorganization is incurring lots of losses with subrogationpotential relative to all lossesincurred); and

• Outside counsel fees andexpenses as a percentage ofgross recoveries; time to recoverfrom date of subrogationrecognition and/or fromplanned date of recovery;gross amount recovered as apercentage of amount planned(both in first plan and afterdepositions are completed).

There are surely more but theseare a good start.

Sound management ofengaged suppliers and vendors

The management of engagedsuppliers is vital to the overallsuccessful management of aclaim and meeting policyholderexpectations. Outside serviceproviders should excel in thespecific area in which theypractise and have a proven track record to support theirexcellence. It is important that

interviews be conducted andreferences checked beforeentering into a relationship with an outside service provider.The scope of the interview iscontingent upon the nature and extent of the work to beperformed. Those conducting the interviews should be wellversed in the subject matter andrelevant issues.

Once an outside service provideris selected for a specificassignment, the scope of theengagement should be clearlydiscussed and defined in writingto the service provider. Thatengagement letter should alsocontain a budget the adjusterand service provider must bothagree up front is sufficient to dothe work contemplated within theagreed upon time frames fordelivering the findings.

Changes in the scope of theassignment should be discussedin advance of any changes beingeffectuated and then documentedboth verbally and in writing. In addition, the scope of theoutside service provider’sengagement should be explainedto the policyholder to ensure thepolicyholder fully understands andappreciates what that engagedexpert is about to do. If thepolicyholder intends to engage asimilarly-skilled consultant, thena meeting should be held of theconsultants along with the adjusterand policyholder at the outset to develop a game plan for themto work cooperatively with oneanother. After all, if you’re workingin a Good Faith Claims Handlingmode, this is merely a logicalextension of that philosophy.

It is important to monitor thework product and measure theresults achieved by engagingoutside consultants. Severalgood measures of success mightinclude: budgeted lossadjustment expense to actual,ratio of overall loss adjustmentexpense to paid loss in a givenyear, policyholder and adjustersatisfaction. The best way to getthis information would be througha review of each file and theresults of the claim,surveys/focus group meetings ofpolicyholders or comments madeto the adjuster directly by thepolicyholder about the work doneby the consultant. Networkingwith claims personnel outsideyour own organization is a reallyuseful and easy way to learnabout the performance ofconsultants.

Regularly scheduled qualityreviews of claims files

As difficult as it might be tospend several days in a fieldclaims office reviewing the qualityof claims files, it is probably thebest way to assess the casework product and compliancewith Good Faith Claims Handlingprinciples of individual adjusters,the field claims manager and theclaims executive. Quite often thereviews provide an opportunity topraise an adjuster for a job thatwas particularly well done, aswell as identify areas for processor individual adjusterimprovement identified.

The reviews can be conducted in several ways: self reviews,peer review, supervisory reviewand Home Office review. Claimsmanagement should be fullyengaged in performing the



reviews along with internal auditpersonnel. These reviews arebest if carried out in a consistentfashion (checklists are well-suitedto this task), are well documentedand results reported in writingand in person. The findingsshould be used to praise local claims personnel andmanagement and to provide a means to identify areas thatneed improvement.

Common areas one wouldexpect a review to cover include:

• Notice to incurral timing;

• Appropriate loss coding;

• Timeliness of correspondenceto/from insured vs. requirements;

• Reserves are establishedpromptly and are properlysupported by the facts anddocumentation;

• Outside resources(investigators, attorneys, etc.)are employed when needed;

• Timely outside serviceagreements are issued and are specific to the claim athand and provide appropriatedirection;

• Regular direction andfeedback is given to outsideservice providers;

• Vendor billings are reviewed for accuracy and appropriateness in a timely fashion;

• Expenses are reviewed andauthorized in accordance withcompany standards;

• Payments falls within limits;

• Liability investigationcommences in timely fashion;

• Evidence that liability wasconfirmed or denied in atimely fashion, both verballyand in writing, citing allappropriate policy references;

• Assign a supervising adjusteras required to perform theappropriate function;

• Adjuster reports are done ontime and include all requiredinformation;

• Identification of recoveryopportunities and follow updone to ensure opportunitybeing properly pursued;

• File is well documented;

• Notify reinsurers in a timelymanner with appropriate levelof detail; and

• File has been closedappropriately.

The claims processing system

Proprietary versus off the shelfclaims management systems is a frequently heard debate in theindustry. Advances in technologyfar exceed many organizations’ability to keep up-to-date. These issues make it virtuallyimpossible to blindly recommenda solution; as such we willhighlight a few common areas ofimportance. It is necessary fororganizations to fully investigateand understand their data needsfrom a complete organizationalperspective rather than solelyfrom a specific function such asclaims. All too often decisionsare made without the benefit ofhaving a full appreciation of how

one area impacts on another,leaving system and processingholes that require manualintervention and leave room forerror. Most organizationsrecognize the need for data fromthe actuarial area and theimportance of tracking paymentactivity, but frequently issuesrelating to aggregate balancesand reinsurance collections areignored. These areas must betied together with the claimsdepartment and a stronginterface feeding accurate dataimplemented.

Should an organization consideraltering its current systemprocesses, all avenues should be researched. This includes fully understanding the currentsystem, the strengths andweaknesses, the direction of the organization and end userperspectives along with thevision of where they want to be.Products should be thoroughlyreviewed for what they offer andwhat they do not. Stay awayfrom products that promise your solution in the next releaseor for modification for a feearrangement. The smart supplierof a system solution willthoroughly investigate yourcurrent systems, including needs that are not addressedand interface issues for datadownloads, prior to committingtheir package as being the bestsolution. Once a package isselected, implementation mustbe carefully planned with theappropriate testing, includingparallel runs prior to going live.Be cautious not to dictate a‘drop dead’ date as issues willarise leading to delay.



The smartsupplier of asystem solutionwill thoroughlyinvestigate yourcurrent systems…

Performance indicators for theclaims organization

All organizations need some wayto measure, as objectively as ispossible, how the business isperforming. There are numerousresults that can potentially bemeasured but the key isdetermining which few providethe best picture of what’s goingon in the business.

The claims executive, regionaland field office claims managermay be interested in regularlyviewing some of the followingkey results as they compare withplanned or expected results:

• Opening to closing ratios;

• Claims aging statistics;

• Actual expenses;

• Employee turnover;

• Reserve development;

• File quality review results;

• Recoveries;

• Lessons learned;

• Customer satisfaction; and

• Reinsurer recoveries anddisputes.

That’s not to say these are theonly areas of the business tomeasure. But at the executivelevel, it’s important to focus onthe few things that give youcomfort your organization isrunning as expected.

Conclusion

This paper does not address all ofthe specific areas and issues thatgo into establishing an operationthat is in alignment with bestpractices standards, but it doesprovide an overview of key areasto consider. Different lines ofbusiness, organizational structureand other issues will ultimatelydictate the specific directives andactions a particular operation willpursue. It is important toremember that claims operationsare impacted by both internal andexternal environments and as suchthey are continually evolving as arethe best practices standards.Quality claims organizationsmust be able to anticipate andaddress change and incorporatenew practices and ideas in theorganization in order to progressand meet the expectations of allstakeholders.



AUTHORS

Steven KesslerDirector, AdvisoryTel: 1 713 356 [email protected]

Barbara MurraySenior Manager, AssuranceTel: 1 312 298 [email protected]



Update on IFRS, XBRL andSarbanes-Oxley Act – Section 404

AUTHORS: MARIE BRAVERMAN, FRANCESCO NAGARI, ROBERT LEMBACH AND JOHN S. SCHEID


Following are three brief updates on IFRS 4 for Insurance Contracts,XML/XBRL and Sarbanes-Oxley and internal control requirements ofSection 404.

IFRS 4, Insurance Contracts – An update from March 31, 2004

The insurance industry has beenwaiting a long time to find outwhat the International AccountingStandards Board will require of it.On March 31, 2004, the IASBdropped the first shoe, releasingIFRS 4, the first phase in its two-phase approach to establishingnew accounting rules forinsurance contracts.

To coincide with the issuance ofIFRS 4, PricewaterhouseCoopershosted a forum on internationalstandards for North Americaninsurance executives, assemblingleading experts within the globalfirm to decode the new standardand discuss its implications forinsurance accounting. A keychallenge of discussions that day was identifying how IFRS 4differed from US GAAP. Whatdoes it all mean to companieswith US GAAP as the primarybasis for preparing their financialstatements? What aspects ofIFRS 4 should US GAAPpreparers focus on?

Almost six months later, and the picture has become muchclearer. This SeptemberPricewaterhouseCoopers is due torelease a revised edition of IFRSand US GAAP Similarities andDifferences, updated to include,

among other things, the similaritiesand differences related toinsurance contracts.

This article gives you a briefsummary of some of the moresignificant differences betweenIFRS and US GAAP accountingfor insurance contracts, primarilyresulting from the issuance ofIFRS 4.

Insurance and reinsurancecontracts – what’s in adefinition?

IFRS 4 introduces a definition ofinsurance contracts based on theconcepts of insured event andsignificant insurance risk transfer.This definition applies to bothinsurance contracts issued andreinsurance contracts held. This isunlike US GAAP, where there is nosingle definition of an insurancecontract. In US GAAP theclassification of contracts isperformed by reference to thecombined requirements of severaldifferent standards (FAS 60, FAS97, FAS 113 and FAS 120). Tomake matters more complicated,FAS 97 has been used by analogyin US accounting practice toestablish accounting for certaininvestments products issued byinsurers. FAS 97 investmentcontracts are not insurance

contracts under IFRS and they areaccounted for under IAS 39.

One of the results of applying the IFRS 4 insurance contractdefinition is that companies canno longer analogize to FAS 97measurement principles withrespect to their accounting fordeferred acquisition costs (DAC).IFRS preparers with investmentcontracts must look to IAS 18 foraccounting guidance related tothe recognition and measurementof acquisition costs. In addition, if an entity elects to adopt the fairvalue option the accounting forliabilities associated withinvestment contracts can bedifferent from US GAAP wherethese liabilities are typicallyreflected at their account value. Inthe context of fair value, therequirement to keep the liability atno less than the amount payableon demand (also known as the‘deposit floor’) adds anotherdifference on the accounting for investment contracts.

One area where contracts that arenot accounted for as insuranceunder US GAAP, but may bedefined as insurance contractsunder IFRS, is reinsurance. Forexample, reinsurance contractsthat compensate the cedant for

IFRS 4 introducesa definition ofinsurance contractsbased on theconcepts ofinsured event and significantinsurance risktransfer.

UPDATE ON IFRS, XBRL AND SARBANES-OXLEY ACT – SECTION 404


losses but contain a timing delayin reimbursement are subject todeposit accounting under USGAAP but are classified asinsurance contracts under IFRS.

Pending the finalization of PhaseII of the IASB Insurance Project,IFRS 4 allows for contracts thatmeet the definition of aninsurance contract to continue tobe accounted for using theentity’s current local GAAPstandards. In the reinsurancecontracts example above, thiscould result in the depositaccounting under US GAAPcontinuing in the IFRS financialstatements if the entity decidesto continue its existingaccounting policies.

Another area where differences indefinition arise is the concept ofinsured event. Under IFRS, lapseand expense risks arising frominsurance contracts are insurableevents and an entity that decidesto mitigate these risks bytransferring them to anotherparty purchases an insurancecontract under IFRS. Howeverthe fact that lapse or expenserisk arises from insurancecontracts is not sufficient to meetthe definition of insurance for areinsurance contract because itis not transferring a pre-existinginsurance risk accepted from apolicyholder. As a result, theentity that purchased thecontract will have to account forthese contracts as purchasedinsurance contracts (outside thescope of IFRS 4 and within IAS37) rather than reinsurancecontracts held. The entity thatissued the contract will accountfor it as an insurance contractand continue with its existing

accounting policies. Under USGAAP the issuer would classifythis contract as reinsurance but itwould be required to use depositaccounting because it does notcompensate the cedant forlosses that arise from theunderlying insurance contracts.The cedant would be subject tothe same requirement.

Insurance and reinsurancecontracts - measurement

The existing accounting policiesof an entity for insurancecontracts issued and reinsurancecontracts held (including relatedintangible assets like DAC) are exempted from the IFRSHierarchy and need not bechanged on adoption of IFRS 4except for the following fiverequirements:

1. Provisions for possible claimsunder contracts that are not inexistence at the reporting date(such as catastrophe andequalization provisions) areprohibited.

2. Insurance liabilities must betested for adequacy.

3. Reinsurance assets must betested for impairment.

4. Insurance liabilities can be de-recognized only when theyare discharged or cancelled,or expire.

5. Insurance liabilities andincome shall not be offsetagainst related reinsuranceassets and expenses.

This means that US GAAPpreparers can continue to followthe specific measurement

guidance as provided in FAS 60,FAS 97, FAS 113 and FAS 120,as these requirements aregenerally similar to US GAAP.However a few noteworthydifferences deserve considerationupon implementation. Forexample, under IFRS the liabilityadequacy test requirement willbe met by the FAS 60 premiumdeficiency test. However, anydeficiency resulting from theassumed realization of unrealizedgains or losses is alwaysreflected through the incomestatement under IFRS. In otherwords, IFRS does not have theoption to reflect a shadowpremium deficiency adjustmentthrough equity. In addition, IFRS requires the considerationof guaranteed options (likeguaranteed annuitization options)in the liability adequacy test. In US GAAP these are providedfor under SOP 03-1 and notexplicitly considered in thepremium deficiency test.

Insurance and reinsurancecontracts – depositaccounting and unbundling of deposit components

IFRS 4 requires the unbundlingand separate measurement ofthe deposit component bundledin an insurance contract if andonly if the deposit can be reliablymeasured and the entity’saccounting policies do notrecognise all rights and obligationsarising from it. This requirementis limited in practice to situationswhere the insurer or reinsurer hasestablished experience accountsthat refund the policyholder orcedant but has not appropriatelyreflected this obligation in itsbalance sheet.

In addition to this requirement,IFRS 4 also allows the unbundlingof deposit components on avoluntary basis if the depositcomponent can be reliablymeasured. This permission wouldallow preparers to use the FAS97 deposit accounting approachfor universal life-type contractsmost likely (these contractsqualify as insurance contractsunder IFRS because they usuallytransfer significant insurancerisk). For these contracts US GAAPrequires the recognition of theliability representing thepolicyholder’s account balancewith the insurer. The accountbalance concept is equivalent tothe deposit component conceptin IFRS.

Accounting for insurancecontracts sold by an insurer toits own defined benefit plan

As outlined in the IFRS 4implementation guidance,insurance contracts sold by aninsurer to its own defined benefitplan will generally be eliminatedin consolidation. The financialstatements will then include:

(a) the full amount of the pensionobligation under IAS 19Employee Benefits, with nodeduction for the plan’s rightsunder the contract.

(b) no liability to policyholdersunder the contract.

(c) the assets backing the contract.

Under US GAAP these contractsare recorded by including thevalue of the insurance contractas plan assets in the calculationof the company’s net definedbenefit liability, and reflecting the

UPDATE ON IFRS, XBRL AND SARBANES-OXLEY ACT – SECTION 404 continued


insurance contract liability inaccordance with the applicableinsurance accounting guidance.

Insurance and reinsurancecontracts – embeddedderivatives

In IFRS embedded derivativesthat also meet the definition ofinsurance contract are not requiredto be separated and fair valued.In addition, options to surrenderthe insurance contract areexempted from separation andfair value measurement if theoption price is a fixed amount or a fixed amount plus interest.Under US GAAP, embeddedderivatives are not subject toexemptions from the generalprinciple of separation and fairvalue measurement when theyare not closely related to the host contract.

Conversely, a notable differencebetween IFRS and US GAAPrelates to the accounting forpersistency bonuses. IFRS 4classifies persistency bonuses asembedded derivatives. SOP 03-1treats them as an effective yieldadjustment and does not requiretheir separation and fair valuation.

Insurance and reinsurancecontracts – disclosures

IFRS 4 requires extensivedisclosures to allow the users of financial statements tounderstand the measurementbases adopted, the materiality of the reported amounts arisingfrom insurance contracts and thefactors that affect the uncertaintyof the amount and timing of thecash flows arising from insuranceand reinsurance contracts.

US GAAP disclosures are lessdemanding than IFRS 4. Howeversimilar disclosures are includedin other sections of the annualreport (for example in theManagement Discussion andAnalysis section). One exampleof such disclosures is the claimsdevelopment table.

The path forward

By the end of this year mostinsurers adopting IFRS 4 will haveassessed its impact on their 2004accounts in order to prepare forcomparative financial statementsrequired in 2005. The next shoe tofall is Phase II, which will establishlong awaited recognition andmeasurement guidance, andhopefully provide the consistencyin financial reporting still lackingunder IFRS 4.

On the heels of the issuance ofIFRS 4, the FASB and the IASBannounced that they areseriously considering Phase II for insurance contracts to moveforward under a ‘modified’ jointapproach, with the IASB boardtaking the ‘lead’. Soon afterwardsthe IASB announced its plans tostart its project with a ‘blankpiece of paper’, putting to oneside the large body of work it hasaccumulated so far, and statingthat is committed to working withthe insurance industry to find thebest answer.

We will continue to keep youinformed on the developments ofthis and other IFRS guidance asthe move towards IFRS and USGAAP convergence continues.



AUTHORS

Marie BravermanPartner, AssuranceTel : 1 646 471 [email protected]

Francesco NagariSenior Manager, IFRS Technical ServicesTel : 44 20 7804 [email protected]



To meet the increasing demandsplaced upon a company’s controlenvironment, management needscommon sense solutions it canrapidly deploy across theorganization to ensure itscompliance with the Sarbanes-Oxley Act. By applying commonstandards across both internaland external reporting processes,management has the lever itneeds to drive the institutionalchanges it wants. Thesecommon business standards,targeted at control objectives,can help improve manualprocesses within corporatereporting. These standards will lay the groundwork forcompanies to implementinformation standards likeExtensible Markup Language(XML) and eXtensible BusinessReporting Language (XBRL) thatcan further automate thecorporate reporting process and embed controls within thedata itself.

Today many insurancecompanies are struggling tocomply with Section 404 of theSarbanes-Oxley Act. Someinsurance companies, who arenot subject to Sarbanes-Oxley,have audit committees thatrequire them to perform similarcontrol reviews. In addition, theNational Association of InsuranceCommissioners (NAIC) hasissued an exposure draft thatwould amend the Model Audit

Rule to include significant portionsof the Sarbanes-Oxley Act.

Corporate reporting relies onmanual processes

With this backdrop, mostinsurance companies arestruggling at some level withdocumenting their controlenvironment and remediating the weaknesses they uncover.Many companies are finding theircorporate reporting processesare heavily reliant on manualintervention. In a survey conductedfor PricewaterhouseCoopersManagement Barometer, onlyfifteen percent of the executivesinterviewed said their reportingpolicies and procedures werefully automated. Seventy-onepercent of the respondentsindicated their policies andprocedures were both manualand automated and seven percentreported that their processeswere completely manual.

Manual spreadsheets lead to errors

The results from this surveyillustrate the very manual natureof corporate reporting. Even withthe very expensive and elaborateERP, data warehouses andgeneral ledger packagesemployed by companies,material errors are still occurringbecause of the manualintervention that occursthroughout the reporting process.

There have been some ratherlarge restatements at Fannie Mae($1 billion of equity) andProvident Financial ($70 million of earnings) as a result of errorsin complex calculations done byspreadsheets that fed thecompany’s reporting process.These errors highlight the needfor management to leverage thestandards it uses for data housedon mainframe systems to coverthe data found in spreadsheetsand other manual processes.

Common standards improvecontrols

Common sense needs to rule asmanagement extends commonstandards and controls overinformation produced by manualprocesses, especially thoseprocesses involving spreadsheets.Insurance companies use complexcalculations to report financialbalances related to DAC, Lossand Benefit Expense Reserves,Taxes and Reinsurance that aredeveloped, by most companies,through the use of multiplespreadsheets. Management candrive positive change through itsorganization by developing aninventory of these keyspreadsheets and implementingthe following controls:

• Change Control – ensure thatchanges to the spreadsheet’slogic are reviewed by anindependent individual;

• Version Control – developnaming conventions anddirectory structures to ensurethat only the current approvedversion of the spreadsheet isused;

• Access Control – usepassword protection to restrict access;

• Input Control – ensure thatinformation input to thespreadsheet is reconciledback to source data;

• Security and Integrity ofData – ensure the logic of thespreadsheet is secure throughthe use of ‘locking’ orprotecting key cells fromunintentional changes;

• Back-ups – ensure there is aprocess for appropriatelybacking up and archiving keyspreadsheets;

• Information Standards –ensure that informationstandards used within theseapplications provideconsistent definitions forautomated import and exportof data via the use ofXML/XBRL;

(Source: PricewaterhouseCooperswhite paper ‘The Use ofSpreadsheets: Considerations forSection 404 of the Sarbanes-Oxley Act)

Common sense solutions for Sarbanes-Oxley: Howsolutions based on common standards can help companiesenhance their reporting processes and related controls

The above list is not exhaustive,but it provides a vision as towhat types of common sensecontrols and standards anorganization can employ to drivechange.

XML/XBRL are informationstandards

Once a company has employedthese common sense standards,it can consider the next step andimprove the automation of itscorporate reporting processthrough the use of XML/XBRLsolutions. These solutionsdigitally tag data, so it can bepassed from mainframe systemsto spreadsheet and back again.XBRL, through its use of link-bases, can embed validationcontrols within the data itself.This means that certainvalidation controls can beperformed to ensure data quality,before data is released to thenext stage of the reportingprocess (e.g. ‘Does total assetsminus total liabilities equal totalstockholders’ equity?’). Theautomation of specific datavalidation steps saves time andreduces the likelihood of errorsdue to clerical mistakes.

The SEC is also in the midst of its implementation of theSarbanes-Oxley Act. Undersection 408 of the Act, the SECis now required to review at leastone filing of a registrant everythree years. In July 2004, the

SEC announced it was assessingthe benefits of tagged data toimprove its analysis of registrantsfilings. Specifically, the SEC islooking into a proposal to allowregistrants to file supplementalinformation in an XBRL format.

This movement by the SECunderscores the speed at whichchange is taking place regardingcorporate reporting. TheSarbanes-Oxley Act is one of the catalysts; data quality,cost savings and timeliness of information are others.Management needs to deploy a common set of standards fordata to control the informationthat passes through both itsautomated and manual financialreporting processes. Once thesecommon standards aredeployed, additional automationcan occur through the use ofXML/XBRL enabled solutions. As a result of the efficienciesgained from increasing theautomation of the internal andexternal reporting processes,management has more time tospend on the analysis data andproviding insight into the issuesdriving the business.



The survey and white paper cited in article can be found on the web at:

http://www.barometersurveys.com/production/barsurv.nsf/vwAllNewsByDocID/2D661C6B82D4391185256EE0006EED74andhttp://www.cfodirect.com/cfopublic.nsf?opendatabase&content=http://www.cfodirect.com/cfopublic.nsf/vContent/THUG-63CNN5?open

AUTHOR

Robert LembachSenior Manager, AssuranceTel: 312 298 [email protected]

http://www.barometersurveys.com/production/barsurv.nsf/vwAllNewsByDocID/2D661C6B82D4391185256EE0006EED74

http://www.cfodirect.com/cfopublic.nsf?opendatabase&content=http://www.cfodirect.com/cfopublic.nsf/vContent/THUG-63CNN5?open

As we have discussed inprevious editions of Insurancedigest, the incrementalobligations imposed by Section404 of the Sarbanes-Oxley Acton both management and theexternal auditor of publiccompanies are quite substantialand require a significant amountof time and resourcecommitment. Most insuranceexecutives are concerned aboutthe costs associated withimplementing Sarbanes-Oxleyand the demands required tomeet the internal controlrequirements of Section 404.

Complying with Section 404 will cost public companies anaverage 62% more thanpreviously anticipated, accordingto a July 2004 FinancialExecutives International (FEI)survey. The increase in Section404 compliance costs stemsfrom a 109% rise in companies’internal costs and a 42% increasein the fees charged by externalauditors, the FEI study found.Total estimated average ‘yearone’ costs for compliance withSection 404, for companies withover $5 billion in annualrevenues, almost doubled since a similar survey in January 2004from $4.6 million to over $8 million.

Once companies were well intothe documentation phase of theSection 404 project the estimateof internal hours needed tocomply with all the requirementsfor management’s report oninternal controls more thandoubled to an average of

25,668 hours according to theFEI survey. Companies of allsizes have increased theirestimates of internal effortrequired for compliance.

A comprehensive plan andtimeline that includes all therequired activities and resourcesand allows adequate time forevaluation, remediation andretesting of deficiencies identifiedduring the project is a fundamentalprerequisite. Tight projectmanagement throughout the yearin order to continually gauge thestatus of the project and ensurethat it stays on schedule is alsocritical to success. Since this isthe first year of these newrequirements, there is aheightened risk of encounteringunexpected delays and obstaclesto completing the project.Companies are also finding thatthe time required to aggregateand evaluate the significance of the deficiencies identified can easily be underestimated.The review and testing by theexternal auditor should, ofnecessity, typically follow thework performed by managementthroughout the project, soadequate time needs to beallowed for that as well. All of this suggests that it is wise toaccelerate the planned timetablewherever and whenever possible.

Insurance executives are alsoconcerned that implementingSarbanes-Oxley Section 404 willdistract management from otherkey priorities within theirbusiness. Many believe thatconcerns over total

implementation cost andcompeting priorities couldovershadow the positive aspectsof implementing Section 404. A better understanding ofmanagement’s internal controlenvironment, a morecomprehensive assessment of risk management issues,together with improved financialreporting transparency have beencited as some of the positiveoutcomes from the Section 404exercise. Others have commentedthat as a result of the internalcontrol documentation project,they have identified opportunitiesto restructure their businessworkflows and increase security understanding in their technology processes.

With the rising costs ofcompliance with the Sarbanes-Oxley Act many financialexecutives are searching for anyopportunities possible toleverage their investment todayfor future operational benefits.



Three months to go…and the costs continue to rise

AUTHOR

John S. ScheidChairman, Americas Insurance GroupTel: 1 646 772 [email protected]



Insurance executivesare also concernedthat implementingSarbanes-OxleySection 404 willdistract managementfrom other keypriorities within their business.

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 Advisory Services Leader and Chairman, Americas Insurance GroupTel: 1 646 772 3061 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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