Executive scandals in corporate America continue to disgust shareholders and to incite vocal opposition, but to what effect? Maybe one player is whispering softly and carrying a big stick over errant companies. This move might be a more effective persuasion to clean up corporate accounting and malpractice.
The insurance industry now emerges as a key enforcer in refusing to cover corporate executives, or to cancel current policies if executives do not open their company books to deeper scrutiny. Insurance providers of directors and officers (D&O) liability coverage have been less willing to pamper company clients. The risks were formerly passed on to the insurance companies who wrote the D&O policies. Incompetence or malfeasance would have to be paid for by the insurance companies and the shareholders – executives go scot-free. This no longer seems an acceptable business model for risk management.
Furthermore, the burden of proof is being passed back to the executives under examination. The previous assumption was that a company was clean unless there was overwhelming evidence to prove fraud. The “innocent until proven guilty” principle worked well in law courts for individuals, but when you are talking about potential damage to thousands of investors, this get-out clause seems inadequate. CEOs and executives have such remunerative incentives to cover up company bad news that an auditor is battling uphill. Shifting the burden of proof upon the client executives becomes an effective way of concentrating the mind upon finding all evidence. This is the well-known scientific technique of “null hypothesis” where it is easier to disprove a theory by finding exceptional data, rather than proving a hypothesis.
Countermeasures against errant executives are already in place. There has been a flurry of shareholder-initiated lawsuits, possibly empowered as US senior company officers are forced to swear to the accuracy of their financial statements. Punishment terms up to 10 years’ jail are on the scoreboards just to keep CEOs on the righteous path.
Marsh, AON, Chubb and AIG in the USA control most of the US underwriting business, including D&O coverage. Insurance companies are shoring up the ramparts by hiring more forensic accounting staff. More exacting financial data are requested from clients, followed by questioning top executives on their corporate performance and knowledge of the reports stated. A proper due diligence examining current management practices, accounting standards and board skills means that this procedure is no longer a rubber-stamp for the client.
The big stick waved by the insurer comprises demanding higher D&O premiums or refusing coverage. Former risk game rules permitted corporations to pay a few hundred thousand dollars for annual D&O coverage against litigation. The same policy will cost more than $1 million. There are additional deductibles running into millions of dollars that force companies to shoulder a large part of the cost of any litigant’s claim. Companies are given incentives to reduce the element of doubt in the insurer’s eyes by furnishing detailed proof of innocence.
Insurers are not suckers who are going to soak up the risks of “moral hazard” originating from immoral CEOs. Some insurers are rejecting coverage for clients that are judged to have questionable accounting and management practices because of the considerable downside risks. The insurers are faced with:
huge potential pay-outs for the D&O policies; the regulator imposing strict penalties; threat of shareholder lawsuits; the reputation risk from underwriting fraudulent accounts.
The investor public wants to know that corporate cleanliness is next to godliness. Only sound corporate management practices, instigated by a determined and ethical board, can provide it. Where the board feel that the operational loss events can have such high impact as to endanger the continuing business of the bank, then they may seek to insure against the severe loss. This brings in the role of “captives” within the financial markets. Banks may feel confident enough to take on, or self-insure (SIR) themselves for a part of the operational risk damage estimated. The captive can take or reinsure the rest in excess of the SIR. Captives may offer more cover than is readily available in the open market, they will go to the international market to reinsure their portfolio. The reinsurers will also want to avoid the “moral hazard” risk posed by inept or corrupt CEOs of the client bank.
Nevertheless, the insurance sector can provide a very useful foundation for enterprises trying to negotiate the modern risk conditions and a new raft of regulations. One is the use of risk financing using contingent capital. This offers some mitigation against severe operational risk events. Clients can sign up by paying a stream of premiums known as “commitment fees” that have some analogous points to options or warrants. It enables the substitution of on-balance sheet economic capital for contingent capital provided by the insurer. The purposes are limited only for operational loss events affecting the bank.
The contingent capital can only be unlocked or exercised when a major operational risk event triggers or breaks the agreed limit. Thus, the insurer can agree to provide cover for major risk impacts by providing contingent capital when the operational risk event is $50 million damage. This triggers the release of capital for covering damage. There is no cover for P&L damage or for protecting directors against the moral hazard of their own mistakes.