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October 2003
Are Your Consultants and Advisors Wearing Multiple Hats?
Lest They Doubt Our Sincerity
By Webb Hubbell
After Enron, labor unions and pension funds were at the forefront calling for corporate governance reforms. First on everyone's list of reforms was the elimination of conflicts of interest and the wearing of multiple hats by corporations' "independent" auditors and consultants. The major accounting firms have now sold off their consulting businesses, the Sarbannes-Oxley Act of 2002 was passed and signed into law, and the SEC and all the major stock exchanges have adopted Rules and Regulations on consultant independence for publicly-held companies.
These reforms, long past due, also have a direct effect on the management of pension fund assets. Just as publicly-held corporate board members have a fiduciary duty to the shareholders, pension fund trustees have a fiduciary duty to their fund participants. Although there aren't currently any direct prohibitions regarding pension fund consultants wearing multiple hats, pension fund managers who engage consultants to perform multiple functions may be at risk of violating the "prudent man" rule even if the potential for a "conflict of interest" is fully disclosed and discussed. Lecturer and leading expert on Fraud Prevention, Gary Zeune, says, "Although I'm not aware that it's prohibited by the rules, it is certainly prohibited by common sense."
The Department of Labor says, " The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries….Fiduciaries must act prudently and with the undivided loyalty to the plan's participants." ERISA mandates strict fiduciary requirements on a plan's fiduciaries, including the standards of "exclusive benefit" (duty of loyalty) and "prudent person" (duty of care) rules. Against these standards, labor leaders and pension fund managers will be hard pressed to defend allowing auditors and actuaries to provide other "consulting services" for their pension funds. At the same time they are advocating that publicly-held companies' auditors not be allowed to provide consulting services because it is "unsound."
Arthur Levitt, former chairman of the SEC, has for some time argued against the delivery of consulting services by companies charged with evaluating a company's financial health. After Ernst & Young sold its consulting business, Jim Turley, chairman of E&Y was asked why they sold the business. His response- " It is simply the right thing to do." On December 11, 2002, the AFL-CIO petitioned the SEC to strengthen the rules on auditor independence. Subsequently, the AFL-CIO commented that an auditor could also do the company's tax return as long as the auditor does not act as an "advocate of the company." Recently, a Building Trades International Union filed a shareholder resolution with Walt Disney calling for auditor independence. The Washington Post has also reported that "Although executives at privately held companies do not have public shareholders to answer to, many feel their firms should adopt the stricter governance standards passed by Congress last year," citing a recent poll of 1350 CFO's of privately held companies. Recently, the Retirement systems of North Carolina, California and New York adopted new standards to protect their funds from the risks of conflicts of interest including requiring disclosure of some consultant's complete methods and manners of compensation. These are just a few examples of the current atmosphere in which pension fund trustees operate and will be scrutinized.
Pension Fund managers must rely on their fund's auditors and actuaries to determine the financial health of their fund. These functions are so critical that they may rise to a fiduciary relationship itself. A clear example of this "conflict of interest" would be an actuary, charged with evaluating the financial health of a fund, helping to place the fund's fiduciary insurance thus "advocating" the financial health of the fund before the carrier.
Allowing an actuary to place insurance always presents a conflict of interest. The Actuarial Board for Counseling and Discipline wrestled with this issue in a recent opinion. It concluded that the "dual role almost always involves difficult conflict of interest issues. In some situations, the only way to avoid violating Precept 7 will be to avoid the dual role. In others, it may be manageable provided there is no question about the actuary's ability to act fairly." This opinion written for an actuarial consulting firm affords no protection for a Trustee in the current highly scrutinized atmosphere from criticism or liability if the Trustee is wrong that the conflict could not be avoided or there was " no question about the actuary's ability to act fairly."
Furthermore, consultants who wear numerous hats may have Errors and Omissions Insurance only for their primary function. Attorney's and Accountant's malpractice insurance may exclude "acting as a fiduciary." Actuarial policies may not cover "other consulting services," especially if they are provided "free." An actuary may tell the Trustee that it is not receiving an insurance commission or other fee or reducing the actuarial fee to cover the commission thus giving the Trustee false comfort that there is no conflict, when in fact, as the recent opinion noted, the actuary may be receiving an "Expense Reimbursement Allowance" known as an ERA or other undisclosed compensation. In the case where some insurance companies offer an ERA and others do not, the "actuarial consulting firm has a vested interest in choosing one of the insurance companies over the others," perhaps at the detriment to the fund.
Enron and its aftermath have raised the bar of scrutiny of a pension fund's trustee. The need to scrutinize the "independence" of a fund's consultants and advisors is critical to a trustee's fiduciary duties. The McLaughlin Company believes that each of its clients is entitled to an insurance representative free of any conflicts of interest. Creative Risk Management was established to support and enhance the insurance efforts served by The McLaughlin Company. The Mclaughlin Company will not provide "other services" to its clients exposing the fiduciaries to potential liability.
Unions and pension funds should be proud of the leadership role they played in insisting that companies hired to monitor the financial health of a company be free of conflicts of interest and cease providing consulting and other services. They must be equally vigilant in requiring the same of its pension fund auditors and actuaries. Otherwise, they not only risk liability, they also risk in the words of Abraham Lincoln, "… it enables the enemies of free institutions, with plausibility, to label us as hypocrites—causes the real friends of freedom to doubt our sincerity."
Webb Hubbell is the former Associate Attorney General of the United States. Before coming to Washington with the Clinton administration, he was Chief Justice of the Arkansas Supreme Court. He practiced law for over 20 years specializing in litigation involving insurance, fiduciary liability and malpractice. He is now a Vice President of The McLaughlin Company.
Condition of the Insurance Market
By Ted Pappas
While the market has improved some since the beginning of 2003, the future does not hold out much hope for immediate improvement. Insurance companies invest primarily in the bond market and interest rates are not likely to improve significantly in the next six months.
Since June the industry has lost two major insurance companies and a third is shedding it's most profitable line.
Kemper, a mutual company, did not have a mechanism to raise additional capital. They were over burdened by debt and had no alternative but to close their doors. Kemper sold their Personal Lines Business and the renewal rights to their Commercial Lines.
In September the Royal Sun Alliance announced they were exiting the North American market and sold their renewal rights to Travelers.
Atlantic Mutual recently announced the sale of the renewal rights on their Marine Line to Travelers. This line was Atlantic Mutual's most profitable segment.
Companies buy the renewal rights because they want to avoid unprofitable business segments and insureds. Since the largest problem in the industry is under reserving of outstanding claims, this is a way to avoid the responsibility for those past claims.
AM Best rated all three of these companies A- a year ago.
AIG, Chubb and Travelers increased their reserves by more than $5 billion in 2003. The reinsurance market is worse. Insurance companies are abandoning unprofitable classes of business. The construction class is particularly hard hit as is the market for fiduciary and directors and officers liability, which continue to have unacceptable losses.
Workers Compensation is a very difficult line. Claim frequency is down but severity is up dramatically.
Terrorism continues to be a problem particularly in New York City, Washington, DC, Chicago and San Francisco. Recently we were made aware of a problem with post tension construction. Post tension is one of the best construction types for fire protection. However, as little as two pounds of explosives can bring down this type of construction immediately. An attack on a post tension building with 200 employees in Washington, DC could result in a $400 million reserve.
We expect insurance companies to further refine their appetite for risks with such massive exposures. Some companies may be unwilling to write any risk that is a post tension building. Premium has become less important in cases like this. If they do not want a particular class, more premium will not make it acceptable.
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CREATIVE RISK MANAGEMENT, INC.
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