Specialty Insurance Blog

Mark to Market Accounting

You may have heard about mark to market accounting, also known as fair value accounting, but did you know that this accounting theory has contributed to the economic crisis and can lead to professional liability insurance losses?  Unfortunately, this particular accounting technicality, FAS 157, may have contributed - some say caused - the credit crisis, and may lead to more litigation.  These claims are starting to make the rounds in professional commentary and on blog posts.

Mark to market, or fair value, accounting is the new standard for GAAP accounting contained in FAS 157.  I have put some links on this subject below.  An excellent article from Duane Morris (see here) outlines some of the issues relating to causes and potential litigation from the application of FAS 157.  Additional articles are available here, here, here and here.

FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair value accounting sounds great in theory, but it creates some very significant and real problems in reality.  FAS 157 requires asset values on balance sheets be adjusted to reflect the current market values.  For example, a bank is required to write down a loan on an asset where the value of the asset has fallen below the loan amount regardless of whether the loan is performing.  In times like these, when asset value are falling, FAS 157 requires massive write downs on loan portfolios even if they are performing.  These write-downs create a real loss of GAAP capital, and can impair the financial strength of the institution with the technically impaired assets.

Take another example.  A venture capital firm invests in a new technology company that is expected to take a number of years to get to profitability (ie it is burning cash as it develops the technology).  The VC firm must make a market-based estimate each year, and sometimes more frequently, of the market value of its investment.  Typically, the market value of early stage companies would be zero (0), even though the investment might be performing exactly as expected.  [Note that this example assumes no interim rounds with outside investors that would set a market price.]  So the VC firm must, according to FAS 157, write the value down to zero (0) early in the process.  That might be okay for the VC firm if everyone understands what is going on, but it does not reflect long-term economic reality.

Now, some are anticipating that the fair value, or mark to market, valuation approach will add volatility to reporting company financial statements, and that this will lead to increased litigation against directors and officers, accountants and other professionals.  Obviously, increased litigation will drive up the costs of professional liability insurance.

If significant restatement activity results from increased levels of scrutiny, legal implications can be anticipated, as history has shown during other periods of financial results restatement activity. This could result in additional litigation through shareholder lawsuits.

It is too soon to tell whether the increased litigation, and increased professional liability insurance pricing, are coming.  But the controversy around FAS 157 continues.

Info & Articles on FAS 157:

FAS 157
Private Equity Guidelines
PE Blog Post – Fair Valuation
VC Valuation Committees
VC Perspective on 157
General Commentary on 157
General Commentary on 157
General Commentary on 157
VC Perspective on 157
Tuck School Valuation Survey
Tuck School Valuation Article

Brought to you by Tennant Risk Services.

 

Specialty Lines & Technology

The internet is having a profound impact on how society interacts and how business is conducted, and this extends to the insurance business.  Companies like GEICO and Progressive operate online as well as in person – the client chooses.  Has the use of technology impacted the specialty lines insurance segment as well?

A recent article in Insurance Journal highlights some of the challenges, and the perceived lack of progress, in the specialty lines market (see here).  Our perspective – different – is noted below.  The article is a summary of an interview with Jeff Ward, a director of London Market reform technology specialists TriSystems.  Key points in the article:

• the wholesale market is miles behind the retail market...they haven't even come close to the level the retailers have.
• In most cases - other than certain specialty lines - a potential wholesale buyer gets only limited information.
• The London market basically doesn't do business electronically
• It [electronic transactions] may not work for complex risk[s]...They will probably always require face to face negotiations, but there's a great deal that can be done electronically. Much of the actual work is not so complex that computers can't handle it.
• For wholesale business, a true global electronic market is probably many years away. Retail will get there first.

This characterization of the specialty lines market is only partially correct, and not because the specialty lines market has failed to adopt technology.  The specialty lines market (see here) is composed of insurance accounts that do not neatly fit into the rigid underwriting boxes of the standard markets due to more risky exposures, unique operating characteristics or adverse loss experience. 

The key is the underwriting approach in the specialty lines business - art, not science.  It is all about risk assessment.  Different underwriters will look at the same account differently, and will want to review different information.  And because the exposures presented can vary substantially, underwriter requests for information are not always consistent.  Additionally, the terms that are provided are not consistent between accounts or between underwriters, and are often negotiated.  This makes it difficult to neatly define the information needed by underwriters for large parts of the specialty lines business.

The article points out that some complex risks may require face to face negotiation.  Maybe, maybe not.  But today many complex risks are negotiated by specialty brokers, like Tennant Risk Services, and specialty underwriters without face to face meetings.  How?

Specialty lines brokers and underwriters are actually heavy users of technology.  The primary method of communication today, and of exchanging exposure and quote information, is email, and many specialty lines organizations (including Mercator) are completely paperless.  Negotiation of complex risks takes place every day via email and phone.

Most specialty lines rating and quote systems today are electronic, at least in some form.  They differ substantially from their standard market peers in that they allow for significant customization of rating and terms by underwriters.

While most of the business written in the specialty lines business is customized, there are significant segments that are handled completely electronically, online, by end to end underwriting and rating systems.  Tennant Risk Services provides online quoting for its retail insurance broker clients on its website for some lines of business.  The challenge for the specialty lines business is that some percentage of the business gets rejected from these systems due to the exposure variations or coverage adjustments inherent in specialty lines business.  Specialty lines brokers like Mercator have built in processes to efficiently handle this rejected business to ensure that, in most cases, the specialty lines applicant receives terms.

Bottom line, the nature of the specialty lines business is the driver of the differences in the use of technology, not a failure to adopt technology.  The use of technology in specialty lines is significant and continues to grow, but how technology is used will not exactly match the commodity-like approaches of the standard lines businesses.

Readers should note that this subject is very complex, the specialty lines business large and equally complex, and that this short commentary does not do the subject justice.

Brought to you by Tennant Risk Services.

Fraud

With the economic downtown, the frauds come to light.  Fortune has chronicled four alleged frauds and the ringleaders.  What is most interesting is the people behind the schemes, and how they pulled if off for so long.  Audacity?

Madoff - Trader (here & here)
Dreier - Lawyer (here)
Stanford - Money manager (here & here)
Salander - Art dealer (here)

None of these people were in the insurance business.  Recently and within the actual insurance business itself (ie AIG’s problems were/are, we are told, not in the insurance entities), the amount of fraud by insurance practitioners is not anywhere near the same scale.  That doesn't mean the insurance business has been without problems.  A few years ago we had the Near North/Segal scandal (see here & here).

Brought to you by Tennant Risk Services.