Retirement Planning
Chapter 29 – Due Diligence
It is common for an agent to go to work for an agency and simply accept whatever companies and products are given them to work with. While we would like to assume that agencies have done their homework, this may not always be the case. In addition, it is possible that the agency viewed the companies and products only from a profit point of view, not a consumer point of view.
What responsibilities fall on the selling agent? The answer to this question will certainly vary depending upon whom you ask. As little as twenty years ago, due diligence was something done by broker-dealers, people selling securities and by some home offices. Seldom was due diligence thought to be an agent's responsibility.
Today agents know that due diligence is their responsibility. This realization is the result of court actions. In other words, it has now been legally determined that individual agents are responsible for the recommendations they give, the products they sell, and the companies they represent.
Defining Due Diligence
For the agent, due diligence is the analysis of a particular company's products, performance and financial standing. Where life insurance is concerned, this is often done to determine whether there is a reasonable expectation that the illustrated values presented can actually be achieved. Life insurance is, in some measure, the business of making long-term promises to clients. It is vital for clients that the insurance company is able to keep the promises they make. Due diligence is the agent's analysis of whether the company can, in fact, keep their promises. The term, due diligence, is primarily derived from the securities industry.
For the insurance company, due diligence is an ongoing process which insures that pricing objectives are being realized, and that integrity and consistency of internal procedures are being maintained. It is working with the agents and agencies, as well as their policyholders, to preserve fairness in all parts of the operation. An insurance company that is concerned with due diligence will treat its sales force and back-up members as well as they treat their policyholders. Company due diligence also means making investments that are sound and prudent. For life insurance companies, due diligence is not a new concept, even though it is for many agents.
The life insurance industry has moved their product design away from fully guaranteed values and benefits towards a dependency on current, sometimes more favorable parameters. This means consumers have taken on more risk. The factors more often used these days also tend to be more volatile. In many cases, only the strength and the integrity of the company involved can ensure that projected, non-guaranteed elements of the policy are, in fact, realistic.
As agents and consumers have become more educated on the variety of options available, insurance has seen a change in how it is perceived. While price has always been considered, additional elements are now commonly looked at as well. Consumers want to know if the company they are considering can manage its overhead expenses, mortality expenses and investment returns in a way that allows the company to make good on its promises in the contract.
In addition, the role of insurance agents has changed in some ways. Whereas the agent was typically thought of as only the salesperson, consumers now consider him or her to be someone who must give reliable information for the good of the policyholder. Consumers no longer accept the view that the agent represents only the company. This change in the general perception of insurance agents places greater responsibility, both legal and ethical, on agents.
In the public's view, the level of service and quality of the advice given are linked directly to the insurance company and that company's performance. From a legal view, court cases have established agents as professionals and therefore, legally responsible for the statements they make and the products they suggest. In fact, some types of insurance are especially taking this view (annuities and long-term care). Practicing due diligence makes sense from many standpoints, one of which is financial protection of the agent, as well as the consumer. When an agent takes the time to investigate his or her companies (and document that investigation), he or she is also protecting his or her own financial future. Lawsuits are common, and it is reasonable to believe that even a good agent can experience one. Due diligence is, of course, an ongoing process since companies can and do change how they operate. Due diligence might be considered a method of self-protection through knowledge.
Many agents groan when due diligence is brought up. They picture hours of work put into a schedule that is already difficult. It should brighten their day to know that there are more answers than one might imagine online and at their local library. A morning spent looking up the companies they are representing or considering, is a morning well spent. There are several reasons to do so, including the following:
1. Lawsuit prevention from angry consumers who feel they have been treated unfairly;
2. To protect the trust agents have spent hours building up with their clientele; and
3. To determine if the people associated with the companies they sell have the level of integrity desired.
If an agent bases his or her company affiliations on commission levels, leads provided, or where the next convention will be held, he or she is in for a few surprises down the road. Agents should request copies of the insurer's annual statement and pay particular attention to the interrogatories, because they are brief and speak to short-term changes from the previous report.
Agents need to begin the due diligence process by gathering information on the major components of the company from as many sources as possible. This would include seeking information directly from the company. In fact, this is probably the first place to seek information and it is generally easy to obtain. Agents should not overlook another simple way to gather information: asking questions. Agents should talk to their immediate manager or regional manager, the home office (especially the underwriting department), and even the company's competitors. Anytime an insurance company seems reluctant to provide information to their own agents, a red flag should go up.
Agents can often learn more than one might imagine from simply asking other agents who have been with the insurance company for a relatively long period of time. Ask about the speed demonstrated when claims are submitted and the difficulty or ease of receiving benefit payment. The company's claim is often an indicator of company solvency. Find out if commission checks seem to be consistent, correct and on time. When a financial error is made, how long does the company take to correct it?
Agents should collect the three most recent sets of financial statements and study them. Does the company seem to be making excessive profits? Does the company seem to be making minimal profits, perhaps too little to ensure continuance? Compare the surplus in relation to the amount of business being produced. Ask the state Insurance Department to see if there are any watches or cautions outstanding. How many complaints from consumers has the company experienced in the past year? Agents may also wish to look at complaints over a three-year period to see if any pattern seems apparent. Watch for any shifts in management personnel or management style of the company since this can affect the philosophy of the company.
Once a measure of information is gathered, agents must assimilate it in a manner that is easily understood. There are several ways to assess this information, but often the agent can simply look at it from the standpoint of "Does it feel right?" With so many carriers to choose from, there is no need to represent any carrier that does not feel comfortable.
Rating services have not always given the public indications of trouble in a timely manner. Even so, it is important to seek out the information that they offer. A.M. Best states that the primary source of the information presented in their publication is obtained from each insurance company's sworn NAIC annual financial statement as filed with the Insurance Commissioner in the state in which the company is domiciled and licensed to conduct business. These financial statements are prepared in accordance with statutory accounting requirements established by the NAIC.
Ratings reflect some amount of opinion regarding each company's financial strength and operating performance, but that opinion is based on sound information. Rating companies are certainly not giving any type of warranty. Neither do rating companies give any recommendations for any particular companies.
The objective of the rating services is to evaluate the factors, which affect the overall performance of the insurance companies. By doing so, they provide their opinion of the company's financial strength, operating performance and ability to meet its obligations to the policyholders. The procedure, according to A.M. Best, includes quantitative and qualitative evaluations of the company's financial condition and operating performance.
Evaluating the financial condition of a company is subject to variations depending upon the person or company doing the analysis. This is especially true when it comes to evaluating insurance companies because so many of their assets are interest and economic sensitive investments. Many of these investments are based predominantly on actuarial projections of future claim payments.
It has become increasingly difficult to predict the amount of loss reserves that must be held to maintain financial security. As the California wildfires of 2017 demonstrated, this is especially true for the property and casualty insurance companies. They are also affected by liberalization of insurance contract interpretations and expansion in theories of tort liability. The insurance companies have the potential of much larger losses in today's world than was present in the past.
In the life insurance industry, the cash flow and liquidity necessary to meet policyholder obligations has also seen an increase in the complexity of investment oriented life and annuity products, interest rate volatility, the reduced certainty of future cash demands and growing policyowner and public perception. Today's world is simply more complex than was yesterday's. As policyholders feel less secure about major institutions (including life insurance companies) more responsibility lands on agents. All these factors have affected even well-established life, health, property, and casualty insurers.
There are several areas that must be looked at in order to understand a quantitative analysis of a company.
(1) Profitability
It should come as no surprise that profit is a measure of the competence and ability of the management of any company. This is certainly true of insurance companies. Profit is the result of efficient management that provides viable insurance products at competitive prices, which maintains a financially healthy company. Operational profitability (underwriting and investment income) is the single most recurring and important source of surplus growth for an insurance company. Surplus represents additional security for the policyholders. It is protection against events, such as hurricanes and flooding, that negatively affect the company.
(2) Leverage
A company typically has exposure to various risks. Leverage measures the exposure of an insurance company's surplus to the various operating and financial practices. A highly leveraged company can show a high return on their surplus, but may also be exposed to a high risk of instability. A conservative level of leverage enables an insurer to better withstand adverse changes in such things as underwriting results, investment returns, regulatory, or economic conditions. This is generally at the cost of lower returns on surplus.
While leverage may be generated from several different sources, there tends to be four typical ones:
1. Current writings;
2. Reinsurance;
3. Policy or loss and loss adjustment expense reserves; and
4. Investments.
These types of leverage are reviewed by A.M. Best for a five-year period to analyze changes in trends and magnitudes. Each rating company will perform similarly. In order to measure each company's exposure to pricing errors in its book of business, they review the ratio of direct and net premiums written to surplus, gross and net of reinsurance. To measure each company's exposure to unpaid obligations, unearned premiums and exposure to reserving errors, A.M. Best reports that they analyze the ratio of net liabilities to surplus. There are adjustments made which take into consideration many factors that might affect these analyses. This would include such things as pyramiding, inadequacy or redundancy of policy or loss reserves, equity in unearned premiums, differences between statement and market value of assets and potential asset default risks. This list is not inclusive and may also include other factors.
It should be noted that leverage is a relative measure. Each company may have unique features that affect the end result. Some of these features may include such things as:
1. Spread of risk,
2. Soundness and appropriateness of the reinsurance program,
3. Quality and diversification of the assets, and
4. Adequacy of loss or policy reserves.
(3) Liquidity
Liquidity measures a company's ability to meet its anticipated short-term and long-term obligations, which includes policyholder claims. Each company must have liquidity to some degree. The level of a company's liquidity depends upon the degree by which it can satisfy its financial obligations by holding cash and other investments that are sound, diversified and liquid. If a company experiences unexpected obligations, and does not have enough liquid assets on hand to meet those obligations it might then be forced to sell other less liquid assets at a bad time which might result in investment losses. The company might also be forced to borrow funds, or sell long-term investments too soon. A high degree of liquidity enables the company to meet unexpected obligations, such as massive wildfires in California, without adverse effects on their general investment portfolio.
As we said, there are several good rating companies that rate insurance companies. This text does not endorse any particular rating company, and several should be utilized when assessing an insurer. Professionals recommend that several company-rating services be considered. They may not necessarily give the same performance rating to the insurers, so it does give agents a better perspective when several (at least two anyway) rating firms are considered.
Any agent that does not understand how insurance companies are rated for financial strength will be at a disadvantage when selecting or recommending products and companies. Agents are often held accountable since an aspect of his or her job is performing due diligence.
Insurance Archaeology
After years of worldwide mergers, it has become evident that insurance is an important aspect of these mergers. A body of literature has emerged that details the challenges of merging operations, IT systems, personnel, and corporate culture.
Also emerging: a set of best practices to meet the transition challenges proactively. These include the following.
One low-profile but often crucial factor affecting both the advisability of a contemplated merger or acquisition and its success is the condition and content of the prospective company’s or partner's insurance portfolio. Any corporation moving toward merger with or purchase of a corporation in the United States must recognize the litigious climate there in which business is transacted and the methods necessary to defend itself, in advance in many cases, by making sure that both its own and its prospective partner's insurance coverage is adequate.
It is not enough to simply assess known liabilities facing a prospective partner. Under current U.S. law, environmental liabilities and product liabilities that may be unknown to the seller or potential partner may emerge years and even decades after the damage occurs. In many cases, such liabilities do not become evident for many years following the merger or sale. At the same time, insurance assets are generally transferable from a purchased company to its purchaser. Moreover, old liability insurance policies in many cases do not expire if damage is later found to have taken place within the policy period.
It is therefore a key element of pre-merger due diligence to examine not only a prospective partner's current insurance coverage, but also its long-term insurance history including the past insurance of major acquisitions. In the transaction's execution phase, it is essential to ensure that the long-term insurance records of both parties are effectively recovered, preserved, integrated, and organized.
A comprehensive historical insurance audit in two stages is thus advisable, with as much of the prospective partner's insurance history as possible being obtained prior to the transaction, and a more comprehensive reconstruction and organization taking place once the transaction has closed. This historical reconstruction requires its own set of best practices, evolved over the past 20 years in the discipline of insurance archaeology.
Retroactive Liability
Typically, mergers and acquisitions review insurance that is currently in place prior to conclusion of the change. The need for a comprehensive audit of past insurance is the product of two decades' worth of rapid escalation of the litigation threats facing all businesses, indeed all institutions. During that period, the concept of retroactive liability in particular has multiplied the legal risks of doing business. Under the provisions of the federal government's Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA, commonly known as "Superfund"), a broad range of parties can be held jointly and severally liable for extraordinarily expensive environmental cleanup, often for pollution that occurred decades ago. Under the laws of successor liability, moreover, even a corporation that purchases assets may be liable for the seller's liabilities in four situations:
Fortunately for prospective purchasers, there is also some protection against potential and unforeseen liabilities in the transferability of insurance assets from sellers to purchasers. U.S. courts have generally held that a corporation deemed liable for a predecessor's products or pollution is entitled to coverage under the predecessor's applicable insurance policies. While it is advisable that the acquired corporation expressly assign its insurance coverage to the purchaser, insurance coverage can be assigned without the insurance company's consent after a loss has occurred. Even when the insurance policy contains a "no assignment" clause, courts have granted successor corporations coverage under policies sold to the acquired corporation.
Given the broad transferability of insurance policies to corporate successors, coupled with the high value of old insurance policies, a comprehensive audit of a potential acquisition's long-term insurance history can spell the difference between acquiring a dynamic asset and acquiring a perpetual asset drain. Assessing a target company's insurance coverage, therefore, is an essential part of due diligence for any prospective purchase or merger.
Maintaining Old Records
Current business conditions have greatly multiplied both the urgency and the difficulty of reconstructing a historic insurance portfolio. Under the best of conditions, old records for companies large or small tend to evaporate. They can be erased by relocation, retirement, or movement of employees; prior ownership changes; scheduled document destruction; and far more pervasive accidental destruction or misplacement. Add to this natural entropy and a host of new factors accelerating institutional memory loss, including the following.
Under these conditions, a systematic search, or "insurance archaeology dig," is often required to ensure that a company's full range of current and past insurance policies remains accessible.
Mergers and acquisitions represent perhaps the single greatest challenge to a company's maintenance of institutional continuity, including maintenance of the historic insurance portfolio. The main obstacle to record-preservation imposed by mergers and acquisitions are their effect on personnel. Not only do mergers generally trigger at least moderate waves of personnel loss, either through downsizing or defections, they also, at least temporarily, affect productivity by forcing large numbers of employees to adopt new procedures, move down the hall or cross country, and learn to use new software and other equipment.
Mergers create high levels of anxiety and often have a negative effect on morale, at least temporarily. At the same time, there are the logistical and physical challenges of merging files and electronic records. The latter generally requires at least one party to revamp its IT infrastructure, including systems used to file and maintain them. Oddly, it is often the most mundane physical details that enable employees to lay their hands on long-filed documents. Mergers and acquisitions are can be difficult to incorporate and combine file and record maintenance procedures previously used.
The difficulty of working conditions in the execution phase of a merger underscores the need to prepare the ground with as complete a coverage audit as possible in the negotiation phase. As with all facets of post-merger integration, solid advance planning followed by prompt and vigorous execution once the deal has closed will ease rather than aggravate transition trauma. Difficult as working conditions may be in the immediate post-merger period, it is imperative to move fast, before old records are destroyed, and large numbers of people disappear through downsizing or defection. If the insurance audit is postponed, or omitted until a liability crisis leads to a desperate search for missing insurance assets. Recovery may prove impossible.
Audits
Conducting at least a preliminary insurance audit prior to purchase is important not only because it provides the purchaser with data potentially crucial to assessing the seller's true value, but because the conditions for such an audit are much more favorable before the purchase than after. As noted above, merger or acquisition inevitably creates some disruption, and often considerable resentment, particularly when major personnel changes result. Recently fired employees, or employees with new bosses, new expectations, and new anxieties, are not likely to put their full efforts into uncovering and documenting old insurance assets. A comprehensive effort will uncover more assets, preserve evidence, and ensure greater protection for unanticipated liabilities for decades to come.
At the same time, the negotiation phase of the merger and acquisition process has a momentum of its own, and circumstances often do not allow adequate time to reconstruct the past coverage in detail prior to closing. Yet the buyer can still prepare the ground for complete audit following the purchase and thus prevent a worst-case scenario in the years ahead. A partial audit can provide an outline of existing coverage and "freeze" the evidence, ensuring that critical documentation will not be misplaced, lost, or destroyed, and setting the stage for a more complete post-merger project.
At a minimum, then, a prospective purchaser ought to establish a corporate history to identify all predecessor companies of the target company with existing or potential liabilities. The audit should include pre-acquisition coverage for operations with significant liability exposures. Then, as soon as possible, copies of all existing liability policies should be obtained and gaps in coverage history identified while negotiations are in progress. After assembling all available documentation of the coverage history of the target company, buyers need to understand whether the historic policies actually provide coverage. The presence of customized endorsements, high deductibles, expensive claims handling agreements, aggregate limits that are nearly or already exhausted, and insolvent insurers may, in fact, spell inadequate protection for future losses. Consider the need for specific contract assignment or transfer of insurance policies in negotiating the purchase and sales agreement. While courts have upheld the transferability of insurance coverage without such explicit assignment, insurance companies often attempt to deny coverage on the grounds that such assignment is missing. Obtaining the assignment can thus forestall costly legal battles.
In order to complete the audit after the acquisition, develop a checklist of company insurance records and relevant non-insurance documents. Investigate records in storage, and arrange to have records retained. Finally, interview insurance personnel before the transition occurs to determine what they recall about past coverage and records retention. In the negotiation phase, a prospective buyer's demand for an insurance audit of a prospective acquisition need not seem a distraction or intrusion, if it is made clear that the audit may well uncover assets that enhance the seller's value. Indeed, the seller may be induced to perform the audit, since doing so potentially augments its saleable assets. Selling a company with a complete and well-documented insurance history is like selling a house with a new roof and solid foundation.
Post-Purchase Issues
Reconstructing, documenting, and charting a company's full insurance history is a formidable task even under favorable circumstances. Getting started years after an acquisition, when significant litigation or claims are pending, poses unique but not insurmountable problems. Corporate records will most likely have been destroyed, and the search will rely heavily on sources outside of the corporate records.
In this type of situation, begin a search as soon as possible. This will ensure that no further records are lost. It will also help to avoid a late notice problem with past insurers. Even if there are no insurance documents, other corporate records may provide a wealth of leads to outside sources. For example, the purchase closing documents may contain schedules of insurance, references to third-party claims or civil lawsuits, names of former employees, and information on the types of contracts that would have required evidence of insurance. Former employees may also provide crucial recollections of former owner's internal records as well as domestic and London brokers, additional insureds, and past lawsuits. In the aftermath of mergers and acquisitions, identifying outside sources is often the key to a successful policy search.
Growth and Mobility
Current business theory puts a great premium on speed: fast decision-making, fast execution, fast changes in direction, fast growth. Employees have adapted to this dynamic by learning to move fast themselves, whether by frequent job shifting or a move to free agency. Technology has both driven and adapted to the growth dynamic, so that record-keeping systems change as fast as personnel, business strategy, corporate identity, and location.
But business at Internet speed has its costs. While the corporate "brain" boosts its processing speed, the corporate memory, which is the foundation not only of sound decision-making but also of learned defensive strategies, is in danger of eroding. Insurance archaeology preserves one element of corporate memory that can provide tens of millions of dollars’ worth of defense against current liabilities.
Applicable Insurance Programs
Due diligence is a major part of any corporate transaction, whether it is a stock purchase, asset purchase, or merger. A review of applicable insurance programs, and the liabilities they may or may not cover, must be part of the due diligence because insurance is an important corporate asset. But there is much more involved in due diligence than just figuring out what insurance policies exist. Careful consideration of frequently overlooked aspects of the insurance program might help the buyer properly determine the value of the asset and protect against post-transaction liabilities.
As with most issues involving insurance, the buyer must begin with the existing policies, collecting all the seller’s insurance policies, such as commercial general liability, property, environmental, directors and officers, errors and omissions, cyber, excess, umbrella, and any others the entity may have. This also means gathering the policies dating as far back as possible, especially if the business is one that could be subject to liabilities that occurred decades ago, such as asbestos contamination. Today, climate change liability is also considered an important part of insurance protection.
Once all policies are collected, the review begins, which should include a few important elements. Some of these include:
1. Is the risk properly covered? The first objective in any insurance due diligence review is determining whether the seller bought the right policies in the first place. Knowledge of the risks and loss exposure is critical. This involves the seller’s operations, products, countries in which it operates, and the like. Once complete, existing risk must be compared to existing insurance coverage in place.
2. Who is insured? The seller is likely to be the named insured on the policy, but, depending on what is being acquired, it is important to determine if any of its subsidiaries are also covered.
3. Are there any risk transfer agreements benefiting or obligating the seller? The seller might also be listed as an additional insured under policies held by third-parties to this or other transactions. It is critical to know, to ensure that post-transaction entities retain similar insured status.
4. What are the policy deductibles or retentions? Buyers must take note of particularly high deductibles or retentions because they might be responsible for bearing that amount post-transaction before the insurer starts to pay on a claim.
5. Does the policy say anything about assignments? Many insurance policies contain “anti-assignment” or “change of control” clauses that state that the insurer’s consent must be obtained before the insurance policy is assigned or where there is a change in control of the original policyholder.
In the first instance, the parties should evaluate whether such clauses have any effect on the transaction. For example, a stock purchase might leave the original entity intact, which may not require an assignment.
If there is an “assignment,” courts in some jurisdictions might not enforce an “anti-assignment” clause where the assignment occurs after the loss. Understanding the law for the particular jurisdiction is essential.
6. Does the policy have any unusual or pertinent exclusions? Because insurers will likely argue that some policy exclusions negate coverage, either in whole or in part, knowing what exclusions are written into the policy, and evaluating whether any exclusions are pertinent to the buyer’s business or circumstances, can help the buyer identify where coverage might be challenging to obtain.
7. What is the seller’s claim history? It is critical to evaluate the amount of available coverage remaining under the various insurance policies. This requires getting information about the claims that have been made under each policy and the amount of money the insurer has paid (in defense costs, settlements, and indemnifications), which may erode the amount of available coverage.
This should include research into whether there are pending claims or if potential claims may or should be pursued. The likelihood of potential claims could similarly erode policy limits in the future, thereby lessening the amount of post-transaction coverage. Potential claims could also create a notice issue.
8. Are there retroactive premiums associated with the policy? Some insurance policies calculate the amount of premiums retroactively based on the cost of claims to the insurance company. If a policy has a retroactive premium component, the buyer might be responsible for paying the premium post-transaction.
9. Is runoff or tail coverage available? Where the transaction results in expiration or cancellation of the insurance policy, runoff or tail coverage can provide some coverage for pre-existing wrongful acts that took place during the expired or canceled policy’s policy period. Purchasing this coverage is a cost of doing business.
Many other questions will arise in the insurance and liability review, especially depending on the businesses involved, the jurisdiction, and the specific policy language, but by asking certain foundational questions, risk managers can begin a productive conversation that helps to ensure the financial success of the post-transaction entity.
Insurance is a valuable asset that can have an impact on the price and value of the company, and thus should be given the same consideration as other assets and liabilities
End of Chapter 29
2017