It's Time To Admit Sarbanes-Oxley Doesn't Fit Mutuals

The ALEC resolution comes on the heels of a statement from the National Conference of Insurance Legislators that was equally scathing in its criticism of the NAIC's SOX proposal.

Indeed, the only support for the NAIC SOX proposal comes from an increasingly isolated group of regulators who seem to think that every insurance company–public and non-public alike–is an Enron waiting to happen. Indeed, during the NAIC's summer meeting last June, a reporter quoted a prominent member of the NAIC's AICPA Working Group, who asked: "What's the difference between what happened at Enron and insurer insolvency?"

Enron, of course, was emblematic of the handful of high-profile public company scandals that inspired the creation of the Sarbanes-Oxley Act. The scandals infuriated investors and undermined public confidence in the capital markets.

Accordingly, Congress aimed the act's key provisions exclusively at public companies. The idea was to ensure the accuracy of information communicated to the investing public about the financial condition of shareholder-owned companies.

In contrast, the NAIC's SOX-inspired proposal would apply to every insurance company, whether public or non-public. Since non-public companies have no investors and do not trade on the capital markets, Congress's goal of protecting the interests of shareholders has no relevance to mutual companies and other non-public insurers–or so one would think.

The NAIC's SOX enthusiasts, however, insist that applying certain elements of the act–especially Section 404–would enhance the existing system of state-based solvency regulation.

As incorporated within the NAIC proposal, Section 404 would require an insurer's management to document and assess the effectiveness of the company's internal accounting control over financial reporting. In addition, it would require the insurer's independent auditor to provide a formal attestation regarding management's assessment of the adequacy of the insurer's internal control.

Presumably this "enhancement" would reduce the incidence of mutual company insolvencies, thus creating a substantial benefit that justifies any costs to insurers entailed by the proposal.

To test that assumption, the National Association of Mutual Insurance Companies commissioned a study by Finnell & Company that measured the benefits that proponents claim would result from the proposal against the cost to insurers of complying with it.

Our study found that first-year implementation of the proposal would cost about $300 million for all mutual property-casualty insurers. That amount is equal to the total net guaranty-fund payments related to all mutual insolvencies from 1990 through 2003–the most recent period for which such data are available.

Setting aside the fact that no insolvency has ever been linked to a misreported financial statement, our analysis generously assumed a best-case scenario in which the adoption of Section 404 would eliminate all mutual company insolvencies.

Based on recent insolvency payout trends, Mr. Finnell estimated that the cost of complying with the NAIC proposal would be nearly eight times the cost of all projected insolvencies combined.

Our study also showed that Section 404-related compliance costs would be proportionately greatest for the very companies that have the best record on insolvency–small mutual insurers. In effect, Section 404 compliance would be the functional equivalent of a regressive tax.

When the dust finally settled, the proposal's most ardent champions were reduced to playing the Enron card.

Even in the world of public companies, where firms are motivated by the desire to favorably impress Wall Street analysts and investors, Enron was without peer. In the mutual insurance environment, where a company's performance is judged by its ability to pay claims rather than by its ability to exceed quarterly earnings targets, the Enron debacle has about as much relevance as the seventeenth-century Dutch tulip mania.

None of this is to suggest that the current system of solvency regulation is perfect. As well as the system has worked over the years–and it has worked remarkably well, with mutuals writing 33 percent of p-c industry premium and accounting for only 5 percent of insolvency costs–it is worth exploring whether it could be improved.

Following our presentation to the NAIC, our representatives outlined a process for identifying potential weaknesses in the existing regulatory regime. We recommended that:

o The NAIC should undertake a thorough study of the causes and effects of insurer insolvencies across the country.

o This should be coupled with a comprehensive examination of the existing body of solvency regulation to identify any shortcomings that might be linked to recent insolvencies.

o Finally, we urged the NAIC to develop narrowly-tailored, cost-effective measures to address the identified weaknesses.

It may turn out that the most practical and effective solution to a demonstrated weakness in the existing system of solvency regulation is something akin to SOX's Section 404.

However, until that weakness is demonstrated, and the cost of the new regulation is justified in the context of extremely low mutual insolvency rates and costs, SOX should not be applied to mutuals.

Considering public company compliance costs, the fact that SOX was never intended to apply to non-public companies and the stunning results of NAMIC's cost-benefit analysis, it's no wonder that legislator organizations such as ALEC and NCOIL are unequivocally opposed to the idea of applying SOX-like rules to non-public insurance companies.

Charles M. Chamness is president and CEO of the National Association of Mutual Insurance Companies in Indianapolis.

"In the mutual insurance environment, where a company's performance is judged by its ability to pay claims rather than by its ability to exceed quarterly earnings targets, the Enron debacle has about as much relevance as the seventeenth-century Dutch tulip mania."

Charles M. Chamness