“Standard & Poors relies on the issuer and its counsel, accountants and other experts for the accuracy and completeness of the information submitted in connection with the rating process,” he said. “We are not auditors, we do not audit the auditors of the companies that we rate or repeat the auditors accounting work, and we have no subpoena power to obtain information that a company is unwilling to provide.”

Is deception possible in the insurance industry? Are auditors and actuaries providing rating agencies and regulators with accurate and complete information about insurance companies? Can Enron happen here?

Stating the obvious, its clear that, in many cases, the insurance company financial statements presented to regulators and rating agencies often “misstate” an essential item–the companys loss reserves. The loss reserve figure is inaccurate in spite of the fact that financial statements are accompanied by auditors letters of opinion and statements of actuarial opinion attesting to their accuracy. (Theres some debate over how big the inaccuracy is for the industry overall, but most experts agree, its some multiple of billions of dollars.)

In some cases, three groups of people have evaluated the adequacy of those loss reserves for an individual insurer. Is it possible, or even likely, that the evaluations of the highly-trained and talented professionals that make up the audit teams, the outside actuarial firms and the internal actuarial staffs were all off the mark?

Setting aside the often-repeated caveats about the judgmental nature of loss reserving and how the process of setting reserves is more art than science, there are cases when adjustments clearly need to be made, when all three groups of reviewers know it, and the reserves remain inadequate anyway.

Lets consider some situations to find out why.

First, lets assume that the actuary on a Big Five audit team uncovers a problem. He goes to the audit partner and says the clients reserves need to be bumped up significantly for the Big Five firm to issue a clean audit opinion.

How will the audit partner respond? Will it be: “Nice job. Our client will be pleased that you have saved him from a potential future problem. Lets go share this analysis with him immediately.”

Thats unlikely.

At the heart of the Enron matter is the central question of whether auditors were tainted by the fees that other areas of the audit firm pulled in from major non-audit consulting engagements. What seems to be ignored in that debate is the fact that, even without non-audit consulting work, Big Five firms still rely heavily on fees from their audits.

In the insurance world, where the insurance company client can have many reasons for not wanting to boost its loss reserves, it is the basic audit engagement that introduces conflicts. While not technically an auditor, the actuarial consultant employed by an audit firm does not operate independently of the pressures to continue to retain the client and protect those fees.

The trouble-making actuaries or auditors, who stick to their guns in situations involving mega-sized audit clients, might find themselves kicked off an engagement. “The client doesnt like him,” and “Shes not polished enough,” or “The client finds him abrasive” are some of the many excuses Ive heard.

Actuaries who work for independent actuarial consulting firms dont have to contend with the problem of being strong-armed by an audit partner, but they are still subject to considerable pressures. This is particularly true for small independent firms.

As I write this, I cant help but recall some folklore from the world of actuaries about an actuarial student taking a loss-reserving exam. The story goes that when presented with a loss-reserving problem and asked to state the correct reserve, the “consulting actuary” wrote a single sentence as his response. “What does the client want the number to be?”

Going from folklore to reality, I also recall a situation a few years ago, when I was writing a series of articles about a California workers compensation insurer that no longer exists. I received more than 500 pages of documentation that a liquidator put together documenting the downfall of the company. One of those pages was a photocopy of a “Post-It” note, responding to someones concern about not being able to get an actuary to agree that the companys reserves were reasonable.

“Get [Joe Actuary] to do it. He owes us,” the chairman of the company scribbled on the note, alluding to the fact that the insurer was one of a handful of companies that had given business to the small independent actuarial shop in the past.

Not to be overlooked is the third pair of eyes that might review an insurance companys loss reserves–those of the companys own in-house actuary. Lets peek in on her as she starts to pull together the loss development triangles to calculate incurred-but-not-reported loss reserves.

“Hows my IBNR coming?” the CFO asks as he passes her office. “You know, our bonuses depend on where those loss numbers come out,” he reminds her.

I have not presented these examples to suggest that a collapse the size of Enron is imminent in the insurance industry, or to suggest that actuaries and auditors are to blame for decisions by insurance company managements to carry inadequate reserves. What is relevant to consider here is the fact that pressures facing the professionals who review the financial statements of this industry are very real.

Whenever human beings are faced with choices between some immediate compensation and the more remote intangible triumph that comes from doing the right thing, theres an opportunity to make the wrong decision–to bend the truth, to introduce a tiny deception.

In this business, its easy to trade the risks that unseen policyholders, employees and other stakeholders might get hurt at some time in the future for today's rewards.

Why not bow to the demands of an audit partner, go back to the drawing board and widen a range of estimates so the clients number falls within it? There is enough room for judgment, after all, for the actuary or auditor to convince himself that its an honest reassessment, and not a deception.

How different is this from the type of reassessment some Andersen auditors might have made to convince themselves that Enron didnt “technically” violate any accounting principles.

I hesitate to reveal such subtle parallels because the specifics of Enrons accounting are well beyond my understanding. But when I heard an Andersen partner back in December testify about how he made a deal with Enron officers, giving them time to correct a problem, there was a similarity that seemed inescapable.

How many insurance company officers have told their auditors, “We know we're short. We'll pick up the reserves next year?”

What is likely to happen next year?

There are no easy ways to make these dilemmas go away. It would be na?ve to suggest that well-intentioned professionals become whistleblowers, taking their problems to the guidance and disciplinary boards of their professions, or to regulators and rating agencies directly, even if such mechanisms existed.

I know this personally. Human nature allows many of us (not all of us) to reevaluate our answers to avoid conflict and criticism. Some auditors refer to this as making a “business decision.”

There is certainly a possibility that the world of auditing insurance companies has changed some during the more than six years Ive been writing for NU. But looking back on my more than 14 years of experience as an actuary, seven with two Big Five accounting firms, and reviewing them in light of the recent deluge of reserve charges, gives me cause for concern.

Perhaps, as some have suggested, the charges are a hopeful sign, pointing to increased post-Enron accounting scrutiny and diligence taking hold in our industry. Perhaps audit and actuarial professionals have become more willing to stand firmly behind the high quality work I know they produce.

Sadly, however, the recent experience shared by an auditor friend who works in our industry tells me otherwise. With all eyes on Andersen, he reports that audit professionals at the other firms have become less vigilant. The way to solve the problem is to decree that only the SEC has the power to fire an auditor, he asserts.

That strikes me as a radical solution. And yet for our industry, its only a partial answer. (What happens with all the mutual companies that arent regulated by the SEC?)

Another expert suggests that auditors should be required to publicly disclose the number (and names) of client companies that restated their earnings within 12 months of giving clean opinions.

A public report card?

For that matter, why not have rating agencies rate the auditors?

Clearly there are no easy answers. But I do think theres merit in shining the spotlight on our industry before dismissing the possibility of an Enron happening here.

NU Senior Editor Susanne Sclafane is a fellow of the Casualty Actuarial Society.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 29, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.