On Black Holes

Simon Lee, CEO at RSA, under pressure following two profit warnings in a week (www.rsagroup.com)

Simon Lee, CEO at RSA, under pressure following two profit warnings in a week.

What a week for Royal Sun Alliance, already unpopular with investors following their decision earlier this year to cut their dividend payout. The impact of the St. Jude storm particularly on their large Danish subsidiary forced the company to release a profits warning. Worst still was their second warning four days later after revealing irregularities in the accounts of their company in Ireland. The subsequent share price collapse and downgrade by the rating agencies added to the firm’s misery.

Yet the current troubles at RSA are nothing compared to what has been going on at Bermuda based Tower Group. Its failure to file financial statements after announcing huge reserve charges and impairment to goodwill is now raising substantial doubts over whether they can continue to operate as a going concern, according to Insurance Insider. The problems at RSA and Tower are of a different magnitude relatively speaking but the root cause appears to be much the same; each seems to have experienced a breakdown in financial controls.

Since most insurers are cash-positive and adopt some fairly opaque devices to recognise long-term liabilities, financial inaccuracies can go undetected for a surprisingly long period. By the time it is discovered that claims reserve amounts have been ignored or suppressed or premium earning patterns distorted, the impact can be quite devastating. Even after raising the capital required plugging a black-hole, it may take years for a management team to untangle a business strategy built upon a false expectation of profit: Ireland being a case in point; RSA must now be seriously reconsidering its aggressive growth plan in that market.

Despite the best efforts of regulators, even with a much greater degree of oversight these days, mistakes of course still happen and will continue to do so. It is nevertheless perhaps too convenient to characterise incidents like those at RSA and Tower simply as ‘one-offs’. Arguably as we slide further into a market downturn and over-stretched insurers push for growth in weak pricing conditions, the more vulnerable companies will be prone to making errors. The new system of corporate governance that has evolved over the past few years to prevent financial mismanagement is sure to be tested.

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2 Responses to On Black Holes

  1. Torquil McLusky says:

    Insurers have traditionally been undervalued on markets because of a lack of understanding of their figures (analysts reports have been shown to have a significantly higher impact on insurer share prices than other listed businesses). Perhaps as insurers have sought to make themselves easier to understand (and therefore more accessible to investors) they have started to believe the hype themselves – in other words to believe that you can manage an insurance business like any other just by looking at high-level MI – maybe they have also spent too much effort employing CEOs who can talk to investors and not enough on employing CEOs who understand insurance.

  2. Rick Murray says:

    The remarks of both the author and the commentator are fair, considering that illustrations of the conditions they describe are not hard to find. However, not all insurer revisions of reserves involve shadowy financial reporting or control system weaknesses. A lack of appreciation for the intrinsic risks of a line of business can operate alongside the best of intentions and controls. Latent liability exposures have brought down some of the best of intentions, as the history of asbestos, environmental and audit liability experience shows. The presumption of guilt may sometimes fit, but should not be the only or first response.

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