Governing principals: corporate scandals and the Sarbanes-Oxley Act are causing insurers to pay attention to the objectivity and transparency of their boards.

Like the rest of corporate America, insurance companies are paying more attention these days to how their organizations are governed. From considering the size of boards of directors and board members' qualifications to revisiting codes of conduct and conflict-of-interest policies, insurers are affected directly or indirectly by provisions of the Sarbanes-Oxley Act of 2002, a sweeping overhaul of corporate fraud, securities and accounting laws.

This business reform bill, enacted in the wake of a series of corporate scandals starting with the bankruptcy of energy giant Enron, largely applies to publicly traded companies. But its residual effects are beginning to carry over to nonpublic companies as well.

"Publicly traded insurance companies, which would be the large nationwide companies subject to Securities and Exchange Commission filings and therefore directly regulated by the standards in Sarbanes-Oxley, have taken very significant steps in response to that new law," said Linda S. Kaiser, a senior member of the law firm Cozen O'Connor. For example, she noted that the certifications required under Sarbanes-Oxley have caused senior executives at publicly traded companies to ensure that they are fully aware of financial reporting and internal audit matters. "So the structure for ensuring that the top executives have full knowledge has become much more documented and rigid than what it would have been before that new law," Kaiser said.

But as she pointed out, more than 2,000 insurance companies operate in the United States, and most of them are not publicly traded. A mutual insurance company, whose policyholders are its owners, falls into this category. Therefore, Sarbanes-Oxley does not directly apply to those companies, nor does it apply to subsidiaries of publicly traded companies which are not directly obligated to comply with the new law's standards, she said.

"So the vast majority of the insurance industry was not directly affected," said Kaiser, a former insurance commissioner of Pennsylvania. "And even though that law was passed in July 2002, the indirectly affected insurers are just now coming to grips with the changes and the fallout from that law."

One Approach for All

For example, accounting and auditing functions performed by accounting firms are undergoing some transformation and review, said Gregg Dykstra, general counsel for the National Association of Mutual Insurance Companies. "There are accounting firms that have to gear up for compliance with Sarbanes-Oxley," he said. To the extent that those firms serve both public and private companies, they either have to make a decision about how they might segment their practice or they're simply going to use the same approach with both types of companies, he said. "That is probably one of the more substantial, indirect impacts of Sarbanes-Oxley on mutual insurance companies," Dykstra said.

Regulators also are beginning to apply the same approach, Kaiser said. At its December meeting, the National Association of Insurance Commissioners began a study of the effect of Sarbanes-Oxley on its model audit rule which sets forth standards for auditors of insurance companies.

"Some of those provisions don't comport with the new Sarbanes-Oxley standards, so the NAIC is looking at its existing audit rule and pairing that up with the new standards to see where changes in state laws that govern insurers should be made," Kaiser said. Thus, through regulatory action, many of the Sarbanes standards likely will migrate to insurance companies regardless of whether they are publicly traded or not. Kaiser thinks this transition will be accomplished in all states within two to three years.

Just because Sarbanes-Oxley doesn't apply directly to mutual insurance companies doesn't mean they aren't very interested in the whole subject of corporate governance, corporate integrity and accountability, Dykstra said. NAMIC has been providing a variety of services to help its member companies understand and stay abreast of these topics and to help them in individual decision making about corporate governance, Dykstra said.

Looking to the Outside

Also, in this post-Enron era, there's a growing need for more dynamic directors who can help chart a company's course amid market changes, and greater attention is being brought to bear on having directors carry out their roles in a more independent way, said Mike Magsig, senior client partner for Korn/Ferry International's Financial Services Market and co-leader of the firm's insurance search practice. As a result, the composition of insurance boards is becoming more heavily weighted to directors from outside the company, he said.

"As the industry may go through another round of consolidation, as companies attempt to create meaningful returns in a very challenging environment, the enlightened chief executive officers are recognizing more and more today that they can't rely on their own skills and those of the internal management team," he said. "They're looking for board members who can bring more to the table in that context. CEOs who are strong leaders want to have the benefit of a board that can help them execute, shape and evaluate the strategic direction of the organization."

To drive home this point, Daniel Hale, chief financial officer of Allstate Corp., recently stressed to equity analysts at a New York conference that Allstate's 13-member board included only one "insider"--CEO Edward M. Liddy.

As board vacancies occur, many insurers are trying to achieve at least a majority of independent members on their boards, Kaiser said. Some states, including Pennsylvania, already have a requirement regarding the number of independent directors that insurance company boards should maintain, she said. In Pennsylvania's case, "it's only a third, not a majority, but I think the regulators are starting to look at the existing standards and see if the bar should be raised," Kaiser said.

Increasingly, executive search firms are being hired to recruit new outside directors, Magsig said. "We're seeing more movement, as board seats become available, to bring in outsiders. Certainly on public companies, there's a definite trend toward having one, maybe no more than two, insiders on that board," he said.

Also, the level of recruiting activity for directors has risen as boards have become more active in self assessment and in examining the skills that they want brought to the board as a whole, he said. "More and more, that work is being done with the CEO having a more limited degree of involvement, so that the need for due diligence and an objective process to fill those openings becomes more critical," Magsig said.

In filling senior level positions--chief financial officers, chief operating officers and chief investment officers--boards are becoming more involved in seeing that there is a process in place to examine candidates from outside the company, and not to automatically fill these posts with an internal candidate, he said. "Not that an internal candidate won't be selected, but there's more of a growing desire that internal candidates be benchmarked against the best talent in the marketplace and that benchmarking process be done in an independent, objective way before those C-level roles are filled," Magsig said.

Dykstra expects the issue of independent directors to be addressed by regulators on the private side, just as it has been on the public side. "How far that will go has yet to be determined," he said. Many mutuals, however, think that inside directors are an important resource on a board, Dykstra said. "There is a belief that inside directors do provide valuable information and perspective," he said.

Magsig said that Korn/Ferry also is finding that active CEOs or other members of senior management are taking on fewer and fewer board assignments. This means the recruiting firm has become "creative," looking for board candidates among service providers to the insurance industry, namely people who understand the forms of risk and the degree of competitive pressures being brought to bear on the industry from other financial services groups, he said. Other prospects include those who may be nearing retirement and are not actively involved in boards, but may have a desire to serve, he said.

Assessing Personal Liability

For their parts, director candidates are conducting personal due diligence, holding private meetings with outside auditors and other centers of influence. This stems from rulings in recent court cases, currently under appeal, that said directors may have personal liability with respect to decisions that have been taken by a board or should have been taken by a board, but were taken by management, Magsig said.

"With that elevated level of risk, you're finding that directors are not necessarily signing on because they are intrigued by the challenge or the prospect. They truly want to understand the values of an organization, they want to understand its financial condition beyond what they might

be told by management, or perhaps other members of the board who would be part of the recruiting process," he said. "This is something that has been growing in prevalence within the last year or so. And directors who are really dedicated to becoming active participants of the board are really wanting to make certain they know what they are signing onto."

Recently, Magsig's firm was involved in the creation of an entirely new board for a life insurer. This amounted to recruiting six outside directors. This group, before signing on to serve on the board, held a series of off-site meetings to conduct intense discussions with management as well as outside auditors, advisers and actuarial consultants, he said. All six eventually decided to join the board, Magsig said.

"On the whole, there is a much higher degree of attention being given to objectivity, due diligence and transparency of what is occurring at the board level with regard to its oversight of management than certainly I've seen throughout my career," he said.

In most cases, boards are indeed recognizing the need for change and, even if they are not required to, are adhering to New York Stock Exchange or SEC requirements, said Robert W. Stein, chairman of global financial services for Ernst & Young, New York. Most of the larger insurance companies, public or not, are moving to make meaningful changes with respect to the board's role, he said.

"No company is going to say that they're not taking this seriously and changes are being minimized," Stein said. "All companies recognize the importance of doing the right thing, and trying to regain some trust and confidence from the external world, from customers in the markets and, by and large, companies are marching along shoulder to shoulder on this."

As Stein sees it, the critical elements for change are separation of the CEO and the chairman posts, and a substantially improved information flow to the board. "For the board to exercise their oversight role, they just have to get better information about the businesses that are being run, the risks, the controls, and that will allow them to dig in and ask the kinds of questions and challenge management as they should in representation of the shareholders' or investors' interests," he said.

Aside from a few shareholder-interest groups, there is virtually no stockholder pressure on these insurance companies to adhere to best practices, Stein said. "One of the sad things at the moment in this whole effort to enhance governance is the absence of the strong voice of the owner," he said. "My view is that boards represent owners' interests, they represent shareholders' interests, and shareholders shouldn't abdicate totally their responsibility to the board. They should become more active."

Stein thinks the passivity of shareholders in general will tend to slow the pace of any significant change to improve corporate governance. "Boards would move farther and more rapidly to challenge management to exercise what we have defined as the role and objective of good governance if shareholders were more active in the process," he said.

Some proposals within companies to grant shareholders limited fights to nominate directors and put shareholder proposals onto the ballots are moving ahead, but slowly, Stein said. "Any steps in that direction would be good," he said.

It's important to remember, Dykstra emphasized, that the insurance industry is already extensively regulated through state regulators and the NAIC. "So perhaps, at least in some respects, the industry is ahead of the curve with regard to some of these issues than are companies in less regulated industries," he said.