Outside opinion: with greater accountability being demanded in the business world, independent underwriting auditors can help life insurers find problems and pass scrutiny.

Equity Funding Corporation of America, which Fortune once referred to as the fastest growing financial institution in America, actually grew on the basis of fictitious life insurance policyholders and fictitious underwriting files by obtaining hefty reinsurance allowances. The fraud grew dramatically for eight years until finally it was reported by a disgruntled Equity Funding employee and became a multibillion-dollar scandal in 1972. Between 1964 and 1972 at least 50 people in the company knew what was happening. Unlike some of the major corporate frauds that followed, it wasn't just about padding numbers; it was also about creating artificial business by taking names out of telephone books and transforming those names into ersatz policyholders.

What was the purpose of having fictitious policyholders? Certainly nonexistent people cannot pay premiums. With 50% of the company's business in this category, the asset base of the company couldn't grow, but the Equity Funding reinsurance agreements gave first-year coinsurance allowances of 180%. With each transaction reinsured, money flowed into the company's coffers, and the strategy was to generate the appearance of enough business to drive up the stock price.

The fraud was sustained with astonishing thoroughness and ingenuity. With high volumes of business being written, a certain amount of death claims would eventually be expected. Equity Funding therefore dutifully decided to kill off some fictitious policyholders to collect the death claim benefits from the reinsurers.

The most obvious question from a 21st-century standpoint is where the underwriting audits were in all of this debacle. The answer is disturbing: internal audits were performed by the chief underwriter, who unfortunately was part of the fraud. Reinsurers performed audits, but focused on treaty details and missed the big picture. No independent, external underwriting audit was completed.

One procedure would have made the deception impossible. If a truly independent and expert audit had been performed by a skilled underwriter, the antiseptic nature of the files might have been detected. Most files contain numerous communications between the agents and underwriting departments. They contain notes from underwriting support personnel about individually needed requirements, attending physicians' notes on prescription pads and handwritten notes exchanged between the underwriters and medical directors. The forged underwriting files did not contain the activity that exists in a real underwriting file. The underwriter's perspective was the missing link that made the fraud possible.

In addition, an independent underwriting auditor would have communicated with a sampling of the policyholders. The policyholder, if real, would need to reply to an address other than the company's. Presumably, the nonexistent policyholder could not reply to the auditor.

Had the new Sarbanes-Oxley law been in effect back then, arguably this scandal most likely would not have happened. Sarbanes-Oxley has been enacted by Congress to address the corporate scandals of recent years. The intent of Congress is to greatly enhance the reliability of all corporate financial results. But while the industry has made many advances since the Equity Funding scandal and some safeguards have been put in place, has it gone far enough in the area of underwriting audits?

How It Works

Currently, when a company wants to examine its underwriting, it resorts to an internal process where the audit is conducted by the very folks being audited, or alternatively, the audit responsibility falls upon the company's reinsurers. The assessment of a company's underwriting practices by a team of expert professionals not affiliated with the company itself is still absent in today's market. It is the crucial step that might have obviated the Equity Funding disaster, and that still is amazingly in shortage today.

Underwriting results are critical in determining the success or failure of a company's bottom line. Why should the auditing review process be left to an informal, sometimes casual process? The reasons it worked in the past may be no longer relevant in an industry where pricing is down and profitable underwriting results are important.

Many professionals now believe that the Sarbane-Oxley law will eventually demand that external, independent underwriting audits be completed just as other financial audits are required.

The law requires corporate America to tighten its "quality control" process. Currently, the quality control process for underwriting is typically inadequate. U.S. insurers would never dream of not obtaining external, professional audits of their accounting practices, but very few companies require the same scrutiny of their underwriting results, even though poor underwriting can have a profound impact on the bottom line.

Many insurers ask themselves if their reinsurer's underwriting audits are adequate. The real question, however, is whether the audits are independent. Reinsurers conduct these audits, not as a "value added" service, but because they are looking to avoid unwarranted risks. The reforms recently enacted by the accounting profession now make the days of having an accounting firm provide audits and consulting all in one package obsolete; having the reinsurer play independent auditor should be obsolete, too. The world now demands greater accountability.

Benefits and Steps

Underwriting management should be at the center of professionalizing the underwriting audit process. Typically, underwriters are squeezed between the marketing department's claim that they are too conservative and too much business goes to competitors, and the tendency of management to wring their hands when there is a "blip" in mortality. It should be comforting to senior underwriting management to have a truly independent, professional underwriting audit validate the underwriting process and make recommendations for pulling a few of the monkeys off the underwriting department's back.

Independent, professional audits have an array of additional benefits. They will:

* Confirm the authenticity of the business;

* Pinpoint the company's competitive positioning;

* Provide external validation to the company's constituencies;

* Evaluate underwriting practices and staff;

* Validate merger and acquisition assumptions;

* Monitor the coordination of underwriting and pricing: and

* Demonstrate to reinsurers that the company takes underwriting seriously by providing external confirmation of its underwriting results.

The elements of a professional underwriting audit process should include:

* A valid sampling of new applications;

* Examining claims to see it" they were underwritten correctly;

* Monitoring preferred criteria;

* Concentrating on such critical areas as jumbo cases, substandard and older-age applicants;

* Reviewing underwriting staff and procedures:

* Evaluating the company's underwriting requirements;

* Validating the company's underwriting philosophy; and

* Verifying reinsurance treaty requirements.

Only the underwriter is optimally equipped to facilitate the process. The case for independent audits is strengthened dramatically by the tendencies of today's market, including recent evidence that reinsurers may be pulling in their horns and that ceding companies may be faced with having to retain more and reinsure less.

Obtaining a professional independent underwriting audit makes good sense and provides the sleep assurances that all companies want to achieve. It should be and will be an essential ingredient in the new world order of accountability and transparency.

Jerry Warshaw and Howard Margules are senior partners in the firm of Independent Underwriters Associates LLP.