The new scrutiny: insurers are facing additional pressure to prove they have adequate internal and external financial controls in place.

Enron. WorldCom. Global Crossing. What were once the names of profitable companies have become synonyms for accounting fraud. Lawmakers and regulators seeking to prevent other Enrons from happening have stepped up accounting and auditing standards for public companies under the Sarbanes-Oxley Act.

While the act has affected all public companies, as well as many nonpublic companies that have decided to comply, perhaps no industry has been hit harder by the additional accounting and auditing requirements than insurance, an industry in which future predictions, as well as past financial practices, must be reviewed.

Insurance is the only industry that markets and sells products before their final cost is known. It is an industry driven by numbers, yet it must rely on its best and brightest people to estimate future costs. No one can predict the future, but insurers have to try. And under SOX, which went into effect in 2004, not only do they have to prove their financial picture of the past is accurate, they also have to prove their future predictions are reasonable.

The additional regulatory scrutiny is shining the light on actuaries and auditors, who both play key roles in insurance companies. Actuaries look to the past and try to predict the future by determining how much money a company should put into loss reserves to cover its future claims. Auditors review insurers' financial records to vouch for their accuracy, and sign off on a company's annual statements.

Insurers are required by law to have an independent certified public accountant approve their annual statutory audits. They can use internal or external actuaries to come up with loss reserves, which are included in their annual reports. A company's auditors also can sign the required annual actuarial opinion--as long as they did not create the loss reserve estimates. In other words, they can audit another actuary's estimates, but they can't be the ones who created the estimates. Auditors also are barred from acting as consultants in other areas. (See "The Leaders" on page 24.)

Extra Expense

"It's a lot of work for us to comply:' said Bill Star, chief executive officer of Kingsway Financial. Kingsway is listed on the New York Stock Exchange and is subject to SOX, but as a Canadian company, it has until the end of 2006 to comply. The group includes seven companies--all of which must comply with SOX.

"It's difficult, because KPMG signs off on our audit statements, so we can't use them for advising us on Sarbanes-Oxley, We're working with two different auditing firms to make sure we are in compliance" Star said.

Under SOX Section 404, public companies now are required to annually evaluate the effectiveness of their internal controls over financial reporting, and once a quarter, review the effectiveness of their disclosure controls and procedures. SOX also requires the company's annual statement to include the auditor's opinion on management's assessment of the effectiveness of the company's internal controls and procedures for financial reporting.

In addition, audit firms can no longer be advocates for a company's management. For instance, audit firms used to be able to represent their clients in tax disputes with the Internal Revenue Service. SOX bans them from doing that.

"It's an enormous expense for public companies" said Steve Broadie, vice president of financial legislation and regulation for the Property Casualty Insurers Association of America. The act is well-intentioned, Broadie said, but too burdensome.

"Any company has got to have internal controls in place over their financial reporting. That's a piece of good management:' Broadie said. "SOX requires you to report formally on whether your controls are effective, and then have an auditor's opinion on your opinion. Companies are spending more time and more money."

Financial Executives International, a trade group representing 15,400 chief financial officers, treasurers and controllers, found companies paid an average of $4.36 million to comply with SOX Section 404 in 2004, the first year the measure was in place. This was 39% more than they expected to pay, according to a survey FEI conducted in July 2004. Auditor fees, in particular, have increased by an average of 57%.

Star said Kingsway expects to spend $3 million to $4 million a year to comply with SOX, and has spent $6 million to $7 million to date. Meeting the regulations hasn't changed the way Kingsway does business, but has increased the paperwork load tremendously, Star said.

"You have to verify each step that we are in compliance. That's where you spend a lot of money, and wonder if it's really worth the effort," Star said. "I personally don't think there's enough of an offset."

More than half of all companies surveyed by FEI said Section 404 gives investors and others more confidence in a company's financial reports, but 94% said the costs of compliance outweigh the benefits." The spirit was right on. However, the execution to the level of detail that was required was more than necessary," one respondent told FEI.

Positive Impact

While companies complain about the cost of complying with SOX, they say it does have benefits.

Cincinnati Financial found while it paid an additional couple of million dollars for outside auditors in 2004, and an unknown additional amount was spent in-house to meet SOX's requirements, it led to improvements in the way the company operates, said Kenneth W. Stecher, chief financial officer.

"By reviewing our processes, we found there were better ways to increase results. When things are going along well, there's no reason to review something; we're all busy," Stecher said. "This forced us to review all procedures. In some cases, we found ways to improve the ways things were done. If you did a cost/benefit analysis, you probably wouldn't have [implemented SOX] but there are benefits."

Star of Kingsway also said there are some pluses. SOX "requires you to have the best business practices, which ultimately are probably good for us, but we are going overboard to make sure these things are done," he said.

Beyond Public Companies

While SOX does not apply to nonpublic insurance companies, the National Association of Insurance Commissioners has been discussing whether the act should be extended to apply to all insurers--including mutuals, fraternals and captives.

"The cure is far worse than the disease," said Bill Boyd of the National Association of Mutual Insurance Companies. "The Enrons, Tycos, WorldComs and others who were the impetus for Congress to pass the Sarbanes-Oxley Act were all investor-owned companies. Investor-owned companies have within them reasons or motivations that led to some of the outrageous behavior that occurred. Since mutuals are a distinct form that doesn't include that motivation, we question that the legislation intended for investor-owned companies should apply to mutual companies."

Boyd said the existing system of state regulation is adequate to minimize the occurrence of insolvencies. "But no medicine will preclude them altogether," he said.

Some mutuals have voluntarily agreed to comply with SOX, said Chuck Emma, principal with Pinnacle Actuarial Resources, a midsized property/casualty actuarial firm.

"Whether they are publicly traded or not, many insurance companies see the need to move to independent sources," Emma said.

Nature of the Beast

SOX has had a significant impact on insurers and how they handle their loss reserves--their predictions of how much future claims will cost--and the internal controls used to develop reserves, Emma said.

This has intensified the spotlight on actuaries, both internal and external.

"No longer can a CEO or CFO just concern themselves with the result of the reserve process. They have to understand the process itself and the risk around that number. Traditionally, they just asked whether the reserve was in the range, and then signed off," Emma said. "Under Sarbanes-Oxley, they have to address the risk issues affecting the loss reserves. It's effectively caused an evolution, from concern over the result of the reserve to concern over the process involved in creating the reserve."

Unlike public companies that restate past financial statements to reflect possible accounting errors, it's natural--and expected--that insurers change their loss reserves as more information becomes available, especially for property/casualty companies, Emma said.

"The actuary is always required to ponder the imponderable. When they get new information, they will update their numbers. Managing that and minimizing the effect is the trick. Part of that is communicating to outsiders so they understand the source and the reason for the reserve developments. Some people consider reserve developments as disturbances, that someone has done something wrong. It's just updating information," Emma said. "If you put two actuaries in a room, you will come up with three different answers. Even the same actuary won't come up with the same answer year after year, because their assumptions will change. It's just one version of many, many possible outcomes."

As a result of the additional regulatory scrutiny, more actuaries are giving ranges for reserving, rather than picking a specific number, Emma said.

"Obviously, you're going to have differences of opinion. There's a range of reasonable possibilities," said Alan Hines, managing director of PricewaterhouseCoopers. "Two actuaries won't come up with the same answer, but they should get to a similar answer."

While actuaries base their work on hard numbers, they are called upon to make hundreds of judgment calls, such as whether to look at 3-year, 5-year or 10-year averages and whether to provide the low end and the high end of the range of "reasonable" estimates.

"Providing the range of reasonable estimates requires considerable judgment since there are no actuarial or accounting standards for what constitutes 'reasonable'," Hines said.

Actuaries also use multiple actuarial methods to produce various indications, and then use their judgment in selecting their best estimate. "If we give a point estimate in lieu of a range, we need to be prepared to defend it as the best estimate. We cannot just pick and choose the number we want," Hines said.

Life insurers can be expected to adjust their reserves, too, but it's much less frequent and generally only if a business is in a permanent loss position, said Henry Siegel, an actuary with New York Life and a member of the American Academy of Actuaries. New York Life is a mutual, but has tightened its internal controls to comply with much of SOX, he said.

SOX "doesn't change what we, as life actuaries, basically do or the way we do it, but it means people have to understand more clearly what it is that we do. I think that's good," Siegel said.

But the burden isn't just on actuaries. Managers should take responsibility for knowing about how the loss reserving process works, Emma said.

Over the past three years, property/casualty insurers have had $45 billion in loss reserve development, Emma said. "Management decides for itself what it wants to book [for loss reserves]. They can smooth earnings. Some companies during a hard market feel it's OK to take a large reserve hit when they can afford it. It's not just actuaries that are driving this."

Emma sees SOX as raising the profile for actuaries, and said it's an opportunity for the actuarial community to educate the public, the investment community and even insurance company managers.

"Historically, the significance of reserves and the risk associated with reserves have been underappreciated by people on the outside, and perhaps even by senior management," Emma said. SOX "is helping to put the right focus on items that need to be managed properly in reserving. We need to help them understand this beast of loss reserving."

Key Points

* Complying with the Sarbanes-Oxley Act is difficult for insurers, for which future predictions, as well as past financial practices, must be reviewed.

* Because of SOX, more actuaries are giving ranges for reserving, rather than picking a specific number.

* Companies paid an average of $4.36 million annually to comply with SOX Section 404 in 2004.

SOX in a BOX

The Sarbanes-Oxley Act of 2002 was intended to improve accounting oversight for public companies. The far-reaching bill includes many provisions, such as the following:

* Prohibits auditors from performing the following functions for an audit client: Bookkeeping

Designing and implementing financial information systems Actuarial services Appraisal or valuation services Internal audit outsourcing Management functions or human resources Broker, dealer, investment adviser or investment banking services Legal services and expert services unrelated to the audit

* Requires management to establish and maintain adequate internal controls and procedures for financial reporting.

* Requires accounting firms to also report on the internal controls of the client.

* Creates new penalties for the destruction, alteration or falsification of records in federal investigations and bankruptcies.

* Adds criminal penalties for defrauding shareholders of public companies.

* Limits companies from hiring the same person (not firm) to conduct the audit more than five years in a row.

* Gives the Securities and Exchange Commission authority to de-list any company that does not comply with the corporate responsibility provisions of SOX.

* Requires companies' CEOs to certify annual and quarterly reports to the SEC.

* Requires executives to forfeit any bonus or profit from sales of stock received 12 months before an earnings restatement.

== What SOX Has Cost

A survey of 217 public companies with $5 billion in average revenues found:

$4.36 million average amount companies paid to comply with S0X Section 404 in 2004

$1.34 million average amount paid in internal costs

$1.72 million average spent on external costs

$1.3 million average spent on audit fees

55% of companies surveyed believed Section 404 gives investors and others more confidence in a company's reports

94% said the costs of compliance exceed the benefits

What SOX Has Done

A survey of 968 internal control deficiencies and 1,000 remediation actions taken by 329 companies, disclosed as required under Sarbanes-Oxley in filings with the U.S. Securities and Exchange Commission from Nov. 1,2003, to Oct. 31, 2004, found:

3 average number of internal control deficiencies companies reported

50%+ percentage of those deficiencies classified as material weaknesses. Sales revenue, accounts receivable, inventory and accounts payable were the most common areas experiencing control weaknesses.

44% percentage of companies that changed from a Big-4 auditor to a non Big-4 firm

59% net less of clients from Big-4 firms

49% net gain of clients for non Big-4 firms

Source: Financial Executives International

Learn More

Cincinnati Insurance Cos. A.M. Best Company # 04294 Distribution: Independent agents

Kingsway Financial Services Inc. A.M. Best Company # 58159 Distribution: Independent agents and program managers

New York Life Insurance Co. A.M. Best Company # 06820 Distribution: Career agents, independent agents and brokers, alternative channels

For ratings and other financial strength information about these companies, visit www.ambest.com.

The Leaders

PricewaterhouseCoopers is both the top auditor and top actuary in the insurance industry. It audits the books of 31.5%, and is the actuary for 29%, of the property/casualty and life/health industry markets by 2004 net premiums written.

It provides services to 84% of the Fortune Global 500 companies and employs enough people to fill the city of Savannah. Ga.

PWC was formed in 1998 when Price Waterhouse merged with Coopers & Lybrand. Both firms can trace their histories to London 150 years ago. Price Waterhouse was strong in the life insurance arena. and Coopers was strong in the property/casualty market, said John Scheid, global leader for the insurance business of PWC.

"To a great extent, our growth is a credit to our professionals doing a great job of serving our clients, and our clients being pleased to talk us up. We got a lot of referrals," Scheid said. The company audits 19 of the top 50 property/casualty insurers and 18 of the top 50 life insurers. he said.

The company's success is due in part to its efforts to continually educate its employees. From new hires to partners, all continue to learn every year Even partners spend one week a year in a program nicknamed "the insurance MBA."

Under Sarbanes-Oxley, the company is now limited to what services it can provide to its audit clients. That hasn't restricted growth for PWC, which saw its insurance practice revenue jump 21% in 2004.

"We have a lot of publicly traded insurance clients [for which] we were required to do Section 404 compliance. which was a significant project. Also, our advisory business is blossoming," Scheid said.

Alan Hines. a managing director at PWC, said the company has always prohibited its employees from serving as both a company's actuary--the one setting reserves--and the company's auditor. "We can't audit our own work," Hines said.

PWC issues actuarial opinions for audit clients only when PWC can independently test the work performed by the insurer to establish the reserves, Hines said.

Part of the reason PWC separates employees into actuarial consultants vs. auditors stems from the skills of the people involved, Scheid said. Some actuaries are more creative and enjoy building modeling systems and setting reserves, while others prefer financial reporting.

The company dominates the insurance actuary marketplace--in fact, the top four actuaries (PWC, KPMG, Milliman and Deloitte) have clients whose combined net premiums written represent 70% of the industry not covered by internal actuaries. Yet there will always be a place for smaller players.

"Is there room for specialty actuarial firms? Absolutely," Scheid said. For instance, companies may call on a boutique actuarial firm for help in setting prices, or regulators may call if they feel the Big 4 companies have too many clients.

The concentration of insurance auditors is denser. The top four audit companies (PWC, Ernst & Young, Deloitte and KPMG) audit 98% of the 2004 insurance industry's net premiums written.

PricewaterhouseCoopers LLP

Headquarters: New York

Structure: Privately held, limited partnership Employees: 130,203

Cities with offices: 769

Countries with offices: 148

2005 net revenues; $19 billion

Number of P/C Insurance Audit Clients; 676

Number of L/H Insurance Audit Clients: 388

Number of P/C Insurance Actuarial Clients: 196

Number of L/H Insurance Actuarial Clients: 24

Source: PricewaterhouseCoopers, A.M. Best

Top 30 Audit Firms--Total Industry

Rank is based on insurance clients' net
premiums written.
                                                 %
                                             Market           NPW
Rank   Auditor                               Share    ($ millions)

1      PricewaterhouseCoopers                 31.43     391,532.8
2      Ernst & Young                          24.39     303,833.9
3      Deloitte                               24.02     299,171.8
4      KPMG                                   17.90     222,993.4
5      BDO                                     0.31       3,840.1
6      Strohm Ballweg LLP                      0.14       1,792.3
7      Grant Thornton LLP                      0.14       1,721.1
8      Eide Bailly LLP                         0.14       1,703.6
9      Carr Riggs & Ingram LLP                 0.08         965.6
10     Johnson Lambert & Co                    0.07         883.2
11     Seward & Monde                          0.07         835.6
12     Jaynes Reitmeier Boyd & Therrell PC     0.05         589.1
13     McGladrey & Pullen LLP                  0.05         572.7
14     Brown Schultz Sheridan & Fritz          0.04         524.8
15     Plante & Moran LLP                      0.04         505.5
16     Cherry Bekaert & Holland LLP            0.04         475.5
17     BKD                                     0.04         470.6
18     Galusha Higgins & Galusha PC            0.03         413.6
19     Kernutt Stokes Brandt & Co LLP          0.03         374.4
20     Dalby Wendland & Co                     0.03         368.7
21     Bonamassa Maietta & Cartelli LLP        0.03         331.4
22     Blackman Kallick Bartelstein LLP        0.03         329.2
23     Buff amante Whipple & Buttafaro PC      0.03         322.9
24     Crowe Chizek & Co LLP                   0.02         273.9
25     Clare Chapman Storey & Brwen LLP        0.02         267.7
26     Elliott Davis LLC                       0.02         261.7
27     Postlethwaite & Netterville             0.02         251.7
28     Andrews Hooper & Pavlic PLC             0.02         214.2
29     Ewbank Hunter Martin & Co LLP           0.02         211.7
30     Loeb & Troper                           0.02         201.0

       Total % Mkt Share of Top 30            99.24

Source: A.M. Best Special Report

Top 30 Actuarial Firms-Total Industry

Rank is based on insurance clients' net
premiums written.

                                                 %
                                             Market           NPW
Rank   Actuaries                             Share      millions)

1      PricewaterhouseCoopers                 28.77       80,473.7
2      KPMG                                   18.66       52,188.2
3      Milliman                               13.83       38,680.9
4      Deloitte                                8.50       23,776.9
5      Ernst & Young                           6.65       18,597.5
6      Tillinghast-Towers Perrin               5.31       14,841.7
7      Reden & Anders Ltd                      2.48        6,943.3
8      Eckler Partners Ltd                     1.62        4,532.8
9      Beneficial Consultants LLC              1.44        4,029.6
10     Mercer Oliver Wyman Actuarial           1.09        3,044.0
         Consulting Inc
11     Oliver T Wilson Inc                     0.88        2,454.9
12     Pinnacle Actuarial Resources Inc        0.82        2,285.8
13     Regnier Consulting Group Inc            0.65        1,818.6
14     Stergiou & Gruber Risk Consultants      0.42        1,174.1
         Inc
15     Huggins Actuarial Services Inc          0.39        1,099.9
16     Lewis & Ellis Inc                       0.36          994.5
17     JS Cheng & Partners Inc                 0.34          963.1
18     Baron Insurance Services Inc            0.33          918.3
19     Huttleston Associates Inc               0.32          881.4
20     MBAActuaries Inc                        0.28          796.9
21     Actuarial Advisors Inc                  0.27          756.9
22     Kilbourne Go, The                       0.23          645.1
23     Mellon Human Resources & Investor       0.23          635.1
         Solutions
24     Barbara V Scheil & Associates Ltd       0.22          626.7
25     Van Elsen Consulting Inc                0.20          566.9
26     Jeffrey D Miller FSA MAAA FCA           0.19          539.2
27     Bickerstaf Whatley Ryan &               0.19          520.7
         Burkhalter
28     Access Insurance Consulting             0.17          475.5
         Services Inc
29     Griffith Ballard & Co                   0.16          455.7
30     Butler Dunlap & Lindquist LLC           0.15          419.2
       Total % Mkt Share of Top 30            95.15

Source: A.M. Best Special Report

Top 15 Audit Firms-P/C Only

Rank is based on insurance clients' average policyholders surplus.

                                              Avg
                                              Client
                                              PHS            P/C
Rank   Auditors                               ($ millions)   Companies

1      Cherry Bekaert & Holland LLP           260.7                2
2      Mader Tschacher Peterson & Co          134.8                1
3      Berberich Trahan & Co PA               110.0                1
4      Deaton & Co Chartered                   77.4                3
5      Musco Marchewka & Co PA                 70.7                1
6      Wagner & Farina PC                      56.0                4
7      Mangum Goodwin & Co PA                  44.2                2
8      Dean Dorton & Ford                      43.9                1
9      Tullius Taylor Sartain & Sartain LLP    41.5                3
10     Meuwissen Flyyare Kaddik &
         Associates PA                         40.9                3
11     Jeanne S Duhe CPA                       38.4                1
12     Kutas & Hawes PC                        37.1                1
13     Hutchinson & Bloodgood LLP              33.7                2
14     Ehrhardt Keefe Steiner & Holtman PC     33.5                1
15     Meriwether Wilson & Co PLC             32.45                5

Source: A.M. Best Special Report

Top 15 Actuarial Firms-P/C Only

Rank is based on insurance clients' average policyholders surplus.

                                              Avg
                                              Client
                                              PHS            P/C
Rank   Actuaries                              ($ millions)   Companies

1      Beneficial Consultants LLC             2,790.1        15
2      Oliver TWilson Inc                       391.4         5
3      Access Insurance Consulting Services     260.7         2
         Inc
4      Marsh Management Services Inc            193.9         3
5      Richard E Sherman &Associates Inc        176.9         3
6      Dennis L Rivenburgh FCAS MAAA            138.8         1
7      Watson Wyatt                              82.9         2
8      Pinnacle Actuarial Resources Inc          74.0        42
9      Western Actuarial Services Inc            68.3         1
10     Regnier Consultini Group Inc              58.7        26
11     Aon                                       54.0         4
12     Select Actuarial Services                 54.0         3
13     Ronald T Kuehn Actuarial Services         48.4         1
         Inc
14     Complete Actuarial Solutions Co           44.9         1
         (CASCO)
15     Huggins Actuarial Services Inc            43.3        22

Source: A.M. Best Special Report

Top 15 Audit Firms-L/H Only

Rank is based on insurance clients' average capital
and surplus.
                                              Avg
                                              Client
                                              US             UH
Rank   Auditors                               ($ millions)   Companies

1      Seward & Monde                         1,529.0        1
2      McCay Duff & Co LLP                      195.7        1
3      Ginoli & Co                              122.5        1
4      Kernutt Stokes Brandt & Co LLP            84.6        1
5      Tait Weller & Baker                       83.0        1
6      Allen J Lambert                           74.0        1
7      McGee Hearne & Paiz LLP                   46.9        2
8      Dalby Wendland & Co                       42.7        3
9      Horovitz Rudoy & Roteman                  38.6        3
10     Frank J Baker & Co Ltd                    36.2        2
11     LeBlanc Nadeau Bujold                     35.8        2
12     Brown Edwards & Co LLP                    32.8        1
13     Hauser & Taylor LLC                       28.9        1
14     Lott Vernon & Co PC                       24.7        1
15     Symonds Evans & Co                        24.0        1

Source: A.M. Best Special Report

Top 15 Actuarial Firms-L/H Only

Rank is based on insurance clients' average capital
and surplus.

                                              Avg
                                              Client
                                              US             UH
Rank   Actuaries                              ($ millions)   Companies

1      Valani Consulting Inc                  561.8          1
2      Insurance Strategies Consulting LLC    430.1          2
3      James D Lamb FSA MAAA                  302.0          2
4      Mellon Human Resources & Investor
         Solutions                            200.6          1
5      Richard A Swift Inc                    173.0          1
6      Donald W Hagen                         143.1          1
7      Huttleston Associates Inc              100.1          2
8      Jeffrey D Miller FSA MAAA FCA           79.2          4
9      Sarah S Plotkin                         71.8          1
10     MWM Consulting Group Inc                69.9          1
11     Barbara V Scheil & Associates Ltd       69.4          1
12     Van Elsen Consulting Inc                62.1          3
13     ESILINS Inc                             56.4          3
14     Reden & Anders Ltd                      52.0         23
15     Leif &Associates Inc                    49.4          2

Source: A.M. Best Special Report