More Evidence of Slabberator Misuse: The Farm’s “Sham Transactions”, Zurich’s Sham Reinsurance Deals

Ladies and Gents if you or I were to do these things that insurance companies do regularly, a stretch in the federal pen would be a certainty so please do not try this at home. (H/T Steve, Mr CLS and unnamed others)

First let’s start at the National Underwriter to find out  why Zurich is paying a substantial fine to the captured regulators at US Securities and Exchange Commission who could not ignore the “round robin” transaction:

Zurich Financial Services has paid $25 million to settle a securities fraud action by federal regulators over its use of phony reinsurance transactions to pump up its financial statements.

The Zurich, Switzerland based corporation, which admitted no guilt, said it had settled the civil case to “eliminate the burden, expense and uncertainty of potential enforcement proceedings.”

SEC’s action stemmed from company activity from 1999 through 2001 with a former Zurich subsidiary, Converium Holding AG (now known as SCOR Holding (Switzerland) AG). The company said, “None of the individuals responsible for these transactions has been employed by Zurich for several years.”

According to the SEC announcement, the company helped Converium with a fraud that involved the use of finite reinsurance transactions to improperly inflate Converium’s financial picture.

Zurich reinsurance group management Zurich Re, in 1999 developed three reinsurance transactions to obtain accounting benefits, SEC said.

The company was accused of making the transactions appear to transfer risk to third-party reinsurers, when, in fact, no risk was transferred outside of Zurich own entities.

For two of the Zurich transactions, the SEC said, the company ceded risk to third-party reinsurers, but took it back through retrocession agreements with another Zurich entity.

A third transaction, regulators said, involved ceding a risk to a third-party reinsurer, but at the same time entering into an undisclosed side agreement with the reinsurer under which Zurich Re agreed to hold the reinsurer harmless for any losses realized under the reinsurance contracts.

Because the risk actually remained with Zurich, the transaction should not have been accounted as reinsurance, the SEC explained. A number of entities used for the circular transactions were in Cologne Germany and the Barbados and only identified by letters of the alphabet.

The SEC complaint alleged the phony deals were part of misleading filings when Zurich spun Converium off in an initial public offering.

According to the government, Converium understated its reported loss before taxes by approximately $100 million or 67 percent in 2000, and by about $3 million or 1 percent in 2001, which had the effect of decreasing Converium loss ratios.

The complaint indicated that a motivating factor for some of the activity was Zurich executives’ concerns in 2000 about the financial statement impact of Zurich Re’s exposure to losses arising out of Zurich Re’s involvement in the failed Unicover Occupational Accident Reinsurance Pool (“Unicover Pool”).

Today’s settlement took care of a lawsuit that was filed against the company in Manhattan U.S. District Court. SEC said it took into consideration cooperation the company had provided in accepting the settlement. 

Next up is State Farm’s bewildering request for huge rate increases in Florida. This is what happens when human judgement is removed from the slabberator equation. At some point in time you think the fools toting State Farm’s water in Florida would realize taking smoke and mirror before a judge, even an administrative judge is bad for their professional reputations. You can read the judge’s entire 37 page ruling here. This blurb found on pages 16 and 17 of the opinion tells the tale:

Transactions between State Farm Mutual and State Farm Florida for reinsurance and credit risk provisions totaling approximately $561.8 million, when viewed in the light of economic reality………may be transactions which State Farm Mutual engages in with itself and which lack any independent economic significance. Transactions with no independent economic significance would be sham transactions which may distort the economic costs of the reinsurance and credit risk provisions purchased from State Farm Mutual. Such economic distortions may enable the group to derive a rate advantage from the legal form in which State Farm Mutual chooses to do business in Florida.

Beatrice Garcia at the Miami Herald has written extensively on insurance issues that impact South Florida and she covered this latest State Farm rate debacle as well. Here is her story which describes the end result of the tie in of executive bonuses and policy premiums via the slabberator. Note how they blame wind risk mitigation for their decline in premiums and forgot to mention how many policies they have cancelled:

A state administrative judge has rejected State Farm Florida Insurance’s bid for an average statewide 67 percent increase in homeowner insurance rates.

After Florida’s insurance commissioner rejected State Farm’s initial average 47.1 percent rate hike request, State Farm, Florida’s largest private insurer, appealed to the Division of Administrative Hearings. Then, in court papers last month, the insurer said its analysis of its risk and projections of losses supported a 67 percent increase in rates.

But Judge Daniel Manry ruled that much of the evidence State Farm presented to support its demand for higher rates was at times ambiguous, contradictory and lacked credibility.

For instance, State Farm said it needed to raise rates in part because hefty discounts it was giving homeowners for measures to mitigate against heavy winds were cutting into premium revenues.

The insurer claimed it was saving less on claims then the amount of wind mitigation credits it was supposed to issue.

Yet when Manry asked for specifics, the company couldn’t provide them.

The judge noted that State Farm’s premiums are declining in part because it is renewing fewer policies, or removing wind coverage from policies, saying the number of policies State Farm planned not to renew rose from 50,000 to 85,000 after the first rate request was submitted.

So it’s not clear, he said, how much of the rate increase is directly tied to the discounts versus a decline in the number of policies.

In a statement, State Farm said it realizes “this rate increase poses a difficult situation for our customers, especially in light of these tough economic times; however, it is the only responsible choice.”

Chris Neal, a company spokesman, said no decision on an appeal has been made.

In his decision, Judge Manry also said he couldn’t determine whether the high cost of reinsurance, which State Farm said also justified higher rates, was reasonable.

He was troubled by the company’s purchase of reinsurance to cover a probable loss of $9.25 billion, even though State Farm noted that the decreased number of policies plus savings from wind mitigation measures taken by policyholders had reduced that probable loss to about $7.1 billion.

State Farm paid $842 million for reinsurance coverage this year. The largest chunk — $549 million — went to State Farm Mutual, the company’s parent company in Illinois.

He noted that State Farm Florida, formed in 1998, is the legal entity that the parent company chooses to do business in this state, but they are essentially the same entity.

He said dealings between the Florida company and its parent might be ”sham transactions” that could distort the true cost of reinsurance and credit provided by State Farm Mutual to the Florida company and could allow the insurer “to derive a rate advantage.”

Commissioner McCarty, as the final hearing officer, has 30 days to issue a final order.

One thought on “More Evidence of Slabberator Misuse: The Farm’s “Sham Transactions”, Zurich’s Sham Reinsurance Deals”

  1. Simple formula which has worked well for so long. Reduce risk assumed, raise rates for reduced risk assumption, suck profits out the backdoor via RE to tax haven, money disappears in some island bank…

    Nice business model. But where are the interest of taxpayers, consumers and shareholders being addressed in this business model. Looks like a crooks paradise.

    14. State Farm Florida obtained an approval from Respondent for a prior rate filing of 52.7 percent. The rate increase became effective November 1, 2006.

    17. The decline in premium revenues is the moving force behind the current rate filing. The Legislature has found in Subsection 627.062(2)(e)3. that rates are inadequate if they are insufficient, together with investment income attributable to them, to sustain projected losses and expenses in the class of business to which the rates apply. 8

    18. The reasons for the reduction in premium revenue are undisputed. State Farm Florida has non-renewed some policies; excluded wind from the covered risk of other policies, a process described by the parties as ex-winding; provided discounts to policyholders who improved covered property with wind-mitigation features identified in Subsection 627.0629(1), identified by the parties as wind-mitigation discounts; and allegedly incurred an increase in costs, not the least of which is the cost of reinsurance for excess losses.

    19. State Farm Florida asserts that the decline in premium revenue caused by non-renewals, ex-winding, wind-mitigation discounts, and increased costs such as the cost of reinsurance justifies a rate increase equal to the indicated rate of
    67.0 percent or the requested rate of 47.1 percent.

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