On December 11, 2008, the SEC reached agreement with Zurich Financial Services (Zurich) to settle the commission's charges against Zurich Financial Services Group for aiding and abetting a fraud by Converium Holding AG involving the use of finite reinsurance transactions to inflate improperly Converium's financial performance. The commission's complaint alleges that Zurich aided and abetted Converium's violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Under the settlement, Zurich consented to the entry of a final judgment directing it to pay a $25 million penalty plus $1 in disgorgement and, in a related administrative proceeding, consented to the entry of a cease-and-desist order against it.1 The accounting issue in question deals with the complex topic of reinsurance. The facts of the accounting fraud have been simplified as much as possible to focus mainly on the legal liabilities of the company.
Zurich is a corporation organized under the laws of Switzerland with its principal place of business in Zurich, Switzerland. Historically, Zurich operated its reinsurance business under the brand name Zurich Re, which operated as a separate division within Zurich Insurance Company (ZIC), a wholly owned subsidiary of Zurich, and through its North American subsidiary, Zurich Reinsurance (North America) Inc. (Zurich Re North America). Prior to Converium's IPO, Zurich restructured its reinsurance operations and transferred substantially all of the reinsurance business operated under Zurich Re to Converium. In December 2001 and January 2002, pursuant to the Registration Statement and Prospectus, Zurich sold 40 million shares of Converium in the form of shares and American Depository Shares (ADSs), representing its entire stake in Converium, for proceeds of approximately $1.9 billion.
Securities and Exchange Commission, SEC v. Zurich Financial Services, 08 Civ. 10760 (WHP) (S.D.N.Y.), Litigation Release No. 20825, December 11, 2008, Accounting and Auditing Enforcement Release No. 2910, December 11, 2008.
Accounting Issues
The SEC announced on December 11, 2008, the filing and settlement of charges against Zurich Financial Services Group for aiding and abetting a fraud by Converium Holding AG involving the use of finite reinsurance transactions to inflate improperly Converium's financial performance. The commission's complaint alleges that beginning in 1999, the management of Zurich Re developed three reinsurance transactions for the purpose of obtaining the financial benefits of reinsurance accounting. However, in order for a company to obtain the benefits of reinsurance accounting, the reinsurance transaction must transfer risk. Here, Zurich Re management designed the transactions to make them appear to transfer risk to third-party reinsurers, when, in fact, no risk was transferred outside of Zurich-owned entities. For two of the transactions at issue, Zurich Re ceded risk to third-party reinsurers, but took it back through reinsurance agreements-known as retrocessions-with another Zurich entity. For the third transaction, Zurich Re ceded the risk to a third-party reinsurer but simultaneously entered into an undisclosed side agreement with the reinsurer pursuant to which Zurich Re agreed to hold the reinsurer harmless for any losses realized under the reinsurance contracts. Because the ultimate risk under the reinsurance contracts remained with Zurich-owned entities, these transactions should not have been accounted for as reinsurance.
The complaint also alleges that, in March 2001, Zurich announced its intent to spin off its reinsurance group in an initial public offering (IPO). Zurich then created and capitalized Converium, which assumed the rights and obligations of Zurich's assumed reinsurance business. On December 11, 2001, Zurich spun off Converium in an IPO. At the conclusion of the IPO, the members of Zurich Re management responsible for the three reinsurance transactions ceased to be affiliated with Zurich. As a result of the improper accounting treatment of reinsurance transactions, the historical financial statements in Converium's IPO documents, including the Form F-1 it filed with the Commission, were materially misleading. Among other things, Converium understated its reported loss before taxes by approximately $100 million (67 percent) in 2000 and by approximately $3 million (1 percent) in 2001. In addition, for certain periods, the transactions had the effect of artificially decreasing Converium's reported loss ratios for certain reporting segments-the ratio between losses paid by an insurer and premiums earned that is frequently cited by analysts as a key performance metric for insurance companies.
The complaint further alleges that Converium's misstatements were material to investors who purchased shares in the IPO. Through the IPO, which was the largest reinsurance IPO in history, Zurich raised significantly more than it would have raised had Zurich and Converium not improperly inflated Converium's financial performance.
Reinsurance Accounting Principles
In basic terms, reinsurance is insurance for insurers. Reinsurance is the transfer of insurance risk by the primary insurer to a second insurance carrier, called the reinsurer, in exchange 320321for a payment or premium. Whether a contract is accounted for as reinsurance depends on whether the contract indemnifies the ceding company-here Zurich and Converium-from loss or liability. Such indemnification is known as risk transfer. Risk is transferred when (1) the reinsurer assumes significant insurance risk and (2) it is reasonably possible that the reinsurer will realize a significant loss in the transaction. A risk transfer analysis for a contract emphasizes substance over form and GAAP requires "an evaluation of all contractual features that ... limit the amount of insurance risk to which the reinsurer is subject." Accordingly, under GAAP, "if agreements with the reinsurer ... in the aggregate, do not transfer risk, the individual contracts that make up those agreements also would not be considered to transfer risk, regardless of how they are structured."
Where there is insufficient risk transfer, a transaction may not be treated as reinsurance under GAAP, and must be accounted for using the deposit method, which lacks the potential accounting benefits of reinsurance accounting. Under reinsurance accounting, when losses on the ceded business are incurred, the ceding insurer records an offset to the increase in its gross loss reserves in an amount equal to the reinsurance it expects to recover from the reinsurer, thus increasing its net income by that amount. Deposit accounting has no comparable income statement benefit.
From 1999 through 2001, management of Zurich Re designed three reinsurance transactions that created the appearance of risk transfer in order to benefit from reinsurance accounting. These three transactions affected the financial statements included in Converium's IPO prospectus. In two of the three transactions, Zurich Re purchased reinsurance from Inter-Ocean, which, in turn, ceded these liabilities to a Zurich entity (the Inter-Ocean transactions), in one transaction directly and in the other transaction indirectly through a third reinsurer (Company A). Zurich Re's use of Inter-Ocean as an intermediary in the transaction helped obscure the transactions' circular structure and the fact that Zurich Re had merely moved the risk from one Zurich Re entity to another. In the third transaction, Zurich Re entered into a reinsurance transaction for which the risk transfer was negated by an undisclosed and purportedly unrelated side agreement that protected the reinsurer against losses suffered under the reinsurance contract. Zurich Re improperly accounted for these transactions using reinsurance accounting.
Although Zurich Re accounted for the transactions with Inter-Ocean and Company A as reinsurance, in reality, Zurich Re had recirculated the risk from one Zurich entity to another, while interposing intermediaries (Inter-Ocean and Company A) that obscured the transactions' circular structure. Because this transaction was circular, there was no risk transfer and Zurich Re and later Converium should not have accounted for the contract as reinsurance. As a result, and as reported in Converium's December 2001 Form F-1, Converium understated its pretax losses for the year ended December 31, 2000, by $1.36 million.
The Converium IPO
On March 22, 2001, in connection with its announcement of disappointing financial results for 2000, Zurich reported that it intended to exit the assumed reinsurance business. In a September 6, 2001, press release, Zurich announced that its reinsurance business would be spun off in an IPO, and that as of October 1, 2001, the business would operate under the name Converium.
The Registration Statement and Prospectus filed by Converium in connection with the IPO, which became effective on December 11, 2001, was derived from data from the Zurich subsidiaries combined to form Converium and failed to disclose the impact of the circular Inter-Ocean and the Z-1 Facility transactions on Converium's business operations, financial results, and shareholders' equity at the time of the IPO.
Accordingly, the statements in the prospectus regarding Converium's financial results for 2000 and the first half of 2001 were materially false and misleading. As a consequence of the circular Inter-Ocean transactions and the Z-1 Facility transactions, rather than reporting a loss before taxes of $48.8 million for 2000, Converium should have reported a loss of at least $148.4 million. Converium also overstated its $1.09 billion in reported shareholders' equity as of December 31, 2000, by at least $72.3 million (approximately 6.6 percent of the total reported shareholders' equity), an amount including the effect of $100 million attributable to the Inter-Ocean and Z-1 Facility transactions and partially offset by $27.7 million attributable to other reinsurance transactions not addressed within the complaint.
Finally, because Converium's loss ratio for its non-life reinsurance business was directly affected by the improperly recorded reinsurance obtained through the circular Inter-Ocean and the Z-1 Facility transactions, Converium materially understated its reported loss ratios.
SEC Charges
Based on the foregoing, the SEC charged Converium with violating Section 10(b) of the Exchange Act and Rule l0b-5 in that it knowingly or recklessly made false and misleading statements, or omitted to state material facts necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading to purchasers of Converium securities in connection with the 2001 IPO.
Zurich substantially assisted Converium's violation of Section 10(b) of the Exchange Act and Rule l0b-5 by, among other things, entering into the finite reinsurance transactions previously described for the purpose of improperly inflating its financial performance and improperly using reinsurance accounting rules to account for the transactions with the knowledge that such accounting was improper.
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Questions
1. Why do you think it is important for a reinsurance transaction to transfer risk in order for a company to obtain the benefits of reinsurance accounting? Discuss the accounting and legal issues behind such a requirement.
2. Assume the external auditors of Zurich Re and Converium knew about the Inter-Ocean and the Z-1 Facility transactions. What legal issues could have been raised by the purchasers of stock in Converium's IPO to successfully bring an action against the auditors?
3. Evaluate the ethics of Zurich Re's actions with respect to its reinsurance transactions and the transfer of economic risk.