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Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
Professor Joshua Ronen, Stern Business School

[An edited version of this article first appeared as “Put Your Money Where Your Audit Is: Financial Statement Insurance In The UK?”, Journal of Risk Finance, The Michael Mainelli Column, Volume 7, Number 4, Emerald Group Publishing Limited (August 2006) pages 446-450.]


During 2002, in the wake of Enron and WorldCom, Professor Joshua Ronen suggested an idea that he had been considering for some time, Financial Statements Insurance (FSI). After an invitation to write a page for the New York Times, things started rolling. Another column in the Wall Street Journal led to FSI featuring in Senator Elizabeth Dole’s successful campaign for the North Carolina senate seat and later the idea was presented to the Senate Banking Committee. Numerous bodies in the USA are considering the idea of requiring listed companies to take FSI. At two events in London in February 2006 hosted by Gresham College, New York University in London and the Centre for the Study of Financial Innovation, FSI was discussed and its applicability to the UK debated.

Ronen starts by questioning “who are the gate keepers for financial probity of management?” Of course, analysts are gate keepers, rating agencies are gate keepers, the SEC (in the USA) is a gate keeper, but auditors are the main gate keepers and audit failure is one of the most important reasons why financial scandals and failures occur.

While nominally shareholders appoint auditors, management in public companies ends up hiring auditors and structuring their fees and assignments. There is an inherent conflict of interest in the cosy relations between auditors and management. The Sarbanes Oxley Act of 2002 sought to offer a partial remedy by prohibiting some non-audit services, but an indefinite stream of future audit engagement is a potent temptation. As an example, it suffices to show that the Houston office of Arthur Andersen was getting $25 million a year of fees from auditing alone. If you look at the present value of a timely stream of $25 million, you get a very large number that must have been extremely interesting to the Houston office of Arthur Andersen. Conflict of interest is endemic to the relation between Management (Principal) and Auditor (Agent). The Principal structures the contractual relation so that the Agent does what the Principal wishes.

Financial Statements Insurance – In Brief

Ronen’s fundamental proposal is to change the identity of the Principal from company Management to a Principal whose interests would be aligned with those of shareholders because it would be forced to ‘put money on its agent’s (the auditor’s) opinion’. A good candidate for such a role would be an insuring body. It could be an insurance corporation, the auditor itself, an investment banker, or a government corporation.

Ronen, in the first instance, suggests that the company solicits proposals for FSI from insurance companies to the benefit of shareholders. FSI would insure shareholders against losses that they would incur as a result of omissions or misrepresentations in financial statements. Insurers would undertake an underwriting review using independent experts, who would probably consist of retired audit partners, financial analysts and risk management experts - and there are such organisations that would like very much to offer their services. The underwriting review panel might go to the company, examine the internal auditing and control systems, look at the management compensation structure, analyse management’s incentives, look at historical occurrences of earning or negative earning surprises and the market’s response to these negative earning surprises, and in general look at the corporate governance mechanism that exists in the company

Using the underwriting review, the insurer would be able to assess the risk and price the insurance, firstly whether the insurer would be willing to provide any coverage for this company, and secondly what premium is commensurate with the risk involved. Proposals from different insurers would be submitted to the insured’s management. Management would ponder and submit its own proposals for the shareholders’ vote. These proposals would consist either of shareholders voting on the maximum coverage and the associated premium, or no insurance at all, or management recommendations for coverage and premium, which may be less than the maximum coverage. Shareholders having voted, the decision, the coverage and the premium would be published. Note that the audit fee, now paid by the insurer who, instead of the company, hires the auditor, would also be published.

Benefits of FSI

Investors are not only subject to the risk of business failure, they are also subject to the risk of misinformation, i.e. the unreliability of the information provided in the financial statements, and they would pay a premium for reduced information volatility. So, consider an investor might see Companies A and B having the same coverage. Where Company A has a higher premium, that means that the insurer, in a competitive equilibrium, insisted on a higher premium because the insurer assessed a higher risk of omission and misrepresentation. Given a higher premium, investors would be willing to buy the stock (or the debt) only if they pay lower prices, as a higher premium implies higher risk. Conversely, if Company B with the same coverage has a lower premium, the capital markets would infer that underwriters found a lesser risk of omission and misrepresentation. For a given coverage, the lower premium would invite investors to pay a higher price; they would be willing to pay a higher price because of the higher quality of the financial statements.

So let’s see what goes on from here. What happens is that the company that is insured anticipates in advance and knows that low-coverage/high-premium securities will fetch lower prices, and that would increase the cost of capital. Conversely, they know that high-coverage/low-premium securities fetch higher prices at a lower cost of capital. As a result, in anticipation of this, the insured would have a market-based incentive to improve the quality of financial statements. But, as mentioned, that is not all, the auditor would not be hired by the company, but would be hired and paid by the insurer, However, the insurer would be reimbursed for the fee as part of the premium. The premium, the coverage and the audit fee would be distinctly disclosed.

Ronen’s FSI idea ensures that the insurer’s interests are aligned with the interests of shareholders. Having underwritten the policy the insurer would be interested in minimising omissions and misrepresentations that cause the losses to shareholders that would be the basis for claims that they submit against the insurer. So the insurer would put money where his or her mouth is: he or she has underwritten the policy, he or she is committed to pay. There is a real liability, real money at stake.

This Side of the Pond – Mainelli Musings

I’ve been a bit disappointed at typical UK reactions to FSI - they need it over there; too complex for our market; we’re principles-based rather than rule-based; just the kind of thing that might suit the USA’s litigious market. I also have problems with the possible need to change articles of association or figure out who should be the beneficiary of any claim. Would shareholders really care overly much about a few pence refund for a major misstatement?

Robert Bruce says, “Such a move would also bring to the fore differences in intent between audited financial statements in the UK and the US. What would be insured in the US would be the loss suffered by investors as a result of a subsequent fall in the stock price. In the UK what would be insured would be the possible loss should negligence result in the collapse of the company.”

However, are we being too glib? Perhaps FSI has more potential on this side of the Atlantic? Ronen has worked hard, and successfully, to get USA regulators and lawyers to work through the details such that there are few issues remaining other than to start changing the US regulations. However, oddly, it might be more beneficial and easier to launch FSI in the UK or Europe than in the USA.

I start by noting that the beneficiaries might well be company management, an exchange harmed by sloppy statements or a structured shareholder such as an investment manager. There are three potential ways to launch FSI that require no regulatory changes whatsoever, but would also benefit, through competitive advantage, three distinct commercial constituencies – audit firms, stock exchanges, and investment funds.

Audit for Advantage

Over-concentration on four firms in the audit market is partially due to the fact that small or medium size firms cannot effectively compete with the big four firms. There are no visible, credible signals on the quality of the audit. If there were visible, credible signals on the quality of the audit, then firms would strive for higher quality that would be revealed through these signals. Once audit firms can prove this higher quality, then underwriters, investment bankers and companies would not shy away from hiring middle size firms or small firms.

There is nothing stopping a medium-sized firm offering FSI. A medium-sized firm could offer to pay out from partner proceeds today. To go a bit further, they need to team up with an insurer. In fact, I have had discussions with some firms, and some insurers, to find that the idea ‘has legs’. From an insurer’s point of view, insurers already have exposure to the risk of financial statements omissions and misrepresentations through their existing products of professional indemnity insurance for the auditors and errors & omissions insurance for the company directors. FSI gives insurers an opportunity to add value to an audit firm, and an opportunity for a mid-range audit firm to compete for the FTSE250 range of audits. A number of FTSE250 FD’s would be interested in moving to non-big-four auditors, but they need a reason other than price. “We chose X because they provided a £10 million guarantee to our shareholders” is a pretty compelling statement.

Exchange FSI Risk/Reward

AIM (the secondary market of the London Stock Exchange) is an interesting place to look at the potential application of FSI. As more and more foreign companies seek to list on AIM as the global alternative investment market, maintaining market probity becomes more important. At the same time, foreign companies create new challenges for due diligence and listings. Foreign companies have higher due diligence costs arising from location, unusual jurisdictions, translation and increased professional services risks.

It would be a simple matter for AIM, or other exchanges, to require FSI for new (or even existing) shares. This would push the burden of investigating and reconciling international issuers onto insurers and auditors, but instead of having a pile of paper the exchange would have some level, however small, of financial guarantee. An exchange could make it a listing requirement to have FSI for a specific percentage of the market capitalisation of a company. The FSI requirement might be time-limited, e.g. the first three years. Naturally, the publication of premium and coverage would help provide better ‘quality of listing’ information for investors.

Exchanges suffer when companies listed on their markets fail to provide rigorous numbers. The advantage of specifying FSI as a listing requirement is that the exchange is able to demonstrate to investors the same premium and coverage numbers that indicate financial statements risk, while also being able to gain recompense for harm when companies play ‘fast and loose’ with ‘their’ market. The exchange could use the monies obtained from being the beneficiary in a number of ways ranging from more due diligence, to better enforcement, to advertising.

If insurers offered FSI readily, it might also allow investment managers to create funds targeted at FSI-covered companies. Arguably, FSI-covered companies should be lower risk, and risks among FSI-covered companies can be easily compared. There is an opportunity for funds to re-examine how they conduct due diligence and to consider new products combining FSI with other risk/reward selection criteria. Perhaps we should look forward to funds, particularly international funds, that only invest in FSI-covered companies?

FSI in the UK

In some ways, critics are right. FSI as proposed for the USA is not suited to the UK. However, that may well be to miss the big opportunity that Professor Ronen’s idea affords – if capital markets professionals or exchanges or auditors can enlist insurers to provide FSI cover, they may well gain competitive advantage.

It would be fascinating to see a financial services innovation proposed in the USA taken up first, with appropriate modifications, in the UK. Even more fascinating would be to notice that the initiative was bogged down in the US regulatory quagmire, while it provided competitive advantage on this side of the pond.

Professor Joshua Ronen, PhD CPA, is Professor of Accounting at the Stern School of Business, New York University. He received his BA in Accounting and Economics from Hebrew University, his PhD in Business Administration from Stanford University and was a member of the faculty of the University of Chicago’s Graduate School of Business. He is a licensed CPA in Israel and practiced public accounting for seven years. Since Enron and other accounting scandals, Professor Ronen has focused his attention on corporate governance, in particular on the role of the auditors in safeguarding and promoting the integrity of financial statements. His proposal on financial statement insurance and restructuring the auditing profession has received wide acclaim and been introduced to the Senate Banking Committee.

Professor Michael Mainelli, PhD FCCA MSI, originally did aerospace and computing research followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen ( where he does much work on governance. Michael pushes for fundamental reform of the audit profession, including the application of Confidence Accounting (similar to an idea of Professor Ronen’s in the 1970’s, Relevant Accounting), recognising the underlying stochastic basis of financial statements. Michael is Mercers’ School Memorial Professor of Commerce at Gresham College.