Enron and the Insurance Industry

Executive Summary
Insurers suffered substantial losses following the collapse of Enron Corporation. Many insurers, particularly those specializing in life, not only wrote policies to Enron, these companies also invested heavily in Enron-backed securities. Suddenly insurers found themselves caught between servicing their clients and serving the needs of the bankruptcy court. Many important lessons would come from the industry’s experience with Enron, however. Life insurers learned whether or not their long-term planning and asset management programs functioned adequately. While sustaining heavy losses related to Enron’s demise, not a single insurer had its debt rating downgraded as a result of either investment losses or exposure. Surety bond insurers learned the consequences of not acting on a suspicion, as they guaranteed millions in fictitious energy trades used as a vehicle for major financial institutions to provide Enron with low-cost, off-balance-sheet loans. Insurers have learned the importance of carefully evaluating policyholders and their business relationships in today’s complex world of structured finance. The directors and officers’ liability insurance (D&O) carriers suddenly found themselves in a morass, weighed down by years of complacence and poor risk management. Caught in the middle of shareholder and creditor lawsuits, many settled rather than risk admitting guilt. In certain cases, this further damaged an already tarnished corporate image. Just as Enron executives learned there was a limit to their greed, so did insurers that blindly underwrote Enron’s activities. Thus, these carriers were faced with the unpleasant task of substantially increasing premiums, thereby pricing customers out of the market. D&O carriers, and the industry alike, did gain some sense from Enron’s demise, however, which was quickly tested by successive corporate scandals.

The bankruptcy of Enron in December of 2001 had wide ranging impacts, from some 4,000 displaced workers who lost their 401(k)s to the many insurance carriers writing Enron policies. Insurance carriers’ losses are not limited to one particular business line, but will be felt across many areas, said John Cavanaugh in his April 2002 article, “The Status of the Insurance Industry.”¹ The investment side of the insurance industry suffered as well. As an example, Mr. Cavanaugh cited Safeco, which expected a $20 million loss on surety bonds it issued, as well as a $20 million loss on the write down of Enron bonds it held for investment.² This case illustrates what just one of the many Enron insurers faced as the company collapsed in late 2001. One of the hardest hit specialties was directors and officers’ liability insurance, with hundreds of millions of dollars in exposure on Enron alone. The industry responded by increasing premiums, just as the corporate fraud that has plagued this decade was unfolding. Herein I endeavor to explore the wide-ranging impacts of Enron’s disastrous demise. The nightmare is far from over, and the insurance implications are still unclear, as litigation related to corporate fraud will continue for years to come. The collapse brought awareness to an industry that had languished in comfort for years, while also forcing insureds to review their policies or risk a costly surprise should something go wrong.

One of the most profound impacts of Enron Corporation’s spectacular 2001 demise was felt in the insurance industry. Insurers such as Hartford Financial Services Group, XL Capital, AXA, and SAFECO, along with many more, faced exposures in many forms. Not only were many of these companies underwriters on policies held by Enron, many held Enron stock in their investment portfolios. This was particularly true of life insurers. In total, insurers held $3.5 billion in Enron securities when the firm filed for bankruptcy, $2.6 billion alone with life insurers.³ As a result of Enron’s collapse, many insurers were now exposed to liabilities outside of Enron itself. Surety bond insurers and parties to secured transactions—even shareholders—were impacted and would seek redress. Following the collapse, insurers would face suit and countersuit related to the complex activities Enron engaged in.

Life insurers, by nature of their business, were heavily invested in Enron. Historically, the stock had been highly rated and widely held. In the year preceding its collapse, its common stock traded at an average of $84 per share.⁴ Some insurers had begun to liquidate or reduce in the weeks and months preceding Enron’s December 2, 2001 bankruptcy filing.⁵ Despite this fact, Standard & Poor’s estimated that insurers still held $2.6 billion of Enron securities. Insurers such as John Hancock had exposure of $320 million, Aegon reported $300 million in loans to Enron, and AXA Group estimated its exposure at about $180 million in fixed-debt securities. Hartford Financial Services Group, with an estimated holding of $92 million, wrote down $61 million in corporate fixed maturities on its 2002 income statement.⁶ Despite the staggering size of these losses, life insurers were prepared for the inevitability of failure in their investment portfolios. This is due largely to the size of the investment pool held by life insurers. The decline in portfolio value experienced in this market did not affect the credit ratings of any of the insurers, preventing the loss of portfolio value from damaging other aspects of the business.⁷ Another market with significant exposure to Enron is property and casualty.

Property and casualty insurers Chubb Corp and Swiss Re are just two of the insurers affected by Enron. Both companies, along with other smaller insurers in the sector, estimate their exposure at $700 million, largely due to surety bond obligations. These surety bonds covered gas and electricity transmission contracts entered into between Enron and companies worldwide. Chubb Corp’s liability was approximately $220 million, while $173 million was attributable to Swiss Re.⁸ Safeco reported a $20 million loss on surety bonds and a $20 million loss on corporate bonds, and St. Paul Insurance Co. reported an after-tax loss of $83 million.⁹ St. Paul Insurance was a guarantor to “gas supply bonds, financial guarantees and construction bonds as well as surety reinsurance….”¹⁰ It is this final item that was most troubling for St. Paul Insurance. Not only did it have primary exposure on surety bonds, it reinsured certain of Enron’s surety bonds. Regardless of this increased risk, St. Paul Insurance’s successor, Travelers, continues to offer surety reinsurance.¹¹ Given its size, it is likely that Travelers has analyzed the risk involved with offering both surety insurance and reinsurance and found it to be reasonable. Outside of the direct risk of claims from Enron, many surety insurers and business-liability insurers faced suits from Enron’s clients and business partners.

One notable case to arise from Enron’s collapse involved JP Morgan Chase. Chase was one of many major banks involved in the intricate financial workings that facilitated Enron’s fraud. In this particular case, JP Morgan set up an offshore energy-trading venture with Enron. Based in the Channel Islands, Mahonia Ltd. entered into contracts with Enron to purchase gas for future delivery.¹² The company was fully controlled by Chase and 60% of its business was with Enron.¹³ Under these contracts, Enron agreed to sell gas to Mahonia for periodic delivery over a certain time. Enron recorded the full value of the transaction at the time the contract was entered into and made related purchases at the end of each year in an attempt to justify this treatment. Enron, through eleven different insurers, then issued surety bonds to guarantee the gas deliveries.¹⁴ Between 1992 and Enron’s collapse, JP Morgan purchased nearly $1 billion of the surety bonds issued, while simultaneously entering into delivery contracts. When Enron collapsed, Chase sought remedy from Enron’s surety bond insurers for $1 billion. The insurers refused to pay, citing JP Morgan’s involvement in the fraudulent gas delivery contracts. JP Morgan filed suit against the insurers. In court briefs, the insurers contended that Chase used the transactions as a way to loan Enron money and knew all along that the contracts would never be executed.¹⁵ In court documents, however, one sees a picture of Chase as more of a victim, blinded by the supposed strength of Enron. Citing JP Morgan’s minimal credit risk insurance for its Enron debt, the documents suggest, “…bankers did not believe Enron was a substantial default risk.”¹⁶ Furthermore, insurers begin to look like more-liable parties. Memos between General Re and Chubb, for example, suggest some of the surety bond insurers were aware that Chase was using these transactions to provide Enron with low-cost, off balance sheet loans.¹⁷ Another memo from Kemper Insurance shows that employees there were beginning to question the merits of writing surety insurance for Enron. Though the employee considered the outstanding bonds to be very risky, “Enron’s stature makes [the underwriting] a risk worth taking” given that, “[it] is a large enough account with a strong balance sheet, cash flow, and available credit facilities to warrant Kemper to issue such bonds.”¹⁸ In hindsight, the Kemper employee’s concern was well placed. Regardless, the suit was settled out of court in 2003, allowing both parties to avoid admitting any wrongdoing. This was essential, as a ruling for either party could have led to further lawsuits by Enron’s shareholders. Another notable Enron case dealt with the company’s directors and officers liability insurance.

Directors and officers liability insurance (D&O) is used to protect the management of a company from liability for actions during their employment. Following Enron’s collapse, numerous shareholder lawsuits were filed against the company’s directors. To cover their mounting legal expenses, the directors petitioned the bankruptcy court for payment from their D&O insurer. The unsecured creditors objected, as the payment would have eliminated millions from what they hoped to recover.¹⁹ They claimed that any D&O proceeds were property of the Enron estate and should be preserved for the directors’ defense against claims brought by Enron’s creditors. The directors claimed that, though the policies cover the corporation and the directors, the primary intent of the insurance was to protect the directors. Specifically, the foundation of the directors’ claim was an endorsement to the primary D&O policy stipulated that any payment under the policy first be made to the director, and then to the corporation.²⁰ Though no final decision has been reached, it seems likely that the former directors will prevail. Since this dispute began, insurers and insureds alike have reexamined the payment provisions of their policies. Enron’s collapse also led directly to sharp increases in D&O premiums.

In the wake of Enron’s collapse, D&O insurers were faced with poor results and a mounting crisis. Enron held roughly $350 million in D&O coverage, and lawsuits had already been filed to assert or block various parties’ claims to the proceeds.²¹ An industry that typically saw between two- and three-hundred class action lawsuits filed annually was suddenly faced with more than five hundred.²² As D&O insurers came to terms with the impact that years of increasing loss ratios, an unstable economy, the dot-com bust, and a growing number of shareholder lawsuits, carriers discovered to just what extent they had neglected to examine their exposure.²³ Premiums spiked as a result, increasing by fifty percent for companies with market capitalizations in excess of $1 billion, according to Willis Group Holdings, Inc, the world’s third largest broker.²⁴ D&O premiums increased across all markets, though, not just for those of Enron’s size. Carriers perceived an increased risk of corporate fraud, and their caution would be rewarded just months later. Just one month after Enron, Global Crossing Limited filed for Chapter 11 bankruptcy protection. Six months after that, in July of 2002, WorldCom filed for Chapter 11 protection with nearly double the assets of Enron.²⁵ Lawsuits were filed after every one of these bankruptcy filings related to the companies’ directors and officers insurance. Again, shareholders and creditors argued that the D&O proceeds were property of the firms covered. Carriers also contended that the applicants had provided misleading information when seeking coverage.

As insurers assessed the impact of Enron’s collapse, several D&O carriers reexamined Enron’s applications for coverage. These insurers claimed that directors had provided false and misleading information on their applications and that as such, the policies were void.²⁶ Regardless of whether the insurers’ assertions are true, it raises a bigger issue as to the extent that blame can be placed reliably with one director and not another. Attention turned to the “application-severability” clause in the policies. This clause provides that in the event one director provides dubious information on his or her application, only that individual’s coverage is void. The policy remains in force for other directors. This clause is an important consideration when protecting oneself from personal liability, regardless of the employer.

Enron’s spectacular collapse, as well as that of WorldCom and Global Crossing, had far-reaching consequences that will be felt for years to come. The insurance industry was not immune to the damage, far from it in fact. Insurers held billions in Enron stock as investment, and saw the shareholder’s equity it represented disappear in an instant. Not surprisingly though, the insurers were not severely harmed by this loss. Life insurers, by far the heaviest investors, suffered little, seeing no negative affect on their debt ratings, and thus far no bankruptcy filings. A more substantial impact was felt in the surety bond insurance market. Here, insurers had guaranteed billions in natural gas and other commodity contracts, while simultaneously ignoring Enron’s strange financial arrangements. In certain cases, insurers may have even looked on without concern as Enron and major financial institutions continued to disguise low-cost loans in the form of transmission contracts. This comfort, or smugness, proved costly; nothing wakes a company up like a multi-million dollar loss. Carriers are now more likely to exercise caution when issuing surety bonds for exceedingly complex or questionable financial transactions. Directors and officers’ liability insurance was also severely affected by Enron and other corporate fraud. Not unexpectedly, premiums surged as carriers reassessed the risk of companies making claims. In a single year, the number of claims doubled, and carriers awoke to the realities of doing business in the twenty-first century. Likewise, companies holding policies, seeking renewals, or purchasing new policies turned their attention to shareholder lawsuits over the rights to D&O payouts and clauses in the policies pertaining to fraud. While both tragic and unimaginable, Enron’s collapse had some functional purposes for the insurance industry. Insurers were suddenly more aware of their business environment and their policyholders are more concerned than ever about purchasing adequate coverage.