Understanding “Enronesque” Structures What is the Risk?

1. Understanding “Enronesque” StructuresWhat is the Risk? Casualty Actuarial Society Toronto July 8, 2002

2. Elements • Removing or recasting financial statement elements to sculpt desired financial outcomes to management’s desire • Typically involves complex structures • Using accounting rules to define structures, not necessarily avoiding them • Not a fidelity issue - there is no element of theft in the normally accepted sense • Lack of transparency Objective - Push the stock price up by showing rapid growth and consistency in earnings

3. Consider • Insurance is a tool to smooth and improve financial results - does that make it bad? • Finite structures, by definition, have as their sole purpose the smoothing of financial outcomes and building off-balance sheet reserves - are they wrong? • The insurance industry provides many types of guarantees through surety and other financial guarantees - are we party to fraud? Not all complex structures and market arrangements are inherently sinful nor should we run from them due to improper uses of a few organization

4. Enron’s Sins • Desired to make the company asset free, resulting in huge rate of return on invested capital • Recognize future income before its earned through sale of future revenue streams - common in securitization • Many of the deals and SPVs were tied to Enron’s credit rating and in some cases, their stock price • Without the credit rating or stock price strength, all the structures implode • Enron’s business was trading, which is dependent on their financial strength • Enron’s sin was its fragile nature, based on non-transparent leverage

5. Example #1Selling ticket revenues not yet earned Future ticket revenues Investors Management Services Fee + Incentive Theater Chain Concessions

6. Example #2 - Step 1 of 5Removing Phantom Liability Corporation Booked Liability Removed from Balance Sheet $10,000,000 Premium Payment $9,500,000 Stamp Liability $20,000,000 Insurer (Offshore)

7. Example #2 - Step 2 Insurer (Offshore) Booked Liability Removed from Balance Sheet $XXXXX Premium Payment $9,500,000 Stamp Liability $12,000,000 Subsidiary Insurer (Offshore) Cash Balance $9,500,000

8. Example #2 - Step 3 Insurer (Offshore) Booked Liability Removed from Balance Sheet $XXXXX Purchase Agreement Subsidiary Insurer Promise to pay $500,000 Heirs Premium Payment $9,500,000 Stamp Liability $12,000,000 Reinsurance Agreement Subsidiary Insurer (Offshore) Cash Balance $9,500,000

9. Example #2 - Step 4 (five years hence) Insurer (Offshore) Booked Liability Removed from Balance Sheet $XXXXX Stock in Subsidiary Insurer payment $500,000 Heirs Cash drawdown Subsidiary Insurer (Offshore) Cash drawdown Taxable income to heirs but not Corporation Cash Balance $12,124,000 less cash drawdown

10. Example #2 - Step 5 (five years hence) Subsidiary Insurer (Offshore) Heirs As reserve need decreases release income for drawdown Cash drawdown Cash drawdown Taxable income to heirs but not Corporation

11. Example #3Make your office building disappear • Create offshore SPV • Sell building at fair market value to SPV • Insurance company guarantees floor value • SPV issues bonds on building value • SPV rents to seller with short term operating lease • SPV “owned” by Cayman orphanage

12. Conclusions • Complex does not equal bad • Risk transfer and asset securitization are potentially tools for good and bad • Is underlying purpose to support an inappropriate activity? • Accounting profession may be their own worst enemy • Complex may be harder to structure and sell - whether right or wrong