Philip R. Ballinger, CPCU, ASLI Executive Director, Surplus Lines Stamping Office of Texas

1. Avoiding “The Sting” Recognizing Scams & Abuses in the Nonadmitted Market Philip R. Ballinger, CPCU, ASLIExecutive Director, Surplus Lines Stamping Office of Texas

4. From the Press… June 2009:Two Insurance Agents Charged with Multi-Million Dollar Insurance Fraud Scheme (Michael Swetnam & Brent Carter, $4 million, US DOJ, TX) April 2009: Chattanooga Agent Allegedly Skims $2.6 Million in Unearned Commissions (Edward Prater, $2.6 million, GA OCI) June 2007:Canadian Man Pleads Guilty to Multi-Million Dollar Bogus Insurance Policy Scheme (Ian Stuart, $7 million, US DOJ, NY) May 2007:Leddee Sentenced for Insurance Fraud (William A. Leddee / Professional Liability Insurance Co., St. Vincent & Grenadines / Bermuda, $24 million, US DOJ, GA)

5. From the Press… February 2007:California Man Sentenced to Ten Years in Prison for $6 Million Insurance Fraud Involving Fake Lloyd’s of London Policies (Richard Peterson, $6.6 million, US DOJ, NY) May 2006:Federal Judge Sentences Insurance Broker to 33 Months in Prison for Fraud on Major Insurance Company (Martin Hoffman, $4 million, US DOJ, NY) February 2006:Fraud Inquiry into Insurer of Capsized Boat (Global Property Owners Association, 20 deaths, Lake George, NY) December 2005:Segal sentenced to More Than 10 Years in Prison (Michael Segal, $30 million, US DOJ, IL)

6. From the Press… August 2005:Former Co-Owner of Insurance Agency Charged with Insurance Fraud, Wire Fraud and Money Laundering (Mary Ann Locke, $8 million, US DOJ, CA) February 2005:Leader of Insurance Fraud Scam Extradited to California (Matthew W. Schachter / Tri-Continental Exchange, $20 million, US DOJ, CA) May 2004:Owners of Insolvent Insurance Company Charged with Theft, Racketeering and Conspiracy (Marcos Fraynd – Paul Fraynd – Saul Fraynd – Fanny Fraynd / Aries Insurance Co., $60 million, FL DFS)

7. Implementation of anti-fraud controls appears to have measurable impact on an organization’s exposure to fraud. Source: 2008 Report to the Nation on Occupational Fraud & Abuse; Association of Certified Fraud Examiners Occupational Fraud • Fraud schemes tend to be extremely costly (median loss for insurance = $216,000). • Schemes frequently continue for years before detection. • Frauds more likely to be detected by tip than by audits, controls, or other means.

8. Fraudsters generally first-time offenders. Source: 2008 Report to the Nation on Occupational Fraud & Abuse; Association of Certified Fraud Examiners Occupational Fraud • Small businesses especially vulnerable, suffering both higher incidence of fraud and higher median loss. • Lack of adequate internal controls are most commonly cited as factor allowing fraud to occur. • Fraud most often committed by the accounting department or upper management.

9. Nonadmitted Scams • Insurer or agent • Target: - Markets with availability / affordability problems (e.g., hard markets) - Markets outside “routine” regulation • “Surplus lines” – rely on gullible, ignorant, greedy retail agents • “Direct procurement” • RRGs and PGs • Mandated coverages • Specialty programs • Surety / promissory notes • Health care plans

10. “Many business men cannot obtain sufficient insurance in companies licensed in the State where the property to be insured is located, and are compelled to place the “surplus line’ with unadmitted companies or associations. Here great care is necessary. The “surplus line” concerns as a class are inferior in financial responsibility and general caliber to the companies regularly licensed. Many of them are wholly unworthy of confidence. These considerations apply with especial force to unadmitted foreign companies, of which a number are transacting business in the United States. Many brokers making a specialty of placing “surplus lines” are incompetent, dishonest, or both. They collect premiums which they fail to pay to the companies, and, as they act as agents for the insured, the premiums must be paid again, or the policy will be cancelled.” Why Accuse Surplus Lines? • A little history… Dangers of “Surplus Line” Insurance A.M. Best - 1916

11. Why Accuse Surplus Lines? • A little history… Kenilworth Insurance CompanyA Case Study Presented to the NAIC Annual Meeting - December 1982 “… over ten years ago the author determined that most of the fraudulent activity which had occurred in the sixties in the insurance industry was related to the excess and surplus lines and reinsurance business.  (Surplus lines) is a book of business that is essentially not subject to any regulation other than surplus lines brokers who generally have to file certain reports with the state insurance departments, primarily for tax reasons.  It is attractive for the high premiums per risk, both in terms of cash flow and the fewer number of individuals exposed to claims.  … if a company wants to write in a particular state, but cannot be admitted in that state by the Insurance Department, it can go to the London market and write the risk through a London broker. … risks such as these are treated in the convention blank as reinsurance and rarely, if ever, broken down by state.”

12. 1970’s Sasse syndicate (Bronx slum property business - $15 million)Jack Goepfert Den-Har (Dennis Harrison) 1980’s Kenilworth Insurance CompanyJack GoepfertCarlos Miro (Transit Casualty Company) Alan Teale (Victoria Insurance Company & many others) Why Accuse Surplus Lines? • A little history…

13. Why Accuse Surplus Lines? • Ease of market entry • Lax regulation • Reliance on “broker responsibility” • Untrained agents • Inability to monitor market conduct & activity • Continuing perception of unregulated market dominated by insolvent Caribbean insurers & scam artists

14. The Current Reality • Evolution of US surplus lines industry (now 75% of the market) • Eligibility lists • Regulatory focus on surplus lines licensee • Stamping offices in 14 states • NAPSLO & AAMGA • Technical, unintended violation of complex state surplus lines laws is not fraud

15. OFFSHORE INSURERS Anguilla Turks & Caicos Costa Rica St. Vincent Ireland Netherland Antilles Antigua Aruba Dominica Isle of Man Belgium Vanuatu Panama Cayman Islands Dominion of Melchizedek

16. Offshore InsurersExamples of Known Fraud • Tri-Continental Exchange / Combined Services, Ltd. multiple insurers (St. Vincent/ Matthew Schachter, aka Robert L. Brown) • Regency Insurance of the West Indies, Ltd. (Capistrano Beach, California) • Alpine Assurance, Ltd. (Turks & Caicos) • West Point Insurance Company (Antigua) • American Trust Insurance Company, Ltd. (Turks & Caicos / Alan Teale) • International Casualty and Surety Company, Ltd. (New Zealand)

17. Offshore InsurersExamples of Known Fraud • International Fidelity & Surety, Ltd. (Vanuatu) • Westwood Insurance Company, Ltd. (Antigua) • Global Insurance Company, S.A. (Uruguay) • North American Marine and General Insurance Company, Ltd. (Panama) • New England International Surety, Inc. (Panama / Belgium) • Provident Capital Indemnity, Ltd. (Dominica / Costa Rica) • California Pacific Bankers & Insurance, Ltd. (Melchizedek)

18. Domiciles of Convenience • Superficial regulation • Domiciliary secrecy laws / no public disclosure / no records • Permissive laws on holding companies & affiliates • Jurisdictional issues (“judgement proof”) • Intentional use of names similar to reputable insurers

19. The Importance of Insurer Identity • Nationwide Insurance Company Tri-Continental Exchange Nationwide Group Best-rated A+ XV • California Indemnity Insurance CompanyAdmitted company in Florida California Indemnity InsuranceCorporation Unauthorized, ineligible insurer issuing crop insurance in Florida in 1995 • Alpine InsuranceCompanyIllinois insurer Alpine Assurance, Ltd.Turks & Caicos insurer

20. The Importance of Insurer Identity • Associated International Insurance CompanyCalifornia insurer Associated International Insurance Ltd.Bermuda insurer • Voyager Indemnity Insurance CompanyA- rated insurer, part of American Bankers Group Voyager Insurance Company Ltd.Insurer delicensed by Bermuda

21. The Importance of Insurer Identity • Phoenix Assurance Public Limited CompanyPart of prestigious Royal SunAlliance Group Phoenix Insurance CompanyFronting company for St. Eustatius Insurance Co., Netherland Antilles (which was capitalized with a fraudulent gold mine in the mountains of Columbia) • Pacific Insurance CompanyA-rated member of CNA Group Pacific Insurance Company, Ltd.A+ rated member of Hartford Insurance Group

22. Problems • Obscure ownership • Weak local management • Bogus financial statements • Fraudulent / overvalued assets • Understated liabilities • Insider deals • Transfer of assets • Sham transactions • Unauthorized changes in ownership, possibly to fictitious persons, to facilitate flow of premium to unknown persons

23. Problems • Inadequate reinsurers • Writing high-risk liability coverages • Use of purchasing groups to circumvent state regulation • Common ownership of management, underwriting agencies, reinsurance brokers, reinsurers, and purchasing group administrators • Premium skimming

24. Primary Causes of Insolvencies 1976 - 2007 Surplus Lines vs. Admitted Insurers Surplus Lines Admitted Primary Cause # of Cos. % of Total # of Cos. % of Total Deficient loss reserves (inadequate pricing)Affiliate problems Alleged fraudInvestment problems (overstated assets) Rapid growthCatastrophe losses MiscellaneousReinsurance failureSignificant change in businessSubtotalUnidentified Total 19 8 7 5 4 2 2 2 150 959 38% 16% 14% 10% 8% 4% 4% 4% 2%100% 218 43 45 37 76 45 44 21 26555 308 863 39% 8% 8% 7%14% 8% 8% 4% 5%100% Source: A.M. Best Special Report: US Surplus Lines – Market Review; August 2008

25. “For decades, we have tended to blame insolvencies on mismanagement and fraud. Seeing it that way fits the characteristically American view that the natural state of affairs is good and getting better. So when something really awful happens, there must be a villain behind it. Contemplating an insolvent insurance company, we search for fools, wastrels and criminal masterminds. Sometimes we find them. More often we do not. Then sometimes we invent them out of people who simply failed. Competitive decline is the big cause of insolvency. It is true that some company failures are due to incompetence alone, some to fraud alone, and some to the two combined. But even villainy is most destructive when conjoined with competitive decline.

26. The problem with the villain theory – mismanagement and fraud as the causes of insolvency – is that it ignores the economics of a mature, overcrowded and price-driven business. A company with high costs and no advantages will either go out of business or be absorbed by a competitor. A management that cannot figure out how to survive such a situation is not necessarily incompetent or dishonest, even if in terminal desperation it takes foolish chances or fudges some numbers. And it is a short step from blaming the management for causing an insolvency to blaming the regulator for letting it happen.” Managing Insurer Insolvency 2003 Stewart Economics

27. Financial Size of Failed SL Insurers 1976 – 2007 Capital & Surplus % of Total < $5 million$5 - $10 million$10 - $15 million$15 - $20 million$20 - $25 million> $25 millionTotal 41% 25% 6% 12% 6% 10%100% Source: A.M. Best Special Report: US Surplus Lines – Market Review; August 2008

28. Agent Liability for Insurer Insolvency “…an agent is not liable for an insured’s lost claim due to the insurer’s insolvency if the insurer is solvent at the time the policy is procured, unless at that time or at a later time when the insured could be protected, the agent knows or by the exercise of reasonable diligence should know, of facts or circumstances which would put a reasonable agent on notice that the insurance presents an unreasonable risk.” Higginbotham & Associates v. GreerTexas Court of AppealsSeptember 1987

29. TEXAS INSURANCE CODE § 981.211. FINANCIAL CONDITION OF SURPLUS LINES INSURERS (a) A surplus lines agent must make a reasonable effort to determine the financial condition of an eligible surplus lines insurer before placing insurance with that insurer. (b) A surplus lines agent may not knowingly place surplus lines insurance with a financially unsound insurer.

30. Agent Liability for Insurer Insolvency “…deficiencies in the filings were not “technical” or “minor” as characterized by Genatt.  …the Court finds that the broker’s failure to comply with the strict provisions of the Insurance Law are evidence that they did not act with reasonable care. … the Court also finds that the defendant breached its contract with the plaintiff in failing to procure proper insurance for it.  …The Court finds that the admitted failure to strictly comply with the provisions of Insurance Law § 2118, constitute a breach of Genatt’s fiduciary duty to the plaintiff.  …An insurance broker who breaches his duty to an insured by not obtaining proper insurance becomes liable to the extent that the carrier would have been.” East Coast Management Ltd. v Genatt AssociatesSupreme Court, Nassau County, New YorkJune 2005

31. Financial Statement Fraud

32. Overstated / Fraudulent Assets Paper transactions - not backed by anything of value • Industrial development bonds • T-bills (Sovereign Cherokee Nation Tejas) • Debentures • Futures contracts • Gold certificates & other precious metals contracts • Mineral / timber interest (gold tailings under parking lot in Colorado, kaolin mine in Brazil) • CDs issued by non-existent financial institutions • Siberian crab pancreatic gland extract

33. Overstated / Fraudulent Assets Pink Sheet Stocks • Companies not highly traded • Market quotes non-existent • Not accepted on major stock exchanges • Trade at value less than $5 per share (often investments in affiliates) • Questions of value and liquidity

34. Overstated / Fraudulent Assets Real Estate Questionable appraisals

35. Overstated / Fraudulent Assets Real Estate Questionable appraisals

36. Overstated / Fraudulent Assets Rented assets • Often occurred with GNMA securities in the past • Insurer leases rights to bonds for fee paid to “broker” • Insurer can only produce lease agreements & fraudulent trust receipts, not bonds themselves • “Brokers” not own GNMA securities either - no authority to assign interest and actual ownership often impossible to determine

37. Liabilities • Poor accounting controls • Failure to record claims • Inadequate reserving practices

38. Surplus NotesTypically long-term highly subordinated debt instrument used to directly enhance surplus (“debt treated as equity”) Standards for Evaluation • % of note to total surplus (conservative -- <15%) • Length of note’s maturity (>10 years) • Interest rate (low) • Supports prudent business plan • Permission of regulator for repayment of principal & interest

39. Accountants / Auditors / Actuaries • Forged reports Reinsurers • Fraudulent reinsurance Related parties • Co-conspirators • Professional negligence • Overstated credit for reinsurance

40. Violent Crime Control & Law Enforcement Act • Creates criminal liabilities & penalties for insurance professionals • Targets management fraud • Applies to insurance & reinsurance transactions • Covers company executives, directors, agents, brokers, MGAs, & employees • Enforced by the Department of Justice & US Attorneys, with support from the FBI

41. Presenting materially false financial reports about an insurer to either regulators or business associates Misappropriating premiums and other funds belonging to an insurer Attempting to influence or obstruct the administration of the law in an insurance matter pending before a regulatory official Anyone ever convicted of a criminal felony involving dishonesty or breach of trust from engaging in the business of insurance without the prior written consent of the Commissioner of Insurance Permitting a person convicted of a felony involving dishonesty to participate in interstate insurance transactions The VCCLEA prohibits:

42. Occupational Fraud -Initial Detection Fraud by Owners / Executives All Cases TipInternal ControlsBy AccidentInternal AuditExternal Audit 46%23%20%19% 9% 52%15%17%12%16% Source: 2008 Report to the Nation on Occupational Fraud & Abuse; Association of Certified Fraud Examiners

43. Agent Fraud • Bid-rigging / price-fixing • Misappropriation / conversion • Premium finance scams • Forgery / alteration of documents • Bogus claims

44. Agent Abuses • Failure to monitor financial condition of insurers • No resident / non-resident surplus lines agent (courtesy filings) • Unfair competition (no diligent effort / fictitious affidavits) • Binding authority (misuse / wrongful delegation) • Taxes • Coverages

45. Stamping Offices Contribute to a stable, efficient, reputable, financially strong surplus lines market • Evaluate insurers for surplus lines eligibility • Encourage / obtain compliance • Improve quality of policies issued • Provide technical assistance / distribute information • Education to agents and insurers • Accumulate statistics on surplus lines market

46. US STAMPING OFFICES 1941 2009 1989 1937 1958 1996 1995 1985 1982 1937 1970 1998 1987 1998

47. Associate in Surplus Lines Insurance ASLI • Nationally recognized insurance designation • Developed by Derek Hughes / NAPSLO Education Foundation & the Insurance Institute of America • Highest level of professional education available in the surplus lines market • Courses : 2 dealing specifically with surplus lines 2 electives approved by IIA • ASLI exemplifies commitment to professionalism, dedication to pursuit of excellence, and investment in future of the surplus lines industry

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