Ethical Underwriting

Ethics are the standards for what is right and wrong, what ought to be done versus what ought not to be done. Ethical companies represent better insurance risks, benefiting underwriters, brokers and insurance applicants alike. Insurance applicants benefit because they have employees with higher ethical standards; these employees are less likely to expose the firm to fidelity losses.

Traditional underwriting rating factors for fidelity insurance include the number of a company’s employees, the office locations, the limits and deductibles, previous losses, the nature and health of the applicant’s business and financial situation. It is relatively straightforward to generate a premium estimate using these factors. However, rating in the absence of risk analysis neglects important factors such as the:

* business ethics of the principals;

* history, track record and reputation of the firm;

* education and experience of the employees; and

* compensation structure for rewarding employees.

At the end of the day, underwriting is a subjective process: one must ultimately decide whether or not to accept the insurance risk. If the decision is made to accept the risk, the question then becomes: At what terms and conditions? The real “art” of underwriting, and arguably the factor differentiating insurance carriers and their underwriting philosophies, should lie with integrating more qualitative factors. Such is the challenge with analysis of ethical practices.

The ethical component of underwriting is obvious in examples drawn from the world of financial institution applications for crime bond insurance. The financial institutions sector provides textbook examples of the ethical component of underwriting because of the heavy regulation imposed on the industry’s member firms. Most firms in the Canadian securities industry are members of Self-Regulatory Organizations (SROs). SROs are required to set a standard equal to or higher than those imposed by provincial securities regulators. As a result, dealer members are held to higher ethical and business conduct standards.

Within these examples lies the importance of ethics to the underwriting process. Of particular interest is what brokers and underwriters should look for when analyzing insurance applications, as well as factors to consider when underwriting and brokering these applications.

CRIME BOND INSURANCE: A PRIMER

Financial Institution Bonds are variations of the 3-D (Dishonesty, Disappearance, Destruction) Bond. The primary purpose of financial institution bonds is to protect the financial institution from fidelity losses related to business activities. Provincial securities regulators require companies to have such bonds as a measure of consumer protection. There are several types of bonds, each adapted for the specialized requirements of differing types of financial institutions, but discussion here will focus on the Form 14 bond for stockbrokers (hereafter referred to as “dealers”).

Trust is a critical component of the financial advisor/client relationship. Violations in the securities industry can often be attributed to its members taking “me-first” approaches to business rather than looking out for the best interests of customers within an ethical framework. Identifying a dealer’s true values can be as simple as looking at how the firm spent its time and money over the past year.

For example, an ethically-oriented dealer is more likely to spend time and resources on work with and support of charities and social programs, conducting honest advertising, and training employees in ethical behavior. This is not to say the absence of these activities in the dealer’s balance sheet indicates unethical behavior. Rather, the presence of these is more likely found within an ethical organization than inside an unethical organization.

Values are the basis of ethics: they determine the standards against which an organization evaluates its actions. A careful analysis of the dealer’s values can offer excellent insight into the dealer’s ethical practices – and thereby help determine underwriting risk. This is difficult to accomplish for an underwriter, who is essentially an outsider. There are, however, several key things for which to look.

Corporate value statements

The presence of corporate value statements is extremely important. These statements provide guidance for ethical employee conduct. An underwriter should investigate to determine whether they are prominently displayed in a dealer’s annual reports and other official publications and marketing material.

Having said that, the underwriter should also employ a healthy degree of skepticism. Some statements of corporate values are made for the sole purpose of satisfying regulators and attracting customers. Well-intentioned corporate value statements provide motivation, common devotion to a task, stability in changing environments and encourage ethical behavior. Indeed, a corporation’s values make up its basic identity.

Training programs

Codes of ethics and corporate value statements are only as good as the ethical training and/or programs that support them. Ethical training is of particular importance in our culturally diverse society and workforce. People with different cultural backgrounds will approach ethics and morality in different ways.

One goal of ethical training is to help ensure consistent ethical standards are applied across the company. An underwriter should look for the presence of ethics programs tailored to the company’s specific risks and business. “Off-the-shelf” ethics training has limited practical value because it fails to connect the company’s value statements to the employees’ specific daily activities. Senior management should review ethics programs to determine whether they are meeting stated goals and that gaps have not developed.

Corporate Pride

An ethical corporate culture typically manifests itself in a strong corporate and professional reputation, employee pride and satisfaction, and reduced risk of loss.

Of course there are other qualitative considerations when assessing the ethics of a company and its potential underwriting risks. These include:

Compensation of employees

A firm that compensates its employees fairly and on par with its competitors and the market can reduce the risk of loss. Fair compensation practices reduce the (perceived or actual) need for employees to commit dishonesty and fraud. Compensation structures must be careful not to reward, either directly or indirectly, unethical behavior.

Being a member of an SRO

A dealer who is a member in good standing with an SRO presents a better risk for underwriting insurance purposes. The Investment Dealers Association (IDA) and the Mutual Fund Dealers Association (MFDA) are the SROs for investment dealers and mutual fund dealers, respectively. They have detailed requirements for their members in terms of registered representative qualifications, capital adequacy requirements, etc. Underwriters can take some comfort in knowing that an applicant has a clean history of compliance with its SRO. In this way, the underwriter is relying on the compliance vetting by the SRO.

FINAL THOUGHTS

In reality, the underwriter would have difficulty determining the existence of the above-noted considerations. However, by using them as an ideal benchmark, the underwriter can better assess the specific risk in question. At the end of the day, the underwriter’s acceptance of a risk – and the terms with which that risk should be presented – comes down to professional training and experience. While the impact on the above on underwriting decisions and pricing is admittedly subjective, this information can ultimately help to assess the likelihood of a dishonesty loss under the financial institution bond.

Assessing the ethical practices of an applicant for fidelity insurance can benefit both the underwriter and the broker. The underwriter benefits from a more comprehensive analysis of the insurance risk. The broker benefits from improving the quality of his or her book of business and loss ratio. In addition, the broker benefits from an enhanced reputation in the eyes of the underwriters to whom he or she submits risks.

Ultimately, underwriting that scrutinizes the ethical practices of firms applying for fidelity or any other kind of insurance can better serve the insured’s industry, the insurance industry and the consumer. This is accomplished by encouraging higher ethical standards of firms as they seek the best combination of coverage terms and pricing.

Rob Bickerton is Senior Underwriter in the Corporate Risk Division of The Guarantee Company of North America. He is a Fellow of The Insurance Institute of Canada (FCIP) and a Fellow of The Canadian Securities Institute (FCSI).

Encouraging Corporate Ethical Behavior

The Corporate Ethics Monitor, a bi-monthly Canadian publication, includes a list of signs that senior management is committed to monitor compliance with ethical codes and encouraging ethical behavior. According to this list, management should:

* Have an up-to-date and well-received ethics code.

* Implement an effective internal control, monitoring, and compliance program for ethics.

* Offer dilemma-resolving ethics training.

* Conduct regular satisfaction surveys of clients, staff, and others.

* Appoint an ethics officer or ombudsperson to foster open communication.

* Establish and maintain a complaint process that is fair to any complainant or accused.

* Update policies on sensitive topics such as confidentiality, gifts and conflicts of interest, where appropriate.

* Stress ethical decisions that meet and exceed legal compliance.

* Recognize and reward ethical behavior.

* Perform ethics audits of certain departments or divisions.