Report 2001-102 Summary - July 2001

Department of Insurance Conservation and Liquidation Office

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Stronger Oversight Is Needed to Properly Safeguard Insurance Companies' Assets

HIGHLIGHTS

Our review of the operations and internal controls of the Department of Insurance's (department) Conservation and Liquidation Office (CLO) disclosed that the CLO:

Additionally, the department has allowed the CLO to continue its poor management practices by failing to properly oversee its activities.

RESULTS IN BRIEF

The Department of Insurance (department) needs to strengthen its oversight of the activities of its Conservation and Liquidation Office (CLO). Through the CLO, the department is responsible for conserving and liquidating certain companies (insurers) doing business in the State that have financial or other problems or that are not authorized to transact business in California. Despite numerous findings in previously issued reports, a lack of adequate oversight and poor management practices still exist at the CLO.

In May 1994 and April 1996 the Bureau of State Audits issued reports stating that the CLO (called the Conservation and Liquidation Division in 1994) needed to improve its administration and management of conserved and liquidated insurers. For example, in our past audits, we found that the CLO did not regularly update its closing plans for the insurers' estates it managed, did not follow its policies and procedures for hiring, and failed to properly monitor contracts. Moreover, another independent auditing firm (external auditor) identified problems with the CLO's efforts to recognize and bill for reinsurance-a method used by insurers to spread a portion of their risk to other insurers, known as reinsurers. In exchange for taking on a proportionate share of the original insurer's risk, the reinsurer typically receives a percentage of the premiums paid by the policyholders of the original insurer. Once an insurer is conserved or liquidated, the CLO attempts to offset the claims paid on behalf of the insurer by collecting any applicable reinsurance. During our current audit, we found that the department and the CLO have not addressed many of the issues raised in our previous two audit reports, nor have they corrected some of the problems identified by the other external auditor. Among the problems we most recently identified are a failure to follow either department or CLO guidelines and procedures with respect to internal audits, hiring, and contracting; no recent reviews or updates of estate closing plans; and an allocation system that inequitably assigns fixed costs among insurers' estates.

The CLO does not adequately protect insurers' assets. For example, we found that the CLO did not complete an inventory of the assets of a title company it had seized until at least three weeks after receiving the seizure order. By allowing this much time to elapse, the CLO failed to adequately safeguard the fixed assets of the company. Seizures are ordered only when there is high risk that assets are being diverted or when the insurer is not licensed to conduct business in California and poses a threat to policyholders. Moreover, when the CLO attempted to sell the assets of this insurer at auction, it did not adequately protect all the assets offered for auction.

The CLO also does not ensure that investment decisions are optimized. For instance, the CLO has never included projections of cash flows in its estate closing plans or updated its plans since 1998, even though such plans would help the CLO maximize the assets of liquidated insurers and provide planning and budgeting information for the CLO's operations. In addition, the CLO has not evaluated its investment managers' fees since reducing them in 1998. Nor has it evaluated its investment guidelines and strategy since 1999, when the CLO added the ability to invest in the bonds of certain foreign countries beginning in May 1999. However, further revisions may be needed, as the investment pool it manages is now more than triple the size it was in 1996. Over the past three years, the average return on the CLO's investment pool was 5.94 percent, slightly higher than the 5.69 percent return on the State's Pooled Money Investment Account (PMIA), which has investments similar to the CLO's investment pool. However, for 2000, the CLO paid its investment managers an average of $930,000 without knowing whether another investment firm could achieve the same or better results for less.

In addition, the CLO has poor practices in place to conserve insurers' assets. For instance, the CLO does not seek competitive bids on contracts when it should. Moreover, the CLO does not effectively manage its contracts nor adhere to its own contractual agreements, causing it to overpay one contractor by more than $43,000. It also does not have effective policies and procedures for its contract managers to follow. Without such guidance, the CLO's contract managers are unaware of even the most basic management controls in this important area. Instead, they rely on accounting personnel who are neither responsible for nor have sufficient information about contracts.

Weak hiring practices is another problem we previously reported, but we found no evidence that the CLO acted on our recommendation. Our current audit found that the CLO does not ensure that its employees meet its minimum job qualifications by checking references to verify applicants' level of education and employment history-a weakness similar to the one we reported in 1996. Additionally, the CLO has never adopted a comprehensive conflict-of-interest policy for its employees and vendor contractors to follow, although in 1999 it discussed the need for such a policy and developed a draft that it has yet to finalize and implement. Shortcomings in these two areas could lead to erroneous or improper actions by CLO employees and, ultimately, the waste or misuse of estate assets.

In addition to not following prudent business practices, the CLO does not equitably allocate costs to insurers. Because the CLO has not recently verified the relevancy of its basis for allocating fixed costs to insurers, it has unfairly burdened some insurers while undercharging others. Fixed costs can include the CLO's rent, storage costs, and equipment depreciation. For example, in one month, the CLO inequitably charged one insurer almost $55,000 when it should have only charged $900 and failed to charge another insurer more than $4,000 in fixed costs. Further, because the CLO does not regularly review insurers' status to determine which ones meet its criteria for sharing a portion of fixed costs, one insurer has never been charged its fair share. Using the CLO's current basis for allocating fixed costs, we found that the insurer's estate should have paid more than $58,000 in fixed costs incurred since January 2000. Moreover, if the CLO were to use a method that we believe is more equitable, the amount of fixed costs that it should have allocated to this estate since January 2000 would increase to more than $190,000.

The CLO has also spent at least $6 million of insurers' money on a claim processing system that does not meet its needs. In 1995 the CLO initially spent $400,000 for a system that required modifications; however, before the CLO purchased the system, it did not adequately assess its claims processing needs. Despite a series of expensive modifications and ongoing maintenance costs that have increased the initial cost by more than $5.6 million, the system is difficult to use and is incapable of handling the CLO's claims processing needs. Consequently, the CLO's use of the system is limited, and it manually processes claims for reinsurance-a method that is inefficient, prone to error, and does not ensure that all reinsurance recoverables are identified and collected. In one instance, an employee of the CLO's reinsurance department retired before he billed a reinsurance company for more than $900,000 and the CLO discovered the error only when the reinsurance company notified it months later.

Finally, the department has allowed the CLO to continue its poor management practices by failing to properly oversee its activities. Specifically, the CLO's internal auditor might have identified several serious weaknesses that we detected if the department had enforced state law and its policy that all administrative and accounting controls be reviewed to identify and audit the most risk-prone operations of the CLO every two years (defined here as an audit cycle). The internal auditor has not completed a full audit cycle, despite his five-year tenure with the CLO, and has yet to audit the inventory process and other critical areas within the CLO. The department has also not required the CLO to act on the recommendations made by either the CLO's internal auditor or external auditors. For example, since 1999 the department has been aware that the CLO did not have a comprehensive policy regarding employee conflicts of interest and incompatible activities. The CLO's internal auditor also reported this problem in calendar year 2000. Although the internal auditor and the chief operations officer developed a draft of such a policy as early as 1999, the CLO never finalized and approved it.

RECOMMENDATIONS

To adequately safeguard the fixed assets of insurers under its control, the department should ensure that the CLO promptly identifies and inventories insurers' assets and develops work plans tailored for each inventory, based on prudent business practices.

The department should also ensure that the CLO maximizes the return on the assets it manages by periodically reevaluating its investment guidelines to reflect changing conditions and requirements. In addition, the department should ensure that the CLO update its estate closing plans and include estimates of the future cash needs of each estate. The CLO should give this information to its investment managers to help them optimize their investments of estates' assets, and use the information for its own budgeting purposes. The department should also ensure that the CLO periodically evaluates its contract for investment management services to ensure that the fees that it pays are reasonable compared to what other investment firms would charge to manage an investment pool of similar value.

To guard against squandering insurers' assets, the department should require the CLO to obtain competitive bids where appropriate, seek a $43,000 refund from the contractor it overpaid, and assign a unique number to each contract. In addition, the CLO should direct its contract managers to develop spreadsheets to track contract payments, periodically review the spreadsheets and the contracts to determine if and when they should be renewed, and ensure that contractors adhere to all contract terms and conditions.

The department should also require the CLO to verify that applicants being considered for a position meet its minimum job qualifications for education and experience, thus ensuring that it is hiring qualified applicants and promoting qualified employees to positions requiring technical knowledge and experience. The department should also see that the CLO finalizes, approves, and implements a conflict-of-interest policy.

In addition, the department should work with the CLO to review its options for fairly allocating fixed costs to insurers and make sure it develops a system of review to enable it to include only appropriate insurers in its fixed cost allocation and exclude from the allocation process insurers that should not be paying fixed costs.

The department should ensure that the CLO works diligently toward defining its overall system needs. In the event that the CLO chooses to purchase a new claims processing system, it should explore the option of alternative procurement, whereby the software company would have a direct financial stake in the successful implementation of the claims processing system.

To strengthen and improve its oversight process, the department should ensure that the CLO's internal auditor reviews all CLO accounting and administrative controls to identify and audit risk-prone operations at least once every two years. In addition, the department should ensure that the recommendations of its internal auditor are implemented or should document why they are not.

AGENCY COMMENTS

The insurance commissioner concurs with all our findings and believes the report validates concerns he had about the management of the CLO. In addition, the commissioner states that the report provides him the needed baseline to focus his efforts on improving the management of the CLO and ensuring that the assets of entities conserved are safeguarded and efficiently used.