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Case 6-10
SEC v. Zurich Financial Services
Background
On December 11, 2008, the SEC reached agreement with Zurich Financial Services (Zurich) to settle the
commission’s charges against Zurich Financial Services Group for aiding and abetting a fraud by
Converium Holding AG involving the use of finite reinsurance transactions to inflate improperly
Converium’s financial performance. The commission’s complaint alleges that Zurich aided and abetted
Converium’s violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 there under.
Under the settlement, Zurich consented to the entry of a final judgment directing it to pay a $25 million
penalty plus $1 in disgorgement and, in a related administrative proceeding, consented to the entry of a
cease-and-desist order against it. The accounting issue in question deals with the complex topic of
reinsurance. The facts of the accounting fraud have been simplified as much as possible to focus mainly on
the legal liabilities of the company.
Zurich is a corporation organized under the laws of Switzerland with its principal place of business in
Zurich, Switzerland. Historically, Zurich operated its reinsurance business under the brand name Zurich Re,
which operated as a separate division within Zurich Insurance Company (ZIC), a wholly owned subsidiary
of Zurich, and through its North American subsidiary, Zurich Reinsurance (North America) Inc. (Zurich Re
North America). Prior to Converium’s IPO, Zurich restructured its reinsurance operations and transferred
substantially all of the reinsurance business operated under Zurich Re to Converium. In December 2001
and January 2002, pursuant to the Registration Statement and Prospectus, Zurich sold 40 million shares of
Converium in the form of shares and American Depository Shares (ADSs), representing its entire stake in
Converium, for proceeds of approximately $1.9 billion.
Accounting Issues
The commission’s complaint alleges that beginning in 1999, the management of Zurich Re developed three
reinsurance transactions for the purpose of obtaining the financial benefits of reinsurance accounting.
However, in order for a company to obtain the benefits of reinsurance accounting, the reinsurance
transaction must transfer risk. Here, Zurich Re management designed the transactions to make them appear
to transfer risk to third-party reinsurers, when, in fact, no risk was transferred outside of Zurich-owned
entities. For two of the transactions at issue, Zurich Re ceded risk to third-party reinsurers, but took it back
through reinsurance agreements—known as retrocessions—with another Zurich entity. For the third
transaction, Zurich Re ceded the risk to a third-party reinsurer but simultaneously entered into an
undisclosed side agreement with the reinsurer pursuant to which Zurich Re agreed to hold the reinsurer
harmless for any losses realized under the reinsurance contracts. Because the ultimate risk under the
reinsurance contracts remained with Zurich-owned entities, these transactions should not have been
accounted for as reinsurance.
The complaint also alleges that, in March 2001, Zurich announced its intent to spin off its reinsurance
group in an initial public offering (IPO). Zurich then created and capitalized Converium, which assumed
the rights and obligations of Zurich’s assumed reinsurance business. On December 11, 2001, Zurich spun
off Converium in an IPO. At the conclusion of the IPO, the members of Zurich Re management responsible
for the three reinsurance transactions ceased to be affiliated with Zurich. As a result of the improper
accounting treatment of reinsurance transactions, the historical financial statements in Converium’s IPO
documents, including the Form F-1 it filed with the Commission, were materially misleading. Among other
things, Converium understated its reported loss before taxes by approximately $100 million (67 percent) in
2000 and by approximately $3 million (1 percent) in 2001. In addition, for certain periods, the transactions
had the effect of artificially decreasing Converium’s reported loss ratios for certain reporting segments—
the ratio between losses paid by an insurer and premiums earned that is frequently cited by analysts as a
key performance metric for insurance companies.
The complaint further alleges that Converium’s misstatements were material to investors who purchased
shares in the IPO. Through the IPO, which was the largest reinsurance IPO in history, Zurich raised
significantly more than it would have raised had Zurich and Converium not improperly inflated
Converium’s financial performance.
Reinsurance Accounting Principles
Reinsurance is a complicated area in accounting. Exhibit 1 describes some of the main features of the
accounting rules.
Exhibit 1
Accounting Rules for Reinsurance
In basic terms, reinsurance is insurance for insurers. Reinsurance is the transfer of insurance risk by the
primary insurer to a second insurance carrier, called the reinsurer, in exchange for a payment or premium.
Whether a contract is accounted for as reinsurance depends on whether the contract indemnifies the ceding
company—here Zurich and Converium—from loss or liability. Such indemnification is known as risk
transfer. Risk is transferred when (1) the reinsurer assumes significant insurance risk and (2) it is
reasonably possible that the reinsurer will realize a significant loss in the transaction. A risk transfer
analysis for a contract emphasizes substance over form and GAAP requires “an evaluation of all
contractual features that . . . limit the amount of insurance risk to which the reinsurer is subject.”
Accordingly, under GAAP, “if agreements with the reinsurer . . . in the aggregate, do not transfer risk, the
individual contracts that make up those agreements also would not be considered to transfer risk, regardless
of how they are structured.”
Where there is insufficient risk transfer, a transaction may not be treated as reinsurance under GAAP,
and must be accounted for using the deposit method, which lacks the potential accounting benefits of
reinsurance accounting. Under reinsurance accounting, when losses on the ceded business are incurred, the
ceding insurer records an offset to the increase in its gross loss reserves in an amount equal to the
reinsurance it expects to recover from the reinsurer, thus increasing its net income by that amount. Deposit
accounting has no comparable income statement benefit.
From 1999 through 2001, management of Zurich Re designed three reinsurance transactions that created
the appearance of risk transfer in order to benefit from reinsurance accounting. These three transactions
affected the financial statements included in Converium’s IPO prospectus. In two of the three transactions,
Zurich Re purchased reinsurance from Inter-Ocean, which, in turn, ceded these liabilities to a Zurich entity
(the Inter-Ocean transactions), in one transaction directly and in the other transaction indirectly through a
third reinsurer (Company A). Zurich Re’s use of Inter-Ocean as an intermediary in the transaction helped
obscure the transactions’ circular structure and the fact that Zurich Re had merely moved the risk from one
Zurich Re entity to another. In the third transaction, Zurich Re entered into a reinsurance transaction for
which the risk transfer was negated by an undisclosed and purportedly unrelated side agreement that
protected the reinsurer against losses suffered under the reinsurance contract. Zurich Re improperly
accounted for these transactions using reinsurance accounting.
Although Zurich Re accounted for the transactions with Inter-Ocean and Company A as reinsurance, in
reality, Zurich Re had recirculated the risk from one Zurich entity to another, while interposing
intermediaries (Inter-Ocean and Company A) that obscured the transactions’ circular structure. Because this
transaction was circular, there was no risk transfer and Zurich Re and later Converium should not have
accounted for the contract as reinsurance. As a result, and as reported in Converium’s December 2001 Form
F-1, Converium understated its pretax losses for the year ended December 31, 2000, by $1.36 million.
The Converium IPO
On March 22, 2001, in connection with its announcement of disappointing financial results for 2000,
Zurich reported that it intended to exit the assumed reinsurance business. In a September 6, 2001, press
release, Zurich announced that its reinsurance business would be spun off in an IPO, and that as of October
1, 2001, the business would operate under the name Converium.
The Registration Statement and Prospectus filed by Converium in connection with the IPO, which
became effective on December 11, 2001, was derived from data from the Zurich subsidiaries combined to
form Converium and failed to disclose the impact of the circular Inter-Ocean and the Z-1 Facility
transactions on Converium’s business operations, financial results, and shareholders’ equity at the time of
the IPO.
Accordingly, the statements in the prospectus regarding Converium’s financial results for 2000 and the
first half of 2001 were materially false and misleading. As a consequence of the circular Inter-Ocean
transactions and the Z-1 Facility transactions, rather than reporting a loss before taxes of $48.8 million for
2000, Converium should have reported a loss of at least $148.4 million. Converium also overstated its
$1.09 billion in reported shareholders’ equity as of December 31, 2000, by at least $72.3 million
(approximately 6.6 percent of the total reported shareholders’ equity), an amount including the effect of
$100 million attributable to the Inter-Ocean and Z-1 Facility transactions and partially offset by $27.7
million attributable to other reinsurance transactions not addressed within the complaint.
Finally, because Converium’s loss ratio for its non-life reinsurance business was directly affected by the
improperly recorded reinsurance obtained through the circular Inter- Ocean and the Z-1 Facility
transactions, Converium materially understated its reported loss ratios.
SEC Charges
Based on the foregoing, the SEC charged Converium with violating Section 10(b) of the Exchange Act and
Rule l0b-5 in that it knowingly or recklessly made false and misleading statements, or omitted to state
material facts necessary in order to make the statements, in the light of the circumstances under which they
were made, not misleading to purchasers of Converium securities in connection with the 2001 IPO.
Zurich substantially assisted Converium’s violation of Section 10(b) of the Exchange Act and Rule l0b-5
by, among other things, entering into the finite reinsurance transactions previously described for the
purpose of improperly inflating its financial performance and improperly using reinsurance accounting
rules to account for the transactions with the knowledge that such accounting was improper.
NOTES
The key issue in this case is whether the transactions entered into by Zurich transferred economic risk with
respect to its reinsurance business. As students what does transferring the “economic risk” in general, and,
specifically, the Zurich case mean? You may want to equate it to accounting for leases as capitalized vs.
operating.
Ethical Issues:
The ethical values in this are integrity, honesty, and transparency in financial reporting. The firms entered
into contracts that did not transfer risk so did not qualify for the accounting treatment. The company used
the wrong accounting treatment to understate losses before taxes and loss ratios, a key performance metric
for insurance companies. The misstatements were material to the investors who purchased shares in the
IPO. The case raises questions on inter-company contracts, and ethics of corporate oversight in holding
companies.
Questions
1. Why do you think it is important for a reinsurance transaction to transfer risk in order for a
company to obtain the benefits of reinsurance accounting? Discuss the accounting and legal issues
behind such a requirement.
If an insurer sells a hundred policies, each with a $10,000 policy limit, then the insurer could lose $10,000
on each policy for a total of $1,000,000 possible liability. If the insurer can reinsure 80% of the policies,
then the insurer has a possible liability of $200,000 instead of the $1,000,000. Insurers have to meet
regulations on the maximum amount of insurance policies it can underwrite based upon their capital (equity
2. Assume the external auditors of Zurich Re and Converium knew about the Inter-Ocean and the
Z-1 Facility transactions. What legal issues could have been raised by the purchasers of stock in
Converium’s IPO to successfully bring an action against the auditors?
The purchasers of stock in Converium’s IPO would have to prove that they sustained a loss, the financial
statements were misleading and that they relied upon the misleading financial statements. If the external
3. Evaluate the ethics of Zurich Re’s actions with respect to its reinsurance transactions and the
transfer of economic risk.
Zurich Re’s actions, with respect to its reinsurance and transfer of economic risk, are window dressing the
balance sheet by reducing the liability reserves. Zurich’s actions are misleading and deceitful therefore
