Passing the Trash
By Robert Lenzner and Bernard Condon

IT'S NOT EASY TO SUCKER WARREN Buffett, Saul Steinberg and a half-dozen of the nation's biggest insurance companies. But John E. Pallat III, a former risk management instructor at Georgia State, initiated a complex and convoluted insurance scheme two years ago that seems to have done just that.

The potential fallout is huge: the possible disintegration of Saul Steinberg's Reliance Group, the potential bankruptcy of several California insurers, numerous credit downgrades and the likelihood of big charges to earnings in several widely held insurance companies.

"This is shaping up to be one of the worst scandals in the history of the [insurance] industry," says Alice Schroeder, a Paine-Webber analyst. This is a story of wild excess in a business seemingly made for wild excess: the poorly regulated world of reinsurance pools. Reinsurance is a process whereby an insurance company spreads its risk by transferring a portion of a policy's liability to another insurer, which keeps part of the premium. When it works, reinsurance makes it possible for insurers to write a lot more business than they can safely absorb on their own.

When it doesn't work out, reinsurance takes on the nasty appellation "pass the trash." The reinsurer may discover that it has taken on a far worse liability than it bargained for. The reinsurer, in turn, may pass part of its risk along to some other corporate victim. That's what happened here. Risk, in this case for Workers' Compensation liability, got passed from hand to hand in a game of hot potato. Some reinsurers that ought to have known better got stuck with low premiums but the potential for big claims against them.

The man at the center of it, John Pallat, runs Unicover Managers, an insurance middleman based in South Plainfield, N.J. Five years ago Pallat, an articulate 39-year-old former industry consultant who is quick with numbers, saw a huge opportunity in the business of brokering liability for Workers' Compensation coverage, which by law most companies in the country must buy. For a roofer in Sacramento, say, the policy might cost his employer $4,000 a year and would cover disability and medical payments to him if he falls off a roof. Since those payments are open-ended, the potential exposure to the underwriter is huge. Insurers collect $25 billion a year in Workers' Comp premiums in the U.S.

As a middleman, Pallat's Unicover could reap a 7.5% fee of all the insurance it underwrote, while passing along almost all of the risk. You can get rich off a spread like that, if the volumes are big enough. And the volumes were big. Over just the 14 months ended in January 1999, Unicover handled $2.6 billion worth of reinsurance on $8 billion worth of Workers' Comp policies. In this fashion the firm that Pallat and five other men owned has earned from these dealings a cumulative sum of $250 million in the form of spreads and fees. It was quite a sum for a tiny firm; Unicover had at its peak 30 or so employees.

If it took a while for the reinsurers to perceive that something had gone wrong--that risk exposures were gravely underestimated--that was because of the immense complexity of this operation. Policies passed through layer after layer of insurers, reinsurers and brokers (see chart). Unicover was not the only transactional cost in this equation. All told, more than $500 million in fees and brokerage commissions (including Unicover's cut) would be drained out of that $2.6 billion of reinsurance premiums.

Even without any reinsurance, Workers' Comp is an actuarial monster. If the roofer breaks his arm he may be back on the job at a cost to the underwriters of a few thousand dollars. If he breaks his back he may be collecting $500 a week for 40 years--a $1 million claim. Now picture all the ways to carve up the liability. Company A and Company B could split the policy down the middle, each pocketing $2,000 of the $4,000 premium and each on the hook for half the payouts. Or A might agree to absorb all of the first $100,000 of claims while B pays everything beyond that.

In the business of trading risks around, insurers use a peculiar kind of bookkeeping that will be familiar to anyone who has played the lottery. In the lottery business a $25,000-a-year payout lasting 40 years is called a $1 million prize, even though in economic terms it's worth only a fraction of that. In similar fashion, a $1 million disability payout expected to be spread over the next 40 years is called a $1 million claim. Take in $600,000 of premiums to cover that future liability, and you have a $400,000 underwriting "loss," even though you may be ahead of the game when you invest premium dollars in the bond market at 6%.

Here's what happened in the Workers' Comp mess. Start with the primary insurers, a group of mostly small companies, many in California, including Fremont General and Paula Financial. Their policies were priced to create an underwriting "loss." For every dollar they collected in premiums, they anticipated an eventual $1.25 of claims and expenses. Trash? Probably not at this point.

But then a portion of the liabilities was passed to the next level. Pallat arranged through various brokers for three reinsurance vehicles to insure those primary carriers. One was Reliance, another Lincoln National and the third a pool of companies that included Cigna.

But here the pricing was not so favorable to the companies absorbing risks. Companies at this layer could expect $1.75 in eventual costs and payouts for every dollar of premium. Profit is almost impossible at this level, unless the reinsurer can get rid of most of the exposure while retaining a disproportionate share of the premium.

That's what Pallat was evidently able to do. Next he and his brokers got a triumvirate of companies--Cologne Life Re, a subsidiary of General Re (now part of Berkshire Hathaway), Phoenix Home Life and Sun Life--to take on most of the exposure under the policies. Incredibly, these three reinsurers took on portions of the premium at a ratio of 400%. This meant they were taking on $4 of loss and expenses for every $1 of premium. They underestimated the future payouts.

It will take years to sort out the mess. A dozen lawsuits have been filed. Several insurers may go bankrupt; others may eat huge losses.

But the trash-passing did not stop here. It went on and on, with some brokers entering the equation in more than one place and with some insurers at a remove of several layers from where the insurance originated. The daisy chain began to break in late 1998. Sun began hearing rumors about huge volumes of reinsurance. It belatedly realized it was exposed to significant losses, later pegged at up to $910 million. In early 1999 both Sun and Phoenix withdrew from Unicover, refusing to accept any more business. They returned the premiums and refused to pay claims. Cologne also refused to accept more business, but continued to pay.

By refusing to pay claims, Sun and Phoenix stuck it to Reliance. That left Reliance vulnerable to $1 billion of losses, or virtually its entire statutory book value. Reliance is fighting their withdrawal in an arbitration hearing. Meanwhile, Steinberg's company is scrambling to raise capital and avoid a perilous credit rating downgrade. Other companies further down the reinsurance chain are left holding the bag, too. John Hancock is exposed to large potential losses. So are Lincoln National, Allianz and Fairfax Financial. The layers of reinsurance run so deep now that even billionaire Laurence Tisch, who controls CNA, a major casualty insurer, knew nothing of his company's involvement in the Unicover mess until FORBES phoned him.

Cologne took a $275 million pretax charge in early 1999 and so far is the only company to recognize a loss on Unicover. It appears that Warren Buffett was completely unaware of this Workers' Comp exposure when he had Berkshire Hathaway buy General Re in 1998. Others aren't taking writedowns because they believe they are protected by reinsurance, or are awaiting resolution of the disputes. "Vast amounts of losses generated haven't even been recognized by companies yet," says Karen Horvath, insurance analyst at A.M. Best, a credit-rating agency.

Who is to blame for the still-unfolding disaster? Bodies are already piling up. Reliance's executive responsible for its involvement is off the payroll. Cologne fired its guy. But those are scapegoats. Some of the blue-chip reinsurers, with spare capital to burn, were far too anxious to take risks that lacked the potential for adequate returns. Management controls and risk analysis techniques were abysmal.

One problem: Cologne, Sun and Phoenix, all life insurance specialists, were not sophisticated, to be kind, about pricing casualty contracts, and ended up taking in $700 million of premiums in return for a potential future payout of $2.8 billion. Connecticut regulators, responding to the Unicover case, have ordered life companies not to reinsure Workers' Comp policies.

Did Unicover do anything wrong? Some of the losers accuse it of writing on their behalf a far greater volume of reinsurance than they authorized. In an affidavit Pallat denies the charge and argues that Sun and Phoenix gave him a free hand. This much is clear: For a small, young firm, Unicover had extraordinary powers over the handling of reinsurance on $8 billion of insurance. It was, among other things, the manager of a pool of five companies and was able to underwrite, price, quote, bind and issue contracts of reinsurance on behalf of the pool. It will take years to sort out the mess. Reinsurers have filed a dozen lawsuits, some claiming fraud, against brokers and underwriters. So far there are no lawsuits against Pallat personally. He still expects to get more fees.

Could this mess have been avoided? A congressional inquiry into the insurance industry concluded with a report predicting big blowups if insurers didn't change their ways. "They [treat] the reinsurance process as a way to pass loss problems to somebody else in exchange for easy premium dollars, rather than as a prudent method to share risks."