CSA
Summary
Read the report at California State Auditor ↗
Department of
Insurance
Conservation and
Liquidation Office:
Stronger Oversight Is Needed to Properly
Safeguard Insurance Companies’ Assets
July 2001
2001-102
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C S A
ALIFORNIA TATE UDITOR
ELAINE M. HOWLE STEVEN M. HENDRICKSON
STATE AUDITOR CHIEF DEPUTY STATE AUDITOR
(cid:1)(cid:2)(cid:3)(cid:4)(cid:5)(cid:6)(cid:7)(cid:8)(cid:5)(cid:9)(cid:10)(cid:10)(cid:7) (cid:9)(cid:10)(cid:10)(cid:7)(cid:11)(cid:7)(cid:10)(cid:9)
(cid:12)(cid:13)(cid:14)(cid:5)(cid:15)(cid:16)(cid:17)(cid:14)(cid:18)(cid:19)(cid:16)(cid:18)(cid:5)(cid:16)(cid:20)(cid:5)(cid:21)(cid:22)(cid:3)(cid:23)(cid:20)(cid:16)(cid:18)(cid:19)(cid:23)(cid:22)
(cid:24)(cid:18)(cid:14)(cid:25)(cid:23)(cid:26)(cid:14)(cid:19)(cid:27)(cid:5)(cid:28)(cid:18)(cid:16)(cid:5)(cid:12)(cid:14)(cid:29)(cid:28)(cid:16)(cid:18)(cid:14)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:30)(cid:14)(cid:19)(cid:22)(cid:27)(cid:14)
(cid:30)(cid:28)(cid:14)(cid:22)(cid:31)(cid:14)(cid:18)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5) (cid:25)(cid:25)(cid:14)(cid:29)!(cid:3)(cid:4)
(cid:30)(cid:27)(cid:22)(cid:27)(cid:14)(cid:5)(cid:21)(cid:22)(cid:28)(cid:23)(cid:27)(cid:16)(cid:3)
(cid:30)(cid:22)"(cid:18)(cid:22)(cid:29)(cid:14)(cid:19)(cid:27)(cid:16)(cid:8)(cid:5)(cid:21)(cid:22)(cid:3)(cid:23)(cid:20)(cid:16)(cid:18)(cid:19)(cid:23)(cid:22)(cid:5)(cid:5)#$%(cid:7)&
’(cid:14)(cid:22)(cid:18)(cid:5)(cid:15)(cid:16)(cid:17)(cid:14)(cid:18)(cid:19)(cid:16)(cid:18)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)((cid:14))(cid:23)(cid:25)(cid:3)(cid:22)(cid:27)(cid:23)(cid:17)(cid:14)(cid:5)((cid:14)(cid:22)(cid:26)(cid:14)(cid:18)(cid:25)*
(cid:25)(cid:5)(cid:18)(cid:14)+(cid:2)(cid:14)(cid:25)(cid:27)(cid:14)(cid:26)(cid:5)!(cid:4)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:1)(cid:16)(cid:23)(cid:19)(cid:27)(cid:5)((cid:14))(cid:23)(cid:25)(cid:3)(cid:22)(cid:27)(cid:23)(cid:17)(cid:14)(cid:5) (cid:2)(cid:26)(cid:23)(cid:27)(cid:5)(cid:21)(cid:16)(cid:29)(cid:29)(cid:23)(cid:27)(cid:27)(cid:14)(cid:14)(cid:8)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5),(cid:2)(cid:18)(cid:14)(cid:22)(cid:2)(cid:5)(cid:16)(cid:20)(cid:5)(cid:30)(cid:27)(cid:22)(cid:27)(cid:14)(cid:5) (cid:2)(cid:26)(cid:23)(cid:27)(cid:25)(cid:5)(cid:28)(cid:18)(cid:14)(cid:25)(cid:14)(cid:19)(cid:27)(cid:25)(cid:5)(cid:23)(cid:27)(cid:25)(cid:5)(cid:22)(cid:2)(cid:26)(cid:23)(cid:27)
(cid:18)(cid:14)(cid:28)(cid:16)(cid:18)(cid:27)(cid:5)"(cid:16)(cid:19)"(cid:14)(cid:18)(cid:19)(cid:23)(cid:19))(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:16)(cid:28)(cid:14)(cid:18)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:25)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)’(cid:14)(cid:28)(cid:22)(cid:18)(cid:27)(cid:29)(cid:14)(cid:19)(cid:27)(cid:5)(cid:16)(cid:20)(cid:5)-(cid:19)(cid:25)(cid:2)(cid:18)(cid:22)(cid:19)"(cid:14).(cid:25)(cid:5)/(cid:26)(cid:14)(cid:28)(cid:22)(cid:18)(cid:27)(cid:29)(cid:14)(cid:19)(cid:27)0(cid:5)(cid:21)(cid:16)(cid:19)(cid:25)(cid:14)(cid:18)(cid:17)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:5)(cid:22)(cid:19)(cid:26)
((cid:23)+(cid:2)(cid:23)(cid:26)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:5)1(cid:20)(cid:20)(cid:23)"(cid:14)(cid:5)/(cid:21)(102(cid:5)(cid:5)(cid:30)(cid:28)(cid:14)"(cid:23)(cid:20)(cid:23)"(cid:22)(cid:3)(cid:3)(cid:4)(cid:8)(cid:5)3(cid:14)(cid:5)(cid:18)(cid:14)(cid:17)(cid:23)(cid:14)3(cid:14)(cid:26)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:16)(cid:28)(cid:14)(cid:18)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:25)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:22)(cid:18)(cid:14)(cid:5)(cid:16)(cid:2)(cid:27)(cid:25)(cid:23)(cid:26)(cid:14)(cid:5)(cid:27)(cid:13)(cid:14)
"(cid:16)(cid:19)(cid:27)(cid:18)(cid:16)(cid:3)(cid:5)(cid:25)(cid:27)(cid:18)(cid:2)"(cid:27)(cid:2)(cid:18)(cid:14)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:30)(cid:27)(cid:22)(cid:27)(cid:14)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:14)(cid:20)(cid:20)(cid:14)"(cid:27)(cid:23)(cid:17)(cid:14)(cid:19)(cid:14)(cid:25)(cid:25)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:26)(cid:14)(cid:28)(cid:22)(cid:18)(cid:27)(cid:29)(cid:14)(cid:19)(cid:27).(cid:25)(cid:5)(cid:16)(cid:17)(cid:14)(cid:18)(cid:25)(cid:23))(cid:13)(cid:27)(cid:5)(cid:28)(cid:18)(cid:16)"(cid:14)(cid:25)(cid:25)(cid:5)(cid:23)(cid:19)(cid:5)(cid:29)(cid:16)(cid:19)(cid:23)(cid:27)(cid:16)(cid:18)(cid:23)(cid:19))(cid:5)(cid:27)(cid:13)(cid:14)
(cid:16)(cid:28)(cid:14)(cid:18)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:25)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(12
(cid:12)(cid:13)(cid:23)(cid:25)(cid:5)(cid:18)(cid:14)(cid:28)(cid:16)(cid:18)(cid:27)(cid:5)"(cid:16)(cid:19)"(cid:3)(cid:2)(cid:26)(cid:14)(cid:25)(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1(cid:5)(cid:26)(cid:16)(cid:14)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:22)(cid:26)(cid:14)+(cid:2)(cid:22)(cid:27)(cid:14)(cid:3)(cid:4)(cid:5)(cid:25)(cid:22)(cid:20)(cid:14))(cid:2)(cid:22)(cid:18)(cid:26)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)"(cid:16)(cid:19)(cid:25)(cid:14)(cid:18)(cid:17)(cid:14)(cid:5)(cid:23)(cid:19)(cid:25)(cid:2)(cid:18)(cid:22)(cid:19)"(cid:14)(cid:5)"(cid:16)(cid:29)(cid:28)(cid:22)(cid:19)(cid:23)(cid:14)(cid:25).
(cid:22)(cid:25)(cid:25)(cid:14)(cid:27)(cid:25)(cid:5)!(cid:4)(cid:5)(cid:20)(cid:16)(cid:3)(cid:3)(cid:16)3(cid:23)(cid:19))(cid:5)(cid:28)(cid:18)(cid:2)(cid:26)(cid:14)(cid:19)(cid:27)(cid:5)!(cid:2)(cid:25)(cid:23)(cid:19)(cid:14)(cid:25)(cid:25)(cid:5)(cid:28)(cid:18)(cid:22)"(cid:27)(cid:23)"(cid:14)(cid:25)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)(cid:22)(cid:26)(cid:13)(cid:14)(cid:18)(cid:23)(cid:19))(cid:5)(cid:27)(cid:16)(cid:5)(cid:14)(cid:25)(cid:27)(cid:22)!(cid:3)(cid:23)(cid:25)(cid:13)(cid:14)(cid:26)(cid:5)"(cid:16)(cid:19)(cid:27)(cid:18)(cid:16)(cid:3)(cid:25)2(cid:5)(cid:5)4(cid:2)(cid:18)(cid:27)(cid:13)(cid:14)(cid:18)(cid:8)(cid:5)(cid:27)(cid:13)(cid:14)
(cid:26)(cid:14)(cid:28)(cid:22)(cid:18)(cid:27)(cid:29)(cid:14)(cid:19)(cid:27)(cid:5)(cid:13)(cid:22)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:22)(cid:26)(cid:14)+(cid:2)(cid:22)(cid:27)(cid:14)(cid:3)(cid:4)(cid:5)(cid:16)(cid:17)(cid:14)(cid:18)(cid:25)(cid:14)(cid:14)(cid:19)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:16)(cid:28)(cid:14)(cid:18)(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:25)(cid:5)(cid:16)(cid:20)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(12(cid:5)(cid:5)(cid:5)’(cid:2)(cid:18)(cid:23)(cid:19))(cid:5)(cid:16)(cid:2)(cid:18)(cid:5)(cid:18)(cid:14)(cid:17)(cid:23)(cid:14)3(cid:8)(cid:5)3(cid:14)(cid:5)(cid:23)(cid:26)(cid:14)(cid:19)(cid:27)(cid:23)(cid:20)(cid:23)(cid:14)(cid:26)
(cid:25)(cid:23))(cid:19)(cid:23)(cid:20)(cid:23)"(cid:22)(cid:19)(cid:27)(cid:5)3(cid:14)(cid:22)(cid:31)(cid:19)(cid:14)(cid:25)(cid:25)(cid:14)(cid:25)(cid:5)(cid:23)(cid:19)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1.(cid:25)(cid:5)(cid:23)(cid:19)(cid:17)(cid:14)(cid:19)(cid:27)(cid:16)(cid:18)(cid:4)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)(cid:22)(cid:25)(cid:25)(cid:14)(cid:27)(cid:5)(cid:23)(cid:26)(cid:14)(cid:19)(cid:27)(cid:23)(cid:20)(cid:23)"(cid:22)(cid:27)(cid:23)(cid:16)(cid:19)(cid:5)(cid:28)(cid:18)(cid:16)"(cid:14)(cid:25)(cid:25)2(cid:5)(cid:5) (cid:25)(cid:5)(cid:22)(cid:5)(cid:18)(cid:14)(cid:25)(cid:2)(cid:3)(cid:27)(cid:8)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1
(cid:5)(cid:20)(cid:22)(cid:23)(cid:3)(cid:14)(cid:26)(cid:5)(cid:27)(cid:16)(cid:5)(cid:28)(cid:18)(cid:16)(cid:29)(cid:28)(cid:27)(cid:3)(cid:4)(cid:5)(cid:25)(cid:22)(cid:20)(cid:14))(cid:2)(cid:22)(cid:18)(cid:26)(cid:5)(cid:23)(cid:19)(cid:25)(cid:2)(cid:18)(cid:14)(cid:18)(cid:25).(cid:5)(cid:22)(cid:25)(cid:25)(cid:14)(cid:27)(cid:25)2(cid:5)(cid:5)4(cid:2)(cid:18)(cid:27)(cid:13)(cid:14)(cid:18)(cid:8)(cid:5)3(cid:14)(cid:5)(cid:19)(cid:16)(cid:27)(cid:14)(cid:26)(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1(cid:5)(cid:26)(cid:16)(cid:14)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:14)(cid:20)(cid:20)(cid:14)"(cid:27)(cid:23)(cid:17)(cid:14)(cid:3)(cid:4)(cid:5)(cid:29)(cid:22)(cid:19)(cid:22))(cid:14)
(cid:23)(cid:27)(cid:25)(cid:5)"(cid:16)(cid:19)(cid:27)(cid:18)(cid:22)"(cid:27)(cid:25)(cid:8)(cid:5)(cid:23)(cid:27)(cid:25)(cid:5)(cid:13)(cid:23)(cid:18)(cid:23)(cid:19))(cid:5)(cid:28)(cid:18)(cid:22)"(cid:27)(cid:23)"(cid:14)(cid:25)(cid:5)(cid:19)(cid:14)(cid:14)(cid:26)(cid:5)(cid:23)(cid:29)(cid:28)(cid:18)(cid:16)(cid:17)(cid:14)(cid:29)(cid:14)(cid:19)(cid:27)(cid:8)(cid:5)(cid:22)(cid:19)(cid:26)(cid:5)(cid:23)(cid:27)(cid:5)(cid:13)(cid:22)(cid:25)(cid:5)(cid:25)(cid:28)(cid:14)(cid:19)(cid:27)(cid:5)(cid:22)(cid:27)(cid:5)(cid:3)(cid:14)(cid:22)(cid:25)(cid:27)(cid:5)56(cid:5)(cid:29)(cid:23)(cid:3)(cid:3)(cid:23)(cid:16)(cid:19)(cid:5)(cid:16)(cid:19)(cid:5)(cid:22)(cid:19)(cid:5)(cid:22)(cid:2)(cid:27)(cid:16)(cid:29)(cid:22)(cid:27)(cid:14)(cid:26)
"(cid:3)(cid:22)(cid:23)(cid:29)(cid:5)(cid:28)(cid:18)(cid:16)"(cid:14)(cid:25)(cid:25)(cid:23)(cid:19))(cid:5)(cid:25)(cid:4)(cid:25)(cid:27)(cid:14)(cid:29)(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:26)(cid:16)(cid:14)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:29)(cid:14)(cid:14)(cid:27)(cid:5)(cid:23)(cid:27)(cid:25)(cid:5)(cid:16)(cid:17)(cid:14)(cid:18)(cid:22)(cid:3)(cid:3)(cid:5)(cid:19)(cid:14)(cid:14)(cid:26)(cid:25)2(cid:5)(cid:5)-(cid:19)(cid:5)(cid:22)(cid:26)(cid:26)(cid:23)(cid:27)(cid:23)(cid:16)(cid:19)(cid:8)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1(cid:5)(cid:2)(cid:25)(cid:14)(cid:25)(cid:5)(cid:22)(cid:5)!(cid:22)(cid:25)(cid:23)(cid:25)(cid:5)(cid:27)(cid:16)(cid:5)(cid:22)(cid:3)(cid:3)(cid:16)"(cid:22)(cid:27)(cid:14)
"(cid:14)(cid:18)(cid:27)(cid:22)(cid:23)(cid:19)(cid:5)(cid:16)(cid:20)(cid:5)(cid:23)(cid:27)(cid:25)(cid:5)"(cid:16)(cid:25)(cid:27)(cid:25)(cid:5)(cid:27)(cid:16)(cid:5)(cid:23)(cid:19)(cid:25)(cid:2)(cid:18)(cid:14)(cid:18)(cid:25)(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:23)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:14)+(cid:2)(cid:23)(cid:27)(cid:22)!(cid:3)(cid:14)2(cid:5)(cid:5)7(cid:14)(cid:5)(cid:22)(cid:3)(cid:25)(cid:16)(cid:5)(cid:20)(cid:16)(cid:2)(cid:19)(cid:26)(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:27)(cid:13)(cid:14)(cid:5)(cid:21)(1(cid:5)(cid:13)(cid:22)(cid:25)(cid:5)(cid:19)(cid:16)(cid:27)(cid:5)(cid:18)(cid:14)"(cid:14)(cid:19)(cid:27)(cid:3)(cid:4)(cid:5)(cid:2)(cid:28)(cid:26)(cid:22)(cid:27)(cid:14)(cid:26)
(cid:23)(cid:27)(cid:25)(cid:5)(cid:14)(cid:25)(cid:27)(cid:22)(cid:27)(cid:14)(cid:5)"(cid:3)(cid:16)(cid:25)(cid:23)(cid:19))(cid:5)(cid:28)(cid:3)(cid:22)(cid:19)(cid:25)(cid:5)(cid:16)(cid:18)(cid:5)(cid:28)(cid:18)(cid:14)(cid:28)(cid:22)(cid:18)(cid:14)(cid:26)(cid:5)"(cid:22)(cid:25)(cid:13)(cid:5)(cid:20)(cid:3)(cid:16)3(cid:5)(cid:28)(cid:18)(cid:16)8(cid:14)"(cid:27)(cid:23)(cid:16)(cid:19)(cid:25)(cid:5)(cid:22)(cid:25)(cid:5)(cid:22)(cid:5)(cid:29)(cid:14)(cid:22)(cid:19)(cid:25)(cid:5)(cid:20)(cid:16)(cid:18)(cid:5)(cid:14)(cid:19)(cid:25)(cid:2)(cid:18)(cid:23)(cid:19))(cid:5)(cid:27)(cid:13)(cid:22)(cid:27)(cid:5)(cid:23)(cid:19)(cid:17)(cid:14)(cid:25)(cid:27)(cid:29)(cid:14)(cid:19)(cid:27)
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BUREAU OF STATE AUDITS
555 Capitol Mall, Suite 300, Sacramento, California 95814 Telephone: (916) 445-0255 Fax: (916) 327-0019
CONTENTS
Summary 1
Introduction 7
Chapter 1
The CLO Neither Adequately Protects Insurers’
Physical Assets nor Ensures That Investment
Decisions Are Optimized 15
Recommendations 23
Chapter 2
The CLO Has Poor Practices in Place to Conserve
Assets of Estates It Manages 25
Recommendations 41
Chapter 3
The Department of Insurance Must Strengthen
Its Oversight of the CLO 45
Recommendations 52
Response to the Audit
Department of Insurance 53
SUMMARY
RESULTS IN BRIEF
T
he Department of Insurance (department) needs to
strengthen its oversight of the activities of its Conserva-
tion and Liquidation Office (CLO). Through the CLO, the
Audit Highlights . . . department is responsible for conserving and liquidating certain
companies (insurers) doing business in the State that have
Our review of the operations
financial or other problems or that are not authorized to transact
and internal controls of the
business in California. Despite numerous findings in previously
Department of Insurance’s
(department) Conservation issued reports, a lack of adequate oversight and poor management
and Liquidation Office (CLO) practices still exist at the CLO.
disclosed that the CLO:
(cid:1) Does not adequately In May 1994 and April 1996 the Bureau of State Audits issued
safeguard and conserve reports stating that the CLO (called the Conservation and
assets that come under
Liquidation Division in 1994) needed to improve its administra-
its control.
tion and management of conserved and liquidated insurers. For
(cid:1)
Has not updated estate example, in our past audits, we found that the CLO did not
closing plans since 1998, regularly update its closing plans for the insurers’ estates it
and has never included
managed, did not follow its policies and procedures for hiring,
projected cash flow needs
and failed to properly monitor contracts. Moreover, another
in these plans.
independent auditing firm (external auditor) identified problems
(cid:1)
Does not effectively with the CLO’s efforts to recognize and bill for reinsurance—a
manage its contracts and
method used by insurers to spread a portion of their risk to
its basis for allocating
certain costs to insurers’ other insurers, known as reinsurers. In exchange for taking on a
estates is inequitable. proportionate share of the original insurer’s risk, the reinsurer
(cid:1) typically receives a percentage of the premiums paid by the
Has never adopted a
policyholders of the original insurer. Once an insurer is conserved
comprehensive conflict-of-
interest policy for its or liquidated, the CLO attempts to offset the claims paid on
employees and behalf of the insurer by collecting any applicable reinsurance.
contractors to follow.
During our current audit, we found that the department and the
(cid:1) CLO have not addressed many of the issues raised in our previous
Spent at least $6 million
of insurers’ money on a two audit reports, nor have they corrected some of the problems
claims processing system identified by the other external auditor. Among the problems we
that does not meet
most recently identified are a failure to follow either department
its needs.
or CLO guidelines and procedures with respect to internal
Additionally, the department audits, hiring, and contracting; no recent reviews or updates of
has allowed the CLO to
estate closing plans; and an allocation system that inequitably
continue its poor manage-
ment practices by failing to assigns fixed costs among insurers’ estates.
properly oversee its activities.
1
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 policy-
holders. 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.
2
Weak hiring practices is another problem we previously reported,
but we found no evidence that the CLO acted on our recommen-
dation. 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 compre-
hensive 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
3
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 admin-
istrative 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 require-
ments. 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
4
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 appro-
priate, 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 employ-
ees 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.
5
AGENCY COMMENTS
The insurance commissioner concurs with all our findings and
believes the report validates concerns he had about the manage-
ment 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. n
6
INTRODUCTION
BACKGROUND
T
he Department of Insurance (department) is responsible
for protecting California policyholders by regulating the
1,600 insurance companies and 300,000 brokers and
agents operating in the State (collectively referred to as insurers
in this report). Taking a lead role in helping the department
fulfill this responsibility, the Conservation and Liquidation
Office (CLO) assists in conserving, rehabilitating, or liquidating
financially distressed or insolvent insurers. Section 1011 of the
Insurance Code (code) authorizes the insurance commissioner
(commissioner), on obtaining a court order, to take possession of
the real or personal property, books, records, and assets of an
insurer and to conduct, as conservator, as much of the insurer’s
business as the commissioner deems necessary. In addition,
Section 1013 of the code authorizes the commissioner to take
possession of an insurer’s assets without first obtaining a
court order if certain conditions exist, such as the threat of
embezzlement or wrongful diversion of company assets. The
current commissioner was sworn in by the Legislature on
September 18, 2000, following the former commissioner’s
resignation on July 31, 2000.
As of May 31, 2001, the CLO was managing the estates of
54 conserved or liquidated insurers. Forty-six of these insurers
were incorporated in California and are referred to as domiciliary
insurers. The remaining 8 insurers were incorporated in another
state or country and are called ancillary insurers. According to
Section 1064.3 of the code, when an ancillary insurer with
operations in California is conserved, the court will appoint the
commissioner as the ancillary receiver. As the ancillary receiver,
the commissioner has the sole right to recover and liquidate
certain of the ancillary insurer’s assets located in California, pay
certain priority claims established and allowed by the court, and
pay necessary expenses of the proceedings. The code requires
that the remaining assets of an ancillary insurer be transferred
promptly to the receiver located in the insurer’s state or country
of incorporation.
7
During conservation, a financially troubled insurer is placed
under court-ordered control of the insurance commissioner.
If it is determined that an insurance company cannot be
rehabilitated—that is, its identified problems corrected—the
commissioner can apply for a court order to liquidate the
company. During liquidation, the CLO closes the insurer, cancels
its policies, and converts its assets into cash. After liquidation,
the commissioner applies for a court order to distribute the
liquidated insurer’s assets to the policyholders, creditors, and
other parties having a financial interest in the estate and
distributes the assets in the order required by the code.
State insurance guarantee funds cover many policyholders of
California-licensed insurers that become insolvent and are
subject to conservation and liquidation. Two associations, the
California Insurance Guarantee Association and the California
Life and Health Insurance Guarantee Association, process and
pay covered insurance claims to policyholders of all insolvent
property, casualty, life, and health insurers, up to the limits
specified by law. The CLO’s responsibilities in managing conserved
and liquidated insurers consist primarily of reviewing claims not
covered by the insurance guarantee funds; determining the
amounts owed to the claimants; and taking action to identify,
marshal, and manage the assets of insurers in conservation to
maximize the return to policyholders and general creditors
should liquidation of assets become necessary.
The CLO administers an investment pool in which it deposits
the cash assets of liquidated insurers under its management. As
of May 2001 the market value of the investment pool was more
than $916 million. Section 1035 of the code allows the CLO to
allocate all the costs of managing the estates under its control
among those qualified conserved and liquidated insurers with
sufficient assets to pay these costs. Annual appropriations from
the department’s Insurance Fund pay for the management of
estates without sufficient assets to cover the administrative costs.
During 2000 the CLO’s total operating expenses were approxi-
mately $9 million.
The CLO incurs both direct and indirect costs in managing
estates. Direct costs, such as a contractor who works exclusively
on a particular insurer’s estate, are charged directly to that estate
each month. Indirect costs are accumulated in a cost pool and
are allocated to estates on a monthly basis. Indirect costs generally
include administrative and other overhead costs. The CLO
categorizes indirect costs as variable or fixed, and it uses different
8
methods to distribute each type of cost to estates it manages.
Indirect variable costs include salaries, wages, and certain
professional fees; examples of indirect fixed costs are rent,
utilities, and equipment depreciation. The CLO charges its
indirect variable costs to each estate in proportion to the number
of hours employees have worked on that particular estate in a
given month. Indirect fixed costs are allocated in proportion to
the number of outstanding claims each estate has.
Of the 54 estates the CLO was managing as of May 2001, 16 were
no-asset estates—those without enough assets to cover the CLO’s
administrative costs and claims. In accordance with the code,
the CLO cannot spend the assets of one estate to pay for the
costs of another estate, although it does borrow estate funds for
this purpose. To cover the costs of managing estates with little or
no assets, the CLO is granted an annual appropriation of
$623,000 from the department’s Insurance Fund. However, the
CLO does not receive this appropriation in advance. Instead, it
temporarily borrows money from the investment pool to pay
the expenses associated with no-asset estates, bills the department
for the funds it borrows, and receives reimbursement from the
Insurance Fund. The CLO has recently improved its billing
procedures to more promptly reimburse the investment pool.
In February 2000 the CLO seized two large no-asset title
companies and incurred management and other costs of
approximately $3.5 million as of May 2000. As a result, the
CLO exceeded its Insurance Fund allocation by $3.6 million for
fiscal year 1999-2000.
Previous Reports by the Bureau of State Audits
In April 1996 the Bureau of State Audits issued a report titled
Department of Insurance: The Management of Conserved Insurers
Has Improved, but Problems With Liquidation and Administration
Continue. The purpose of the audit was to follow up on a May
1994 audit of the department’s conservation and liquidation
operations with respect to the management of conserved insurers,
personnel practices, contracting, allocation of costs to conserved
companies, disposition of assets, and claims processing.
During the 1996 audit, we found that the CLO had not adequately
monitored its budgets or updated its plans for closing estates.
The report also noted that the CLO needed to further improve
its administrative practices. Specifically, we found that the CLO
did not always follow its policies and procedures for hiring
9
employees and managing outside contractors. Moreover, we
found that the CLO did not always properly allocate its indirect
administrative costs to conserved and liquidated insurers.
We recommended that the CLO improve and implement its
estate closing plans to maximize the assets of insurers and
distribute the assets as early as possible. In addition, we made
specific recommendations for the CLO to improve its administra-
tive policies and procedures and to follow them so it could better
manage the conserved and liquidated insurers under its control.
The CLO’s Reorganization and Staffing
Since our 1996 report, the CLO has experienced high turnover
in its executive management. In the past four years, the CLO has
had four different chief executive officers. The CLO is currently
in the process of reorganizing its operations. Five officers now
direct each essential function of the CLO: finance, reinsurance,
information systems, claims, and operations. In addition to
serving as the second in command, the chief operations officer
oversees human resources, administration, and the estate finance
managers (formerly called the estate trust managers). In the past,
it has been the department’s belief that the CLO is not required
to follow the administrative procedures used by most state
departments. Therefore, the CLO has created its own administra-
tive policies and procedures for managing the activities of
conservation and liquidation for the estates in its trust.
In accordance with the department’s past interpretation of the
code and long-standing case law, the CLO is exempt from
budgetary oversight by the Department of Finance, oversight of
its expenditures and financial statements by the State
Controller’s Office, oversight of its contracting and purchasing
by the Department of General Services, and oversight of its
personnel practices and policies and salary administration by the
Department of Personnel Administration and the State Personnel
Board. It has been the department’s belief that oversight of the
CLO’s operations is provided by the management of the depart-
ment; by the superior courts (where conservation and liquidation
matters are reviewed); and by the internal and external audits of
the CLO, its financial statements, and the financial statements of
the estates it manages. Section 1061 of the code requires the
Department of Finance to audit the financial statements of the
CLO’s estates at least every two years and report the results to
10
the commissioner and the courts. However, the Department of
Finance has allowed the CLO to contract for these audits with
an independent audit firm since 1994.
The CLO has established 59 permanent positions in its orga-
nization that, except for its chief executive officer, are not
within the State’s civil service system. In addition to permanent
staff positions the CLO engages the services of temporary workers,
department legal staff, Department of Justice attorneys, private
consultants, and private (outside) legal counsel for assistance in
conserving and liquidating insurers. Because it considers itself
exempt from civil service requirements, the CLO does not
establish positions and salaries under State Personnel Board
guidelines. Instead, it follows its own policies and procedures,
under the supervision of the department, when establishing
positions and salaries and hiring and promoting employees.
The Conservation Process
When an insurer is conserved, the CLO works with the
department’s Conservation Legal Bureau to develop and
implement a plan adapted to the insurer’s assets and business
activities and designed to secure the assets, books, and accounting
records of the conserved insurer. After conserving the insurer,
the CLO, along with any needed consultants, attempts to
determine the causes of the conserved insurer’s insolvency or
other business problems and its financial condition. The CLO
then makes recommendations to the commissioner, who deter-
mines whether the conserved insurer can be rehabilitated or
whether he should seek a court order to liquidate the insurer’s
assets. Once the commissioner obtains an order from the courts
for liquidation, the CLO develops and implements a plan to
liquidate the assets of the insurer and identify its liabilities to
policyholders, creditors, and other stakeholders. The CLO also
works with its counterparts in other states to secure and sell
assets and identify claimants and legal issues related to the
insurer’s business activities outside California.
After the CLO completes its efforts to identify the claims against
the assets of a liquidated insurer, it forwards any covered claims
to the applicable insurance guarantee association for processing
and payment. Claims not covered by an insurance guarantee
association are processed and paid by the CLO from the remain-
ing assets of the insurer. Once an insurer’s assets have been
11
liquidated and the claims liabilities against those assets have
been proved by the CLO and allowed by the courts, the CLO
makes a distribution of the insurer’s assets to pay those claims in
the priority sequence detailed in the code. A declaration to the
courts that the CLO has complied with the court order for the
distribution of assets closes the estate and discharges the respon-
sibilities of the commissioner as liquidator.
SCOPE AND METHODOLOGY
The Joint Legislative Audit Committee (audit committee) asked
the Bureau of State Audits to conduct an audit of the operations
of the CLO. Specifically, the audit committee asked us to deter-
mine whether the CLO has adequate internal controls to detect
the mishandling of the assets of conserved and liquidated
insurers. The audit committee also asked us to evaluate the
operations of the CLO that are outside the control structure of
the State and the sufficiency of the department’s efforts to
regularly monitor all CLO operations.
To understand the laws governing the CLO, we reviewed the
code. We also reviewed the relevant policies and procedures of
the department and the CLO.
To assess the sufficiency of the CLO’s investment activities, we
reviewed its investment guidelines and its compliance with
those guidelines by testing a sample of monthly investment
reports. In addition, we compared the CLO’s rate of return for its
investment pool to the benchmark it has selected and to the rate
of return the State receives on its Pooled Money Investment
Account. We initially tried to review the last 10 years’ worth of
investment activity; however, the CLO had records covering
only the last 5 years. In addition, for 2 of those 5 years, the CLO
had five different investment managers. Therefore, to better
compare the results of the CLO’s investments, we confined our
review to the last 3 years. We also evaluated the CLO’s investment
strategy to determine whether its investment goals adequately
match its estate management goals.
To determine whether the CLO appropriately accounts for
insurers’ assets, we evaluated the adequacy of the CLO’s method
for allocating investment gains to the insurers’ investment pool
accounts and tested a sample of allocations. During our review,
we found no instances of the CLO inaccurately allocating invest-
ment gains to an insurer’s account.
12
To determine whether the CLO avoids using insurers’ financial
assets inappropriately, we did the following:
(cid:127) Reviewed the method used to select and compensate the
CLO’s outside investment managers.
(cid:127) Interviewed management regarding its implementation of the
automated claims processing system it purchased in 1995 and
reviewed supporting documentation.
(cid:127) Evaluated its basis for budgets and its process for reporting on
budget variances.
(cid:127) Evaluated its basis for allocating fixed and variable costs to
insurers.
(cid:127) Reviewed its process for paying the expenses of no-asset
estates and billing the Insurance Fund for those expenses.
In addition, to determine the sufficiency of the CLO’s manage-
ment of functions that are outside the State’s control system, we
evaluated the CLO’s processes for executing and monitoring its
contracts, for ensuring that it hires the most qualified staff, and
for ensuring that its salaries are reasonable and appropriate.
Finally, we evaluated the department’s oversight of the CLO’s
operations. As part of this effort, we examined the work per-
formed by the CLO’s internal auditor and analyzed the findings
of his operations review. We also assessed the department’s role
in ensuring that the CLO takes appropriate corrective actions
regarding the findings and recommendations of the CLO’s
internal and external auditors. n
13
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14
CHAPTER 1
The CLO Neither Adequately
Protects Insurers’ Physical Assets
nor Ensures That Investment
Decisions Are Optimized
CHAPTER SUMMARY
T
he Conservation and Liquidation Office (CLO) does not
follow recommended procedures when it inventories the
fixed assets of a company (insurer) that it seizes or places
in conservation. In a recent example, rather than immediately
completing an inventory to identify and protect the assets of a
seized title company, the CLO waited to do so until at least three
weeks after it was authorized to take control of the insurer. More
recently, the CLO omitted several items from the inventory of a
conserved insurer’s fixed assets. In addition, the CLO does not
account for all of the assets of liquidated insurers after they are
auctioned, so it does not know whether the auction company
returns all unsold items. Such practices fail to safeguard and
conserve the assets that come under the CLO’s control.
Because it does not regularly update the individual closing plans
for the estates it manages, the CLO is not as effective as it could
be in managing insurers’ invested assets and budgeting for its
operations. Since 1998 the CLO has failed to update its estate
closing plans (closing plans). Moreover, it has never included an
estimate of each estate’s future cash flows in those plans—
information that would help its investment managers maximize
the assets of the estates they manage. In 1998 the CLO did
prepare a cash flow projection for another purpose, but which
aided its investment managers. Since then, however, the CLO
has neither updated closing plans nor projected its cash flow
needs, so this information has been unavailable for making invest-
ment decisions or to more accurately budget for its operations.
Finally, the CLO’s investment pool has received a slightly higher
average return over the past three years than the average return
received by the State’s Pooled Money Investment Account
(PMIA), which is administered by the state treasurer and has
similar objectives and makes comparable investments. However,
since 1999 when it added the ability to invest in the bonds of
15
16 foreign countries, the CLO has not reviewed its investment
guidelines or performance benchmark to ensure that its invest-
ment strategy is appropriate, even though the market value of its
investment pool has more than tripled since 1996. In addition,
in 2000, the CLO paid $930,000 to its investment managers, but
since reducing them in 1998, it has not evaluated the fees it pays
to ensure that they are reasonable compared to what other
investment firms would charge to manage a pool of similar
value. Consequently, the CLO may be spending estate funds
needlessly on fees for its investment managers.
In April 2001 the CLO’s investment committee agreed to request
that the investment managers review the guidelines and consider
what changes might need to be brought before the committee.
The CLO’s investment managers completed their review on
July 13, 2001, after the end of our fieldwork. Therefore, we did
not evaluate the investment managers’ work product.
THE CLO DOES NOT PROMPTLY IDENTIFY AND SECURE
ALL ASSETS OF SEIZED OR CONSERVED INSURERS
During our review of the CLO’s process for inventorying insurers’
assets, we noted several serious weaknesses in its internal controls.
For example, the CLO did not promptly complete an inventory
of the fixed assets of a seized title company. Fixed assets
include items such as vehicles, office furniture and fixtures,
computer hardware, copy machines, fax machines, and other
office equipment.
Once the CLO obtains a conservation or seizure order, it is
important that it take immediate action to identify and secure
all the insurer’s assets to safeguard against theft or other loss
until the court either determines that conservation is not
necessary or orders that the insurer’s assets be liquidated. When
The CLO had not assets are liquidated, they are auctioned and the auction proceeds
completed an inventory are to be used to help pay the liquidated insurer’s debts.
of assets for one title
company for nearly On February 2, 2000, the department issued seizure orders
three weeks after the authorizing the CLO to take control of two title companies.
Department of Insurance According to the manager of the CLO’s administration depart-
ordered the ment, who is responsible for overseeing the inventory process,
company seized. the CLO began the inventories of the insurers’ assets on
February 8, 2000. However, he could find no documents to
prove the inventories had occurred on that date. Further, during
our review of inventory records, we came across an inventory
16
count sheet indicating that at least part of the CLO’s inventory
of one insurer occurred on February 22, 2000—nearly three
weeks after the date of the seizure order.
According to the CLO’s chief operations officer, to whom the
administration department manager (administration manager)
reports, after receiving authorization to conserve an insurer, the
CLO takes immediate action to assume control of the insurer’s
While changing the locks premises by changing door locks and other security arrangements.
on a seized company’s In the case of the two title companies, the chief operations
premises is important, it officer stated that he understood a decision was made to stagger
is not a substitute for the timing of the inventories for two reasons. First, because the
promptly inventorying two title companies were wholly owned subsidiaries of the same
assets to safeguard parent company and occupied the same premises, the CLO
against their loss. elected to spend time identifying which company owned the
assets before taking inventory. Second, the Insurance Code
(code) gives the insurance commissioner (commissioner), as
conservator, the discretion to defer taking inventory until after a
liquidation order is received when an insurer is making a legal
challenge to a court-ordered conservation; however, this was not
the case for either of the two title companies.
We disagree with the reasons cited by the chief operations
officer. According to its policies and procedures, the CLO must
immediately place inventory tags on all assets of a seized or
conserved insurer. Moreover, we believe it would not be in the
commissioner’s or the estate’s best interests to defer taking an
inventory when an insurer has been seized. Seizures are ordered
only when there is a strong possibility that assets are being
embezzled or diverted or when the insurer is not licensed to
conduct business in California and poses a threat to policyholders.
Finally, although immediately changing locks and other security
arrangements is important, such actions cannot substitute for
the CLO promptly inventorying an insurer’s assets to fulfill its
responsibility of identifying and safeguarding those assets
against loss. By not promptly identifying all the assets of a seized
or conserved insurer, the CLO fails to ensure that valuable items
will not be removed from the premises without its knowledge.
Because assets are often later sold at auction and the proceeds
used to offset creditors’ claims, it is important that the CLO iden-
tify and secure all assets as soon as possible after it takes control
of an insurer, through either a seizure or conservation order.
We also found that the CLO did not thoroughly count fixed
assets during its inventory of a recently conserved insurer. We
noted several items that had inventory tags but did not appear
17
on any inventory count sheet, including a refrigerator, a micro-
wave oven, various pieces of furniture, and a television. When
we inquired about these items and asked the administration
manager about the possibility of some missing count sheets, he
stated that he had given us all the sheets. However, after further
During a recent investigation, the administration manager discovered that some
conservation, the CLO members of the inventory team had not turned in their count
team conducting the sheets. Although the administration manager told us that taking
inventory neglected to inventory is a routine part of the CLO’s work and that the staff
turn in all their count assigned to an inventory are familiar with the process, some
sheets and did not put team members kept their count sheets because they did not
tags on all items so that know what to do with them after the inventory was completed.
they would be included in The chief operations officer told us that the administration
the count. manager would have known which inventory team member had
not turned in a count sheet because the inventory tags are
sequentially numbered and each team member is assigned a
series of inventory tags. Thus, when the administration manager
reviewed the count sheets, a gap in the inventory tag numbers
would have alerted him to the fact that some count sheets were
missing. However, when we asked the administration manager if
he routinely reviewed the inventory count sheets to identify
gaps in the listed tag numbers, he stated that he did not. If it
had not been for our inquiry, the CLO would not have known
that all the count sheets had not been turned in.
In addition, we found that some items were not tagged during
an inventory. The CLO’s policies and procedures manual states
that when a conservation order is received for an insurer, the
inventory process should account for all items taken into custody.
The CLO inventory team is supposed to attach a prenumbered
inventory tag to each item counted, and an inventory team
member must record a tag number, a description, and, if appli-
cable, a model or serial number on an inventory count sheet for
each item. To verify that all items were counted and recorded,
team members must double-check the tag on each item.
However, soon after the CLO had completed its inventory of an
insurer that was conserved during our fieldwork, we observed
several items without inventory tags, including a desk, a marble
table, some paintings, and some potted plants and trees. Accord-
ing to the chief operations officer, staff erroneously began their
counts on the second day of the inventory in a different area of
the insurer’s premises, rather than where they had stopped the
previous day. The chief operations officer further explained that
it is the CLO’s informal policy not to count plants and certain
other miscellaneous items such as small office supplies, because
18
these items have little monetary value. However, this informal
policy conflicts with the CLO’s policies and procedures manual,
which states that all assets should be counted. Moreover, we
noticed that some plants had tags and others did not, leading us
to conclude that at least some inventory team members were
confused about what should and should not be tagged during an
inventory. We attribute this apparent confusion to the fact that
the CLO’s written inventory policy does not clearly address
miscellaneous items or assets having little monetary value.
Moreover, the CLO does not ensure that inventory teams follow
uniform procedures when conducting inventories, because team
leaders do not adequately supervise and oversee the inventory
process. In addition, before starting an inventory, the CLO does
not develop and provide each team member with an inventory
work plan that includes specific instructions for performing that
particular count. Consequently, decisions regarding when to
turn in count sheets, what areas to count, and what is consid-
The CLO neither provides ered a miscellaneous item or one of low monetary value are left
its inventory team to each individual team member.
members with written
instructions prior to the Prudent business practices for the inventory of physical assets
count nor ensures that include holding preparatory meetings to discuss the inventory
the inventory process is process and providing the inventory team with written instruc-
adequately supervised. tions regarding how to conduct the inventory. In addition, the
inventory process should be completed promptly, count sheets
should be prenumbered to ensure that they are all collected once
the inventory is completed, and all items should be checked to
ensure that they are clearly marked or tagged.
The CLO’s Inventory Policies and Procedures Are Inadequate
Two reasons the CLO’s inventory process is problematic is that
its inventory policies are outdated and its procedures fail to
provide detailed instructions as to how an inventory should be
conducted. The CLO’s inventory policy, which was last revised
in July 1994, designates who is responsible for specific tasks,
such as receiving and distributing inventory tags, maintaining a
list of tag numbers and a corresponding list of staff who have
been assigned a series of tags, and placing tags on assets. The
policy also designates who is responsible for completing the
inventory count sheets, but neither the policy nor a sample
count sheet included in the policy indicates that count sheets
should be sequentially numbered. Another reason for the CLO’s
inventory problems is that its staff are not sufficiently trained in
inventory control procedures and may not fully understand
their importance. Unless the CLO develops thorough work plans
19
for each inventory, provides its staff training in the inventory
procedures to be used, and makes sure that the procedures are
followed, it cannot ensure that it promptly identifies and secures
all insurers’ assets.
The CLO Does Not Account for All Assets After an Auction
Another internal control weakness we found is that the CLO
does not account for all asset items after an auction. In
conjunction with its contract with an auction company, the
CLO provides the auction company with a list of items to be
The CLO has no process auctioned, which includes inventory tag numbers. The auction
to ensure that all items company uses this list to create its own list of items for sale.
not sold at auction After the auction, the auction company gives the CLO a list of
are returned. the items that sold and their selling prices as well as a list of
items that did not sell. However, the CLO does not have a
process to reconcile its list with those it receives from the auction
company. According to the administration manager, when he
attends an auction, he uses the auction company’s list of items
available for auction to check off each item that sells and notes
its selling price. However, because he does not compare the
auction company’s lists of sold and unsold items with the CLO’s
list of items available for auction, the administration manager
cannot ensure that all the items are accounted for.
Further, we determined that even if the administration manager
had attempted to reconcile the auction company’s lists to the
CLO’s list of items available for auction, he would not have
succeeded because some items on the auction company’s list of
sold items did not have a corresponding inventory tag number.
We could not determine whether this was because some tags had
fallen off or the auction company had not included some tag
numbers in its list. In addition, when we attempted to identify
some items by comparing the descriptions on the auction
company’s list to the descriptions on the CLO’s list, we were
unable to find a match in some cases. For example, a brown side
chair that we saw on the CLO’s list was not on either of the
auction company’s lists. Rather, several items on the auction
company’s sold list were generically described as “chairs.”
Because the descriptions did not always match, we were unable
to identify some items that did not have inventory tag numbers
on the auction company’s lists. In the CLO’s contract with the
auction company, the CLO does not specify that each item
appearing on the sold and unsold lists must have the same
description as appears on the CLO’s list of items to be auctioned.
Thus, the CLO cannot use the auction company’s lists to
20
determine whether all the items that were available to auction
were either sold or returned to the CLO. In addition, we found
that some items appeared both on the auction company’s list of
items sold and on its unsold list. For example, the auction
company reported a typewriter and several filing cabinets as
being both sold and unsold.
The CLO Does Not Routinely Prepare or Update Estate
Closing Plans
For each estate it manages, the CLO does not routinely update
closing plans or estimate cash flow needs. As a result, the CLO
cannot provide information that would help its investment
managers maximize estate assets, and it limits the CLO’s ability
to accurately plan and budget for its activities. In preparing
closing plans, the CLO has developed a set of master procedures
that guide how the CLO’s estate finance managers conserve and
close insurers’ estates. Closing plans identify timelines and
specify tasks that various units of the CLO and the Department
of Insurance’s (department) legal staff must perform. Procedures
for claims processing and payment, final accounting of estate
assets, partial and final distribution of assets, and estate closing
are normally included in closing plans. However, the estate
finance managers have not prepared or updated any closing
By not regularly updating plans since 1998 and have never made cash flow estimates part
its closing plans and of closing plans. A cash flow estimate would include inflows like
including estimated cash reinsurance recoveries and litigation awards and outflows like
flows, the CLO hinders asset distributions and the administrative cost of managing the
its ability to plan estate. According to the chief operations officer, at one time it
activities and optimize was the CLO’s goal to update closing plans quarterly for all
investment decisions. estates it managed. However, because of high management
turnover and heavy workloads, the CLO has not prepared
closing plans for any estate it has taken over since April 1998,
nor has it updated any existing plans since that time.
In 1998 the CLO did prepare a cash flow analysis of all the
estates in liquidation for a purpose other than to update its
closing plans. According to the chief financial officer, the CLO’s
investment managers found this cash flow projection useful in
managing the investment portfolio. For example, if they knew
that the CLO was planning to make a distribution in the next
year, the investment managers could optimize their investment
decisions so that enough maturing investments would provide
the needed cash while earning the maximum return on the
portfolio’s other investments. Two of the CLO’s objectives for
preparing closing plans are to maximize the assets of managed
21
estates and to provide planning and budgeting information on
the CLO’s operations. When it fails to prepare or update closing
plans and cash flow estimates, the CLO limits its ability to
measure its success in meeting those objectives.
According to the chief executive officer, the CLO intends to
complete closing plans for all estates that do not have one and
to update the plans of the remaining estates by the end of
August 2001. Once these plans are completed, the CLO will
prepare estate cash flow projections and update the plans and
projections either quarterly or every six months.
THE CLO MAY NOT KNOW WHETHER ITS INVESTMENT
STRATEGY IS APPROPRIATE
Although its investment pool has grown significantly, the CLO
has not reviewed its performance benchmark and investment
guidelines since 1999 and has not evaluated the reasonableness
of the fees charged by its investment managers since 1998. The
The CLO’s investment CLO’s investment pool earned a slightly higher three-year
pool earned a slightly average return from 1998 through 2000 than the PMIA earned
higher three-year over the same period—5.94 percent compared with 5.69 percent—
average return than a even after adjusting the two rates for the payment of investment
state-managed pool that manager fees. However, the CLO’s investment benchmark
makes similar investments. performed slightly better at 6.01 percent during that same
period. The CLO last reviewed its investment guidelines in 1999
when it added the ability to invest in the bonds of 16 foreign
countries; however, the guidelines still may not be appropriate
for the CLO’s current situation. For example, the market value of
the investment pool totaled $275 million in January 1996.
Significant growth occurred in September 1998, when assets from
a large estate totaling approximately $766 million were transferred
into the investment pool. Consequently, the market value
increased from $323 million to $933 million, which is net of the
distributions made that month. As of May 2001 the market
value of the investment pool was $916 million, and it is currently
managed by two of the five investment managers who managed
the pool in 1996. Moreover, the last time the CLO evaluated its
investment managers’ fees to determine whether they were still
reasonable was when it reduced them in February 1998. In 2000
the CLO paid $930,000 in management fees without knowing
whether this amount was reasonable compared to what other
investment managers would charge to manage a pool of similar
22
value. As a result, the CLO may be paying higher administrative
fees than it otherwise would to obtain a comparable return and
The CLO has not recently may be needlessly expending estate funds.
done a fee comparison
among investment firms The objectives of the PMIA are to ensure the safety of the invest-
to verify it is receiving ment portfolio by investing in high-quality securities; make
the best results at the certain that the goals of safety, liquidity, and yield are not
lowest cost. jeopardized; and prudently manage the investment pool. The
PMIA makes investments similar to those in the CLO’s investment
pool. Like the PMIA, the CLO has set investment objectives of
maintaining the safety of the principal and maximizing available
yield while minimizing risk through an investment portfolio
based on quality and diversification. Accordingly, the CLO’s
investment guidelines require safe investments, such as high-
quality corporate bonds, and they outline the types of investments
that are permitted, such as U.S. government securities, as well as
investments that are prohibited, such as emerging market
instruments. Based on these objectives and guidelines, the CLO
selected a benchmark to define its investment strategy and
measure its performance. The benchmark it chose was an index
based on low-risk government and corporate investments.
Because the investment pool replicates the composition and
performance of the selected benchmark, the benchmark may
preclude it from maximizing the return on investments.
Because the investment pool’s average value has changed
significantly over the past five years, and because the CLO has
not recently evaluated its investment managers’ fees, the CLO
cannot be certain that its guidelines and benchmark are still
appropriate for managing the assets of the investment pool
and are maximizing its earning potential.
RECOMMENDATIONS
To ensure that it adequately safeguards the fixed assets of insurers
under its control, the department should require the CLO to
take the following steps:
(cid:127) Develop work plans for each inventory it conducts, based on
prudent business practices that include the following:
(cid:1) Holding preparatory meetings to discuss the inventory
process.
23
(cid:1) Providing an inventory work plan that includes instructions
regarding how each inventory will be conducted.
(cid:1) Promptly conducting and properly supervising inventory
counts to reduce the risk of loss.
(cid:1) Ensuring that all count sheets are prenumbered and collected
after the inventory is complete.
(cid:1) Checking all counted items to ensure that they are clearly
marked or tagged to avoid omitting any.
(cid:127) Train its staff in proper inventory procedures and require all
personnel who participate in the inventory process to follow
the new procedures.
(cid:127) In its contracts with auction companies, require auction lists
of sold and unsold items to include the inventory tag numbers
and the same descriptions as included on the CLO’s list of
inventory available for auction, and reconcile the lists to
ensure that all inventoried items are accounted for.
To maximize the return on the assets it manages, the depart-
ment should ensure that the CLO takes the following actions:
(cid:127) Create or update closing plans that include estimates of the
future cash needs for each estate. The CLO should use this
information to ensure that it reaches its goal of maximizing
estate assets and to accurately plan and budget for
its operations.
(cid:127) Periodically reevaluate its investment strategy and benchmark
to reflect changing conditions and requirements.
(cid:127) Periodically review its contract for investment management
services to determine whether the fees it pays are reasonable
compared to what other investment managers would charge
to manage an investment pool of similar value. n
24
CHAPTER 2
The CLO Has Poor Practices in
Place to Conserve Assets of Estates
It Manages
CHAPTER SUMMARY
T
he Conservation and Liquidation Office (CLO) suffers
from poor management practices in several areas, many
of which we have previously reported. For example, we
found that the CLO does not ensure that contract managers
follow its competitive bidding policy, which specifies only three
circumstances when obtaining competitive bids is not required.
Two of the 10 contracts we reviewed should have been competi-
tively bid but were not, and the reasons the CLO gave for using
sole-source contracts did not appear to qualify as exceptions as
defined in its policy. We also found that the CLO does not
ensure that it hires and promotes the most qualified applicants.
For example, the CLO hired two applicants and promoted one
employee who did not appear to meet the CLO’s minimum
qualifications. In addition, we found that the CLO has not
evaluated the structure of its salary ranges since 1995 and has
never had comprehensive conflict-of-interest policies and guide-
lines for its employees and vendor contractors to follow. When
the CLO fails to properly control and monitor its contracts, does
not ensure that it hires the most qualified staff, and does not
guard against potential conflicts of interest, it may spend estate
assets improperly or unnecessarily.
Our audit also revealed inequities in the CLO’s basis for allocating
its fixed costs to the estates of insurers it manages. Moreover, the
CLO does not regularly review the status of estates to identify
those that meet its criteria for sharing fixed costs. For example,
we found that for one estate, the CLO did not allocate more
than $4,000 for one month’s fixed costs, despite staff spending
94 hours working directly on this estate’s activities.
Finally, although the CLO has spent more than $5.7 million to
implement the claims processing system it purchased in 1995,
the claims system continues to be costly and inefficient, and it
does not effectively support the CLO’s operations. For example,
although the processing system was purchased in part to improve
25
the CLO’s reinsurance claims process, reinsurance recovery
claims continue to be handled manually—a process that is
inefficient and prone to error.
THE CLO DID NOT ALWAYS FOLLOW ITS PROCEDURES
FOR AWARDING AND MANAGING CONTRACTS FOR
PROFESSIONAL SERVICES
In our previous report dated April 1996, we found that the CLO
did not consistently follow its procedures for awarding and
managing contracts for professional services. For example, the
CLO did not always seek competing bids for consulting contracts,
made payments to contractors that were not in strict accordance
with contract terms, and paid invoices that did not contain the
required detail of contractors’ expenses. Apparently, the CLO has
not yet addressed these issues because our review of 10 contracts
in effect as of or after January 1998 revealed similar examples of
poor contracting practices.
Sometimes the CLO Did Not Seek Competitive Bids
Of the 10 contracts we reviewed, the CLO should have sought
competitive bids for 2 but did not. The CLO’s policy for entering
In 2 of 10 cases, the CLO into sole-source contracts greater than $10,000 lists three circum-
should have sought stances when competitive bids are not required: in emergency
competitive bids but situations, when the contractor possesses unusual or unique
did not. skills, or when the contracted services are needed in a remote
geographic area.
In the first case involving an unjustified sole-source contract, the
CLO inherited from the department a contract for financial and
claims services on one insurer’s estate. The Department of
Insurance (department) had established this contract in May 1992,
while it was managing the estate. Beginning in July 1997, the
CLO continued to use the contractor’s services under the original
agreement until finally executing a new contract in January 2000.
The contract manager stated he did not seek competitive bids for
this contract because the contractor possessed knowledge of the
insurer’s operations. Further, the CLO had previously used the
contractor’s services and was satisfied with the contractor’s prior
performance. In the second case, the CLO did not seek competitive
bids before awarding a contract for arbitration services. Rather,
according to the CLO’s chief executive officer, the decision was
based on a recommendation made by one of the CLO’s outside
26
legal counsels. The CLO’s reasons for executing both these
contracts do not seem to qualify under the CLO’s policy for
sole-source contracts.
Further, we found that the CLO continues to renew two other
contracts periodically without seeking competitive bids for the
services. The managers for these contracts told us that they had
contacted a few other vendors by phone regarding their rates for
services. However, we could not corroborate the contract
managers’ assertions because neither of them documented their
discussions with these vendors or their analyses of vendor rates.
Without such documentation, we could not verify that the CLO
is receiving the best rates for the services it purchases under
these repeat contracts.
In a previous audit, we reported that the CLO had developed
procedures for professional service contracts that were modeled,
in part, on the consulting contract requirements of the Public
Contract Code and the State Administrative Manual. Although
the CLO’s contract procedures include such critical elements as
obtaining proper approval for contracts and providing detailed
descriptions of the services that are being contracted for, they do
not provide clear guidance in some important areas. For example,
the procedures do not specify when a formal bidding process,
called a request for proposal, should be used and when a less
formal telephone bidding process is acceptable; nor do they
stipulate what documentation is necessary in those instances. In
addition, although the procedures list three circumstances in
which noncompetitive bidding is allowed, the wording is vague
The CLO’s contract and open to interpretation; for example, the CLO policy allows
procedures do not sole-source contracting in “emergency situations” without
provide guidance for defining specific situations. Therefore, the CLO relies on the
when a formal bidding judgment of its department managers to determine when competi-
process is required or the tive bids are required and what type of bid process they should
documentation needed follow. The CLO is in the process of amending its contracting
when using a less formal procedures; however, the new procedures still do not specify
telephone bidding process. when managers should issue requests for proposals for outside
service contracts, or when using a telephone bidding process is
appropriate and how to document that process.
Contract Managers Do Not Adequately Monitor
Their Contracts
We also found that the CLO does not always ensure that its
contractors adhere to the terms and conditions of their contracts,
because contract managers are not always aware of what the
27
terms and conditions are. For example, we found that one
contract required the contractor to provide detailed records of
the hours its personnel worked under the contract and have a
CLO representative certify that the hours were correct and the
work was satisfactory. However, the CLO has not enforced this
requirement. In fact, the contract manager was not even aware
of the requirement until we brought it to his attention. Without
adequate time records, contract managers cannot ensure that
the invoices contractors submit for payment accurately reflect
the time spent on contracted work.
In another example, we found that although one contract
specifies that the CLO will pay the contractor on full and final
completion of the contracted work, the CLO has paid for services
whenever the contractor submitted invoices. The contract is for
actuarial services for certain insurers’ estates that the CLO
Two contract managers currently administers. The contract manager told us that he was
were unaware of some of not aware that this provision for payment was in the contract
the terms included in the until we pointed it out to him. However, he stated that the
contracts they were contract’s provision for payment should be changed because it is
responsible for managing. not reasonable to wait until the end of the contract period to
pay the contractor for these services.
In addition, we noted two instances in which the CLO continued
to receive and pay for services after the contracts had expired. In
one instance, the CLO failed to renew a contract for security
services that had expired at the end of January 2000 but continued
to pay the vendor even after accounting personnel notified the
contract manager of the expiration. As a result, it paid more
than $486,000 to the vendor over a period of more than
11 months without having a contract in place. When the CLO
finally executed another contract for the same services in
January 2001, it was able to negotiate a $39 hourly rate for a
specific type of security service rather than the $50 hourly rate it
had been paying. However, the CLO backdated the term of
service in the new contract to cover services it had been receiving
from this vendor since mid-September 2000 and made the term
effective to mid-September 2001. Further, the new contract
stated that if it were executed after September 15, 2000, its terms
and conditions—including the lower rate—would be retroactive
to that date. The CLO, therefore, not only paid a higher rate for
the services it received while no contract was in place than it
had negotiated under the new contract, but according to the
contract’s terms, it also overpaid this vendor more than $43,000
for the backdated portion of the new contract and about two
weeks after it was signed. Moreover, despite backdating the term
28
of service and retroactively applying all of the terms and
conditions of the new contract, the CLO did not seek a refund
The CLO overpaid for the overpaid amount. According to the contract manager,
one contractor more seeking a refund from the vendor would not be appropriate. We
than $43,000. disagree. As shown in Figure 1 on the following page, if the
CLO had promptly executed a new contract when the previous
one expired and had negotiated the same hourly rate, rather
than overpaying the contractor by more than $43,000, it could
have saved nearly $142,000 in insurer assets.
In another instance, the CLO continues to pay a contractor for
claims and financial services without having a contract in place.
Although the contract expired on December 31, 2000, the CLO
has not renewed it despite its ongoing need for the services. As
of May 2001, the CLO had paid almost $63,000 for services it
received after the contract expired.
The CLO’s contracting procedures require contract managers to
review each invoice to ensure that the rates comply with contract
terms and that it does not pay for services it did not receive.
However, in all of the instances just described, we determined
that the contract managers had not periodically monitored the
contracts for which they were responsible to refresh themselves
on the contracts’ terms and conditions and to determine if and
when they should renew them. Instead, the contract managers
relied on accounting personnel to notify them when problems
arose with invoices and when a contract had expired and required
renewal. Moreover, contract managers frequently ignored
instances when accounting staff advised them that a contract
had expired or that an invoice did not reflect the terms of a
contract. By allowing contractors to perform services without
valid contracts in place, the CLO does not ensure that it receives
quality services at the stipulated prices and hinders its ability to
enforce compliance with unwritten contract terms and conditions.
The CLO’s contract procedures also require the contract managers
to review the amount paid under a contract to ensure that the
contract budget is not exceeded. Contract managers are required
to obtain the approval of a member of the CLO’s senior manage-
ment before exceeding the amount of a contract. However, we
found that the CLO has not been following these controls
because it does not assign each contract a unique number for its
contractors to use when billing for services under a specific
contract. This process would allow the CLO to compare the
aggregate payments made under a given contract before
approving any additional invoices for payment and would
29
30
FIGURE 1
Chronology of the CLO’s Payments for Security Services
Second contract period began
on September 15, 2000
Second contract executed
on January 2, 2001
All terms and conditions Second contract expires
First contract with the vendor
apply retroactively on September 14, 2001
expired on January 31, 2000
7.5 months 4 months
January 15, 2001
No contract in place; however, $98,316 Contract specified $39 per
could have been saved if the CLO had paid hour for police officer
at the lower $39 hourly rate. (off-duty or retired), but the
CLO paid $50 per hour.
Therefore, the CLO overpaid
the vendor $43,340.
Potential savings: $141,656
Source: CLO contract records.
guard against overpaying the contract limit. The CLO’s account-
ing system tracks invoices by vendor number instead of contract
number. Under its current process, the CLO’s contract managers
do not receive information on how much has been expended on
a particular contract, and they do not keep their own records of
this information. Instead, they rely on the accounts payable
manager to notify them when actual expenses are likely to
exceed a contract budget. Therefore, when the CLO enters into
more than one contract with a vendor, which is often the case,
payments could be applied to the wrong contracts or the total
paid to a particular contractor could exceed the applicable
contract limit, and estate assets could be wasted.
THE CLO DOES NOT ENSURE THAT IT HIRES AND
PROMOTES QUALIFIED STAFF
The CLO does not ensure that its employees meet the minimum
qualifications to perform their duties, nor does it check references
or verify the education records and employment histories of
applicants before making hiring decisions. The CLO has developed
minimum qualifications specifying the relevant educational
degrees and the length and type of work experience required to
successfully perform the functions of each position. It has
established salary ranges for each position that are structured to
The CLO hired compensate individuals who qualify for the position. We
two employees and compared the minimum qualifications for the positions held by
promoted another that seven employees to the information they had provided on their
did not appear to résumés and job applications. During our review, we found that
meet the minimum two of the seven employees were hired even though their
qualifications for their information suggested that they did not meet the minimum
respective positions. qualifications required to perform the duties of their respective
jobs. One of these two employees was hired at a starting salary
that exceeded the midpoint of the salary range. In addition, in
our review of employee documents, we found that one employee
was promoted despite not having the associate degree and
specific technical knowledge and experience the position required.
In addition, the CLO did not document its justification for
hiring or promoting staff who did not appear to meet its
minimum requirements. We reported a similar weakness in the
CLO’s hiring practices in 1996.
The CLO does not verify information, such as college degrees
and work experience, listed by applicants on their résumés and
job applications. According to the chief operations officer, the
CLO’s regular hiring practices do not include verification of
31
college degrees and prior work experience, although the minimum
qualifications for some positions require bachelor’s degrees and/
or specific levels of experience to successfully perform the job’s
functions. Consequently, the CLO cannot be certain that it is
employing the most qualified personnel, and it may be compen-
sating some employees for qualifications they do not possess.
THE CLO IS NOT SURE THAT ITS SALARY LEVELS ARE
STILL COMPETITIVE
According to the chief operations officer, a combination of
heavy workloads and inconsistent leadership has hindered the
CLO’s efforts to evaluate the structure of its salary ranges since it
The CLO has obtained last did so in 1995. For example, the chief operations officer
market data on salary stated that when insurers are initially seized, conserved, or
trends, but it has not liquidated, the CLO’s resources are particularly strained. During
used the data to evaluate the early months of the conservation and liquidation processes,
and adjust its salary some members of the CLO’s management team work off-site
structure since 1995. while also trying to manage some of the daily operations at the
office. As a result, the CLO’s management has not had the
resources to focus on issues like evaluating whether its salary
structure is reasonable and competitive.
Since 1994 the CLO has had four chief executive officers. The
chief operations officer stated that these leadership changes
have prevented the CLO from developing and implementing a
strategic plan, which would include a salary structure evaluation.
Although the CLO has obtained market trend reports for salary
scales, it has not considered and evaluated this data. As a result,
the CLO has not adjusted its structure for salary ranges since 1995.
When the CLO does not periodically evaluate its salary structure,
it cannot be sure that its salaries are reasonable and remain
competitive enough to attract and retain qualified applicants.
THE CLO HAS NEVER ESTABLISHED A COMPREHENSIVE
CONFLICT-OF-INTEREST POLICY FOR ITS EMPLOYEES
AND CONTRACTORS
Because CLO employees and contractors are frequently privy to
sensitive financial and other information concerning insurers,
the CLO has a responsibility to ensure that its employees and
contractors are free of any impairments that could bias the
decisions they make in administering insurers’ estates. However,
the CLO has never established conflict-of-interest guidelines that
32
define specific conflicts of interest and incompatible activities or
that give guidance on the acceptance of gifts. Without such a
policy, a CLO employee who makes key decisions regarding how
estates are managed could, for example, hold an ownership
interest in a managed insurer’s estate or in a competing insurance
company without disclosing such information. Because it lacks
comprehensive conflict-of-interest policies and guidelines, the
CLO cannot ensure that its employees and contractors adequately
safeguard sensitive information and act in the best interest of
the estates it manages.
As a state agency, the department requires designated employees
to complete annual statements disclosing their financial interests.
However, because the CLO’s employees are not state employees,
except for its chief executive officer, the CLO does not require
them to make such disclosures. Before 1999 the CLO required
all employees to sign an annual conflict-of-interest certificate
that, according to the chief operations officer, constituted the
CLO’s conflict-of-interest policy. However, the certificate was
merely a retrospective questionnaire and did not provide overall
guiding principles regarding conflicts of interest, nor did it
clearly define what constitutes incompatible activities or give
guidance concerning acceptance of gifts and protection of
Without clear guidance sensitive information. Moreover, the CLO has not required its
on the types of activities employees to sign an annual conflict-of-interest certificate since
that may be incompatible 1998. Beginning in 1999, the CLO has attempted to develop and
with their duties, the CLO implement a comprehensive conflict-of-interest policy. The most
is not assured that its recent draft of the policy provides detailed guidelines regarding
employees are making some incompatible activities, acceptance of gifts, and employee
decisions that are free investment activities. However, the draft policy does not give
from bias. guidance on what constitutes conflicts in the daily decision
making of the CLO’s employees. Further, the CLO has yet to
finalize and implement this conflict-of-interest policy.
The department’s legal bureau, which manages the CLO’s contracts
for outside counsel, has adequate conflict-of-interest guidelines
and policies to ensure that the outside counsel discloses actual
and potential conflicts of interest. All other contracts under the
CLO’s direct management contain standard language requiring
contractors to adhere to the CLO’s conflict-of-interest policies.
However, according to the chief operations officer, those policies
do not currently exist. Until a conflict-of-interest policy is
finalized and approved, the CLO will continue to rely solely on
each employee and contractor’s judgment and knowledge in
identifying and avoiding any incompatible activities they may
have and fully disclosing any conflicts of interest.
33
THE CLO’S BASIS FOR ALLOCATING FIXED COSTS
UNFAIRLY BURDENS SOME INSURERS
The CLO’s method of allocating its fixed costs—such as the costs
of office space, storage, equipment, and computer systems—
among the insurers under its management is inequitable. The
method involves calculating the number of proofs of claim
(a document that claimants are required to file in order to
receive payment from either an insurance guarantee association
or from an insurer’s estate) associated with each insurer as a
percentage of the total and then allocating its fixed costs to each
insurer based on that percentage. Using this method, the CLO
overly burdens some insurers and does not charge anything to
other insurers whose estates the CLO manages using staff and
resources. Between January 1, 2000, and March 31, 2001, the CLO
allocated $2.7 million in fixed costs to 22 insurers with proofs of
claim, out of an average of 52 insurers that it actively managed
during that time. Thus, less than 50 percent of the insurers the
CLO managed paid all the CLO’s fixed costs, despite all insurers
sharing in one or more of the benefits provided by the office
space, storage, or computer services used by staff in managing
the estates.
According to the chief financial officer, the CLO developed its
method of allocating fixed costs several years ago and prior to
his being hired. It is his understanding that the CLO used proofs
of claim to allocate fixed costs because its managers reasoned
that employees would still need to record and maintain proofs
The CLO continues to use of claim whether or not they did any other work on a given
proofs of claim as a basis estate. Therefore, the fixed cost of infrastructure items such as
for allocating its fixed equipment and facility costs were generated to support the
costs to the estates, even CLO’s proofs of claim activities.
though this allocation
method is inequitable. However, there are some flaws in the logic of using the number
of proofs of claim as the basis for allocating fixed costs. Specifi-
cally, one insurer can have few proofs of claim that are very
complex and require a significant amount of work while another
insurer can have thousands of proofs of claim of a more routine
nature that require little work. For example, a proof of claim
filed by an asbestos manufacturer who has had claims made
against it by hundreds of claimants who used the asbestos
product will require more research and possibly involve litigation
compared to a proof of claim filed for automobile damage
caused by a driver accidentally backing into a telephone pole.
Because the amount of staff work that an insurer’s proofs of
claim require is related to the nature of the claims rather than to
34
their volume, by using the number of proofs of claim to allocate
fixed costs, the CLO unfairly burdens some estates by allocating
them a greater portion of fixed costs than they should receive.
Moreover, for some months the majority of estates managed by
the CLO have no proofs of claim, yet the majority of the CLO
staff’s hours are charged to the estates with no proofs of claim.
This happens because some of the CLO’s work is unrelated to
activities associated with proofs of claim. For example, during
the first few months after the CLO takes over an insurer, most of
its staff’s effort is devoted to identifying and taking control of
the insurer’s physical and financial assets, records, books and
other property, and collecting on existing reinsurance receiv-
ables—tasks that are not related to the proofs of claim that are
filed against the estate or their volume. Further, because most
proofs of claim are related to insurance policies issued by a now
insolvent insurer, they are processed and paid by an insurance
guarantee association (IGA), not by the CLO. However, once the
IGA has processed and paid a proof of claim, the CLO’s work on
the estate shifts to reviewing the IGA’s work—a task that is
closely related to the proofs of claim. Consequently, when using
the CLO’s current method for allocating fixed costs, an estate
with proofs of claim will bear a certain portion of each month’s
fixed costs regardless of whether any proofs of claim work was
done in a given month because the allocation is driven by their
number, not the level of work activity associated with the estate
as a whole.
The CLO claims officer informed us that although an insurer
might have proofs of claim that remain outstanding for years,
the CLO staff will not necessarily be actively working on that
insurer the entire time. As a result, the CLO’s method of using
proofs of claim to allocate fixed costs is flawed and is unfairly
burdening insurers that have large numbers of outstanding claims
by making them pay a disproportionate share of these costs.
We believe that the CLO could allocate its fixed costs to insurers
based on fairer methods that more closely reflect the insurers’
share of those costs. For example, it could use a method similar
to the one it uses for variable costs such as employee salaries.
The CLO compiles the number of hours its staff members work
directly on a given insurer each month and allocates its variable
costs based on those hours. This would be a fairer method of
allocating fixed costs because the number of hours spent also
reflects the share of office space and furniture and fixtures being
devoted to managing the insurer.
35
For instance, in February 2001, the CLO staff spent approximately
4,227 hours working directly on the estates of 52 insurers. As
Figure 2 shows, the staff spent only 35 percent (1,478) of those
hours working on the 22 insurers with proofs of claim. More-
over, the CLO allocated 100 percent of the $186,130 in monthly
fixed costs to the 22 insurers, including almost $55,900 to one
insurer that did have more than 30 percent of the total proofs of
claim that month but required only about 22 hours of the CLO
staff’s time. In that same month, the CLO did not allocate more
than $4,000 in fixed costs to another insurer that had no proofs
of claim, despite the fact that CLO staff spent 94 hours working
directly on this insurer’s estate.
FIGURE 2
Staff Hours Spent on Insurers With and Without
Proofs of Claim in February 2001
Hours spent on Hours spent on
22 insurers that 30 insurers that
had proofs of had no proofs of
claim and paid 1,478 2,749 claim and paid no
100% of fixed costs (35%) (65%) fixed costs
Source: CLO accounting records.
THE CLO DOES NOT REGULARLY REVIEW THE STATUS
OF INSURERS TO ENSURE THE FAIR ALLOCATION OF
FIXED COSTS
Each month the CLO’s claims unit reports to the accounting
unit the number of proofs of claim for the insurers it is manag-
ing so that it can allocate fixed costs to those insurers. According
to the claims officer, the claims unit reports the number of
claims outstanding only for those insurers with sufficient assets
to pay for allocated costs, based on information received from
the CLO’s estate finance managers.
36
However, the estate finance managers do not review all insurers
regularly to ensure that the ones with sufficient assets to pay for
their share of the fixed costs are included in the monthly list
and that the ones with insufficient assets are not included.
Without a process to review the assets of all insurers regularly,
the CLO faces a potential for under- or over-allocating fixed
costs to insurers. As we discussed in the previous section, using
proofs of claim as a basis for allocating fixed costs may not be
equitable. In addition to this fundamental inequity, we found
that the CLO does not have a process to ensure that it identifies
and allocates a portion of its fixed costs to all estates that meet
its criteria for sharing them. For example, we found that the
CLO has not charged any fixed costs to one insurer despite its
having sufficient assets and at least 4,663 proofs of claim
outstanding since December 1999.
When we inquired about this case, the chief financial officer
explained that in December 1999, the majority of the CLO’s
fixed costs were for its claims processing computer system.
However, the insurance company in question had its own claims
processing system, which it still uses, so the CLO did not use its
system to manage the insurer. In addition, until late 1999, first a
special deputy appointed by the insurance commissioner and
then the CLO managed the operations of this insurer at a separate
location outside the CLO, and the administrative costs involved
(both variable and fixed) were paid entirely by the insurer.
Consequently, the CLO decided not to allocate fixed costs to the
insurer. Although we agree with this reasoning, in December 1999,
The CLO exempted one the management of this insurer was moved to the CLO. Since
insurer from incurring then, the insurer has received the benefits provided by such
any allocated fixed costs fixed costs as the CLO’s office space and equipment without
even though under the paying for them. Therefore, under the CLO’s current method of
CLO’s method of allocating fixed costs based on proofs of claim, this insurer
allocating such costs should have paid $58,174 since January 2000. If the CLO based
the insurer should have its fixed-cost allocation on staff hours spent working directly
paid $58,174. on each estate—a method we believe is fairer, as previously
discussed—it should have allocated $190,156 to this insurer
since January 2000.
The chief financial officer also argued that because of the sub-
stantial number of claims against this insurer, it would be unfair
to allocate any fixed costs to it based on proofs of claim. We
agree with the chief financial officer’s argument, which only
underscores our previous conclusion that the CLO should
consider other methods of allocating fixed costs that are more
equitable than its current method.
37
THE CLO SPENT MILLIONS IN ESTATE ASSETS TO
IMPLEMENT A CLAIMS PROCESSING SYSTEM THAT
DOES NOT EFFECTIVELY SUPPORT ITS OPERATIONS
The CLO is responsible for administering and processing proofs
of claim (claims) for the insurers under its management. In
October 1995 the CLO purchased a new automated claims
processing system to centralize and more effectively manage its
claims. However, the CLO failed to adequately identify its claims
processing needs before purchasing the system. As a result, the
CLO purchased a claims processing system that was not designed
to handle the complex nature of its claims and has since required
extensive modifications. Despite a four-year, $5.7 million
implementation effort, the CLO uses its system to process claims
for only nine estates, and it is considering abandoning the
system altogether. While the CLO is considering other options,
the claims processing system continues to be costly, inefficient,
and does not effectively support its operations.
The CLO implemented its new claims processing system in
September 1999, nearly four years after having purchased it.
According to the CLO’s chief information officer,
the system was originally designed to process
claims for a standard insurance company. However,
CLO Claims Processing System
Implementation Costs unlike a standard insurance company, the CLO
(October 1995 to September 1999) must process and administer a variety of claims
made against liquidated estates, not just claims
Purchase price $400,000
made against insurance policies. For example, the
Ongoing system costs $1,252,280
CLO must also process claims for administrative
Maintenance
System modifications expenses such as rent payments, legal fees, and
Technical support vendor services associated with the estates it
manages. Because the system was not originally
IT/management consultants $1,634,398
System specifications designed to handle claims that are as complex and
Acceptance testing
varied as the ones the CLO works with, the CLO
Data conversion
contracted with an information technology consult-
Permanent/temporary $2,449,635
ant to help it develop system requirements, testing,
employees*
Acceptance testing and data conversion efforts at a significant cost.
Data conversion
Initially intending to convert claims information
Total $5,736,313
for 5 estates, the CLO later expanded that number
to 8 with the goal of eventually adding to the
* Costs from October 1995 to March 1998.
system all newly liquidated estates that had assets
and were subject to the claims process. Since
purchasing its new claims processing system in
October 1995, the CLO has conserved 14 estates, of which 9
have sufficient assets and are suitable candidates to pay claims
38
and, therefore, justify the CLO’s converting all claims information
onto the claims processing system. As of June 2001, the CLO
was using its system to process claims information for only 1 of
the 9 estates. Another 5 are subsidiaries of a parent company
(noninsurance) in bankruptcy. For these estates, the CLO uses
the system to store some claims information but not to process
claims. According to the chief information officer, the CLO uses
the insurers’ systems to process claims because the CLO does not
have sufficient resources to handle the volume and complexity
of the claims for these 5 estates. The CLO is currently considering
whether to store some claims data on its system for the 3 remain-
ing estates, all of which were conserved in 2001. Claims for the
other estates that the CLO manages are processed on a variety of
systems, including its old claims processing system and the
systems of the estates it has taken over.
Despite costly and extensive system modifications, the CLO’s
claims processing system is still unable to efficiently process the
CLO’s claims information. Because of a variety of problems with
the claims data, such as the amount and accuracy of the data
that was available when the CLO first conserves an estate, the
CLO’s ability to use its system to process claims for the eight
original estates is limited.
Further, the claims system does not produce a full array of
standard reports. According to the chief information officer,
over the years, programmers from the CLO were able to develop
standard reports for the claims department. However, depending
on the nature of the request, whenever users other than the
claims department need a report, they must ask programmers to
specially develop them. Moreover, although the claims system
was purchased in part to improve its reinsurance process, the
CLO has had to continue its inefficient manual processing of its
reinsurance claims. As we discuss in the next section, if claims
are not designated as reinsured and identified as a receivable in
The CLO continues to pay its accounting system, the CLO cannot attempt to recover
costly maintenance and reinsurance receivables related to those claims.
technical support fees
for a claims processing The claims processing system continues to drain the assets of the
system it acknowledges CLO’s estates. Since implementing the system in September 1999,
does not meet its the CLO has paid more than $322,000 in system maintenance
overall needs. and technical support fees alone. The CLO acknowledges that its
system does not meet its overall claims processing needs.
According to the chief executive officer and the chief information
officer, the CLO is in the process of reevaluating its overall
system needs regarding claims and reinsurance processing.
39
THE CLO’S PROCESSING OF REINSURANCE CLAIMS IS
INEFFICIENT AND INEFFECTIVE
As part of its task of conserving or liquidating an insurance
company, the CLO must determine whether any reinsurance
contracts exist. Under a reinsurance contract, an insurance
company pays a percentage of the premiums it receives from
policyholders to another company, called a reinsurer. The
reinsurer then assumes an agreed-on percentage of the original
insurance company’s risk. Reinsurance contracts allow insurance
companies to reduce their exposure to risk from policyholder
claims. For example, when an insurance company receives a
claim from a policyholder, it bills the reinsurer for a portion of
the claim, depending on the terms of the reinsurance contract.
Receivables associated with an insurance company’s reinsurance
contracts thus are treated as an asset.
In managing insurers that are being conserved or liquidated, the
CLO seeks reimbursement from reinsurers for estates that include
reinsurance contracts. In these cases, after the CLO approves and
settles claims, it bills the reinsurer for the percentage of the
claims specified in the reinsurance contract. The CLO’s unaudited
financial statements for 2000 indicate that reinsurance receivables
net of an estimated uncollectable amount make up approximately
$999 million (41 percent) of the estate assets that the CLO
manages. Once it collects on reinsurance contracts, the CLO
credits the reinsurance payments it receives to the appropriate
insurer’s estate. The CLO can use the funds later to pay the
insurer’s creditors.
The CLO’s practice of processing most reinsurance claims manu-
ally is inefficient and prone to error. For example, a supervisor in
The CLO does not the CLO’s reinsurance department retired before he completed
ensure that all the billing process for a $900,000 reinsurance claim. The supervi-
reinsurance receivables sor had sent the reinsurer a letter informing it that the CLO had
are promptly identified, all the information necessary to prepare a request for payment
billed, and collected. but never followed up by sending a bill, which the reinsurer
required before it would authorize the payment. In addition, the
supervisor had not set up a receivable for the $900,000 in the
CLO’s accounting system. Consequently, the CLO was unaware
that this amount was owed until almost three months later,
when the reinsurer notified it that they had not paid the claim.
When the CLO’s reinsurance department generates a reinsurance
bill, the reinsurance supervisor is responsible for setting up a
receivable in the CLO’s accounting system. However, because
most of these claims are processed manually, this is not done
40
automatically. Unless the CLO properly accounts for all its
reinsurance contracts and establishes receivables for all amounts
due, it cannot ensure that it bills for all the reinsurance it is
entitled to and promptly collects payments owed. This, in turn,
causes the CLO to lose interest earnings because of delayed
reinsurance payments, and provides fewer funds to pay the
insurance companies’ creditors.
In one case, the CLO took nearly five months to review and
approve a reinsurance claim from another state’s IGA. Although
the reinsurance manager agreed that an automated reinsurance
claims processing system would improve the CLO’s current
system of processing reinsurance claims, he stated that such a
system would not have prevented the delay in processing this
specific claim. An IGA guarantees insured customer claims
against insurers that subsequently become insolvent, up to
statutory dollar limits, depending on the type of insurance
involved. When a licensed insurance company goes into liquida-
tion, the IGA pays covered claims up to the specified amount. In
this case, an out-of-state IGA had paid on a claim for an insured
party and subsequently notified the CLO of the payment. The
IGA then sent the claim to the CLO for review. However, after
the CLO received the claim, it took two months to recommend
an amount to bill the reinsurer and almost another three
months to approve the amount. Moreover, as of June 2001, the
CLO still had not billed the reinsurer because, according to the
reinsurance manager, the $950,000 amount that the CLO’s
claims department had recommended and the chief executive
officer had approved did not include approximately $435,000 in
expenses that may be recoverable through the reinsurer. When
reinsurance claims are not processed promptly, the CLO loses
potential interest earnings and delays potential distributions
to creditors.
RECOMMENDATIONS
To ensure that it does not squander insurers’ assets, the depart-
ment should see to it that the CLO takes the following steps:
(cid:127) Amend its contracting policies and procedures to define when
and how managers should seek competitive bids, including
the type of documentation required for bids obtained by
telephone, and ensure that its contract managers understand
and adhere to the CLO’s contracting policies and procedures.
41
(cid:127) Ask the vendor who provided security services to pay back
$43,340 in overpayments due to the CLO paying a higher
$50 hourly rate when its contract specified a $39 hourly rate.
(cid:127) Assign each contract a unique number and require its contract
managers to track payments made under each contract they
manage and its accounting staff to account for the payments,
using a spreadsheet or other means as a control against
misapplied payments or overpayment.
(cid:127) Periodically review contracts to determine if and when they
should be renewed and require contractors to adhere to all
contract terms and conditions.
(cid:127) Ensure that it is hiring qualified applicants and promoting
qualified employees to positions requiring technical knowledge
and experience. The CLO should also verify applicants’
references, including work and education records, before
making hiring decisions and should document its justification
when hiring applicants and promoting employees who do not
meet minimum qualifications.
(cid:127) Evaluate its salary structure, using both private and public
sector comparisons, to ensure that it attracts and retains
qualified employees.
(cid:127) Finalize, approve, and implement a conflict-of-interest policy
similar to the policy used by state agencies. Further, the CLO
should require all designated employees and multiyear con-
tractors to complete an annual conflict-of-interest statement.
(cid:127) Review other options for allocating fixed costs to insurers that
are more equitable than its current method, and implement a
method that allocates fixed costs to all insurers’ estates with
assets that benefit from these costs.
(cid:127) Develop a system of review to ensure that insurers that should
be paying a portion of the fixed costs are included in its
allocation process and that insurers that should not be included
are not paying these costs.
(cid:127) Work diligently toward defining its overall claims processing
system needs. In the event that it chooses to purchase a new
claims processing system, the CLO should explore the option of
42
alternative procurement, whereby the software company
would have a direct financial stake in the successful imple-
mentation of the claims system.
(cid:127) Ensure that reinsurance claims are both properly accounted
for and promptly billed. n
43
Blank page inserted for reproduction purposes only.
44
CHAPTER 3
The Department of Insurance Must
Strengthen Its Oversight of the CLO
CHAPTER SUMMARY
H
istorically, the Department of Insurance (department)
has considered its Conservation and Liquidation Office
(CLO) to be exempt from several components of the
State’s control system, but the department has failed to take the
steps necessary to otherwise oversee the CLO’s activities. For
example, although the CLO’s internal auditor acts as the
department’s oversight arm, the department does not require
the internal auditor to adhere to state law and the department’s
policy that requires a two-year internal audit cycle. In fact, the
current audit plan does not have the internal auditor completing
his first audit cycle until 2002—nearly five years after its start.
Consequently, the internal auditor has not yet reviewed the
CLO’s operations in some important areas, such as its processes
for inventorying the assets of the insurance and title companies
(insurers) it manages, preparing budgets, and operating its
information systems. Had the department enforced its policy,
some of the weaknesses we detected and discuss in Chapters 1
and 2 might have been identified and corrected sooner.
The department’s poor oversight of the CLO is also evidenced by
its lack of follow-up on the deficiencies identified by previous
internal and external audits and by its failure to steer the CLO’s
efforts to implement suggestions for improvement made in
those audit reports. For example, the CLO’s internal auditor
reported weaknesses in the CLO’s contract management practices
in 1998, but the department did not ensure that the CLO made
effective improvements in this area. In addition, the department
failed to provide the internal auditor with copies of management
reports prepared by the CLO’s external auditors. The internal
auditor, therefore, was unable to ensure that the CLO took
appropriate corrective action regarding the findings and
recommendations in these management reports. Unless the
department properly oversees the CLO’s activities, it cannot
make certain that insurers’ estates are adequately protected
and conserved.
45
THE DEPARTMENT’S FLAWED OVERSIGHT WEAKENS ITS
ABILITY TO ENSURE THAT THE CLO PROPERLY
SAFEGUARDS AND MANAGES ESTATE ASSETS
The CLO does not fall under the direct control of the State. The
department has interpreted the Insurance Code (code) as exempt-
ing the CLO from budgetary oversight by the Department of
Finance, oversight of its expenditures and financial statements
by the State Controller’s Office, oversight of its contracting and
Most of the CLO’s purchasing by the Department of General Services, and oversight
operations are of its personnel and hiring practices by the Department of
outside the State’s Personnel Administration and the State Personnel Board. Based
control structure. on this interpretation, the department has developed its own
oversight process to monitor the CLO’s operations. However,
during our review of the CLO’s operations, we found significant
flaws in the department’s oversight. Without an effective means
to oversee the CLO’s operations, the department cannot ensure
that the CLO is safeguarding and properly managing estate assets.
An effective oversight process has three basic components:
monitoring, reporting, and accountability. Specifically, an
effective oversight process should include periodic reviews of
accounting and administrative controls to ensure that control
weaknesses are promptly identified (monitoring). Once a weak-
ness is identified, an effective oversight process should ensure
that it is documented and reported to high-level managers who
are in a position to effect change and make policy decisions
(reporting). Finally, an effective oversight process should hold
an organization accountable for correcting control weaknesses
and formally addressing recommendations made by internal
and external auditors (accountability). While the department
has developed the basic components of an oversight process, we
identified significant flaws in both monitoring and accountability
that weaken the effectiveness of its oversight efforts.
The Department Has Developed a Monitoring Process
An effective monitoring process is one that provides the depart-
ment with the independent, objective, and timely information it
needs to correct identified weaknesses and make policy decisions.
The department has developed a monitoring process that includes
annual reviews of the CLO’s administrative and accounting
controls and ongoing auditing and analysis of the CLO’s overall
operations. Under the department’s guidance, the CLO contracts
with an independent auditing firm (external auditors) to conduct
annual financial audits of its asset management practices.
46
Industry standards require the external auditors to review all
administrative and accounting controls that are pertinent to
planning the extent and timing of the transactions to be tested
during the audit. If the auditors note any material weaknesses in
the controls they review, they are required to report them to
both the department’s and the CLO’s management. To fulfill
requirements set forth in the code, the Department of Finance
periodically reviews the reports and supporting documentation
prepared by the CLO’s external auditors and reports to the
insurance commissioner.
The department monitors the ongoing operations of the CLO
through its Internal Audits and Information Security Office
(audits office). As Figure 3 shows, the CLO’s internal auditor is
one of five units of the department’s audits office. As such, the
internal auditor acts as the oversight arm of the department.
Although he is a CLO employee, the internal auditor reports
directly to the department’s chief of the audits office.
FIGURE 3
Organization of the Department’s Internal Audits
and Information Security Office
Office of the
Insurance Commissioner
Internal Audits and
Information Security Office
Chief
Information Internal CLO Internal Fraud Licensing
Security Audits Auditor Audits Audits
Source: Department of Insurance.
47
The chief of the audits office is responsible for reviewing and
approving the CLO internal auditor’s audit plan and ensuring
that the internal auditor adheres to the department’s policies
and guidelines, which are closely modeled after professional
auditing standards. Under the supervision of the department’s
chief of the audits office, the internal auditor is responsible for
the ongoing auditing and analysis of the CLO’s operations and
its accounting and administrative controls.
An Overly Long Audit Cycle Has Weakened the Monitoring Process
State law and the department’s policies require the internal
auditor to conduct a risk assessment every two years based on an
analysis of the administrative and accounting controls over all
the CLO’s operations. The risk assessment identifies the programs
and processes that are most vulnerable to control weaknesses
and thus require review in the internal auditor’s two-year audit
plan (we call this two-year period an audit cycle). Following the
risk assessment, which was completed in 1997, the CLO’s internal
auditor developed a two-year audit plan that covered seven
major processes: contracts, claims, reinsurance, receivables,
certain disbursements, investments, and administration activities
that included the inventory process used by the CLO. The CLO’s
former chief executive officer and chief financial officer approved
the audit plan on October 31, 1997. However, the CLO and the
department have continually approved revisions to the audit
plan, which have extended the audit cycle. Specifically, by
Although a two-year October 31, 1999—the end of the most recent two-year audit
audit plan was approved cycle—the internal auditor had only completed his review of
in October 1997, as of contracts and claims. Within the next year, he completed reviews
June 30, 2001, the CLO’s of reinsurance, receivables, and some disbursements. However,
internal auditor had as of June 30, 2001, the internal auditor had not yet completed
not yet completed the his review of the investment process or administration activities.
reviews called for in the
plan. Because of the slippage in completing the reviews called for in
the two-year audit plan, a new risk assessment on which to base
the audit plan for 2000 and 2001 has not taken place, and the
audit cycle, which was to have been completed in October 1999,
is ongoing. Therefore, new control weaknesses could now exist
in the areas the internal auditor has already reviewed or in other
areas that have not been reviewed. For example, the internal
auditor has yet to review the CLO’s administrative processes for
inventorying insurers’ assets, budgeting, and the operation of its
information systems. As discussed in Chapter 1, we identified
significant weaknesses in the CLO’s inventory and asset
48
identification process. Had the department required the internal
auditor to adhere to its policy requiring a two-year audit cycle,
those weaknesses may have been identified and corrected earlier.
Moreover, conducting risk assessments becomes even more
important when there have been changes in management. As
previously stated, since 1994, the CLO has had four different
chief executive officers and undergone numerous other changes
in upper management. Therefore, it is important that internal
controls are regularly reviewed to ensure that they are in place
and working as intended.
Additionally, in 1996, we reported weaknesses in the CLO’s
personnel policies and procedures. As part of his approved audit
plan for disbursements in this area, the internal auditor followed
Reviewing the CLO’s up on the CLO’s efforts to implement our recommendations for
internal controls became improvement. However, his testing led him to mistakenly
even more important conclude that the CLO had corrected an earlier deficiency we
because of the frequent noted in its hiring of employees who did not appear to meet the
changes in management. minimum job requirements for the position. Consequently, as
we discussed in Chapter 2, the CLO still has shortcomings in its
personnel management practices related to the hiring and
promotion of staff.
The Department’s Reporting Process Is Adequate
The department has developed an adequate reporting process to
ensure that executive management from both the department
and the CLO receive reports issued by internal and external
auditors. As part of their annual financial audit, the CLO’s
external auditors issue reports to management, detailing any
significant weaknesses they detect in its internal controls and
making recommendations for improvement. The external
auditors distribute their reports to executive managers in both
the department and the CLO. Further, the internal auditor issues
audit reports and distributes them to high-level managers in
both the department and the CLO.
To Ensure Accountability, the Department Has
Policies Requiring Follow-Up on Auditors’ Findings
and Recommendations
Accountability is one of the most essential components of an
effective oversight process. Once problems or control weaknesses
have been identified and reported, it is the department’s
responsibility to hold the CLO accountable for correcting them.
49
As part of that responsibility, the department must ensure that
the CLO addresses recommendations made by internal or
external auditors for improving its administrative and accounting
controls or operations.
To carry out its responsibilities, the department’s policies require
the internal auditor to use a three-month, six-month, and
one-year response process—including any necessary follow-up
reviews of his findings and recommendations—to ensure that
the CLO takes corrective action once weaknesses have been
identified and reported. Further, department policies and profes-
sional standards require the internal auditor to follow up on the
findings and recommendations reported by all external auditors
to ensure that the CLO takes corrective action.
The Department Has Not Held the CLO Accountable for
Correcting Weaknesses in Its Internal Controls
When the internal and external auditors report weaknesses in
the CLO’s internal controls or operations, the department fails
to ensure that corrective action is taken. During his 1998 review
of the CLO’s contracting policies and procedures, the internal
The department has not auditor reported weaknesses in the CLO’s contract management
seen to it that the CLO practices. However, the department did not ensure that the CLO
takes effective corrective effectively improved its contract management practices in
action when problems are accordance with the internal auditor’s findings. We found that
identified by its internal the CLO continues to manage its contracts poorly, as we discussed
and external auditors. in Chapter 2. Further, in 2000, the internal auditor reported that
the CLO did not have comprehensive conflict-of-interest
guidelines and policies for its employees. However, the department
has not yet required the CLO to finalize and implement a conflict-
of-interest policy. As the table on the following page indicates,
the department also did not ensure that the CLO corrected
several other problems and control weaknesses, despite repeated
reporting of these issues by internal and external auditors.
50
TABLE
Repeated Control Weaknesses Reported
by Internal and External Auditors*
Year Reported
CLO Control Weakness 1996 1997 1998 1999 2000
Contract management † NR ‡ NR NR
Conflict of interest NR NR NR NR ‡
Closing plans † NR NR NR NR
Reinsurance process NR § NR § ‡ §
Hiring practices † NR NR NR ll
Source: Conservation and Liquidation Office (CLO).
*We identified weaknesses in all these areas during our current audit.
† 1996 Bureau of State Audits report.
‡ CLO internal auditor.
§ External auditor management/audit reports.
ll Reviewed by the CLO internal auditor, but no weaknesses reported.
NR = Not reviewed during this year.
Moreover, the department did not provide the internal auditor
with copies of management reports prepared by the CLO’s
external auditors. Department policies require the internal
auditor to follow up on the findings and recommendations
reported by external auditors. However, according to the internal
auditor, he was not aware that the CLO’s external auditors had
prepared management reports. Consequently, the internal
auditor was unable to ensure that the CLO took the appropriate
corrective action regarding the findings and recommendations
contained in the external auditor’s management reports.
During our audit, the CLO modified its process for responding
to the management reports prepared by external auditors.
According to its chief financial officer, the CLO will now provide
a copy of the management reports, including management’s
response to the recommendations contained in the reports, to
the internal auditor.
51
RECOMMENDATIONS
To strengthen and improve its oversight process, the department
should do the following:
(cid:127) Ensure that the CLO’s accounting and administrative controls
are periodically monitored and the highest-risk areas are
promptly reviewed by requiring the internal auditor to complete
a full audit cycle at least once every two years.
(cid:127) When the CLO’s internal auditor reports on control weak-
nesses and recommends improvements, make sure that the
CLO implements such recommendations or documents why it
does not.
(cid:127) Follow up on the CLO’s efforts to implement recommendations
for improvement made by external auditors and ensure the
status of those efforts is regularly reported.
We conducted this review under the authority vested in the California State Auditor by
Section 8543 et seq. of the California Government Code and according to generally accepted
government auditing standards. We limited our review to those areas specified in the audit
scope section of this report.
Respectfully submitted,
ELAINE M. HOWLE
State Auditor
Date: July 31, 2001
Staff: Doug Cordiner, Audit Principal
Debra L. Maus, CPA
Nuno Da Luz
Ana Mason
Gayatri M. Patel
Jessica A. Tucker
52
Agency’s comments provided as text only.
Department of Insurance
Harry W. Low, Insurance Commissioner
300 Capitol Mall, Suite 1700
Sacramento, California 95814
July 19, 2001
Ms. Elaine M. Howle
State Auditor
Bureau of State Audits
555 Capitol Mall, Suite 300
Sacramento, CA 95814
Dear Ms. Howle:
At the time I took office on September 18, 2000 as Insurance Commissioner, I had concerns about
the management of the Conservation and Liquidation Office (CLO). For that reason, on October 1,
2000, I began my own internal review of the CLO. Also in October, I sought the counsel of the
Attorney General to help me develop a justification that could be used in requesting an audit of the
CLO by the State auditor. Subsequently, on November 13, 2000, I provided Senator Jackie Speier
the audit justification and requested her to present it to the Joint Legislative Audit Committee in
order to have the State Auditor audit CLO. It was my goal to have a credible and independent
auditor aid me in identifying and establishing a critical baseline and determining the scope and
depth of any weaknesses within the organization.
I reviewed your draft audit report of the CLO entitled “Department of Insurance’s Conservation and
Liquidation Office: Stronger Oversight is Needed to Properly Safeguard Insurance Companies’
Assets.” Overall, I concur with the findings presented in the report. The report validated my
concerns and provides me with the baseline I need to make certain the CLO’s operations are
consistent with policies and procedures and in the best interest of the estates it manages.
The results of the audit will allow me to focus my efforts on improving the management of the CLO
and to ensure that assets of the entities conserved are safeguarded and efficiently utilized. I have
already assembled a team to address the findings of the report. I am happy to note that the CLO
was addressing some of the issues identified by your audit prior to its commencement. For ex-
ample, the CLO was in the process of updating estate plans prior to the start of your audit. Addi-
tionally, the CLO had developed an investment advisory committee to begin the process of review-
ing its investment strategy. CLO had also assembled a steering committee to assess CLO’s claims
processing system needs. The goal was to determine whether or not the CLO should retain
Lamda or migrate to a different claim processing system. Lastly, I would like to note the reporting
53
Page 2 of 2
Ms. Elaine M. Howle
State Auditor
relationship of the CLO internal auditor had been changed to strengthen the oversight of the CLO.
Specifically, the CLO internal auditor began reporting directly to the Internal Audit Chief of the
Department. I am confident the information you provided me will be significant in my efforts to
establish greater effectiveness of the CLO while safeguarding estate assets.
I appreciate the thorough efforts of the Bureau of State Audits and look forward to our continued
collaboration as we submit our corrective action plans for your review as part of our 60-day
response.
Sincerely,
(Signed by: Harry W. Low)
Harry W. Low
Insurance Commissioner
54
cc: Members of the Legislature
Office of the Lieutenant Governor
Milton Marks Commission on California State
Government Organization and Economy
Department of Finance
Attorney General
State Controller
State Treasurer
Legislative Analyst
Senate Office of Research
California Research Bureau
Capitol Press
55