Insurance Regulation: Scandal Highlights Need for Strengthened Regulatory
Oversight (Letter Report, 09/19/2000, GAO/GGD-00-198).
Pursuant to a congressional request, GAO evaluated insurance regulatory
oversight and information-sharing in the matter of a highly publicized
insurance investment scam exposed in May 1999, focusing on: (1) the
alleged scam; (2) the oversight and information-sharing by insurance
regulators; and (3) cross-financial-sector coordination issues,
including those emanating from the scam relevant to financial
regulators' efforts to implement the Gramm-Leach-Bliley (GLB) Act.
GAO noted that: (1) throughout the 1990s, Martin Frankel, with
assistance from others, allegedly obtained secret control of entities in
both the insurance and securities industries; (2) he is alleged to have
anonymously acquired and controlled insurance companies in several
states and, despite being barred from the securities industry, to have
exercised secret control over a small securities firm; (3) using the
name of this securities firm, Mr. Frankel allegedly took custody of
insurance company assets and provided false documents on investment
activity to disguise his actual purpose; (4) GAO observed some
regulatory weaknesses in multiple states over several years during each
of the key phases of insurance regulatory oversight--change of ownership
approvals, routine financial analyses, and periodic on-site
examinations; (5) specifically GAO observed inadequate measures for
assessing the appropriateness of buyers of insurance companies,
analyzing securities investments, evaluating the appropriateness of
asset custodians, verifying the insurers' assets, and sharing
information within and outside the insurance industry; (6) GAO also
found some weaknesses in support services provided by the National
Association of Insurance Commissioners (NAIC), a voluntary association
of state insurance regulators; (7) some of these weaknesses were similar
to those GAO identified in its previous reports, including weaknesses in
interstate coordination, oversight of entities under holding companies,
and gaps in controls to prevent migration of unscrupulous securities
brokers to other sectors of the financial services industry; (8) NAIC
and the Tennessee Comptroller of the Treasury have also conducted
parallel reviews of the scam and disclosed similar weaknesses along with
recommendations for corrective actions; (9) the GLB Act financial
modernization legislation highlights the importance of consultation and
information-sharing among federal regulators and state regulators when
banks and insurance companies are affiliated; (10) the fraudulent
activities allegedly perpetrated by Mr. Frankel further demonstrate the
need for heightened coordination of oversight activities among
regulators in cases where affiliated entities exist; and (11) although
the legislation is recent, regulators have recognized the need to
improve their coordination and have taken or plan to take a number of
actions.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-00-198
TITLE: Insurance Regulation: Scandal Highlights Need for
Strengthened Regulatory Oversight
DATE: 09/19/2000
SUBJECT: Insurance regulation
Embezzlement
Insurance companies
Interagency relations
Investments
Fraud
Internal controls
Corporate mergers
IDENTIFIER: NAIC Insurance Regulatory Information System
NAIC Regulatory Retrieval System
NAIC Special Activities Database
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GAO/GGD-00-198
INSURANCE REGULATION
Scandal Highlights Need for Strengthened Regulatory Oversight
United States General Accounting Office
GAO Report to the Honorable John D. Dingell
Ranking Minority Member Committee on Commerce House of Representatives
September 2000 GAO/ GGD- 00- 198
United States General Accounting Office General Government Division
Washington, D. C. 20548
Page 1 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
B- 284347 September 19, 2000 The Honorable John D. Dingell Ranking Minority
Member Committee on Commerce House of Representatives
Dear Mr. Dingell: As you requested, this report presents our evaluation of
insurance regulatory oversight and information- sharing in the matter of a
highly publicized insurance investment scam exposed in May 1999. Under
indictment for embezzling more than $200 million in insurance company assets
over nearly an 8- year period is Martin Frankel. Mr. Frankel, a former
securities broker who was barred from that industry in 1992, allegedly
migrated to the insurance industry and continued to operate as a rogue by
engaging in illegal activity.
The specific objectives of this report are to (1) describe the alleged scam;
(2) evaluate the oversight and information- sharing by insurance regulators;
and (3) identify cross- financial- sector coordination issues, including
those emanating from the scam relevant to financial regulators' efforts to
implement the Gramm- Leach- Bliley (GLB) Act. 1
Throughout the 1990s, Martin Frankel, with assistance from others, allegedly
obtained secret control of entities in both the insurance and securities
industries. He is alleged to have anonymously acquired and controlled
insurance companies in several states and, despite being barred from the
securities industry, to have exercised secret control over a small
securities firm. Using the name of this securities firm, Mr. Frankel
allegedly took custody of insurance company assets and provided false
documents on investment activity to disguise his actual purpose. Instead of
managing these assets in a prudent manner, he allegedly diverted them to
other accounts he controlled and used them to support the ongoing scam and
his lifestyle. The scam was finally exposed after insurance regulators in
Mississippi took enforcement action against three of the Frankel- connected
insurers by placing them under regulatory supervision. At the time this
report was being written, a federal criminal probe against Mr. Frankel was
still ongoing.
1 Pub. L. 106- 102 (Nov. 12, 1999). Results In Brief
B- 284347 Page 2 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Weaknesses in key insurance regulatory oversight activities, including
inadequate analysis of securities investments and failure to detect the
misappropriation of assets, contributed to delays in detecting the
investment scam for years. We observed some regulatory weaknesses in
multiple states over several years during each of the key phases of
insurance regulatory oversight- change of ownership approvals, routine
financial analyses, and periodic on- site examinations. Specifically we
observed inadequate measures for assessing the appropriateness of buyers of
insurance companies, analyzing securities investments, evaluating the
appropriateness of asset custodians, verifying the insurers' assets, and
sharing information within and outside the insurance industry. We also found
some weaknesses in support services provided by the National Association of
Insurance Commissioners (NAIC), a voluntary association of state insurance
regulators. Some of these weaknesses were similar to those identified in our
previous reports on the insurance regulatory system, including weaknesses in
interstate coordination, oversight of entities under holding companies, and
gaps in controls to prevent the migration of unscrupulous securities brokers
to other sectors of the financial services industry. NAIC and the Tennessee
Comptroller of the Treasury have also conducted parallel reviews of the scam
and disclosed similar weaknesses along with recommendations for corrective
actions. Successful implementation of recommendations emanating from the
scandal to improve fraud prevention safeguards will require a sustained,
high- level commitment by NAIC and the states.
The GLB Act financial modernization legislation highlights the importance of
consultation and information- sharing among federal financial regulators and
state insurance regulators when banks and insurance companies are
affiliated. The fraudulent activities allegedly perpetrated by Mr. Frankel
further demonstrate the need for heightened coordination of oversight
activities among regulators in cases where affiliated entities exist.
Although the legislation is recent, regulators have recognized the need to
improve their coordination and have taken or plan to take a number of
actions. Generally, the actions consist of establishing formal agreements
for sharing information and creating working groups for periodic meetings to
discuss matters of mutual interest. These regulatory actions are in their
infancy, but the expected continued blurring of distinctions and separations
in financial markets will require an increased and continuing commitment to
enhance regulatory cooperation in performing oversight. Insurance regulators
and the Securities and Exchange Commission (SEC) have also indicated a
desire to move toward more regulatory coordination, although the GLB Act
does not specifically address coordination between securities and insurance
regulators.
B- 284347 Page 3 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
This report includes recommendations to help prevent or detect similar
investment scams in insurance companies by proposing the adoption of
appropriate asset custody arrangements, improved asset verification
procedures, and the sharing of confidential regulatory information across
industries and agencies. In addition to the above recommendations emanating
from the Frankel matter, this report contains a recommendation designed to
broaden and help sustain cooperation among regulators of different financial
services sectors. Agencies responding to the report with comments generally
concurred with the report's findings, conclusions, and recommendations. We
also suggest that Congress consider requesting periodic status reports on
regulatory progress and plans in these areas. Such reports would enable
Congress to monitor progress and would encourage states to adopt needed
reforms.
In 1999, federal authorities indicted Martin R. Frankel for allegedly
masterminding an insurance investment scam. Mr. Frankel is a former
securities broker who, following a permanent bar from that industry in the
early 1990s, allegedly migrated into the insurance industry where he
perpetrated an investment scam. The insurance companies negatively affected
by the scam were regulated by individual states. Another entity tied to the
scam, a broker- dealer, was subject to regulation in the securities
industry. The migration of undesirable persons, or rogues, from one industry
to another is one of many issues of concern for financial services
regulators that are attempting to implement the GLB Act, legislation aimed
at modernizing the financial services industry. As detailed in appendix I,
our previous work in the insurance and securities industries highlights some
long- standing issues in these industries germane to the fraud allegedly
perpetrated by Mr. Frankel.
On October 7, 1999, the United States Attorney's Office in Connecticut
announced that “a federal grand jury sitting in Bridgeport,
Connecticut returned a thirty- six count indictment against Martin R.
Frankel, age 44, formerly of Greenwich, Connecticut, charging him with
twenty counts of wire fraud, thirteen counts of money laundering, and one
count each of securities fraud, racketeering and conspiracy.” The
indictment identifies entities in the insurance and securities industries
that Frankel allegedly used to steal in excess of $200 million in assets
belonging to insurers. In addition to the criminal indictment, federal and
state authorities have also filed civil actions to recover assets obtained
through Frankel's alleged investment scam. At the time of this report, the
criminal and civil cases involving Mr. Frankel were ongoing. Background
Martin Frankel Is Charged with Stealing Over $200 Million from Insurance
Companies
B- 284347 Page 4 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Insurance companies are regulated by the states. In contrast to banking and
securities entities (other than national banks) that are subject to dual
federal and state oversight, the states are solely responsible for
regulating the business of insurance. An insurance company is chartered
under the laws of a single state, known as its state of domicile. Insurers
can conduct business in multiple states, but the regulator in the insurer's
state of domicile is its primary regulator. States in which an insurer is
licensed to operate, but in which it is not chartered, typically rely on the
company's primary regulator in its state of domicile to oversee the insurer.
States are assisted in their regulatory responsibilities through guidance,
model (or recommended) laws and regulations, and information- sharing tools
provided by NAIC. NAIC is a voluntary association of the heads of each state
insurance department, the District of Columbia, and four U. S. territories.
It does not have regulatory authority over the state insurance departments.
NAIC provides a national forum for addressing and resolving major insurance
issues and for allowing regulators to develop consistent policies on the
regulation of insurance when consistency is deemed appropriate. State
insurance commissioners created NAIC, in part, to help address problems that
differing state- by- state authorities, laws, and regulations can cause as
state insurance regulators oversee insurers that operate in more than one
state. NAIC serves as a clearinghouse for exchanges of information, provides
a structure for interstate cooperation for examinations of multistate
insurers, distributes model insurance laws and regulations for consideration
by states, and reviews state insurance departments' regulatory activities as
part of its national accreditation program.
The oversight activities of state insurance regulators may differ, but each
oversees the safety and solvency of insurance companies through key phases
of oversight activities, which include
� chartering and change in ownership approvals, 2
� routine financial analyses, and
� periodic on- site examinations. Adverse findings in the first phase could
result in the refusal to permit a change in ownership. Adverse findings in
the other two phases could
2 Regulators generally require applicants to follow the same process to
acquire a charter for a new insurance company or to purchase an existing
company. The companies that Mr. Frankel allegedly acquired were all
previously owned and operated by others before their purchase by
Frankelcontrolled entities. Insurance Companies Are
Regulated by the States With Assistance from NAIC
Insurance Regulation Entails Key Oversight Activities
B- 284347 Page 5 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
result in a variety of regulatory enforcement actions up to the takeover
and/ or closure of the company.
The initial oversight activities involve state approval of the proposed new
ownership of an insurance company- whether to start a new company or to
acquire an existing company. Applicants to form or acquire an insurer apply
for approval in the state in which the company will be domiciled. 3 Key
information collected to render a decision on the ownership application is
submitted on a standard form developed by NAIC known as a Form A. In
addition to going through the ownership approval process with the
domiciliary state, an insurer may also apply to become licensed in other
states where it seeks to conduct business.
After a domiciliary state has approved an ownership application, that state
continues to oversee the insurer through routine financial analyses. An
important element of the financial analysis work is the review of annual and
quarterly statements submitted by the insurance companies containing
information, such as financial statements, responses to various questions
about company activities, and various schedules summarizing investment and
other business activity. NAIC assists the states' annual review efforts with
numerous financial analysis tools, including the calculation of financial
analysis ratios on insurance companies, known as the Insurance Regulatory
Information System (IRIS) ratios. 4 These ratios, which are provided to the
appropriate state regulators, help state insurance analysts identify areas
of potential regulatory concern, particularly indicators that could suggest
financial difficulties.
The states' on- site insurance examinations are intended to validate the
insurers' financial condition and market conduct. According to NAIC's
guidelines, examinations are to occur at least once every 5 years. One of
the most fundamental tasks of the on- site examinations is to verify
information the insurers have provided in regulatory reports. Because a
company's solvency is determined by comparing the value of its assets and
liabilities, a key regulatory concern is the existence and value of the
insurer's reported assets.
3 The state of domicile, or domiciliary state, is the primary regulator of
an insurance company. 4 Nearly all insurers, except for the smallest ones,
submit their annual and quarterly regulatory reports to NAIC as well as to
their domiciliary regulator. States where the companies are licensed also
receive copies of the reports. NAIC then calculates a number of financial
ratios, known as the IRIS ratios, performs some preliminary analyses, and
returns the information to the domiciliary state. Ratios that are outside
the “usual range” are flagged by NAIC for regulatory attention.
B- 284347 Page 6 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
NAIC also issues guidance to assist regulators in performing financial
analyses and examinations. For example, NAIC's Financial Analysis Handbook
is designed to help states identify, as early as possible, insurance
companies that may be financially troubled. It includes checklists on
financial concepts and analyses deemed important to assess the company's
financial condition. It is intended to serve as an advisory guide but is not
an NAIC accreditation standard. The Examiner's Handbook is another tool
developed by NAIC to assist state regulators in detecting as early as
possible those insurers in financial trouble and/ or engaging in unlawful
and improper activities and to develop the information needed for timely,
appropriate action. Both handbooks employ the use of checklists, but they
also note or imply that state regulators must exercise sound judgement and
assess the insurers in accordance with their own state laws and regulations.
Within the securities industry, securities firms are regulated by the SEC,
which delegates regulatory responsibilities to several self- regulatory
organizations (SROs). The SROs for broker- dealers include the New York
Stock Exchange and the National Association of Securities Dealers Regulation
Inc. (NASDR). Additionally, state securities offices work in conjunction
with SEC and the SROs to regulate securities firms. The functions of state
securities offices include the licensing of some securities- related
entities and agents. States also collect and monitor financial data of
broker- dealers that they license in their states. The securities firm
connected to the investment scam was a broker- dealer regulated by NASDR and
licensed to conduct business in numerous states.
Federal regulators, among others, have testified in recent years that
constraints segregating various sectors of the financial marketplace have
outlived their usefulness. Banks, securities firms, and insurance companies
have increasingly offered a similar array of products and services.
Moreover, these institutions have been merging. The technological advances
and the development of new financial products and services has increasingly
blurred the lines once separating the offerings of banks, securities firms,
and insurance companies and thus also blurred the lines among regulators.
The GLB Act's purpose was to establish a comprehensive framework to permit
affiliations among commercial banks, securities firms, and insurance
companies, allowing a “level playing field” while maintaining
the safety and soundness of the financial system. It also recognized the
need for greater regulatory consultation and coordination. Broker- Dealers
Are
Regulated by Federal and State Organizations
Congress Has Enacted Financial Services Modernization Legislation
B- 284347 Page 7 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
To identify the nature of Mr. Frankel's alleged insurance investment scam,
we obtained publicly available documents through the Department of Justice,
including the federal indictment against Mr. Frankel. We also met with
officials and conducted file reviews at SEC and NASDR to ascertain Mr.
Frankel's past and recent activities in the securities industry. Within the
insurance industry, we reviewed regulatory files and discussed the
chronology of events with officials in states where the principal insurers
connected to Mr. Frankel's alleged scam were domiciled- Tennessee,
Mississippi, Missouri, Oklahoma, and Arkansas. We also visited officials in
Virginia, where an insurer was negatively affected by a transaction with one
of the Frankel- connected insurers. In addition, we conducted literature
searches related to this investment scam.
To assess the regulatory oversight and information- sharing activities that
occurred in connection with the Frankel matter, we visited the states
identified above that were responsible for overseeing the insurers
victimized by the scam and reviewed the pertinent regulatory files.
Additionally, we reviewed the relevant policies and procedures in effect in
those states during the years that Frankel apparently controlled the
insurance companies. We also contacted officials in other states, including
Alabama and Washington, to understand their dealings with insurance entities
allegedly connected to Frankel. To ascertain the types of regulatory
information available in the insurance and securities industries, we met
with officials from NAIC, selected state securities offices, SEC, and NASDR
and reviewed the appropriate records. We also discussed insurance
regulators' access to criminal databases with Department of Justice
officials.
To understand regulatory efforts to implement features of the financial
services modernization legislation, the GLB Act, we met with regulatory
officials in the insurance, banking, and securities industries who have
worked closely on regulatory coordination issues. Specifically, we discussed
the status of regulatory coordination efforts across industry sectors with
officials at NAIC, the State of Connecticut's Insurance Department, the
Federal Reserve Board, the Office of the Comptroller of the Currency (OCC),
the Office of Thrift Supervision (OTS), and SEC.
The activities and events associated with Martin Frankel described in this
report are alleged in the federal indictment. Federal and state authorities
had criminal and civil cases pending against Mr. Frankel at the time of this
report. Thus, additional facts relevant to regulatory activities are likely
to be revealed as these cases proceed through the courts. Scope and
Methodology
B- 284347 Page 8 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
During our review, NAIC and state officials, with one exception, fully
cooperated with our review, including granting us full access to records. In
Mississippi, state officials did not provide us access to nonpublic records,
such as workpapers associated with annual reviews and on- site exams, citing
concerns over the release of such information because of ongoing litigation
on the matter. During our review, we briefed some state officials and NAIC
on our preliminary findings and observations to assist their efforts in
developing corrective actions. The regulatory weaknesses we observed were
not based upon an exhaustive analysis of all insurance regulatory procedures
and practices, but rather on those most relevant to this particular scam.
We conducted our review in Nashville, TN; Jackson, MS; Jefferson City, MO;
Oklahoma City, OK; Little Rock, AR; Richmond, VA; Montgomery, AL; New York,
NY; Chicago, IL; Kansas City, MO; Hartford, CT; Bridgeport, CT; and
Washington D. C., between October 1999 and August 2000 in accordance with
generally accepted government auditing standards.
Throughout the 1990s, Martin Frankel allegedly gained secret control of
entities in both the insurance and securities industries. While undergoing a
disciplinary proceeding in the securities industry, Frankel allegedly
migrated to the insurance industry. Working through others, he established a
trust that was used to purchase insurance companies. Concurrently, he gained
secret control of a broker- dealer that he used to disguise his diversion of
insurance company assets. With the insurance and securities entities under
his control, Frankel allegedly stole over $200 million belonging to the
insurers before his scam unraveled. An overview of Frankel's alleged
activities is depicted on a time line in Figure 1. His activities to gain
control over entities in the insurance and securities industries and expand
his investment scam are described in the sections below. How Was the Alleged
Scam Carried Out?
B- 284347 Page 9 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
1985- 1988, Mr. Frankel works in the securities industry and is fired from
two firms for personal differences with management and activities
subsequently leading to an SEC investigation.
December 1989, SEC begins a formal investigation of Mr. Frankel for
omissions and misstatements to investors about his investment practices.
August 1992, Mr. Frankel settles with SEC and is permanently barred from the
securities industry.
August 1991, Liberty National Securities registers in Tennessee and is
allegedly controlled by Mr. Frankel.
September 1991, Mr. Frankel allegedly forms Thunor Trust using nominee
grantors and files application and later buys a Tennessee Insurance company.
February 1994 - March 1995, Thunor Trust purchases 4 more insurance
companies domiciled in Mississippi, Oklahoma, and Missouri.
February 1998, Thunor Trust purchases an insurance company domiciled in
Alabama.
February 1999, Thunor Trust purchases an insurance company domiciled in
Arkansas.
The scheme unravels, and Mr. Frankel flees.
9 10 Mr. Frankel migrates to the insurance industry,
and allegedly steals $200 million. 5 4 7 8 A
3 2 1 2 3
4 5
6 7
8
Late 1998, Tennessee and Mississippi insurance regulators became suspicious
of insurers' asset custody arrangements.
Early May 1999, Mr. Frankel flees the U. S.
September - October 1999, Mr. Frankel is arrested in Germany and then
indicted in federal court in Connecticut.
9 10
11 B
C 1
6 11 Mr. Frankel works in the securities industry,
but engages in activities leading to his permanent bar. 1987 1988 1989 1990
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 1986 1985
A B C
Source: GAO.
In the early 1990s, Mr. Frankel is alleged to have gained control over
entities in the insurance industry at the same time he was being
investigated by SEC for misconduct in the securities industry. According to
SEC officials, Frankel's activities as a rogue broker began in the mid 1980s
when he made misstatements and misrepresentations to investors. In a 1991
civil complaint, SEC charged that Frankel raised over a million dollars
through the offer and sale of limited partnerships in an investment fund he
established. The complaint stated that Frankel had made omissions and
misstatements about the use of proceeds from investors, his background and
experience, and the performance of the fund he
Figure 1: Overview of the Scandal
Frankel, a Rogue Broker, Allegedly Migrated to the Insurance Industry
B- 284347 Page 10 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
controlled. In August 1992, Frankel consented to a permanent ban from the
securities industry and agreed to return funds to the investors.
At the time he was being investigated by SEC, Frankel is alleged to have
anonymously established Thunor Trust in 1991 and subsequently used it to
purchase entities in the insurance industry. He is alleged to have
anonymously formed this trust using the names of three acquaintances,
identifying them as grantors to the trust. Another individual, who was named
as the sole and irrevocable trustee, managed the trust.
Frankel allegedly used his anonymous control of Thunor Trust to purchase
insurance companies. Shortly after it was formed in 1991, Thunor Trust
acquired the majority interest in Franklin American Corporation, which, in
turn, owned Franklin American Life Insurance Company, an insurer domiciled
in Tennessee. Frankel allegedly continued to use Thunor Trust as a means to
acquire other insurers with the assets of those that he had previously
acquired.
Our review of the insurance regulatory files on the Thunor Trust group of
insurers confirmed that Mr. Frankel's name did not appear on the change in
ownership applications, which were documented on a Form A (previously
described in the background section). Ownership of the insurers could be
traced back to Thunor Trust, which, in turn, was managed by another
individual who served as the sole, irrevocable trustee on behalf of the
trust's beneficiaries. These beneficiaries were identified in the Form A
documentation as relatives of the three grantors who ostensibly established
Thunor Trust.
At the same time Mr. Frankel was allegedly acquiring the assets of insurance
companies, he also controlled certain business activities of a small broker-
dealer registered with securities regulators. Frankel then allegedly used
the name of this broker- dealer when (1) taking custody of insurance company
assets and (2) providing false documents concerning the insurers' investment
activities. With the broker- dealer serving as a front for his investment
scam, Frankel allegedly diverted insurance company assets unlawfully into
accounts he controlled to support his lifestyle and perpetuate the scam.
Despite being barred from the securities industry in 1992, Frankel allegedly
controlled a small brokerage firm named Liberty National Securities (LNS). 5
Frankel allegedly used LNS as a front, controlling LNS' business
5 LNS, a small broker- dealer established in Ohio in 1991, moved to Michigan
in 1993. Concurrently, Frankel
Allegedly Gained Control of a Broker- Dealer to Help Disguise the Scam
B- 284347 Page 11 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
activities with assistance of an individual associated with the firm.
According to information obtained from NASDR, Frankel paid this individual
$2,000 per month to perform certain business functions in the securities
industry.
Borrowing the name of LNS, Frankel allegedly took custody of insurance
company assets and provided false documents on investment activity to the
insurance companies. Through his association with an individual from the
real LNS, Frankel allegedly got the firm's name licensed in numerous states
throughout the country, including those where he had insurance companies
under his control. In addition, telephone calls and mail were forwarded
through LNS, located in Dundee, MI, to Frankel's mansion in Connecticut.
Authorities charge that Frankel operated the scam from this residence.
Instead of investing the assets in a prudent manner, Frankel allegedly
diverted the insurer assets to other accounts he controlled.
Our review of information available at SEC and NASDR revealed that LNS was a
small broker- dealer located in Toledo, OH, with less than $10,000 in assets
when it was formed in 1991. In April 1993, the firm moved to Dundee, MI. Mr.
Frankel's name did not appear on the filings LNS made with SEC and NASDR.
Regulatory data from state securities offices and NASDR revealed that before
the collapse of the scam in 1999, LNS had approximately $60,000 in assets
and was licensed to conduct business in numerous states throughout the
country, including those where Mr. Frankel allegedly controlled insurers'
assets. In addition, records at SEC revealed numerous investment accounts
under Mr. Frankel's direct control at other brokerage firms.
With entities in the insurance and securities industry under his control,
Frankel allegedly expanded his investment scam throughout the 1990s,
stealing over $200 million of insurer assets. Assets belonging to the
insurers held by Thunor Trust were ostensibly invested with LNS and
systematically funneled by Frankel into other accounts he controlled. Mr.
Frankel allegedly continued a pattern of purchasing insurance companies
using money from previously acquired insurers. By 1999, the Thunor Trust
group of insurers included seven insurance companies, one domiciled in
Tennessee; three in Mississippi; and one each in Missouri, Oklahoma, and
Arkansas. A simplified organizational chart of the entities connected to the
investment scam is shown in figure 2. Frankel Allegedly Expanded
His Scam from 1991- 1999 and Stole Over $200 Million
B- 284347 Page 12 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Thunor Trust (TN)
International Financial Corporation (OK Holding Co.)
Franklin American Corporation (TN Holding Co.)
Farmers and Ranchers Life Insurance Co.
(OK) Franklin American
Life Insurance Co. (TN)
Franklin Protective Life Insurance Co.
(MS) International Financial
Life Insurance Co. (MO)
Old Southwest Life Insurance Co.
(AR) Family Guaranty
Life Insurance Co. (MS)
Real Liberty National Securities
(MI)
$ $
Bogus Liberty National Securities
(CT, NY, MI, OH) First National
Life Insurance Company of America
(MS) a
Source: GAO summary of insurance regulatory data.
To portray his investment operation as legitimate, Frankel allegedly
fabricated phony account statements that seemingly reflected positive
results on investment activities of the insurers' assets that LNS was
managing. These account statements typically reported a relatively high
level of trading volume on the insurers' assets, often indicating that
significant portions of the companies' assets were being traded on almost a
daily basis. Furthermore, the LNS account statements generally reported
above market returns on the trading activity of U. S. government securities.
The insurers subsequently used figures from these allegedly phony statements
in their required annual filings with regulators, attesting to the financial
health and business activities of the insurance companies. Allegedly, the
assets were not traded and invested as reported in the LNS
Figure 2: Simplified Structure of the Thurnor Trust Insurance Companies
B- 284347 Page 13 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
statements. Instead, they were diverted into other accounts controlled by
Frankel, who used the funds to perpetuate the investment scam and support
his lifestyle.
Frankel continued to expand the asset portfolio under his control through
reinsurance agreements, particularly in the later years of the scam. 6 Under
these agreements, insurers under Thunor Trust purchased books of business
from other insurers and assumed the assets and liabilities from the other
insurers. Through these reinsurance agreements, Frankel allegedly obtained
control over significant assets from other insurers outside those under
Thunor Trust. One such insurer was Settlers Life, domiciled in Virginia. The
company lost about $45 million through a reinsurance transaction with one of
the Thunor Trust insurers in April 1999.
After operating for nearly 8 years, the investment scam began to unravel as
insurance regulators placed more scrutiny on the insurers' asset custody
arrangements with LNS. Eventually, the Thunor Trust insurers domiciled in
Tennessee and Mississippi were ordered by their respective state insurance
departments to remove their assets from the custody of LNS. In April 1999,
through the enforcement of a law fashioned after a model law recommended by
NAIC to safeguard insurer's assets, the Tennessee Department of Commerce and
Insurance was able to safeguard the assets belonging to the insurer
domiciled in its state, which were ultimately placed into a state of
Tennessee account in May 1999. On April 29, 1999, the Mississippi Insurance
Department decided to place three of the Thunor Trust insurers domiciled in
that state under Administrative Supervision because of concerns related to
LNS and the possibility that Thunor Trust might have been taken over by
another organization, the Saint Francis of Assisi Foundation, without prior
approval. Prior to the collapse of his investment scam, Frankel had
allegedly attempted to purchase other insurers through this foundation.
During the first week in May 1999, the sole trustee of Thunor Trust and its
affiliated insurance companies announced that the assets of the insurers
were gone. Insurance regulators in Missouri, Oklahoma, Arkansas, and
Virginia said they were informed of the investment scam involving companies
domiciled in their states shortly thereafter. In the aftermath, federal
authorities alleged that Frankel stole the insurers' assets.
6 In reinsurance transactions, generally the insurer that purchases a book
of business assumes the assets and liabilities associated with the policies
of that business in exchange for the purchase price.
B- 284347 Page 14 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Federal and state authorities now have criminal and civil cases pending
against Frankel and others allegedly connected to the scam. In addition to
the criminal indictment information previously described, several states
have now joined in civil suits against Frankel, his associates, an
accounting firm that audited the Thunor Trust insurers, and legal
professionals. Some associates of Frankel have pled guilty on certain
offenses to federal authorities for their roles in the scam, and federal and
state criminal investigations and efforts to recover funds from those who
perpetrated the scam are ongoing. Appendix II summarizes key events
associated with the investment scam.
Taxpayers and certain policyholders in some states will bear much of the
financial burden resulting from the scam unless federal and state
authorities successfully recover significant funds from those who
perpetrated it. According to the National Organization of Life and Health
Insurance Guarantee Associations (NOLHGA), the initial estimated costs to
state guarantee associations is approximately $133 million on covered
obligations of approximately $190 million. 7 Other indirect costs include
additional legal and regulatory costs incurred by state and federal
officials emanating from the scandal. Although state guarantee funds help
protect policyholders in cases where insurers become insolvent, a portion of
such losses is ultimately borne by the public at large, because insurers
domiciled in some states are eligible to offset a portion of the amounts
assessed by the states' guarantee funds against premium taxes collected by
these states. Numerous policyholders have also been victimized by the
scandal through shortfalls in coverage from certain state guarantee fund
programs. For example, according to the liquidator for First National Life
Insurance Company of America (one of the Frankel- controlled insurers),
about 3,000 policyholders and annuitants of the insurer who are California
residents are backed for only 80 percent of the value of their policies
through the state's insurance guarantee program. This insurer also sold
policies with annuity riders on U. S. military installations overseas, and
some policyholders who are not U. S. citizens are not covered by any state
guarantee association program.
7 After an insurance company becomes insolvent, policyholders are protected
to varying degrees by their own state's insurance guarantee program.
Therefore, one insurance company failure can trigger the need for coverage
from numerous state insurance guarantee programs to the extent that
policyholders of the failed insurer are residents of different states.
Coverage under each state's insurance guarantee program is limited, and the
limits vary by state. According to NOLHGA, over 90 percent of policyholders
have been fully protected from insurer insolvencies since 1992, when the
last guarantee associations were established. Victims of the Scandal
Include Taxpayers and Policyholders
B- 284347 Page 15 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Weaknesses associated with insurance regulatory tools and inadequate
oversight and coordination activities contributed to delays in detecting the
investment scam for years. Regulatory weaknesses were observed in the
domiciliary states' oversight activities as well as with certain support
services provided by NAIC. As shown in table 1 below, we identified
weaknesses in the three key phases of regulatory oversight- change of
ownership approval, routine financial analyses, and on- site examinations.
We observed repeated instances of inadequate tools, policies, procedures,
and practices as well as a lack of information- sharing among different
regulators, within and outside the insurance industry. Many of the specific
events and circumstances that we found were not necessarily inconsistent
with laws or regulations; however, they were sufficiently unusual that
either individually or collectively, they provided reasonable grounds for
regulators to have asked additional questions beyond those routinely
addressed. The answers or, in some cases, the lack of answers, to those
questions could have resulted in a much earlier exposure of the scam.
Unfortunately, these questions were not sufficiently pursued and resolved in
a timely manner. Insurance regulators, working through NAIC, have recognized
the regulatory weaknesses we identified and have begun addressing or intend
to address them with corrective actions to help reduce the industry's
vulnerability to fraud. Numerous Regulatory
Oversight Weaknesses Contributed to Delays in Detection
B- 284347 Page 16 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Oversight phase Weakness Specific observations
Inadequate due diligence performed on buyer application data
- Failure to act on “red flags” associated with trust managed by
a sole and irrevocable trustee that left grantors with no control over money
- Inadequate questioning of prospective buyers
Inadequate tools and procedures to validate individuals' regulatory or
criminal backgrounds
- Inability to readily access regulatory history data - Inability to access
criminal history data on individuals
Change in ownership approvals
Lack of coordination between regulators within and outside the insurance
industry
- Failure to exchange insurance regulatory concerns among states on a timely
basis - Absence of an industry “clearinghouse” of insurer
application data - Inability to routinely access data from other financial
regulators
Inadequate analysis of securities investments
- Inadequate state procedures and practices to flag high asset turnover
ratios and no use of thresholds to trigger additional scrutiny - Lack of
NAIC policies, procedures, or practices to assess asset turnover -
Insufficient securities expertise exhibited by insurance departments to
question unusual investment strategy - Lack of NAIC consolidated financial
analysis of affiliated insurers in multiple states
Ineffective mechanisms to safeguard and monitor control of insurers'
securities held by
another entity
- Inconsistent and ineffective policies regarding appropriate asset
custodial relationships - Failure of insurance regulators to require from
insurers sufficient information to allow independent verification of
legitimacy and appropriateness of new custodians - Inadequate information
collected annually to understand who had control of the insurers' assets
Routine financial analyses
Inadequate securities- related expertise and information gathering
- Lack of expertise to assess the viability of the insurers' investment
strategy - Failure to obtain securities- related expertise from state
securities regulators or from contracted assistance - Lack of communication
with state securities regulators to verify the appropriateness and
legitimacy of the broker- dealer
Failure to detect misappropriation of assets
- Failure of four completed exams on companies owned by Thunor Trust to
identify any material weaknesses - Inadequate examination guidelines and
procedures to verify book- entry securities that were not held by a
depository institution - Inadequate assessment of highly unusual investment
activities - Questionable ability of insurance examiners to assess
securities related activities
Inadequate practices and procedures to verify the legitimacy of asset
custodians
- Inadequate efforts to independently validate the identity and
appropriateness of the asset custodian - Improperly executed custodial
agreements not detected
On- site examinations
Limited sharing of information and coordination among regulators
- Lack of proactive alerts to warn other states of examination concerns so
as to deter scam from spreading - Lack of communication with securities
regulators - Lack of coordinated on- site examinations for insurers in the
same group
Source: GAO analysis of insurance regulatory data.
Table 1: Overview of Regulatory Weaknesses
B- 284347 Page 17 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Regulatory weaknesses observed during change in ownership approval
activities included inadequate (1) due diligence of buyer application data,
(2) tools and procedures for verifying applicants' backgrounds, and (3)
regulatory information- sharing both within and outside the insurance
industry. The states' review of the data associated with an application for
the change in ownership of an insurance company, documented in a format
prescribed by NAIC known as a Form A, did not include checks on individuals'
regulatory or possible criminal histories. Furthermore, regulators often did
not appear to question unusual aspects of the purchase of an insurer under
Thunor Trust. Additionally, insurance regulators did not effectively share
information on the status of Form A applications among states nor did they
seek regulatory data on applicants from other financial services industries.
The purchase of insurance companies under Thunor Trust provided a number of
opportunities for regulators to ask questions about the prospective owners.
We believe some of these questions should have been routine-- part of the
normal process of approving a regulated insurer's change in ownership
control. Other questions could have been raised by the unusual
characteristics of the trust or of the change in ownership. Had regulators
exercised a higher degree of scrutiny or professional skepticism during
these purchases, the scam may have been detected earlier.
Routine questioning during the change in ownership approval process includes
determining the intentions and appropriateness of the buyer; that is, those
who are providing the money for the purchase. In the case of Thunor Trust,
the money to purchase the first insurance company was supposedly provided by
three individuals or grantors. However, during our review of change in
ownership application data, we found no evidence that state regulators
sought financial information from the grantors to validate their financial
condition despite the trust's dependence on the grantors for funds.
Moreover, we found no evidence that any state regulators ever directly
questioned the Thunor Trust grantors to validate their ownership interests,
business intentions, and control of the trust in spite of a number of
unusual characteristics associated with the change in ownership
applications.
Unusual conditions or red flags present on the change in ownership
applications associated with Thunor Trust centered on the trust arrangement
itself. A review of the documentation on the trust revealed that the three
grantors who supposedly provided $3.75 million to establish the trust in
1991 had no control over their money. In assessing the ultimate controlling
interests behind an insurance company, one would Regulatory Weaknesses
Observed During Change In Ownership Approvals
Inadequate Due Diligence Performed on Buyer Application Data
B- 284347 Page 18 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
expect to see a connection between the firm's control and the individual( s)
who provided the money to purchase it. Instead, the trust was established in
a manner that left one individual, who was not a grantor to the trust, in
complete control of the trust and whose authority to manage the trust was
irrevocable, even by the grantors of the trust. The trustee was supposed to
manage the assets of the trust on behalf of the trust's beneficiaries, who
were family members of the grantors. However, the trust agreement did not
give the purported grantors any authority to remove the sole trustee on the
basis of how that individual managed the trust, thus leaving the grantors
with no control over their money.
The Thunor Trust entity apparently deceived regulators about who the actual
ultimate controlling interests were behind the trust and, in turn, the
interests behind the insurance companies purchased under the trust. The
trust arrangement that appeared to leave those who established the trust
with no mechanism of control in how the trust operated provided red flags
that could have raised questions for regulators. The federal indictment now
alleges that Frankel himself established the trust using the names of three
acquaintances who never actually contributed funds to the trust. Had
regulators followed the money trail back to the reported sources of origin
and questioned the grantors directly to validate their interests and actual
control in the trust, as the money was being used to purchase insurance
companies, the scam could have been uncovered during the Form A application
process.
Tools and procedures used by insurance regulators were not adequate to
verify applicants' regulatory histories or potential criminal backgrounds.
During our visits to the states and review of the applications associated
with the insurer acquisitions under Thunor Trust, we found that states could
not readily validate an individual's background in other financial services
industries. Furthermore, in contrast to bank and securities regulators,
state insurance regulators generally cannot verify self- reported
information provided by individuals in response to questions about their
criminal history. According to NAIC, most states lack the regulatory
authority to obtain criminal history data for noncriminal purposes.
During this investment scam, a check into the regulatory history of the
grantors of Thunor Trust would have revealed unfavorable incidents with one
of the grantors in the securities industry. These incidents, which were not
necessarily of a nature to preclude the individual from owning an insurance
company could, however, have prompted additional regulatory scrutiny on the
grantor's intentions in the insurance industry. Because Frankel is alleged
to have formed the trust without the money of the Inadequate Tools and
Procedures to Validate Individuals' Regulatory or Criminal Backgrounds
B- 284347 Page 19 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
supposed grantors, questioning these individuals directly about their
regulatory histories and interest in the trust could have unraveled the scam
at the outset.
NAIC officials acknowledged that there is not currently an expectation in
NAIC's guidance for the states to perform regulatory and criminal background
checks on the self- reported information provided in Form A applications.
There are limitations to insurance regulators' access to regulatory and
criminal history data from other government agencies. Insurance regulators
cannot readily access disciplinary- related information generated on
individuals in the banking or securities industry, other than through
publicly available means. Additionally, insurance regulators generally
cannot routinely validate whether or not an individual has a criminal
background in spite of a federal insurance fraud prevention provision that
prohibits individuals with a felony criminal history involving fraud or
breach of trust from entering the insurance industry without the consent of
insurance regulators. 8 Insurance regulators maintain that they cannot
verify an individual's potential criminal background because most state
insurance departments do not have access to criminal history data.
Background data on key individuals associated with the purchase of an
insurer are obtained in the Form A application through self- reported data
on a Biographical Affidavit. This affidavit asks, among other things, if an
individual has ever been charged with any wrongdoing by any governmental
authority or been charged or convicted of a crime.
Although other financial services regulators have established mechanisms
that allow them to routinely conduct criminal history checks through the
Federal Bureau of Investigation (FBI), state insurance regulators and the
Department of Justice have not yet implemented a similar mechanism for
insurance regulators. Officials from several banking regulatory agencies
explained that as part of their due diligence processes on charter
applications, they submit information on key officials associated with the
applications to the FBI for the purpose of conducting criminal background
checks. An FBI representative confirmed that banking and securities
regulators conduct background checks by submitting information on
individuals to the FBI. The representative mentioned that insurance
regulators could obtain criminal history data in such a manner, provided
they had the statutory authority to do so. Another Justice official
concurred that most insurance regulators do not currently have access to
8 18 U. S. C. sect. 1033 provides that, among other things, a person who has
been convicted of any criminal felony involving dishonesty or a breach of
trust or any offense described in the section may engage in the business of
insurance only through the written consent of an insurance regulatory
official authorized to regulate the insurer.
B- 284347 Page 20 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
criminal history data, given their lack of law enforcement status. This
official believed that current legislation may give insurance regulators the
right to such criminal history data for noncriminal justice purposes,
although implementation of such authority has yet to be accomplished and may
require an Executive Order. Justice officials stated that procedural matters
need to be worked out between the FBI and the insurance industry.
Although insurance regulators lacked the tools to directly access regulatory
history information from other financial sectors, we were able to access
such information from other available sources. As previously mentioned, NAIC
officials acknowledged that state insurance regulators are not expected to
validate regulatory or criminal background data provided by applicants on
Form A filings. However, concerning the purchases of insurers under Thunor
Trust, regulatory data available to insurance regulators from state
securities departments could have raised concerns over the regulatory
history of an individual supposedly providing the money to purchase the
insurance companies. Additionally, lack of regulatory coordination within
the insurance industry hindered detection of the investment scam.
During visits we made to the states, we were able to access regulatory
history data available from state securities regulators through a database
known as the Central Registration Depository (CRD). 9 As previously
mentioned, information from CRD revealed that an individual whose name
appeared in the Form A applications as a grantor to Thunor Trust was
involved in incidents concerning consumer complaints while working in the
securities industry. Although the incidents identified through CRD varied in
their degree of severity, they could have prompted insurance regulators to
question the grantors directly concerning their previous activities in the
securities industry and the nature of their business interests in the trust
and insurance industry. Because the grantors may have been unaware of the
trust and deny having provided any funds, this level of due diligence may
have caused regulators to refuse approval for Thunor Trust's purchase of
insurance companies.
Other information- sharing issues that surfaced during the change in
ownership approval oversight phase involved the lack of informationsharing
about regulatory concerns and actions among insurance regulators
9 CRD is a database maintained by NASD and used by state securities
regulators, SROs, and SEC that contains information on broker- dealers,
including incidents of disciplinary items tied to individuals and firms.
Lack of Coordination Among
Regulators Within and Outside the Insurance Industry
B- 284347 Page 21 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
in different states. For example, regulators in Arkansas considered and
approved a Form A application involving the purchase of Old Southwest Life
Insurance Company under the Thunor Trust organization. Prior to this
approval, another Form A application was submitted and withdrawn in Colorado
by the Saint Francis of Assisi Foundation, an entity that had been
identified as being affiliated with the insurers under Thunor Trust.
Arkansas insurance officials indicated they would have been better able to
scrutinize the Form A application submitted on Old Southwest had they known
an entity linked to Thunor Trust, the Saint Francis of Assisi Foundation,
had withdrawn a Form A application in Colorado. However, no such
clearinghouse of Form A information exists. Regulatory officials pointed out
that the withdrawal of a Form A application itself would “raise a red
flag.” On the basis of this experience, the Insurance Commissioner in
Arkansas recommended that NAIC consider creating a resource for regulators
to review other relevant From A application information from other states.
Another information- sharing issue surfaced during the redomestication of an
insurer. 10 When an insurer under Thunor Trust was redomesticating from
Alabama to Mississippi, examiners in Mississippi already had concerns about
the possibility that a broker- dealer, LNS, was affiliated with two other
Thunor Trust insurance companies already domiciled in Mississippi. However,
we found no evidence that Mississippi Insurance Department officials
approving the redomestication of the company from Alabama knew of these
concerns.
The purchase of Old Southwest Life Insurance Company also exhibits another
example of inadequate information- sharing among state regulators. Prior to
this purchase in late February 1999, regulators in Tennessee were warned
that Franklin American Life, the company that intended to purchase Old
Southwest, might have been looted of its assets. However, this information
was not conveyed to regulators in Arkansas, who approved the Old Southwest
acquisition. The insurer subsequently experienced losses of over $5 million.
Similarly, other insurance regulators were unaware of concerns that
regulators in Tennessee and Mississippi had with insurers connected to
Thunor Trust in early 1999. In April 1999, Settlers Life in Virginia lost
approximately $45 million through a reinsurance transaction with First
National Life Insurance Company of America. If Virginia regulators had known
in February that an insurer under Thunor Trust may have been looted of its
assets, they could have had an opportunity to ask additional questions and
warn their domiciled
10 Redomestication of an insurer refers to the insurer's action to change
its state of domicile.
B- 284347 Page 22 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
insurers against entering into transactions with an insurer( s) connected to
Thunor Trust without prior regulatory approval.
An exception to instances of inadequate information- sharing between
insurance regulators during change in ownership approval activities occurred
shortly before the scam collapsed; it involved the coordination efforts
between regulators in Mississippi and the state of Washington. Regulators in
Washington State had been urged by the proposed buyers to proceed in an
expedited fashion with their planned purchase of an insurer domiciled in
that state. The proposed buyer was the Saint Francis of Assisi Foundation,
now reported to have been an entity that Frankel created to further enhance
the appearance of legitimacy in purchasing and controlling the insurance
companies. In contacts initiated by regulators in Washington State,
Mississippi insurance officials warned their counterparts to proceed
cautiously with the approval of the proposed purchase. Mississippi
regulators had encountered the name of Saint Francis of Assisi Foundation in
connection with their ongoing examination of two insurers and became
concerned that the Foundation may have obtained control of Thunor Trust
without prior regulatory approval. Heeding the warnings from their
Mississippi counterparts, regulators in Washington State continued to
scrutinize the legitimacy of the Saint Francis of Assisi Foundation. The
investment scandal unfolded before a formal Form A application was ever
submitted.
Regulatory weaknesses we observed during routine financial analyses
performed on the Thunor Trust insurers included inadequate asset investment
analysis activities, ineffective safeguards and procedures to monitor and
verify control of the assets, and virtually no efforts to seek securities-
related information on the broker- dealer from other financial regulators.
Controls pertaining to asset safeguards and investment activities are key
solvency considerations. Regulatory weaknesses in these areas were observed
in multiple states over several years.
Insurance regulators and NAIC did not have procedures or expertise to assess
the viability of the securities trading activities reported by the Thunor
Trust insurers. State insurance regulators and NAIC received annual
statements from the Thunor Trust insurers that clearly showed the unique
investment activities of the insurers. These activities were characterized
by an unusually high level of trading and turnover of the insurers' assets,
which primarily consisted of government bonds. Generally, our review of
available documents covering several years and related analyses by insurance
regulators and NAIC found virtually no Regulatory Weaknesses
Observed During Routine Financial Analyses
Inadequate Analysis of Securities Investments
B- 284347 Page 23 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
concerns about asset investment practices until the later stages of the
investment scam.
During our review, we found little evidence that state insurance department
financial analysis staff had concerns about the massive asset trading
activity being reported by the Thunor Trust insurers. Only in Tennessee did
we observe isolated instances of concerns by regulatory staff but not
sufficient to generate timely follow- up and resolution of such concerns.
Routine financial analysis reviews conducted in accordance with NAIC's
guidelines on the Thunor Trust insurers in Oklahoma, Missouri, and
Mississippi also did not trigger additional scrutiny.
Our review showed that NAIC's activities and guidance to support the states'
routine financial review efforts did not address asset turnover. 11
Specifically, the ratio analyses that are generated for insurance companies
did not include an asset turnover ratio. For example, NAIC's policies and
procedures in the Financial Analysis Handbook, used by state insurance
regulators to conduct routine financial analyses on insurers, did not reveal
any specific analysis requirement related to asset turnover nor a threshold
test that would trigger additional regulatory scrutiny of this type of
investment activity. Additionally, the analyst worksheets associated with
routine reviews on the Thunor Trust insurers did not disclose evidence of
concerns over the massive trading activity being reported or the
consistently greater- than- normal government bond trading returns. We also
noted that these year- end company numbers were subject to independent
Certified Public Accountant (CPA) audits each year, and the reports were
furnished to regulators and NAIC. Our review of available audit reports,
company management and discussion analysis documents, and NAIC synopses
contained in NAIC files did not reveal any skepticism about the trading
activity. Because of ongoing investigations and civil cases, we could not
assess the adequacy of the financial statement audits conducted by a CPA
firm on the Thunor Trust insurers.
From the company filings made with NAIC and concurrently with the state
insurance departments, we performed a simple financial ratio test
11 NAIC aids the states' efforts to perform annual financial reviews on
companies through the generation of the IRIS ratios and an Analyst Team that
performs an additional financial review on certain companies on the basis of
the IRIS ratio results. The process for generating the IRIS ratios includes
obtaining insurers' annual statements, entering the reported financial data
into a computer system, performing cross- checks on the data to check for
errors, and calculating 12 different financial ratios (for life and health
insurers) to help identify companies that could experience financial
difficulties. Once these ratios are calculated, an Analyst Team conducts a
further review of insurers whose IRIS results exceeded certain unusual
thresholds. This team then recommends to the states the regulatory attention
required by the insurers to help the regulators prioritize their workload.
B- 284347 Page 24 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
structured to flag highly speculative trading activity- also referred to as
an asset turnover test. This analysis, highlighting the unusually high asset
turnover activity, is presented in table 2 below. 12
Life insurance company (domicile state) Time period
(calendar year) Asset turnover ratio (end of year average) Asset turnover
ratio
(end of year range)
Franklin American (TN) 1992- 98 85 10- 207 International Financial Services
(MO) 1994- 98 54 12- 115 First National of America (MS) 1998 27 27 Franklin
Protective (MS) 1995- 98 89 30- 124 Family Guaranty (MS) 1994- 98 113 30-
193 Farmers and Ranchers (OK) 1994- 98 119 29- 204
Source: GAO analysis of insurer financial data in the annual statements.
For perspective, an asset turnover ratio of 52 would equate to selling and
buying the entire value of the company's assets weekly. By contrast, a
mutual fund expert recently cited concern about equity fund managers whose
asset turnovers now average about 0.9. 13
In April 2000, NAIC officials advised us that new ratio tests to flag
possible speculative asset investment activities have been developed and
implemented. The threshold test for indicating abnormal investment activity
is now an asset turnover of 0.25, about one fortieth of the lowest asset
turnover ratio shown for the companies in table 2. NAIC officials also
reported they have revised the Financial Analysis Handbook
instructions in this area. Throughout the 1990s, regulators were unable to
properly safeguard and monitor the assets of the Thunor Trust insurers. The
regulators' inability to effectively safeguard and monitor control of
insurers' assets centered on the varied and ineffective policies regarding
asset custodial arrangements. In some instances, regulators discovered there
was no custody agreement between the insurer and LNS. In other cases, the
custody agreement did not provide sufficient measures to safeguard or
recover insurers' assets.
12 This calculation method consisted of the company schedule showing assets
acquired and sold each year as the numerator and total company assets as the
denominator. This method was selected for illustration because it could be
performed easily (or roughly estimated by visual inspection) by regulatory
financial analysts. The end of calendar year numbers were used for six of
the insurance company submissions during the period the companies were
allegedly under Frankel's control. The remaining company, domiciled in
Arkansas, was acquired shortly before the collapse of the scam, and
regulators had not yet received a quarterly statement for the period that
the insurer was under Thunor Trust.
13 Wall Street Journal, June 20, 2000.
Table 2: Summary of Asset Turnover Ratios
Ineffective Mechanisms to Safeguard and Monitor Control of Insurers'
Securities Held By Another Entity
B- 284347 Page 25 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
In addition, regulators did not seek sufficient information to verify the
legitimacy of new custodians. Lastly, the annual statement information
obtained from insurers was inadequate to monitor who had control of the
insurers' assets.
One key regulatory tool that could have helped regulators hinder the
investment scam at different points in the oversight process was a model law
developed by NAIC to help safeguard insurers' assets. This model law, NAIC
Model Law No. 295, together with its accompanying model regulation, NAIC
Model Regulation No. 298, requires that only national banks, state banks, or
trust companies be used as custodians for securities belonging to insurers.
14 Furthermore, the model regulation includes forms that can be used for the
purposes of preparing custody agreements. However, NAIC, in its
accreditation program, does not require states to adopt or follow this model
law and regulation. We found that asset custodial requirements prescribed by
this model law and regulation were not followed in Missouri, Mississippi,
and Oklahoma on the Thunor Trust insurers domiciled in those states. Another
state, Tennessee, adopted the custody agreement prescribed in the model
regulation, but it failed to properly enforce insurer compliance with the
custody agreement throughout most of the 1990s by allowing the insurer to
execute the agreement with a broker- dealer, contrary to NAIC's guidance and
Tennessee's insurance regulations. 15 Proper enforcement of such
requirements on a regular basis could have helped prevent the scam, because
this would have prohibited a broker- dealer from maintaining custody over
the insurers' assets. Additional information on NAIC's Model Law No. 295 and
Model Regulation No. 298 is discussed in Appendix III.
The procedures and practices to monitor control of the insurers' assets were
also inadequate, because they did not always convey a clear understanding of
who controlled these assets. Insurance regulators monitor the financial
condition of insurers through the analysis of annual and quarterly
statements that are prepared in accordance with NAIC guidelines and
instructions. The General Interrogatories section of the annual statements
addressed the issue of which entity( ies) had control and custody of the
insurer's assets. One of the questions in this section essentially asked the
insurers if they had physical custody of their assets at
14 NAIC's Model Law 295 and the accompanying Model Regulation 298 outline
the asset custody requirements recommended for assets traded through
clearing corporations using the Federal Reserve book- entry system. Book-
entry refers to a method of settlement in which no physical delivery of the
item bought or sold is made, but the change in ownership is recorded by the
custodian, normally on a computer system.
15 Tennessee Rules of Department of Insurance, Chapter 0780- 1- 46.
B- 284347 Page 26 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
year- end. 16 A “yes” response would indicate that the insurer
had custody of its assets, whereas a “no” response would prompt
the insurer to describe further details concerning who had custody of its
assets. On quarterly updates of the financial statements, the General
Interrogatories did not specifically address the issue of physical custody
of the assets.
We found no evidence that state regulators had carefully scrutinized
information in the annual statements that highlighted the asset custody
situation until the later stages of the investment scam. Our review of the
annual statements between 1991 and 1998 revealed incomplete and inconsistent
reporting by the Thunor Trust insurance companies. For example, in 14 of the
28 statements submitted during the 1990s in which the insurer acknowledged
it did not have physical possession of its assets, the insurer did not
provide sufficient information as to who did control its assets.
Specifically, the instructions for this annual statement question state
“If no, give full and complete information relating thereto.”
However, the instructions do not indicate the types of information needed in
the case of a “no” response. In such cases, the Thunor Trust
insurers typically responded that the assets were “HELD BY BROKER IN
STREET NAME.” Such a response did not provide regulators with
sufficient information to determine the entity( ies) that had control of the
insurers' assets. In these instances, regulators needed to pursue additional
questions and research into the matter to determine who did have control of
the assets. Moreover, we found instances in Tennessee, Missouri, and
Oklahoma where the analysts' review of the annual statements did not flag
the “no” response for further supervisory review.
We also observed that inconsistent information reported by the insurers was
not detected due to the lack of procedures and practices to verify the self-
reported data. In instances where the insurer responded affirmatively that
it had physical custody of its assets, we did not find evidence that
regulators attempted to validate the insurer's response. We noted on several
occasions that such a response was inconsistent with other regulatory
information available on the insurer. For instance, in Tennessee, Missouri,
and Oklahoma, insurance companies sometimes reported in annual statements
that they had control of their assets despite other information from annual
reports and examinations that suggested their assets were in the custody of
a broker- dealer.
16 In annual statements filed by the Thunor Trust group of insurers for
years ending 1991 through 1998, in accordance with the format prescribed by
NAIC, a question related to asset control reads “Were all the stocks,
bonds and other securities owned December 31 of the current year, over which
the company has exclusive control, in the actual possession of the company
on the said date, except as shown by the Schedule of Special
Deposits?”
B- 284347 Page 27 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Responses to the asset custody- related question in the annual statement
could have been compared for consistency with other regulatory records
related to the custody of the insurer's assets as well as with financial
statements of other Thunor Trust insurers. Regulatory records associated
with asset control include custodial agreement( s) between the insurer and
the entity( ies) with possession of the insurer's assets as well as those
used by the independent CPA firm to verify asset balances with other
financial institutions annually. However, NAIC's Financial Analysis Handbook
guidance does not address the steps regulators could take to verify
insurers' responses about the custody of their assets. Rather, NAIC
officials indicated that such asset verification steps would occur during
onsite examinations. Because on- site examinations generally occur only once
every 3 to 5 years, an improper response on the annual statements related to
who was maintaining custody of the insurer's assets may not be detected in a
timely fashion. Furthermore, because annual financial reviews were not
conducted on a consolidated basis to assess the financial statement
information across all the insurers of the same group, regulators could not
easily identify inconsistencies in responses related to asset control among
the Thunor Trust insurers.
There are other more general problems with the asset custody information
collected by regulators. For instance, the question in the General
Interrogatories of the annual statements addresses only asset control on
December 31 st . Additionally, the question could be confusing in cases
where assets are maintained in book- entry form with the Federal Reserve,
because the question refers to the physical custody of securities. Although
instructions to this general interrogatory have been revised over time to
clarify its meaning, the responses to the question still did not clearly
convey a meaningful understanding of the entity( ies) that may have
controlled the insurers' assets throughout the year.
When questions concerning an insurer's investment activities did arise,
financial analysts did not generally seek regulatory data or expertise from
regulators in the securities industry. A check of basic information on LNS
at any point throughout the 1990s with state securities offices could have
helped unravel the investment scam. However, during our review, we did not
find evidence that state insurance analysts obtained information from state
securities offices while conducting their annual reviews because the NAIC
guidelines do not specifically require such coordination. During our review,
we collected information from several state securities offices on the real
LNS that revealed inconsistencies with the information on the LNS entity
that insurance regulators had been provided by their domiciled insurers. As
mentioned earlier, Frankel allegedly used the real LNS as a Inadequate
Securities- Related
Expertise and InformationGathering
B- 284347 Page 28 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
front, getting the firm's name licensed in states where he intended to
perpetrate his scam. We reviewed information from the state securities
offices on the real LNS through annual statements on file and information
contained in the CRD system.
The CRD information, which would have been available to state insurance
regulators through their state securities offices during the entire period
of the scam, would have revealed that the real LNS was located in Dundee,
MI, contrary to the location on the account statements insurers received
from LNS. The real LNS was a firm that started out in Toledo, OH and moved
to Dundee, MI. However, the account statements that insurers were receiving
from LNS indicated that the firm had locations in multiple states, including
a New York, NY address. Additionally, financial statements available in
state securities offices revealed that the real LNS typically had reported
assets of less than $100,000 during the 1990s. Such information alone could
have generated other red flags given the high level of trading that was
being reported in the account statements that insurers were receiving from
LNS. Also, a check into the officers of the real LNS would have revealed an
inconsistency between those actually employed by LNS and the name of an
individual who was supposedly signing the asset verification documents used
by state insurance regulators and a CPA firm.
Although some insurance regulators acknowledged the insurers' investment
activities were unusual, they did not seek such outside securities
expertise. For instance, in Tennessee, analysts were sent to Franklin
American Life in 1996 to review the company's unusual investment activities.
According to the Tennessee Comptroller of the Treasury's report, the
Insurance Division was concerned that the company might be “short
selling” its assets, a risky and prohibited type of trading activity
involving the sale of investments instruments without ownership in
anticipation of a fall in prices. 17 However, the analysts involved in the
targeted review acknowledged that they did not have a background in
securities for adequately assessing the reasonableness of the insurer's high
volume of trading. After a 1- day target review to assess the company's
investment practices, which revealed no indication that the company was
“short selling,” analysts recommended that a securities expert
be brought in to review the insurers' investment practices further. However,
rather than seeking such expertise externally or from their local state
securities office, the Tennessee Department of Commerce and Insurance did
not
17 Special Report: Review of Inaction on the Part of Insurance Division
Employee's Involved in the Regulation of Franklin American Life Insurance
Company, Tennessee Comptroller of the Treasury (Jul. 7, 2000).
B- 284347 Page 29 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
conduct a meaningful review into the issue until an on- site examination was
conducted approximately 2 years later.
The regulatory weaknesses observed from our review of the states' on- site
examinations included the failure to detect the misappropriation of assets,
inadequate procedures and practices to verify the legitimacy of the
custodian, and inadequate information- sharing of examination concerns to
prevent the scam from spreading further. Such weaknesses resulted in missed
opportunities for regulators to uncover the scam earlier. Examinations
conducted in the early and mid- 1990s did not reveal the investment scam,
even though assets had already been removed from the control of the
insurers. Finally, during examinations conducted in 1998 through 1999,
examiners in Mississippi and Tennessee began to scrutinize the LNS entity
itself, and the investment scam began to unravel. Unfortunately, the lack of
proactive information- sharing among regulators resulted in additional
losses as the scam spread further before it was fully revealed in May 1999.
We found that four completed examinations on the Thunor Trust insurers did
not uncover any material weaknesses even though Frankel allegedly embezzled
the insurers' assets shortly after their purchase, prior to the
examinations. One key reason that examiners were not aware that the insurers
did not have control over their assets related to NAIC's examination
procedures for verifying securities- related assets. These procedures
require the insurance examiner to verify the insurers' securities by actual
inspection and count unless these securities are being held under a
custodial arrangement by a depository institution, such as a bank, trust, or
securities depository. 18 However, examiners could not physically inspect
the book- entry government securities because records of such transactions
are maintained through computers, and no physical possession of the
securities takes place. Consequently, examiners accepted listings from the
broker- dealer to satisfy asset verification tasks on numerous occasions as
if the entity were a bank or trust custodian, contrary to procedures in
NAIC's Examiners Handbook.
Although adherence to NAIC's model law and regulation on suitable asset
custodians is not currently a requirement of NAIC's accreditation program,
adherence to the Examiners Handbook is. As mentioned earlier, NAIC's Model
Law No. 295 and Model Regulation No. 298 recommend that only
18 NAIC's examination guidelines explains that acceptable securities
depositories are those that are subject to the regulation of SEC, the
Federal Reserve System, and state banking authorities in the state of
domicile. According to NAIC, broker- dealers are not securities
depositories. Regulatory Weaknesses
Observed During On- Site Examinations
Failure to Detect Misappropriation of Assets
B- 284347 Page 30 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
banks and trust companies, including subsidiary trust companies of brokerage
firms, be used as custodians for insurer assets. The Examiners Handbook,
which state insurance examiners follow to conduct on- site examinations of
insurers, contains procedures to verify assets that build upon the premise
that only these types of depository institutions be used as asset
custodians. 19 If these kinds of institutions hold insurers' assets, asset
verification procedures can be satisfied through a certified listing of the
insurers' securities provided by the custodian. Otherwise, the securities
belonging to the insurers are supposed to be verified through physical
inspection and count.
The examination procedures applicable during the examinations completed on
the Thunor Trust insurers did not specifically include measures for
verifying book- entry securities being held by a broker- dealer. Although
the examination procedures require examiners to physically inspect and count
the securities that are not held by a bank, trust company, or securities
depository, the assets were book- entry government securities that could not
be physically inspected. As a result, the existing examination procedures
did not address how to perform independent asset verifications under these
circumstances.
To verify insurers' assets, state regulators requested that the broker-
dealer identify what securities it held on behalf of the insurer and the
associated value of these securities. In turn, an “authorized
representative” of LNS sent back the document, in the form of an
unnotarized letter or account balance type of form, affirming that such
securities belonging to the insurer existed. After the scam collapsed, it
was apparent that LNS and the insurers were, in fact, affiliated
institutions, allegedly being controlled by Frankel. Therefore, the
examinations completed on several Thunor Trust insurers never achieved an
independent check on the assets and failed to detect the misappropriation of
assets.
Additionally, as was the case in the annual financial analyses, the unusual
investment activities being pursued by the Thunor Trust insurers could have
prompted further regulatory action during the on- site examinations.
Although the Examiner's Handbook does not specifically instruct regulators
to assess the turnover of the insurer's assets, the practice of
19 Two portions of this handbook in force when examinations were conducted
on the Thunor Trust insurers relate to the assessment of asset custody
arrangements and procedures to verify insurer assets. The first of such
guidance in Part 1 of the Examiners Handbook contains specific narrative
guidance on acceptable asset verification procedures and custody
requirements. Part 2 of the
Examiner's Handbook, titled “Specific Risk Analysis,” contains a
section on “Investments Cycle.” This section in Part 2 describes
the specific step- by- step procedures to verify insurers' assets that
mirror the general narrative guidance described in Part 1.
B- 284347 Page 31 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
investing virtually all of the firm's assets with one broker- dealer and
constantly turning over these assets could have prompted more queries into
LNS, including an assessment of the possibility that the insurers under
Thunor Trust and LNS were related parties. Such inaction in response to
these red flags raises questions about the level of expertise present in
insurance departments to assess investment strategies being reported and
pursued by the insurers. We did not find evidence that such an issue was
substantively addressed during examinations completed in the mid 1990s on
insurers in Tennessee, Missouri, and Oklahoma. Only in late 1998 and early
1999 did examiners in Tennessee and Mississippi begin to question the
relationship between the insurers and LNS. When regulators finally began to
scrutinize the investment activities and legitimacy of LNS, the investment
scam began to unravel.
Examination procedures used by insurance regulators were also inadequate to
assess the legitimacy of the custodial entity or its authorized
representatives. The examiners accepted custodial agreements and asset
verifications for LNS that were supposedly signed by an individual that
represented an officer of LNS. Such methods were not fundamentally different
from those used to verify asset balances on a yearly basis, even though
examinations may occur only once every 5 years, in accordance with NAIC's
minimum accreditation standards. The individual who supposedly signed as the
asset custodian on several asset verification documents was no longer
employed by the real LNS at the time the asset certifications were made.
State insurance regulators, believing they had received a certification on
the assets from a legitimate entity and individual, were tricked.
On examinations completed on several Thunor Trust insurers, we found no
evidence that any checks were made to validate the legitimacy or
appropriateness of the custodian, LNS, or its representatives despite the
unusual investment practices being pursued by the Thunor Trust insurers. The
Examiners Handbook instructs insurance examiners to “satisfy
themselves as to the integrity of the accounting controls and verification
and security procedures” of the custodian. However, we found no
evidence that examiners evaluated such information on the broker- dealer for
years. This information could have been obtained through audits on the
broker- dealer as well as policy statements on internal controls and risk
management practices. Furthermore, the examination procedures did not
instruct examiners to assess whether or not the insurer performed adequate
due diligence on its asset custodian. Ideally, the “first line of
defense” to ensure the legitimacy of the asset custodian would rest
with the insurer, followed by the regulator. Inadequate Practices and
Procedures to Verify the Legitimacy of Asset Custodians
B- 284347 Page 32 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
One state that had adopted a key feature of NAIC's model law and regulation,
requiring that only depository institutions such as banks or trust companies
be used as custodians, did not properly enforce its rules. Tennessee
insurance regulators allowed insurers to execute asset custodian agreements
with a broker- dealer, instead of a bank or trust custodian, contrary to
NAIC's guidance and Tennessee Rules of Department of Insurance. Furthermore,
the form itself received back from LNS in 1993 was not executed properly.
The document had been altered with text changes to indicate the words
“bank” and “bank corporation” had been replaced with
the words “securities brokerage firm.” In addition, the
custodial agreement had not been notarized as required. It was signed with
the name of a person who was supposedly an officer of LNS, a signature that
now appears to have been a phony.
Had regulators not accepted the custody agreement either for the reason that
LNS was not an authorized custodian or because the form had been altered and
was not notarized, the scam could have been hindered. Enforcement of the
custodial requirements would have prompted LNS to return Franklin American
Life's assets back to the state in 1993, thus further impeding the
perpetuation of the scam. Additionally, a request to obtain a notarized
signature on the custody agreement may have led to suspicions of a fraud
because the signatory on the agreement was phony, as the person had
supposedly already left the country. 20 Thus, a request to obtain a
notarized signature may have complicated matters for the person( s) behind
the scam, requiring them to find another signatory or obtain a fraudulent
notarized signature.
Once serious regulatory concerns surfaced over insurers connected to Thunor
Trust during on- site examinations, such concerns were not adequately shared
with other states to help prevent further losses. Instead, state insurance
regulators appeared to pursue actions that favored their own states'
interests, negating opportunities for other state regulators to prevent or
limit losses to their domiciled insurers.
In 1998 and early 1999, regulators in Tennessee and Mississippi raised
serious concerns during their on- site examinations of insurers under Thunor
Trust. The Tennessee Department of Commerce and Insurance, Division of
Insurance, was conducting an examination of Franklin
20 Our review of information at NASDR indicated that the signature of the
individual in the custodial agreement differed vastly from a notarized
signature of the same individual found on other SEC documents. Documentation
from the examinations performed on the real LNS revealed that the person who
supposedly signed the custodial agreement for the Tennessee insurer's assets
in July 1993 had already left the country. Limited Sharing of Information
and Coordination Among Regulators
B- 284347 Page 33 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
American Life while regulators in Mississippi were conducting examinations
of Franklin Protective Life Insurance Company and Family Guaranty Life
Insurance Company. At times, the examiners were at the same location
together in Franklin, TN, where the headquarters operations for all the
insurers under the Thunor Trust organization were situated. During the
course of the examinations, regulators in both states raised concerns over
the investment activities of insurer assets and concerns that the insurers
might somehow be affiliated with LNS.
On February 1, 1999, the Examiner- In- Charge hired by Tennessee's Division
of Insurance wrote a letter to the Division warning that there was a
possibility that Franklin American Life had been looted of its assets. The
examiner detailed the possible scam that was being perpetrated on the
insurer under Thunor Trust that pointed toward an affiliation between LNS
and the insurer, a scheme that is now being alleged in the federal
indictment against Frankel. During our review, we found no evidence that
this information was proactively shared with other state regulators to help
prevent the possibility of a potential scam spreading.
After regulators in Tennessee had been informed of the possible fraud and
inappropriate relationships between Franklin American Life and LNS by the
Examiner- In- Charge, insurers in Arkansas and Virginia lost approximately
$50 million through the scam because regulators in those states were unaware
of the potential fraudulent activities that existed within Thunor Trust.
Arkansas officials maintained they were not aware of regulatory concerns on
entities affiliated with Thunor Trust prior to its approval of an
acquisition involving Old Southwest Life Insurance Company, domiciled in
Arkansas, with Franklin American Life, a Thunor Trust insurer domiciled in
Tennessee. They approved the purchase on February 25, 1999. Likewise,
regulators in Virginia were not aware of the regulatory concerns associated
with entities connected to Thunor Trust. Settlers Life, an insurer domiciled
in Virginia, fell victim to the investment scam after entering into a
reinsurance transaction with one of the Thunor Trust insurance companies
domiciled in Mississippi, First National Life Insurance Company of America.
Given that Virginia officials were unaware of regulatory concerns on
insurers affiliated with Thunor Trust, they were not able to prevent the
transaction between these insurers on April 9 th that ultimately resulted in
the loss of approximately $45 million.
In 1998 and 1999, Mississippi regulators also had serious concerns with
insurers under Thunor Trust and their investment activities with LNS.
Regulatory officials in Mississippi mentioned that concerns over a possible
affiliation between LNS and the insurers surfaced in the summer of 1998.
B- 284347 Page 34 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
On March 12, 1999, Mississippi regulators sent a series of questions to the
insurers under Thunor Trust domiciled in Mississippi. The regulators were
acting on unresolved examination concerns related to the ownership interests
behind Thunor Trust and the investment activities of the insurers, including
a possible affiliation between LNS and the insurers. On April 8, Mississippi
regulators received responses to these questions that they considered to be
evasive and inconsistent. One of the more startling responses was the
revelation that another entity named the “Saint Francis of Assisi
Foundation, to Serve and Help the Poor and Alleviate Suffering” had
supposedly become the owner of Thunor Trust and all of its insurers.
We noted a few instances where some examination concerns raised in
Mississippi and Tennessee were shared with other regulators, but only in
circumstances where another regulator asked for such information. Regulators
in Mississippi and Tennessee shared some examination- related information
with each other in late 1998 and early 1999, as examiners from both states
met while conducting examinations on different insurers owned by Thunor
Trust that were headquartered at the same location in Tennessee. In April
1999, when regulators from Washington State inquired about the Saint Francis
of Assisi Foundation's desire to purchase an insurer domiciled in
Washington, Mississippi officials warned their counterparts to proceed
cautiously with the Form A approval process because of examination- related
concerns over the interests behind Thunor Trust. These coordination efforts
are laudable. However, a proactive alert to other states on the examination
concerns raised, particularly involving a possible fraud or an affiliation
between LNS and the insurers, may have afforded other regulators an
opportunity to review and alert their domiciled insurers. Instead,
regulators in Missouri, Oklahoma, Virginia, and Arkansas were not aware of
the serious problems and concerns uncovered during the Tennessee and
Mississippi examinations until the insurers collapsed in May 1999.
The NAIC examination guidelines do not require proactive communication by
the state of domicile to other states that have a regulatory interest in a
troubled insurer. Rather, these guidelines simply require that the state
have a policy addressing these communications when requested by another
insurance department. Nevertheless, insurance regulators currently have a
mechanism to alert other regulators about confidential regulatory concerns
within the regulatory environment.
We inquired about existing information- sharing tools available to
regulators with NAIC. The NAIC information- sharing systems that are
available to regulators include databases known as the Regulatory
B- 284347 Page 35 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Information Retrieval System (RIRS) and the Special Activities Database
(SAD). The RIRS database is intended to convey regulatory actions against
companies or individuals, and the SAD system was developed to confidentially
convey areas of regulatory concern that may or may not evolve into
circumstances necessitating a regulatory action or sanction. Accordingly,
such regulatory concerns would be considered confidential. However,
according to NAIC officials, no entries related to the Thunor Trust group of
insurers were made by any states in the system to alert other insurance
regulators of potential problems with the companies.
A principal concern for regulators about sharing such information relates to
the implications of sharing examination- related information prior to the
release of the examination report. Insurance regulators and NAIC officials
acknowledge that regulators are often reluctant to share regulatory
information apart from that disclosed in a published examination report.
However, examination reports, because they are public documents, often do
not include information that could cause negative publicity for an insurer.
A key concern for regulators is the possibility that disclosure of
unfavorable information may, in turn, create cause for other states to
suspend the insurer's business activities, thereby exacerbating the problems
for the insurer. In turn, regulators could be blamed for any harm rendered
to the insurer as a result of such information disclosures.
Another information- sharing issue among insurance regulators that may have
hindered regulators' ability to detect the investment scam was the lack of
coordinated examination efforts focused on insurers belonging to the same
group. Insurance regulators generally do not examine all affiliated
companies at the same time. By 1994, the Thunor Trust family of insurers had
grown to include insurers in Tennessee, Oklahoma, Missouri, and Mississippi.
Concerns present among regulators in one state over the insurers' investment
activities might have prompted greater awareness of these unusual activities
in other states had such concerns been conveyed. Also, a call on all the
insurers' assets at one time would negate opportunities to shift assets from
one affiliated entity to another, or play a “shell game.” Given
that the scam was premised on the ability to take assets from one insurer to
purchase others and, allegedly, to support Frankel's lifestyle, a proper
verification of all the insurers' assets at once could have uncovered the
investment scam earlier.
In addition to the lack of information- sharing within the insurance
industry, insurance examiners did not generally seek information and
resources available from regulators of other financial sectors. In cases
where concerns were raised over the investment activities of the insurer,
B- 284347 Page 36 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
regulators could have sought information and expertise from local state
securities offices. Finally, in January 1999, an examiner hired by Tennessee
visited the state's securities office and noted inconsistencies between the
securities regulatory information available on the real LNS and the
investment account information being reported to Franklin American Life by
an entity named LNS. As mentioned earlier, we were able to access regulatory
information on the real LNS from state securities offices through financial
statements filed by the company and through the CRD system. Such information
was available to insurance regulators throughout the period of the
investment scam and could have helped uncover it much sooner if the
regulators had accessed the information.
NAIC and other state officials have proposed corrective actions to reduce
the likelihood of a scam similar to that allegedly perpetrated by Frankel
from happening again, but other unresolved issues could hamper future fraud
prevention efforts. In addition, NAIC has proposed near- term and longer
term corrective actions to remedy other insurance regulatory weaknesses
highlighted by this scandal. Additionally, the Tennessee Comptroller of the
Treasury, Division of State Audit, identified internal control weaknesses in
the Tennessee Insurance Division, and the Division has implemented new
policies designed to correct the deficiencies. Other unresolved issues that
will also have an impact on future fraud prevention efforts within the
insurance industry center around regulators' ability to access regulatory
and criminal history data maintained by other government agencies. A key
element of insurance regulators' fraud prevention efforts is their ability
to prevent a rogue in another financial sector from migrating to the
insurance industry. Similarly, state insurance regulators are also now faced
with the challenge of fulfilling their responsibility under a federal
insurance fraud prevention provision (18 U. S. C. sect. 1033) to prevent certain
convicted criminals from engaging in the business of insurance. The extent
to which insurance regulators will be able to successfully implement
recommendations emanating from the Frankel case will depend on the sharing
of regulatory and criminal history information across industry sectors and
levels of government (state and federal agencies) and will require a
continuing commitment by NAIC and the states.
In a report issued on April 13, 2000, NAIC's Ad Hoc Task Force on Solvency
and Anti- Fraud recommended immediate and longer term corrective actions
emanating from the alleged scam perpetrated by Martin Frankel. These
corrective actions included recommended improvements to financial analysis
and examination procedures, model laws and regulations, accreditation
standards, and certain antifraud activities. A Number of Corrective
Actions are Planned, But Unresolved Database Issues Remain
NAIC Has Proposed a Series of Corrective Actions
B- 284347 Page 37 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
These corrective actions are detailed in the Task Force's report, which is
reproduced in appendix IV. Additionally, some states have proposed other
corrective actions to help prevent this type of investment scam from
occurring again.
The corrective actions proposed by NAIC include those that can be
implemented relatively quickly as well as longer term measures requiring
adoption by the states' insurance commissioners. Some immediate and short-
term corrective actions include the incorporation of an asset turnover ratio
in the IRIS ratios, revisions to the Financial Analysis Handbook and
Examiners Handbook, enhancements to accreditation standards, and improved
sharing of information among insurance regulators. For example, improvements
to accreditation standards include the adoption and implementation of a
model law and regulation on the “Use of Clearing Corporations and
Federal Reserve Book- Entry System.” Another accreditation change
proposed is a requirement for states to seek input from an investment
specialist on examinations involving high risk or complex investment
strategies. Concerning information- sharing activities, NAIC has proposed
more proactive communications between states and the use of a “Form A
database” to help states track the status of other change in ownership
applications being submitted to other state regulators.
Other longer term corrective actions being proposed by NAIC, requiring the
approval and adoption of the states' insurance commissioners, encompass
improvements to the accreditation program, financial analysis and
examination procedures, and the sharing of information outside the insurance
industry. Improvements to the accreditation program include prioritizing
oversight functions and instituting communication guidelines with other
state and federal banking and securities regulators. Longer term
enhancements to the financial analysis guidelines would consider methods for
reporting and assessing financial statement data of consolidated insurance
groups. Additionally, NAIC has proposed considering methods to coordinate
and conduct examinations on a consolidated basis for insurers belonging to
the same group. In circumstances involving troubled companies, examinations
would also be required more often than once every 5 years. Other longer term
actions proposed by NAIC include obtaining access to nationwide criminal
history data for state insurance regulators and sharing confidential
information among insurance regulators and law enforcement authorities.
NAIC has already implemented some corrective actions to revise its guidance,
but other corrective measures will require sustained cooperation
B- 284347 Page 38 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
from the states. Thus far, NAIC has expanded its IRIS ratio analysis to
include an analysis of asset turnover. NAIC has also revised its Examiners
Handbook to include new guidance on evaluating investment management and
controls. For example, the revised guidance instructs examiners to
periodically evaluate the financial condition and capabilities of bank
custodians, broker- dealers, servicing agents, property managers, and others
with access to the company's assets. Other corrective actions proposed by
NAIC will require sustained cooperation from other state and federal
agencies because changes can take several years from initial development to
implementation. For instance, two of NAIC's proposals, (1) developing a
process for coordinating financial examinations of insurer groups and (2)
providing statutory accounting guidance that will support consolidated
accounting and reporting for groups of insurers, will require further
development and action by NAIC committees and, subsequently, consideration
and action by each state.
Another investigation, conducted by auditors from the Tennessee Comptroller
of the Treasury, has also prompted corrective actions by the state's
insurance regulators. 21 The Comptroller of the Treasury's Division of State
Audit concluded that the Tennessee Department of Commerce and Insurance
failed to detect the fraudulent nature of Frankel's alleged activities
before May 1999 because regulators failed to exercise sufficient
professional skepticism, used inadequate procedures to review Franklin
American Life, and misapplied review procedures. The audit report noted the
Tennessee Insurance Division's gross breakdown in its regulation despite
significant warning signs of questionable activity. The state auditors also
cited a lack of communication between the Insurance Division staff and other
department officials (the state's Securities Division is part of the
Department of Commerce and Insurance). State investigators reported that
many situations that involved unusual business transactions and
circumstances were not acted upon further because department staff concluded
they could take no action unless there was a law, regulation, or policy that
was clearly violated. The report notes that the Insurance Division's
inaction on analysts' recommendations to assess the insurer's investment
activities with a securities expert, available from the Securities Division
of the same department, extended the period the fraudulent scam went
undetected.
21 Special Report: Review of Inaction on the Part of Insurance Division
Employees Involved in the Regulation of Franklin American Life Insurance
Company, Tennessee Comptroller of the Treasury (Jul. 7, 2000). Tennessee
State Auditors
Identified Regulatory Weaknesses Prompting Several Corrective Actions
B- 284347 Page 39 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
In response to the auditor's report, Tennessee insurance regulators noted
that several policy changes had been implemented. These included more
detailed policies and procedures for financial analysts and examiners
regarding reviewing asset custodian status, where assets are located,
investment scrutiny, and supervisory review. Supervisory review procedures
were also implemented regarding the analysis of the general interrogatories
contained in the annual statements submitted by insurance companies and
computation of asset turnover ratios and a benchmark that asset turnover
should be no more than once a year. Other changes were made that were
designed to strengthen documentation of activities on target exams, enhance
supervisory review, and ensure record retention.
Insurance regulators' ability to screen undesirable applicants and reduce
the potential for fraud could be facilitated by improved access to
regulatory and criminal history data during reviews of change in ownership
and licensing applications. As mentioned earlier, insurance regulators can
access NAIC's RIRS and SAD databases to obtain regulatory history
information on individuals and firms in the insurance industry. However,
insurance regulators generally do not have direct access to other financial
regulatory and criminal databases.
Disciplinary- related data on securities brokers are maintained in CRD,
available from state securities offices. Banking regulators use numerous
other systems to track individuals sanctioned in the banking industry.
Although NAIC has met with securities and banking regulators to discuss the
sharing of information across industry sectors, insurance regulators
generally do not have direct access to such systems other than through
publicly available means.
Insurance regulatory access to criminal history data has been limited. NAIC
officials pointed out that only a handful of state insurance departments
have the ability to obtain criminal history data through agencies in their
departments that have some type of law enforcement authority. Thus, NAIC
officials acknowledge that insurance regulators cannot meet their
responsibilities under the federal insurance fraud prevention provision, 18
U. S. C. sect. 1033. In contrast, banking and securities regulators routinely
perform criminal history checks on individuals by submitting information to
the FBI.
Justice officials we spoke to indicated that the National Crime Prevention
and Privacy Compact outlines a legal framework for exchanging criminal
history records between federal and state officials for noncriminal
Unresolved Issues Could
Hamper Future Fraud Prevention Efforts
B- 284347 Page 40 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
purposes. 22 Implementation of this Compact could allow insurance regulators
to access criminal history data, improving their ability to keep certain
criminals out of the insurance business. Justice officials indicated that
the Criminal Justice Information Services Division of the FBI would be the
organization ultimately responsible for coordinating the mechanism through
which the exchange of criminal history data under the Compact might be
implemented. To date, insurance regulators and the FBI have not yet
developed a method by which insurance regulators could conduct routine
criminal history checks on individuals entering the insurance business.
In the future, insurance regulators' fraud prevention efforts could be
strengthened through the assessment and review of regulatory data from
banking and securities regulators and criminal history data from Justice.
NAIC has proposed developing a means to query an individual's regulatory and
criminal history from multiple databases in a batch process during offpeak
business hours. NAIC officials maintain that such an approach would be the
most efficient and effective manner to conduct routine background checks on
individuals from all the states that desire to enter the insurance business.
However, insurance regulators' ability to perform background checks in such
a manner would require the sharing of information across different financial
sectors and government agencies, as well as allowing NAIC, not itself a
regulator, to serve as a clearinghouse and facilitator for such information-
sharing.
The consolidation of financial services industries allowed by the GLB
financial modernization legislation heightens the importance of consultation
and information- sharing between federal and state regulators in the
performance of their respective oversight duties. The fraudulent activities
allegedly perpetrated by Mr. Frankel also demonstrate the need for
heightened coordination among regulators. Although the GLB Act is recent,
regulators recognize the need to improve their coordination and have taken
or plan to take a number of actions. Generally, the actions consist of
establishing formal agreements for sharing information and establishing
working groups for periodic meetings to discuss matters of mutual interest.
These regulatory actions are in their infancy, but the expected continued
blurring of distinctions and separations in financial markets will require
an increased and continued commitment to enhanced regulatory cooperation and
information- sharing across financial sectors.
22 The National Crime Prevention and Privacy Compact, Pub. L. No. 105- 251,
October 9, 1998 (42 U. S. C. sect. 14616), establishes policies and procedures
for the states to access criminal history data for noncriminal purposes.
Financial
Modernization Highlights the Importance of Regulatory Coordination Across
Financial Sectors
B- 284347 Page 41 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
However, the regulatory coordination provision of the GLB Act is focused on
regulating institutions within financial holding companies; that is,
affiliated institutions that have different functional regulators. The
Frankel case illustrates the importance of regulatory coordination even in
the absence of a financial holding company structure.
Lessons learned from Frankel's alleged investment scam highlight the
importance of sharing information between regulators of different financial
sectors at different phases in the oversight process as well as adequately
safeguarding and verifying insurer assets at other financial institutions.
One lesson learned from the scam was the lack of insurance regulatory tools
and procedures for seeking and obtaining information from other financial
sectors. At each phase in the oversight process, insurance regulators could
have benefited from securities regulatory information to review ownership
changes and business transactions involving individuals and entities in the
securities and insurance industries. For instance, applicants desiring to
engage in the business of insurance that had come from the securities
industry could have been better scrutinized. Likewise, banking and
securities regulators have indicated a need to properly review individuals
during charter application and licensing review functions who are entering
the banking or securities industry from the insurance industry. To
facilitate routine regulatory background checks, regulators will have to
resolve long- standing issues concerning the sharing of disciplinary-
related information from databases maintained in different financial
sectors.
Another lesson learned from the scam is the need to strengthen the proactive
sharing of confidential information among state insurance regulators. Once
regulatory concerns were raised during on- site examinations of the Thunor
Trust insurers, these concerns were not proactively conveyed to other state
insurance regulators to help prevent the scam from spreading to other
insurers. As the distinctions between the financial sectors continue to
blur, regulators of different financial sectors will need to ensure the
proactive sharing of confidential regulatory information.
The Frankel case also provides a lesson relevant to efforts to implement the
GLB Act, which is to recognize the importance of properly safeguarding and
verifying assets across affiliated institutions in different financial
sectors. Insurance regulators must consider the appropriate regulatory
procedures as well as the additional accounting and auditing standards
necessary to adequately verify insurer assets being held by Lessons Learned
from
Frankel's Alleged Scam Can Help Regulators Better Prepare for Rogues in the
Future
B- 284347 Page 42 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
related parties, such as affiliate banks or securities entities. As
financial services regulators coordinate their oversight efforts they must
ensure that gaps are not created that could compromise their ability to
obtain independent verification of transactions and assets across affiliated
financial institutions.
The need for increased cooperation between federal bank regulators and state
insurance regulators is clearly recognized in section 307 of the GLB Act.
The section specifically states the congressional belief that the Federal
Reserve Board and state insurance regulators should share, on a confidential
basis, information relevant to the supervision of companies that control
both a depository institution and a company engaged in insurance activities.
Additionally, appropriate federal banking agencies, such as OCC, OTS, and
the Federal Deposit Insurance Corporation (FDIC), should also share
information with their regulatory counterparts in the insurance industry.
The sharing of information, on a confidential basis, with relevant state
insurance regulators should involve transactions and relationships between
depository institutions and affiliated companies engaged in insurance
activities. The purpose of section 307 is to encourage coordination and to
thereby improve the quality and efficiency of the supervision of financial
holding companies and their affiliated depository institutions and companies
engaged in insurance activities.
The Federal Reserve recognizes the importance of blending its
responsibilities for umbrella supervision with the functional regulation of
subsidiaries or affiliates by other regulators, including insurance
regulators. Federal Reserve officials explained that they have had only one
situation to date necessitating close coordination with the insurance
industry. This involved the merger between Citicorp and Travelers Group in
September 1998. Subsequently, in August 1999, the Federal Reserve entered
into a Memorandum of Understanding (MOU) with the state of Connecticut
Department of Insurance, the primary regulator of Travelers, concerning the
sharing of confidential supervisory information. This MOU was designed to
push down to the supervisory levels of the bank and insurance affiliates the
authority for examiners to talk directly to each other. Because this
agreement predated the passage of the GLB Act, it is undergoing revision to
reflect current law. Additional MOUs with other insurance regulators are
anticipated as banks and insurance companies are merged or acquired.
In the future, Federal Reserve officials said some known issues will need to
be addressed, and others may emerge. For example, the treatment of bars and
sanctions that now apply only to banking agencies may need to Regulatory
Coordination
Efforts Recommended by the Financial Modernization Legislation Have Begun
B- 284347 Page 43 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
be extended to institutions in other financial sectors. Also, insurance
companies that become part of financial holding companies are required to
submit Suspicious Activity Reports to the Federal Reserve. To address these
issues, the Federal Reserve is hosting Cross- Sector Regulatory Working
Group meetings, two of which have been held thus far this year. Federal
Reserve officials acknowledge the need for more regularized communication,
although its form has not yet been established. The Federal Reserve has
indicated that coordinating the regulation of Travelers/ Citigroup has not
presented substantial difficulty. However, in the future, when financial
holding companies exist in multiple states, coordination challenges might be
much more difficult.
OCC officials explained they are working to strengthen communication and
coordination with the insurance industry. Specifically, they have signed an
agreement for sharing complaint information with 28 states as of May 31,
2000, and anticipate signing agreements with the remaining states. They are
also working toward sharing supervisory information, but to date, no
agreements have been reached with any of the states. Since passage of the
GLB Act, OCC has received about 30 notifications for designations as
financial subsidiaries, and all but 2 have insurance- related business.
Thus, OCC officials believe they will need formal sharing agreements with
insurance regulators regarding supervisory information. They explained their
belief that they are now legislatively walled- off from directly obtaining
information on insurance affiliates absent a formal regulatory finding that
an affiliated insurer would materially affect the bank and that insurance
regulators are unable to adequately regulate the insurance affiliate. OCC
officials noted that they could more easily obtain insurance affiliate
information when needed prior to the GLB Act. For the future, OCC regulators
specifically mentioned the need to share information on undesirable persons
within the banking and insurance industries to reduce migration from one
industry to another. They also acknowledged they would need to better
understand the operations of insurance affiliates of national banks, how the
insurance affiliates are regulated, and how to proceed with insurance
regulators when insolvency issues arise.
Concerns about OCC's reliance on state- provided insurance information have
been expressed by the Department of the Treasury Inspector General (IG),
however. The Treasury IG recently warned that bank regulators may not be
able to rely fully on each state's regulatory work to adequately assess the
risks banks incur while selling insurance. 23 The Treasury IG
23 Office of the Comptroller of the Currency's Supervision of Banks Selling
Insurance (OIG- 00- 098, Jun. 27, 2000).
B- 284347 Page 44 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
report mentioned that states' ability to monitor banks' insurance- related
activities varied, given the varying resources and regulatory philosophy of
each department. Therefore, the Treasury IG recommended that OCC proactively
assess the reliance it can place on states' oversight of insurance
activities performed by banks. However, OCC regulatory oversight officials
did not concur with most of the report's recommendations, citing that
reliance on state insurance regulatory activities is mandated by the GLB
Act's functional regulatory approach.
OTS officials stated that they recognize the need for improved and
continuing coordination. They also noted that insurance companies have been
able to own thrifts for some time. Since 1996, OTS regulators have begun
seeing increasing operational integration of the thrift with other
affiliates, including insurance companies, within holding companies. Areas
of increasing integration included the cross- marketing of products and the
consolidation of risk management, internal control, and internal audit
functions. In recognition of the trend, a regulatory cooperation and
information- sharing model agreement was approved in March 2000 between OTS
and NAIC, with 22 states and the District of Columbia having signed as of
August 23, 2000. The remaining states are expected to sign similar
agreements. The only complication that has arisen involves a couple of
states with statutes barring sharing of confidential information. We also
found this problem in our work on the insurance regulators' readiness for
the year 2000. 24
OTS officials also explained that in the future, areas needing attention
with the insurance industry will include (1) sharing of information to guard
against the migration of undesirable persons between banking and insurance;
(2) ensuring that key officials of insurance company affiliates have had
appropriate background checks, as now required for key officials of the
affiliated thrift; (3) understanding the statutory framework for insurance
in the 50 states; (4) understanding the similarities and/ or gaps between
insurance and thrift regulation in areas such as shifting of assets, cross-
affiliate activity, employees holding dual jobs, and use of outside
directors on boards of directors and committees; (5) ensuring clear
disclosure of which products are insured- a special challenge with the
growth of Internet marketing of products; and (6) cross- training of
examiners to better understand the extent to which regulators can rely upon
each others' work.
24 Year 2000: Insurance Regulators Have Accelerated Oversight, but Some Gaps
Remain (GAO/ GGD00- 42, Dec. 20, 1999).
B- 284347 Page 45 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
In December 1999, NAIC noted in a letter to federal regulators that mutual
consultation and close cooperation would be essential to achieving the goals
and requirements of the GLB Act. In particular, a need for federalstate
interaction was noted for reviewing mergers and changes in management
control; consultation when regulators contemplate actions affecting
insurers; developing and administering effective consumer rules dealing with
insurance sales practices, customer complaints, and personal privacy; and
sharing regulatory information and examination findings. In March 2000, NAIC
established a series of working groups to implement requirements of the GLB
Act and set regulatory priorities. In the area of regulatory coordination,
working groups will (1) explore all aspects of coordinating with federal
regulators; (2) make recommendations regarding the analysis, examination,
and review of holding companies; and (3) explore options for increased
regulatory uniformity within a state- based system to achieve efficiencies.
The GLB Act does not address all existing gaps or weaknesses in regulatory
coordination. Beyond the efforts toward resolving database access issues to
enhance fraud prevention as previously discussed, the Frankel case
demonstrates, in part, a need for improved coordination between the
securities and insurance regulators, even when there is no known affiliation
between insurance and securities entities. In the Frankel case, had
insurance regulators routinely coordinated with either state or federal
securities regulators, the scam may have been detected much earlier.
The GLB Act focuses on holding company structures and bank activities; it is
silent on the need for coordination between insurance and securities
regulators. However, both NAIC and SEC have stated a desire to improve their
coordination since the passage of the financial modernization legislation.
SEC officials pointed out that prior to the GLB Act, SEC and insurance
regulators had a mutual interest in variable annuity products created by
insurance companies that were also deemed securities products by the courts.
25 Broker- dealers also often sell these products.
SEC also has a regulatory interest in material insurance affiliates of
broker- dealers and in how financial and solvency issues of the insurance
affiliate could affect the broker- dealer. These affiliations were allowed
before passage of the GLB Act. NAIC has established a working group on
holding companies to identify, in part, the insurance information needs of
25 Securities and Exchange Commission v. Variable Annuity Life Insurance Co.
of America, 359 U. S. 65 (1959). SEC and NAIC Have
Indicated a Need to Improve Regulatory Coordination
B- 284347 Page 46 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
functional regulators, such as SEC. In addition, as illustrated by the
Frankel case, sharing disciplinary information could reduce the movement of
undesirables from one industry to another. NAIC officials have told us that
the current level of coordination does not extend to all areas of current
regulatory concern. At this time, we are unaware of specific, direct
regulatory coordination between the SEC and insurance regulators beyond the
narrow issues related to annuities, or any substantive discussions on
mechanisms for improved sharing of regulatory information between insurance
and securities regulators.
Insurance companies in several states lost in excess of $200 million through
an investment scam. A fundamental aspect of the scam was the concealment of
a secret affiliation alleged to exist between entities in the insurance and
securities industries, in which the interests behind the ownership of the
insurers as well as the investment entity controlling the insurers' assets
were one and the same. Other key aspects of the scam that have been alleged
included the use of aliases, fraudulent paperwork and reporting, and
assistance by other individuals or entities serving as fronts. The scope and
duration of this scam indicates that a number of people and entities either
participated in the scam or neglected their legal, fiduciary, or contractual
duties. The role of Mr. Frankel and others is presently the subject of a
federal criminal investigation as well as other state criminal and civil
actions. Taxpayers will ultimately bear much of the losses resulting from
the scandal, as well as policyholders who are not fully covered by their own
states' insurance guarantee programs.
Insurance regulators were not prepared to prevent or detect a scam allegedly
perpetrated among several insurers for nearly 8 years by a rogue broker who
had migrated into the insurance industry. Although routine regulatory
monitoring and examination activities are not designed to proactively look
for fraud, there is a regulatory responsibility to be alert for fraud.
Additionally, mechanisms should be in place that are designed to detect
possible fraud- so called “red flags” that trigger additional
regulatory scrutiny. In the scam allegedly carried out by Mr. Frankel, these
red flags included peculiarities with the trust, inconsistencies in
regulatory data related to asset custody and control, and the unusual
investment activities being reported by insurers. Given these unusual
activities and circumstances, even though they were not specifically
contrary to law or regulation, insurance regulators could have reacted to
the warning signals by judiciously asking additional questions. In a number
of circumstances, those questions could have unraveled the scam. Clearly, in
this particular case, there was a lack of professional skepticism.
Conclusions
B- 284347 Page 47 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Compounding the difficulties in uncovering the scam were inadequate
regulatory tools, policies, procedures, and practices. In addition,
longstanding information- sharing issues among federal and state financial
services regulators further exacerbated the negative impacts of the scam.
Most of the regulatory oversight weaknesses were related to insufficient
means for conducting background checks and measures to safeguard and verify
the insurers' invested assets. In addition, state insurance regulators
apparently did not have or seek sufficient expertise in the area of
securities and investments to adequately scrutinize the unusual investment
activities being reported to them by the Thunor Trust insurers. Similarly,
the most significant information- sharing weakness observed was the
inability or failure of insurance regulators to access regulatory
information available from the securities industry. At each phase in the
oversight process, insurance regulators would have benefited from
information available through local state securities regulators to further
validate the business transactions between the insurance companies and other
individuals and entities. Accessing this information was neither suggested
nor required, either by the policies and procedures of insurance departments
or those of NAIC.
Currently, regulators generally do not routinely conduct regulatory
background checks on individuals trying to enter the business of insurance.
Additionally, most state insurance commissioners do not have the means to
fulfill their responsibilities under a federal insurance fraud prevention
provision to prevent certain convicted felons from engaging in the business
of insurance. In this case, a regulatory review and inquiry of the
individuals associated with Thunor Trust could have helped unravel the scam
at the outset. Furthermore, the safeguards and methods used by state
regulators to protect insurers' assets held by a broker- dealer did not
accomplish their purpose. Adoption and enforcement of a model law and
regulation developed by NAIC that identifies asset custodial requirements
would have been one way to strengthen safeguards on the insurers' assets. In
addition, the asset verification procedures used by regulators during
examinations, generally performed once every 3 to 5 years, failed to work.
Limited or nonexistent information- sharing within the insurance industry
and with securities regulators delayed detection of the investment scam for
years. Additionally, the lack of information- sharing among state insurance
regulators hindered efforts that might have prevented the scam from
spreading to other states. Once concerns arose from examinations on insurers
under Thunor Trust, such concerns were not proactively shared with other
state insurance regulators to help prevent the scam from expanding. Had
concerns over the possible affiliation between LNS and
B- 284347 Page 48 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
the Thunor Trust insurers been shared with other state regulators in early
February 1999, subsequent deals, resulting in the theft of $50 million from
insurers in two other states, may have been averted. Although tools exist to
facilitate proactive alerts, some regulators have been reluctant to share
concerns with their counterparts in other states, citing liability or
regulatory implications and the possibility that such information- sharing
could further harm the insurer if other states restrict its activities. In
this case, we believe that regulators confronted with the possibility of a
fraud and/ or an affiliation between the Thunor Trust insurers and LNS were
presented with clear justification for immediately sharing this information
with the other states.
In the aftermath of the scandal, we have observed a desire by the states and
NAIC to address both the known inadequacies associated with the scandal as
well as other areas of vulnerability. Although the corrective actions
proposed to date are commendable, success in implementing them will require
continued commitment by NAIC and the states, as some are expected to take
several years to implement. Insurance regulators will need to apply the
lessons learned from this scandal to resolve existing regulatory weaknesses
and effectively coordinate with their banking and securities counterparts as
we enter a new environment where the blurring of historical differences in
the financial sectors continues.
We believe that it is too early to fully assess regulatory oversight
coordination efforts emanating from the GLB Act. However, it is clear that
federal and state regulators recognize the need to improve coordination as
they begin implementing the financial services modernization legislation.
Insurance regulators' future fraud prevention efforts will depend on the
sharing of regulatory data between themselves and the banking and securities
industries. Privacy and data security are legitimate concerns that will need
to be addressed as information- sharing mechanisms are developed.
Additionally, enhancements for safeguarding and independently verifying
insurers' assets need to be addressed as affiliations between insurers,
banks, and securities firms become more prevalent in the future. Regulators
in the banking and insurance industries are taking steps to formalize the
coordination mechanisms through memos of understanding and the establishment
of interagency working groups.
We also believe SEC and NAIC are correct in their stated need to improve
their coordination. However, beyond the narrow issue of variable annuities,
we are unaware of any concrete actions or plans for actions to strengthen
coordination. Although the GLB Act does not specifically address
coordination efforts between insurance and securities regulators,
B- 284347 Page 49 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
we believe that such coordination efforts will become increasingly important
as the lines distinguishing the offerings of different financial sectors
continue to blur. Moreover, the movement of undesirables from one industry
to another would be more easily controlled with better sharing of
disciplinary information. Overall, as illustrated by the Frankel case, each
of the financial regulators need to consider regulatory data from other
financial sectors to properly oversee the business relationships and
transactions between institutions in different financial sectors.
We recommend that state insurance commissioners:
� develop and adopt the appropriate mechanisms to adequately safeguard and
verify insurer assets that are not in the physical possession of the
insurance company, including requirements for ensuring the appropriateness
of asset custodians;
� improve information- sharing by
� developing mechanisms for routinely obtaining regulatory data from
individuals and firms from other financial services regulators, and
� implementing policies and procedures for proactively sharing regulatory
concerns with other state insurance departments; and
� increase the level of securities expertise available to their departments'
staff and ensure that insurance analysts and examiners have appropriate
training, tools, and procedures to analyze securities assets and to
recognize unusual investment strategies.
We recommend that the President of NAIC:
� ensure that the corrective actions identified by the Ad Hoc Task Force on
Solvency and Anti- Fraud are implemented as quickly and fully as possible,
in particular those that NAIC can accomplish unilaterally;
� ensure that the accreditation program requires the states to have adequate
controls for safeguarding and verifying assets that are not in the physical
possession of the insurer and to have access to securities- related
expertise; and
� supplement existing guidance in the financial analysis and examiner
handbooks reinforcing the importance of reviewers exercising an
Recommendations to
Regulators
B- 284347 Page 50 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
appropriate level of professional skepticism and due professional care when
indicators of fraud or other irregularities surface.
We recommend that the Chairman of SEC and the President of NAIC:
� increase the attention given to the development of more routine processes
and procedures for sharing and communicating information to address common
regulatory oversight matters, including efforts to help prevent the
migration of rogues between the securities and insurance industries. .
We recommend that the United States Attorney General, the President of NAIC,
and state insurance commissioners:
� work together to establish a mechanism by which state regulators can
perform criminal background checks on individuals for the purpose of meeting
insurance regulators' responsibilities under the federal insurance fraud
prevention provision, 18 U. S. C. sect. 1033.
In order to encourage and monitor progress by insurance regulators, Congress
may want to consider requesting that NAIC periodically report on the status
of corrective actions recommended in this report and by NAIC's Ad Hoc Task
Force on Solvency and Anti- Fraud, including a discussion of
� states' adoption of appropriate laws, regulations, and processes to
safeguard and verify insurer's assets that are not in the physical
possession of the insurer;
� regulators' ability to access criminal history data to meet the
requirements of federal insurance fraud prevention requirements, as
identified in 18 U. S. C. sect. 1033; and insurer;
� efforts and agreements between insurance regulators and banking and
securities regulators to oversee insurance- related entities of affiliated
financial institutions, including methods for safeguarding and verifying
insurer assets held by an affiliated institution and mechanisms to access
individual disciplinary data from other financial services regulators.
We requested comments on a draft of the report from the Insurance
Commissioners of Tennessee, Mississippi, Missouri, Oklahoma, and Arkansas;
NAIC; the Tennessee Comptroller of the Treasury; the Federal Reserve; OCC;
OTS; SEC; NASDR; and the Department of Justice. All of the agencies chose to
respond orally. These oral comments were Matter for
Congressional Consideration
Agency Comments
B- 284347 Page 51 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
approved by commissioners of the state insurance departments; the President
of the NAIC; the Director of State Audit, Tennessee Comptroller of the
Treasury; an Associate Director and other senior officials of the Division
of Bank Supervision and Regulation of the Federal Reserve, the Comptroller
of the Currency, the Director of the Office of Thrift Supervision; the
Assistant Chief Counsel of the Division of Market Regulation of SEC, an
Associate Vice President, Enforcement Department of the NASDR; the
Supervisory Assistant U. S. Attorney in Connecticut; the Deputy Chief of the
Fraud Section, Criminal Division of the Department of Justice; and a
Supervisory Special Agent of the Economics Crimes Unit, Financial Crimes
Section, Criminal Investigative Division of the FBI.
The agencies commenting on our draft report responded orally that they
generally concurred with the report's findings, conclusions, and
recommendations or had no comments on the report. Officials from some
agencies also provided technical suggestions that we incorporated where
appropriate. Additionally, NAIC and SEC commented on implementation issues
associated with our recommendation to them on enhancing coordination and
information- sharing. NAIC emphasized its desire to enhance communications
and information- sharing between insurance regulators and SEC and provided
us with a recent letter sent by the President of NAIC to the Chairman of SEC
requesting future discussions on information- sharing issues. SEC officials
agreed with the need to maintain open lines of communication, but they
specifically mentioned that, by statute, they could not use disciplinary
information from insurance regulators in determining eligibility to license
brokers. NAIC officials also noted that regulatory information- sharing
could be facilitated with federal legislation allowing for and protecting
the confidentiality of informationsharing between federal agencies, state
regulators, and NAIC.
We are providing copies of this report to the President and 55 state and
other governmental entities who are members of NAIC; the Honorable Arthur
Hayes Jr., Director of State Audit, Tennessee Comptroller of the Treasury;
the Honorable Alan Greenspan, Chairman of the Board of Governors of the
Federal Reserve System; the Honorable John D. Hawke, Jr., Comptroller of the
Currency; the Honorable Ellen Seidman, Director of the Office of Thrift
Supervision; the Honorable Arthur Levitt, Chairman of the Securities and
Exchange Commission; the Honorable Mary L. Schapiro, President of the NASD
Regulation Inc.; the Honorable Janet Reno, Attorney General; and other
interested parties. We will also make copies available to others on request.
B- 284347 Page 52 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
If you or your staff have any questions regarding this report, please
contact me at (202) 512- 8678 or Lawrence D. Cluff at (202) 512- 8678. Key
contributors to this report are acknowledged in appendix V.
Sincerely yours, Thomas J. McCool Director, Financial Institutions
and Markets Issues
Page 53 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Page 54 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Contents 1 Letter 56 Appendix I Selected Observations from Prior GAO
Insurance and Securities- Related Reports
60 Appendix II Summary of Key Events Associated With the Scam Allegedly
Perpetrated by Martin Frankel
64 Appendix III NAIC's Model Law and Regulation Related to Insurer Asset
Custodial Requirements
66 Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Contents Page 55 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix V GAO Contacts and Staff Acknowledgments
73 Table 1: Overview of Regulatory Weaknesses 16 Table 2: Summary of Asset
Turnover Ratios 24 Table I. 1: Selected Observations from GAO Insurance and
Securities- Related Reports 57
Table II. 1: Summary of Key Events 60 Tables
Figure 1: Overview of the Scandal 9 Figure 2: Simplified Structure of the
Thurnor Trust
Insurance Companies 12 Figures
Abbreviations
CPA Certified Public Accountant CRD Central Registration Depository FBI
Federal Bureau of Investigation FDIC Federal Deposit Insurance Corporation
IRIS Insurance Regulatory Information System LNS Liberty National Securities
MOU memorandum of understanding NAIC National Association of Insurance
Commissioners NASDR National Association of Securities Dealers Regulation
OCC Office of the Comptroller of the Currency OTS Office of Thrift
Supervision RIRS Regulatory Information Retrieval System SAD Special
Activities Database SEC Securities and Exchange Commission
Appendix I Selected Observations from Prior GAO Insurance and Securities-
Related Reports
Page 56 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
During the 1980s, the number and size of property/ casualty insurance
failures and the number of insurers in danger of failure increased. In
addition, in the early 1990s, several large life insurance companies failed.
At the request of Congress, GAO began a series of reviews of the statebased
system of monitoring insurer solvency and dealing with insurer failures.
These reviews also included an assessment of the capability of NAIC to
create and maintain an effective national system of solvency regulation.
As a result of these reviews, GAO found a number of weaknesses with state-
based insurance regulation and NAIC's ability to both effectively monitor
the essential functions of state insurance departments and establish a
national system of uniform insurance regulation. At least some of these
weaknesses remain. For example, the lack of interstate coordination and
information- sharing about problem insurers is a regulatory oversight
weakness that, in part, allowed the Frankel scheme to go undetected for many
years.
In addition to the insurance- related reviews, some prior GAO observations
of problems in the securities industry are relevant to the Frankel matter.
Specifically, a persistent weakness observed is the difficulty for
regulators to prevent the migration of unscrupulous brokers between the
securities industry and other financial services industries.
Table I. 1 presents selected findings from a range of GAO insurance and
securities- related reports that relate to regulatory weaknesses in the
insurance and securities industries.
Appendix I Selected Observations from Prior GAO Insurance and Securities-
Related Reports
Page 57 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Insurance Regulation: Problems in the State Monitoring of Property/ Casualty
Insurer Solvency (GAO/ GGD- 89- 129, Sept. 1989)
-Time lags in reviewing annual financial data A company can have a problem
for more than a year before a state regulator is aware of it.
-Time lags in field examinations Most states require field examinations only
once every 3 to 5 years (a few states have no statutory requirement), and
such examinations can take months and sometimes years to complete.
-NAIC's warning system is of varied usefulness to states Officials in four
of the five states GAO visited generally regarded NAIC's IRIS ratios and
examiner team reports as of limited usefulness when compared to their own
work in annual statement analysis.
-The need for interstate coordination Although NAIC prescribes in its
Financial Regulation Standards that a state that identifies a financially
troubled insurer should notify other jurisdictions in which the insurers
does business, in practice, states will leave the primary responsibility for
solvency monitoring to the state in which a company is located.
-States vary in the amount of information they will share about problem
insurers State regulators are divided in their policy on information-
sharing between a desire to keep other departments informed and a concern
that doing so may harm efforts to rehabilitate insurers.
-NAIC has had limited success in bringing states together The extent to
which states are willing or able to use the coordination opportunities (such
as participation in committees, subcommittees, task forces, and working
groups) provided by NAIC varied.
Insurance Regulation: State Reinsurance Oversight Increased, but Problems
Remain (GAO/ GGD- 90- 82, May 1990)
-Reinsurance data limitations affect regulatory review Primary insurers
assuming reinsurance combine primary insurance and reinsurance financial
data in their annual statements. These aggregate data have not been detailed
enough to reflect reinsurance activity and its impact on an insurer's
financial condition.
Insurance Regulation: Assessment of the National Association of Insurance
Commissioners (GAO/ T- GGD- 91- 37, May 22, 1991)
-Limits to NAIC's authority NAIC cannot surmount the fundamental barriers to
its long- term effectiveness as a regulator because NAIC lacks authority to
enforce its accreditation standards.
Table I. 1: Selected Observations from GAO Insurance and Securities- Related
Reports
Appendix I Selected Observations from Prior GAO Insurance and Securities-
Related Reports
Page 58 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Insurance Regulation: The Failures of Four Large Life Insurers (GAO/ T- GGD-
92- 13, February 18, 1992)
-Regulators' information was neither timely, complete, nor accurate (1)
Financial statements filed in accordance with statutory accounting practices
did not fairly reflect the four insurers' true financial condition. (2) An
insurance holding company is not required to file consolidated financial
statements based on statutory insurance accounting. (3) Regulators relied on
infrequent field examinations to verify financial data reported by the
insurers. Such examinations were done about once every 3 years and took
months or even years to complete. (4) Regulators did not get financial
information early enough to identify and react to the rapid deterioration in
these companies. (5) States did not keep one another informed about solvency
problems, despite their interdependence in monitoring the troubled insurers.
-Holding companies are a regulatory blind spot Regulators cannot effectively
assess interaffiliate transactions if the insurer fails to report either the
identity of its affiliates or the transactions. Except for infrequent field
examinations, regulators have no way to verify the insurer's reported
information. Interaffiliate transactions can mask an insurer's true
condition, and improper transactions with affiliates have caused previous
life insurer failures. In addition, an insurance holding company is not
required to file consolidated financial statements based on statutory
insurance accounting.
Insurance Regulation: The Financial Regulation Standards and Accreditation
Program of the National Association of Insurance Commissioners (GAO/ T- GGD-
92- 27, April 9, 1992)
-Weaknesses observed in NAIC's accreditation program The accreditation
program experienced three problems: (1) the financial regulation standards
were for the most part general and have been interpreted permissively; (2)
the program has too little focus on a state insurance department's
implementation of its regulatory authorities, that is, how well the state
does its job; and (3) the NAIC review teams' documentation of their
accreditation decisions has not consistently supported their compliance
decisions.
Insurer Failures: Regulators Failed to Respond in Timely and Forceful Manner
in Four Large Life Insurer Failures (GAO/ T- GGD92- 43, September 9, 1992)
-Regulator's information was not timely, complete, or accurate The
infrequency with which on- site examinations are done, even for companies
known to be experiencing difficulty, significantly impairs the regulator's
ability to evaluate financial condition and act on adverse findings.
Insurance Regulation: The National Association of Insurance Commissioners'
Accreditation Program Continues to Exhibit Fundamental Problems (GAO/ T-
GGD- 93- 26, June 9, 1993)
-Weaknesses observed in NAIC's accreditation program Lack of Focus on
Performance Allows States With Weak Examination Quality to be Accredited
Appendix I Selected Observations from Prior GAO Insurance and Securities-
Related Reports
Page 59 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Securities Markets: Actions Needed to Better Protect Investors Against
Unscrupulous Brokers (GAO/ GGD- 94- 208, Sept. 1994)
-Potential exists for the migration of undesirable persons to other sectors
of the financial services industry GAO analyzed the records of 96
unscrupulous brokers who had left the securities industry and found that 3
of these brokers had migrated to the insurance industry. In addition,
existing broker surveillance systems could be improved by enhancing the
reporting of disciplinary actions and information on customer complaints
into the CRD.
Insurance Regulation: Chronology of F. T. Riley's Activities and Related
Regulatory Actions (GAO/ OSI- 95- 5, Oct. 1994)
-Increased regulatory scrutiny can create incentives for insurers to
redomesticate to another state States with statutes prohibiting fraud are
reluctant to investigate and prosecute insurance fraud cases because of
budget and jurisdictional problems. By taking advantage of this environment,
Mr. Riley and his related companies have continued to operate in a
questionable manner by moving from state to state. Mr. Riley's practice was
to locate an insurance company in one state but sell insurance in another
state. He then claimed exemption from home state regulation on the grounds
that he was a foreign insurer (an out- of- state insurer) and was not doing
the business of insurance in the state of domicile. Further, when a state of
domicile strengthened its laws, Mr. Riley moved the company to another state
with weaker regulations.
Insurance Regulation: Observations on the Receivership of Monarch Life
Insurance Company (GAO/ GGD- 95- 95, Mar. 1995)
-Interaffiliate transactions were a regulatory blind spot State regulators
did not regulate either the parent holding companies or the noninsurance
affiliates and subsidiaries of the failed insurers.
SEC Enforcement: Responses to GAO and SEC Recommendations Related to
Microcap Stock Fraud (GAO/ GGD- 98- 204, Sept. 30, 1998)
-Actions on the migration of unscrupulous brokers is not complete No record
exists of the movement of unscrupulous securities brokers.
Year 2000: Insurance Regulators Have Accelerated Oversight, but Some Gaps
Remain (GAO/ GGD- 00- 42, Dec. 1999)
-Limitations in the sharing of information among insurance regulators State
regulators have restrictions on sharing examination- related information
with other state regulators.
Appendix II Summary of Key Events Associated With the Scam Allegedly
Perpetrated by Martin Frankel
Page 60 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
An abbreviated chronology of key events is described in Table II. 1 below.
Some details have been left out to simplify what is in reality a much more
complicated story. Other details are left out for sensitivity reasons.
Readers should also keep in mind that ongoing criminal and civil cases are
likely to provide additional details at a later date.
1985- 1988 Martin Frankel works in the securities industry as a registered
representative. He is fired from two brokerdealers located in Ohio and
Illinois.
December 1989 SEC begins a formal investigation of Frankel. August 1991
Liberty National Securities, a small broker- dealer in Ohio, registers in
Tennessee. August 1991 SEC files a civil complaint alleging that from June
1987 to April 1988 Frankel raised over $1 million through
offer and sale of limited partnerships in the Frankel Fund. Frankel then
made omissions and misstatements about the use of proceeds from investors,
Frankel's background and experience, and the Frankel Fund performance.
September 1991 Frankel allegedly arranges the formation of Thunor Trust
using three nominee grantors. The Tennessee State Department of Insurance
receives the Form A filing and later approves the Thunor Trust's acquisition
of Franklin American Corporation and its subsidiary company Franklin
American Life Insurance Company.
August 1992 Frankel settles with SEC consenting to a bar from the securities
industry and disgorgement of funds. March 1, 1993 The Tennessee State
Department of Insurance receives Franklin American Life Insurance Company's
December 31, 1992, annual financial statement. The statement shows that (1)
the value of Franklin American's U. S. government securities increased 28%
from the prior year's end, and (2) Franklin American's entire portfolio of
these securities “turned over” 17 times during the year. The CPA
firm issued a clean opinion.
April 1993 Liberty National Securities moves from Toledo, OH to Dundee, MI.
June 1993 The Tennessee State Department of Insurance begins an examination
of Franklin American Life as of
December 31, 1992. The examination report is issued April 1994 with no
adverse material findings. February 1994 Family Guaranty Life Insurance
Company domiciled in Mississippi is purchased by an affiliate of Thunor
Trust. February 25, 1994 The Tennessee Department of Insurance receives
Franklin American Life Insurance Company's year- end
1993 annual financial statement showing that (1) the value of Franklin
American's securities portfolio increased by 53% from the prior year's end,
and (2) Franklin American's entire portfolio of securities “turned
over” 40 times during the year.
March 1994 Farmers and Ranchers Life Insurance Company domiciled in Oklahoma
is purchased by an affiliate of Thunor Trust.
August 1994 International Financial Services Life Insurance Company
domiciled in Missouri is purchased by an affiliate of Thunor Trust.
Table II. 1: Summary of Key Events
Appendix II Summary of Key Events Associated With the Scam Allegedly
Perpetrated by Martin Frankel
Page 61 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
February 25, 1995 The Tennessee Department of Insurance receives Franklin
American Life's year- end 1994 financial statement showing that (1) the
value of Franklin American's securities portfolio increased by 3% from the
prior year's end, and (2) Franklin American Life's entire portfolio of
securities “turned over” 172 times during the year.
March 1995 Family Protective Life Insurance Company domiciled in Mississippi
is acquired by an affiliate of Thunor Trust. February 29, 1996 The Tennessee
Department of Insurance receives Franklin American's year- end 1995 annual
financial
statements. They show that (1) the company's securities were “held by
broker in street name” in violation of Tennessee custody regulations,
(2) the value of Franklin American's securities portfolio increased by 14%
from the prior year's end, and (3) Franklin American's entire portfolio of
securities “turned over” 245 times during the year.
April 25, 1996 A routine exam completed of Farmers and Ranchers (Oklahoma)
with an “as of” date of December 31, 1994. There are no material
adverse findings.
September 25, 1996 A target examination is conducted of Franklin American
Life Insurance Company's securities investments by Tennessee State Insurance
Department because of concerns that Franklin might be engaged in
“shortselling” its government securities, i. e., selling a
security before it is actually owned. After a 1- day on- site review, staff
members conclude the company is not short- selling but recommend that a
securities expert be retained to examine Franklin American's securities
investments.
February 26, 1997 The Tennessee State Insurance Department receives Franklin
American's year- end 1996 annual financial statement. This statement
indicated the value of Franklin's securities portfolio increased by 19% from
the prior year's end and that the portfolio of securities turned over 167
times during the year.
May 1997 Missouri's routine exam of International Services Life is made
public and has an “as of' date of December 31, 1995. There are no
material adverse findings in the exam report.
January 1998 Mississippi State examiners begin a routine exam of both Family
Protective Life Insurance Company and Family Guarantee Life Insurance
Company with an “as of date” December 31, 1997. During this
exam, examiners were aware the securities were with a broker and that this
did not violate state law. They also had trouble confirming the relationship
of the broker, Liberty National Securities of NY, and confirming that the
broker had the securities in its possession. By fall 1998, Mississippi
officials had a draft report saying that FAC was not reporting the ultimate
controlling person. This exam continues until January 29, 1999.
February 1998 First National Life Insurance Company domiciled in Alabama is
purchased by an affiliate of Thunor Trust. March- May, 1998 Thunor Trust
officials and representatives meet with Alabama Insurance officials to
advise that they intend to
terminate the existing custodial agreement with a bank holding the
marketable securities and transfer them to a brokerage with a national
reputation. Alabama regulators deny the request because broker- dealers are
not permitted to be custodians under Alabama law. Two years later Alabama
regulators learn that nearly $100 million was removed from the bank
custodian anyway and in violation of the custodial agreement that required
regulatory approval for withdrawals.
May 11, 1998 Oklahoma completes its second routine exam of Farmers and
Ranchers since purchase by Thunor Trust with “as of” date of
December 31, 1997. There are no material adverse findings.
September 1998 An independent contractor for the Tennessee Insurance
Department begins his examination of Franklin American Life Insurance
Company with an “as of” date of December 31, 1997.
September 29- 30, 1998 First National redomesticates in Mississippi from
Alabama.
Appendix II Summary of Key Events Associated With the Scam Allegedly
Perpetrated by Martin Frankel
Page 62 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
October 1998 The St. Francis of Assisi Foundation, another investment
vehicle allegedly controlled by Frankel, files a Form A application with the
Colorado Division of Insurance to purchase an insurance company. The
Colorado Division of Insurance advises the foundation that the Form A filing
is incomplete and requests additional information. A purchase is never
approved.
Late 1998 The Tennessee examination reveals that the insurer was placing
nearly all of its assets with Liberty National Securities, apparently in
violation of state rules that require assets to be held by a bank custodian.
Tennessee insurance regulators issue an order requiring the insurer to
retrieve its investment assets and put them in a bank. Franklin American
Life Insurance Company's securities are, for the first time, placed in a
qualifying banking institution, effective December 31, 1998. However, soon
into the next year, the assets are removed again.
January 14, 1999 A Thunor Trust affiliate files a Form A application to
purchase Old Southwest Life Insurance Company domiciled in Arkansas.
Arkansas regulators approve the purchase in February 1999.
January 1999 The contract examiner for the Tennessee Insurance Department
has problems getting custodial information on the bonds held by Liberty
National and reference material on Liberty National. Tennessee regulators
meet with officials under the Thunor Trust umbrella to discuss concerns
about the lack of public information on Liberty National, the bond trading
strategy's apparent lack of logic, why brokerage fees are so low, bond
custodial issues under Tennessee law, and other matters. Afterward, the
Tennessee contract examiner obtains information on Liberty National from
Tennessee securities regulators that shows geographic location and firm size
inconsistencies with material received from the Thunor Trust affiliates.
January 29, 1999 Mississippi examiners have their closeout conference with
Thunor Trust representatives. They also receive the information obtained
from the Tennessee securities regulators showing the inconsistencies about
Liberty National's location and size. The examiners tell the Thunor Trust
representatives they are taking their concerns about asset verification and
Liberty National's affiliation to their superiors.
February 1, 1999 The Tennessee contract examiner sends a memo to the
Insurance Department Chief Examiner noting the possibility that the
Tennessee insurance company has been looted of its assets. He notes that
fraud would explain some otherwise unexplainable information, including (1)
the grantors giving the sole trustee irrevocable control over millions with
no contractual assurance that it be returned to the grantors or their
beneficiaries; (2) use of a little known brokerage firm for massive bond
transactions; and (3) the expertise/ secretive process, which permits the
Tennessee insurance company to consistently record exceptional gains on bond
trades but prevents the bonds from being under a custodial arrangement with
a bank or trust company.
February 8, 1999 Tennessee State Department of Insurance officials grant a
60- day grace period to the Tennessee insurance affiliate of Thunor Trust to
move its securities to a Tennessee bank. Liberty National Securities now has
until April 1999 to return the assets.
February 23, 1999 Mississippi insurance officials talk to representatives of
the Thunor Trust Tennessee affiliate by phone and once again are told that
Liberty National Securities is not an affiliated entity of Thunor Trust.
February 25, 1999 Old Southwest Life Insurance Company, domiciled in
Arkansas, is approved for purchase by an affiliate of Thunor Trust.
February- April 1999 Mississippi regulators send questions to the
appropriate affiliates of Thunor Trust about their concerns and later
receive written answers. Copies of the questions are also sent to Tennessee
regulators.
Early April 1999 The Thunor Trust affiliate, First National Life, domiciled
in Mississippi, enters into an approximately $44 million reinsurance
agreement with Settlers Life Insurance Company domiciled in Virginia.
Appendix II Summary of Key Events Associated With the Scam Allegedly
Perpetrated by Martin Frankel
Page 63 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
April 28, 1999 Meeting in a Jackson, MS hotel reportedly attended by Frankel
and others to discuss the meeting the next day with Mississippi regulators.
April 29, 1999 Mississippi regulators decide to place all three Mississippi
companies under administrative supervision after the meeting between the
Mississippi Department of Insurance and insurance company officials of the
Mississippi domiciled companies.
May 3, 1999 Mississippi regulators go to Franklin American to take control
of the Mississippi companies. May 4, 1999 First time Mississippi regulators
look at documents belonging to First National Life Insurance Company of
America. May 5, 1999 Greenwich, CT police and firefighters responded to the
burning of Frankel's $3 million estate. May 7, 1999 Sole trustee of Thunor
Trust signs affidavits acknowledging that the whereabouts of the money
belonging to
the insurance companies under the trust was unknown. Mississippi insurance
officials contact the FBI. May 8, 1999 Mississippi regulators meet with Mr.
Heath of Leuty & Heath, the CPA firm for the Frankel companies. Heath
kept very few records. Mssrs. Leuty and Heath were the only CPAs in the
firm. The Frankel companies were apparently the primary clients.
May 10, 1999 Mississippi regulators place three Mississippi companies into
receivership. May 11, 1999 The Tennessee Department of Commerce and
Insurance confirms its request that Franklin American Life
Insurance Company place $57.5 million of its assets into a Tennessee bank,
and the money is transferred. The Arkansas, Alabama, Oklahoma, and Virginia
regulators first become aware of the apparent fraud.
September 4, 1999 Frankel is taken into custody in Hamburg, Germany. October
7, 1999 U. S. Attorney/ Connecticut files criminal indictment alleging
Frankel stole in excess of $200 million in cash
reserves from the insurance companies he controlled anonymously. Following
the theft, the funds were used to purchase cars, real estate, diamonds, and
gold.
December 3, 1999 David Rosse, a bodyguard and associate of Frankel, pleads
guilty to one racketeering conspiracy charge in Federal District Court
(Connecticut).
December 27, 1999 Karen Timmins, an office assistant to Frankel at his
Connecticut mansion, pleads guilty to one count of concealing the laundering
activities of others and failing to report them to authorities.
March 23, 2000 An NAIC committee votes to suspend Tennessee's accreditation
largely because of the Frankel matter. March 27, 2000 Philip Miller pleads
guilty to one count of conspiracy in Federal District Court (Connecticut).
June 2000 Martin Frankel pleads guilty to tax evasion in Germany in
connection with diamonds he purchased and
transported into the country but appeals the sentence.
Appendix III NAIC's Model Law and Regulation Related to Insurer Asset
Custodial Requirements
Page 64 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
In the mid 1990s, NAIC reaffirmed that broker- dealers should not be used as
custodians for insurer assets. 1 In 1993, a working group was appointed to
study the issue of whether or not broker- dealers should serve as custodians
for insurers' assets. After collecting position papers from interested
parties, including those representing broker- dealers, the NAIC working
group expressed concerns over the safeguards present on insurers' assets
should the broker- dealer become insolvent and concluded that safeguards for
insurers' assets with banks and trusts were superior to those of broker-
dealers. Furthermore, the working group noted that additional costs that may
be associated with using banks or trust companies as custodians would not be
significant to most insurers. The working group concluded in 1994 that
NAIC's existing policy to exclude broker- dealers from serving as custodians
of insurer assets be maintained.
NAIC's Model Law No. 295 and Model Regulation No. 298 have not been adopted
in many states, in part, because such adoption is not a requirement for
state accreditation by NAIC. As part of its accreditation program, NAIC
requires that states adopt certain model laws and requirements, or
substantially similar laws and requirements, to receive accreditation. These
accreditation standards do not currently include this particular model law
related to the custody of assets. Although many states have laws related to
asset custody requirements, NAIC officials could not say definitively how
many states allowed institutions other than banks or trust companies to act
as custodians for insurer assets.
During our discussions and reviews of regulatory files at the insurance
departments we visited, we found that Tennessee, Mississippi, Missouri, and
Oklahoma allowed a broker- dealer entity, LNS, to maintain the custody of
insurers' assets, contrary to NAIC's model law and regulation. One of these
states, Tennessee, had adopted the use of NAIC's model custody agreement,
but it did not enforce the agreement properly between Franklin American Life
and LNS. Instead, Tennessee Insurance Division officials allowed the insurer
to place its assets in the custody of a brokerdealer for years, contrary to
NAIC's model law and regulation that required the insurer to place its
assets in a bank or trust company. Later, the state retrieved approximately
$57 million of insurer assets into an approved account by enforcing state
rules regarding asset custody arrangements, which were based on NAIC's
guidelines.
1 According to NAIC officials, an acceptable trust under the model law could
include a trust company that was a subsidiary to a securities firm.
Appendix III NAIC's Model Law and Regulation Related to Insurer Asset
Custodial Requirements
Page 65 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
One state hindered the alleged investment scam through the enforcement of
its insurance requirements that prohibited broker- dealers from maintaining
custody of an insurer's assets. In 1998, after an insurer domiciled in
Alabama was purchased under Thunor Trust, company officials requested that
insurance regulators allow the insurer to invest its assets with LNS. State
officials denied the request, citing state requirements that an insurer's
assets be maintained in a bank or trust, similar to those recommended in
NAIC's model law. Subsequently, the insurer, First National Life Insurance
Company of America, redomesticated to Mississippi, where a similar
requirement did not exist. Unfortunately, the insurer's assets were stolen
through the bogus LNS operation Frankel allegedly established. The evidence
now suggests that officials connected to Thunor Trust pulled out the assets
of the Alabama insurer prior to the redomestication to Mississippi, in
violation of Alabama's rules and without the Alabama Insurance Department's
knowledge.
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 66 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 67 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 68 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 69 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 70 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 71 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix IV NAIC's Proposed Corrective Actions Emanating From the Frankel
Scandal
Page 72 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Appendix V GAO Contacts and Staff Acknowledgments
Page 73 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Richard J. Hillman, (202) 512- 8678 Lawrence D. Cluff, (202) 512- 8678 In
addition to those named above, James R. Black, Thomas H. Givens III,
Rosemary Healy, Barry A. Kirby, Paul G. Thompson, Karen C. Tremba, and
Desiree W. Whipple made key contributions to this report. GAO Contacts
Acknowledgments
Page 74 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
Page 75 GAO/ GGD- 00- 198 Insurance Regulatory Oversight
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