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Roars on Auditor Liability

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4 Responses

  1. Robert Rhee says:

    This is a very interesting idea, and worth exploration on the academic and policy levels. I would add a couple of technical points.

    First, the analogy to natural “cat” bonds is limited in that natural cats are subject to a degree of risk modeling. There are a number of firms that model these things, and thus the risks are somewhat quantifiable. Even so, due to tax and regulatory restrictions, natural bonds are typically issued offshore, and they constitute a small but growing fraction of the capital that supports natural cat risk. Moreover, it has taken this market over a decade to develop. Other asset classes in securitization (i.e., credit cards, mortgages, etc.) also require a long “gestation” period before they become popular with investors. Thus, the securitization of auditor risk would not be an overnight, clean cut solution even if the tax and regulatory issues are cleared away overnight.

    Second, we still have to answer the question: why would capital market investors invest in the bonds when insurers won’t underwrite the risk? If the answer is that they are given a “premium” return, then would not an equivalent in insurance premium suffice to entice insurers. The yields on junk bonds can exceed the equity cost of capital of many firms, and so securitization, depending on how it is price, can exceed comparable insurance premium rates. If the problem is that capital markets can diffuse the risk to many participants, then we could see a consortium of insurers and reinsurers try to solve the problem as well. In any event, the details of pricing will be a major obstacle. The pricing will be greatly affected by the tax and regulatory restrictions and ambiguities.

    The benefits of diversification and additional capital brought to bear on the risk are great, but there has to be a financial raison d’etre to the scheme. Securitization makes sense because there is a cost of capital advantage. This means that if the insurance industry is flush with capital, as it is now, then traditional insurance might be cheaper than securitization. This was the problem encountered when natural cat bonds were being developed in the 1990s, and the reason why natural bonds were slow to take off. As the market hardens, the advantages of securitization becomes more compelling as securitization is simply another form of capital.

    If the details can be worked out to feasiblity, then this could be a piece of the puzzle in how to allocate auditor risk. May the risks can be layered among insurers, reinsurers and capital markets. There are other alternative risk transfer techniques that can be explored as well, such as an XOL auction with possibility of government involvement. This last possibility was discussed in the aftermath of the 9/11 attacks to address terrorism risk. Speaking of which, we could also see a TRIA type of private-public insurance partnership. Lots to think about.

    Nice blog post, Larry.

  2. Lawrence Cunningham says:

    Rob,

    Thanks very much for such a thoughtful and sophisticated analysis. It is very helpful indeed to anyone interested in the subject.

    I can only add that I would advise the large auditing firms to explore precisely these challenges and questions and let the public know the results.

    It seems important for them to pursue the proposal to feasibility, as well as all other reasonable avenues, before neutral observers, including me, can take credibly their asserted inability to handle their business model without statutory caps on liability for audit failures.

    After all, though this proposal may be complex and difficult, it may be less so than designing and administering a workable statutory standard, method or formula for caps.

    Again, thanks truly, for these powerfully insightful points.

  3. Jim Peterson says:

    As sympathetic as we should all be to the lack of substance in the public debate about the challenge of auditor survivability, all reasonable ideas are welcome and should be aired thoroughly. Welcome as is the idea, however, there are some serious issues with auditor cat bonds — which I discuss in a post today on my own blog — http://www.jamesrpeterson.com. With thanks for the contribution to the debate….

  4. Lawrence Cunningham says:

    Jim,

    Thanks for the reference, to which I’ve offered a comment in turn.

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