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Prudential Insurance Case

The Prudential Insurance Company was involved in the largest life insurance churning scam of the 1980s and early 1990s. At the time, Prudential had weak business controls, and its corporate culture was characterized as ineffective and loose. However, this scandal is rooted in something deeper than a poor control environment. Prudential was a company facing several risks; many company decisions allowed these risks to have a dramatic impact on the company. As a result, its weak control environment came to the forefront, allowing the churning scam to reach its record levels. This case demonstrates the value of identifying and assessing risks in an organization. Further, the case demonstrates how to build control solutions to match the risks. Learning how to manage risks is a valuable skill for business professionals. In fact, the AICPA’s Special Committee on Assurance Services (AICPA 1997), also known as the Elliott Committee, identified risk assessment as one of the emerging assurance services offered by CPAs.

“Let’s get beyond the word ‘insurance.’ Let’s don’t be concerned with what we call a plan. Let’s just look at the end result.” —Prudential Training Video (ABC NewsPrimetime Live 1996)

Prudential Insurance Company of America, whose symbol is the Rock of Gibraltar, assures its customers that “for financial security and peace of mind” they could depend on the Rock (Prudential 1993 Annual Report, 5). For years its advertisements built its “ROCK-SOLID” image (Prudential 1991 Annual Report, 5). Prudential (the Rock) was created around its people, who were committed to a set of core values lauded by management: client focus, winning, trust, and respect for each other. The company was dedicated to “selling the right product, to the right client, in the right way” (Parsons and Engdale 1995, 12–13). Yet for Prudential’s customers, selling the right product in the right way proved to result in something less than “peace of mind.”

The Nicholsons’ Story Keith and Carol Nicholson trusted their financial security to the Rock when they purchased a rather sizable life insurance policy from their Prudential agent. At one point, the policy’s cash value was $103,000 (ABC News Primetime Live 1996). Since Keith suffered from leukemia, this policy was comfort for the unstable times that lay ahead of them. Carol Nicholson needed to know that this money was going to be there. Carol had been known to say that she trusted her Prudential agent as she trusted her pastor. He was going to play a vital role in smoothing a very uncertain future. Therefore, when her agent suggested that she and her husband take out a new life insurance policy on Keith “at no additional cost,” the couple agreed, no questions asked. They just signed the forms, believing that they had brought even more certainty to the unpredictable future. Eventually, Keith succumbed to leukemia. Much to Carol’s surprise, the six figure nest egg that she thought would be awaiting her was now a mere $22,000 (ABC News Primetime Live 1996). Carol’s agent had not been honest when he had Carol and her husband change his life insurance policy. The Nicholsons’ agent had taken advantage of the couple’s trust by having them borrow against their old policy to purchase a new and more expensive policy.1 Without even realizing it, Carol and Keith had signed a blank withdrawal form that allowed their agent to raid the cash value of the old policy to begin to pay for the new policy. Carol Nicholson’s only reaction was a tearful plea of “How could they?”

The Nicholsons’ Problem: A Decade in the Making Prudential is a massive entity whose asset base is equivalent to the economy of Sweden (see Exhibits 1 and 2). In late 1994, Prudential’s primary businesses were life insurance, health care, investments, and property and casualty insurance. 1 Such a tactic is referred to as a “churning,” “financing,” or “refinancing.”

EXHIBIT 1 Top 10 Life/Health Insurers in 1990 Ranked by Assets

Ranking  Company Name    1990 Assets % of Total  (in billions)  Industry 1   Prudential Ins. Co. of America $133.5  8.7 2   Metropolitan Life Ins. Co.   $103.2  6.7 3   Aetna Life Insurance Co.       52.3  3.4 4   Equitable Life Assurance Soc.      50.3  3.3 5   Teachers Ins. & Annuity Assoc.      49.9  3.2 6   New York Life Insurance Co.      39.9  2.6 7   Connecticut General Life Ins. Co.      37.4  2.4 8   John Hancock Mutual Life       33.7  2.2 9   Travelers Insurance Co.       33.0  2.2 10   Northwestern Mutual Ins.       31.4  2.0 Source: Best’s Review, July 1991. Walker, Shenkir, and Hunn 293

EXHIBIT 2 Life Insurers Ranked Based on Premium Income 1990       1990 Premium  1989   1980 Ranking  Company Name   (in billions)   Ranking  Ranking 1   Prudential Ins. Co. of America $ 24.1   1   1 2   Metropolitan Life Ins. Co.       19.5   2   2 3   Aetna Insurance Co.          9.6   3   3 4   New York Life Insurance Co.       7.7   4   6 5   John Hancock Mutual Life         6.8   5   7 6   Principal Mutual Life          6.5   6   9 7   Travelers Insurance Co.         4.9   7   5 8   Lincoln National Life Ins. Co.      4.8   9   20 9   Massachusetts Mutual Life Ins.    4.5   16   13 10   Connecticut General Life Ins. Co. 4.4   22   8 Source: Best’s Review, July 1991.

Of all the different types of insurance being offered by Prudential and its competitors, life insurance was the most lucrative for both the company and its agents. From 1983–1987, Prudential saw record-breaking increases in its sales of life insurance policies (see Exhibit 3), even though the industry saw a decline in sales (see Exhibit 4).Carol and Keith Nicholson were not the only victims of Prudential’s churning scam. Before the end of 1995, over 10.7 million life insurance policyholders had allegedly fallen prey to the scam and a class action lawsuit was soon filed. Additionally, investigations of the nation’s largest life insurer spanned the country, from New Jersey to Florida to Arizona, in an effort to answer the question, “How could they?” In 1996, as part of the Florida Department of Insurance’s investigation of Prudential, a former Prudential Vice-President of Regional Marketing testified regarding sales practices. In part of his testimony, the witness discussed the process of how customers buy life insurance (Florida Department of Insurance 1996b, 29).

WITNESS: They said that their agent sits there, and he says sign there, sign here, sign here, sign here, and I have to trust in the agent. I sign, he turns it over and says sign here, sign here, and sign here. I sign. Most people, even after they signed them, didn’t take them home and read them. That is what it’s like applying for life insurance.

EXHIBIT 3 Prudential’s Total Life Insurance Sales 1982–1987 Year  Total Life Insurance Sales (in millions) 1982  $59,779 1983  65,854 1984  66,645 1985  80,167 1986  87,312 1987  92,654 Source: 1987 Prudential Annual Report. Note that this breakout of life insurance sales numbers is not available for other years.

The Nicholsons were among the many insurance customers who just signed forms as instructed by their agent. According to this ex-Prudential employee, the most prevalent financing scam at Prudential was selling a new policy as “free life insurance” by essentially using the accumulated cash value of an older policy to pay the new, increased premiums. In many cases, the old “whole life” or “universal policy” was replaced with a “term” policy. The former policies build up cash value, whereas “term” policies do not. In some cases, insured persons would increase their total life insurance coverage because they had more overall coverage from the term policy. In his two days of testimony, the confidential witness commented as follows (Florida Department of Insurance 1996a, 53):

I would say financing was minuscule in ‘82, ‘83, ‘84—and then started growing rapidly in ‘85, ‘86, ‘87, ‘88, and then started to level off probably in ‘90, ‘91, ‘92, and then may have gone down a little bit in ‘93, ‘94.

Prudential contended that such practices were never condoned. Under oath, the ex-employee stated otherwise (Florida Department of Insurance 1996a, 13):

WITNESS: That has always been Prudential’s public statement, financing and replacement is bad; not generally in the best interests of the policyholder….At the peak, it was used in at least 30 percent of the cases and probably higher.

EXHIBIT 4 Industry Life Insurance Purchases in the United States (policies and certificates in thousands, amounts in $ millions)           Individual    Group    Total Year  Policies  Amount  Certificates  Amount  Policies  Amount 1960  21,021  $ 59,763  3,734   $ 14,645  24,755  $ 74,408 1965  20,429  90,781  7,007   51,385  27,436  142,166 1970  18,550  129,432  5,219   63,690  23,769  193,122 1975  18,946  194,732  8,146   95,190  27,092  289,922 1980  17,628  389,184  11,379  183,418  29,007  572,602 1981  17,629  484,412  11,923  346,702  29,552  831,114 1982  16,964  587,342  11,930  250,532  28,894  837,874 1983  18,571  754,832  13,450  271,609  32,021  1,026,441 1984  18,407  821,258  14,605  293,521  33,012  1,114,779 1985  17,637  911,666  16,243  319,503  33,880  1,231,169 1986  17,116  934,010  17,507  374,741  34,623  1,308,751 1987  16,455  986,984  16,698  365,529  33,153  1,352,513 1988  15,798  996,006  15,793  410,848  31,591  1,406,854 1989  14,850  1,020,971  15,110  420,707  29,960  1,441,678 1990  14,199  1,069,880  14,592  459,271  28,791  1,529,151 1991  13,583  1,041,706  16,230  573,953  29,813  1,615,659 1992  13,452  1,048,357  14,930  440,143  28,382  1,488,500 1993  13,664  1,101,476  17,574  576,823  31,238  1,678,299 1994  13,894  1,107,448  18,061  549,984  31,955  1,657,432 1995  13,830  1,101,349  18,105  499,024  31,935  1,600,373 1996  12,333  1,118,451  17,575  581,366  29,908  1,699,817 Source: American Council of Life Insurance and LIMRA International. Walker, Shenkir, and Hunn 295

According to a Coopers & Lybrand’s (1994, 5) assessment of Prudential’s controls: Training of field management with respect to supervising sales practices and identifying and dealing with compliance-related issues has been inconsistent at best. As such, managers are not always sure as to what constitutes “good” vs. ‘“bad’” sales practices, are reactive toward compliance issues, and are not held accountable for their own actions or those of their representatives.

Prudential Insurance, like many life insurers during this period (1982–1993), offered a very complex product. Without adequate instruction, many agents felt as if they had been misled about what they were selling. Even so, it should be noted that many Prudential employees were fully aware of the consequences of their actions. The deposed former employee noted that there existed an informal system of training on refinancing policies. The witness told how this manipulative practice was able to spread (Florida Department of Insurance 1996a, 54):

WITNESS: What happens is because there is no formal training of this kind of thing, it passes by word of mouth or by transfer of people. So it doesn’t surprise me that you will find it pop up here or pop up there. Then after these people got to be very successful, they would go to conferences and say, ‘this is how we do it.’ And then it spread countrywide, and my belief is it really got heavy in ‘84 and ‘85 because illustration sold so nicely, too.

The ex-employee remarked that many agents set up booths at the Regional Business Conference in an effort to “illustrate” the art of selling financed insurance (Florida Department of Insurance 1996b, 55). The employee also claimed that, in support of these practices, many agents developed and used their own sales materials, as revealed by testimony on these self-developed materials (Florida Department of Insurance 1996b, 54 and 56):

QUESTION: Typically, would he [management] say anything about it? Would he care?

WITNESS: I don’t know. I’m not sure. But keep in mind that the managers are paid overrides. If there is a piece that appears to be working, they’re not going to stop using it, because it affects their pocketbook.

The former Prudential worker also discussed the monetary consequences of churning (Florida Department of Insurance 1996a, 14–16):

QUESTION: So…this document [a memo] would indicate that the company knew way back in ‘76 that financed insurance was regularly producing unacceptable results?

WITNESS: Correct. And the next question is why it was producing unacceptable results. Did you [Prudential] look into it? Did you [Prudential] ascertain what occurred in the sale that produced unacceptable results? The answer is nothing. The reason that Prudential didn’t care was they were sales driven. Everything was measured off new sales….There was a benefit to the agents, to management, to individuals working for the company, because their bonuses grew dramatically…

If you look at the pay scale of management in 1976, a senior vice president in 1976 probably made $100,000 a year, a lot of money. A senior vice president in the company today probably in the same position might make a million dollars a year. Now inflation has been eating away a lot since 1976, but I don’t think it ate ten times….So there was a financial incentive for the employees, all employees, not just senior people.

The incentive for the salesperson was simply commissions. Characteristically, a large percentage of the premium paid by the consumer in the first year went directly to the agent. That commission shrunk in later years. The ex-employee further elaborated upon this subject in the second day of his testimony (Florida Department of Insurance 1996b, 3 and 49):

WITNESS: Another file you would want to look at is Phoenix West. That was an investigation done last year [1995].…As a result of that investigation there were recommendations with regard to the discipline of many, many people; but if you look at that whole investigation, you will see the attitude of the company toward people who were engaged in wrongful financial insurance transactions over a long period of time, with the knowledge of many people…They merely state that we did it because we made money and we didn’t care….And Phoenix West is just a microcosm of what was really going on in the country.

John Vetter, an insurance representative in the beleaguered Phoenix West Agency, admitted to some questionable sales. In an investigation of the Phoenix West Agency, the Florida Department of Insurance (Parsons and Engdale 1995, 7) documented that: He [Vetter] said your judgment gets clouded out in the field when you are pressured to sell, sell, sell. In response to questions on how he could explain a case where he had rewritten a policy instead of reinstating it when the rewrite resulted in a higher premium for the insured, he responded that it was “pure greed.”   With everyone in Prudential benefiting financially from refinanced life insurance policies, there seemed to be no need to stop, regardless of management’s “official” stance on the issue (Florida Department of Insurance 1996a, 9):

WITNESS: You will probably see that in Prudential all the documents that you see or the bulk of the documents you see will be very good on their face, they’ll say “you shall not do this.” The problem was that there was nothing behind “you shall not do this.” There was no mechanism to punish. In fact, I don’t believe you’ll find a single termination of an agent or member of management for financing insurance outside of Cedar Rapids and a couple of other districts in the 80s.    The ex-employee felt not only that churning was condoned by management, but also that management explicitly allowed it. Many Prudential customers complained about their new life insurance policies before this scandal fully surfaced in 1994, and, according to this ex-employee, Prudential addressed such complaints in the following manner (Florida Department of Insurance 1996a, 35):

WITNESS: …whenever they [the customer] had a complaint, the first thing they had to do if they had an oral complaint, they had to put it in writing. That knocked down a number of the complaints right away because most of our customers, because most of their educational level and because of their financial circumstances, hesitated to put things in writing. The second thing we did is we would get the complaint and then would ask the agent what the agent did. If the agent said he did it right, we would deny the complaint and we would hold to that denial through three or four subsequent complaints. And basically we didn’t actually do an investigation except to get the statement of the person who was complained about, and that was the position in Prudential probably until late 1994. Some Prudential executives did seek changes, given the growing number of customer complaints (although it was later alleged that not all complaints were logged into the company’s database). One such measure was having the customer sign a release verifying that he or she fully understood the terms and conditions of his or her new policy. Testimony recounts the reaction to such a measure (Florida Department of Insurance 1996a, 39):

WITNESS: The next one is a memo [dated August 29, 1995] from Bill Hunt [head of Ordinary Agencies]: “I do not believe we should have the applicant sign off on anything. Not only does this imply a lack of trust toward agents, it also has the potential to build skepticism from the prospective insured regarding what they are being sold.” Basically what he is saying is he is not going to ask him to sign anything because it could disrupt the sale.    The selling of life insurance has become a complex process. Clearly, customers frequently do not understand the product they are buying, but instead appear to place a high level of trust in their agent. That trust places additional burdens and responsibilities on agents and Prudential itself. It also appears evident that sales practices such as churning and refinancings were not only widespread but may have been occurring for an extended period of time. The witness implied that financial incentives may have encouraged this activity and that management’s attitude toward controls and problems was questionable.

A New CEO  As early as 1982, the company’s internal auditors reported to the Board of Directors fraudulent practices on the part of sales agents. In addition, internal audits of individual divisions and regional offices in the early 1990s detailed a failure by management to enforce consumer-protection laws and regulations. In a June 1994 report commissioned by Prudential in the wake of regulatory inquiries about insurance sales practices, Coopers & Lybrand stated that Prudential officials failed to act adequately upon such warnings. The Board admitted that it had been made aware of “major irregularities,” but they continually asserted that they trusted management’s claims that the problems were being properly monitored (Scism and Paltrow 1997).    In November 1994, Prudential’s board turned to Arthur Ryan (the president of Chase Manhattan Corp.). This was the first time in over 120 years that Prudential had looked outside the company to fill the position of CEO. Lacking any formal background in the field of insurance, his reputation was built upon his ability to streamline operations and introduce new technology. He is renowned for rolling up his sleeves at his own computer. He enjoys working one-on-one, but is perfectly comfortable at center stage of the company auditorium (Treaster 1997). Simply put, Ryan is direct, open, focused, and engaged.

Ryan’s Reaction and Changes  Ryan had made a conscious choice to change Prudential’s business approach. Under Ryan’s command, Prudential would no longer be a “series of independent silos, freewheeling subsidiaries working at cross-purposes with fragmented game plans” (Treaster 1997). The buzzword at Ryan’s Prudential was “One Prudential” (Prudential 1996 Annual Report, 2). This “One Prudential” would be about facilitating teamwork and cooperation.  To break from the past, Ryan began recreating Prudential’s management team. Much of the old guard was released. Twelve of the 14 executives who reported directly to the CEO were hired by Ryan. Of the top 150 executives, two-thirds were new, and half of these replacements were newcomers to Prudential.  Ryan also decided on cutbacks like those that had won him much praise at Chase Manhattan. Within two years of Ryan’s arrival, a workforce of 100,000 had been reduced to 83,000 (Treaster 1997). Ryan also eliminated about $790 million in overhead (Scism 1997b) by shutting down five regional headquarters (that had once been proud outposts for the company’s management). He also sold the homemortgage operation, thereby reducing the company’s exposure in the homeowner’s insurance side of the business (Treaster 1997). By the end of 1995, Ryan’s restructuring had resulted in seven major operating groups: individual insurance, money management, securities, healthcare, private asset management, international insurance, and a diversified group (Schwartz 1995, 26).

Although Ryan’s actions would appear to be a step in the right direction, not all of his streamlining was met with open arms. The company’s insurance sales force, which numbered 20,000 when Ryan came to Prudential, was cut in half within four years. The company fired or counseled out agents who could barely sell enough insurance to cover the costs of their employee benefits. During the first months of 1997, more than 1,600 junior and senior insurance-sales managers were still going through “very severe reviews.” As a result, about 100 of these employees left Prudential.

Arthur Ryan’s labor troubles did not end with complaints from the sales force over tighter controls. In an effort to mitigate some of the damage to Prudential’s bottom line resulting from the churning scandal, Prudential attempted to increase agent production quotas. The proposed labor contract would have increased quotas by 25 percent, but the union representing Prudential’s insurance agents rejected the deal (Scism 1997a).  In 1998, Prudential officials estimated that the class-action suit could cost Prudential as much as $2 billion. Many questions still remain for Arthur Ryan, but for the customers of Prudential Insurance Co. of America, the most significant question remaining is, “Has enough been done to ensure that they will not be the next Carol Nicholson?”    Prepare typed responses to the following questions.

1. The Committee of Sponsoring Organizations (COSO) ERM Framework states that companies must set objectives in four areas: strategic, operations, reporting, and compliance. COSO further states that to achieve those objectives, companies must have eight components in place: internal environment, objective setting, event identification, risk assessment, risk response, control activities, information and communication, and monitoring. Address the following questions in your response; your response to this questions should be one-two pages – not one paragraph! Evaluate Prudential before Ryan took over! a. How would you describe Prudential’s internal environment? b. What types of events, both external and internal, did management identify as affecting the company and did the company see these events as risks or opportunities? c. Did management do an adequate job identifying risks and, of those identified risks, what was management’s one primary risk response (the 4 “Ts”)? d. How was information identified, captured, and communicated to agents? And, finally, how did upper management monitor the ERM framework within Prudential? 2. As Prudential’s business risk advisor, you identify the following risks within the company: a. The use of sales quotas provokes the scam of churning and refinancing. b. Lack of formal training of agents results in a lack of competence. c. The incentives system (i.e., commissions and bonuses) favors churning and refinancing practices. d. The lack of correction practices (punishment and rewards) does not preclude wrongful sales practices. e. Customer complaints are wrongfully dismissed. Assess the importance of the above risks. First consider whether the dollar significance for each risk is low, medium, or high. Second, evaluate the likelihood of occurrence of each risk as low, medium, or high. Explain why you rated the risks as you did. Using the draw feature of Word, prepare a Risk Map as in Exhibit 5-15 (pg. 5-23). According to the risk map, which of the five risks is/are most critical for Prudential? 3. Consider the five risks (a – e) which were identified in Question 2. What controls has Ryan put in place to mitigate the five risks listed above? You will want to prepare a formal Risk and Control Matrix. After preparing the Risk and Control Matrix, prepare a Risk Control Map as in Exhibit 5-16 (pg. 5-24). Under Ryan’s leadership, has Prudential done enough to adequately manage these risks? Why or why not?

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