Here’s a fascinating idea from Joshua Ronen, via The Economist (gated):
The most elegant solution comes from Joshua Ronen, a professor at New York University. He suggests “financial statements insurance”, in which firms would buy coverage to protect shareholders against losses from accounting errors, and insurers would then hire auditors to assess the odds of a mis-statement. The proposal neatly aligns the incentives of auditors and shareholders—an insurer would probably offer generous bonuses for discovering fraud. Unfortunately, no insurer has offered such coverage voluntarily. New regulation may be needed to encourage it.
The logic of this I think is that an accounting scandal is an uncertain event and so should be evaluated by a company that analyzes random things. Maybe throw in some notion that the private market is better suited to evaluating this sort odd thing than a government body would be.
Lots of problems here:
Are insurers better than the FBI?
These acts are already illegal and there are people who dedicate their lives to finding this stuff out. An insurer could make something like a few hundred grand on a policy like this if no claim. I suspect a full investigation costs millions.
Are they better than internal controls?
It’s not like a company has nothing to lose here. And yet these scandals happen all the time and no doubt many go undetected. How is an insurer going to assess this risk? They’re likely to demand some private evaluation of the risk on the client’s dime. What’s the insurer adding here?
Does this give you the signal you would want?
An insurance price for a specialized cover like this is not a very good market signal. It renews annually only, it represents only a small chance at profit so they underwriting process is light and there are no outlets for insider information to inform the process. The dirty secret of the equity markets is that insider trading drives much of the value they generate. Nobody can get rich shorting an insurance policy so there is no incentive to find bad guys, just take a pass.
Is this business the insurer wants?
Insurance is a cooperative relationship. They want to find clients who do everything they can to avoid problems and charge as little as possible to cover the residual risk. The only tool that works for poor risks is extreme alignment. Second tier deals trend to have the client feel some multiple of the pain that the insurer does.
What would this business do to they insurer’s risk profile?
Another way to think about an insurer is that all they do is hold lots of offsetting tail risks and only record their net expected value on the balance sheet. And nobody asks too many questions about the continent risks. This idea puts them in the middle of a catastrophic event which is probably already correlated to the rest of their portfolio and happens quite frequently. Bad risk management.
Bottom line, what do insurers do when presented with risk where they have an information disadvantage relative to another market, do not want the business culturally, do not want the risk position the business forces then to take asks do not understand why they are being asked to do it?
They screw you.