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RSA: The drawback to clawback

RSA: The drawback to clawback
February 12, 2014
RSA: The drawback to clawback

General insurance is all about managing risk in the face of unpredictable events - and RSA had a horrible end to 2013. In early November, it warned about large household insurance claims from vicious Canadian weather and severe storms in Scandinavia, and, oh, it had spotted a little local difficulty in Ireland.

Within days, the Irish motor insurance claims had hit crisis point. An audit found that internal procedures had been flouted, possibly for two years. The three executives in charge of Ireland were suspended, soon to be sacked. The profit hit was £70m.

A month later and this had grown to £200m, opening up a capital shortfall and prompting Simon Lee, the group chief executive, to resign, even though Ireland now seems to have been an isolated case. It was at this point that some of RSA's large investors began talking about clawing back pay from those responsible.

Clawing back pay, though, is not easy. You can't just decide to do it; clawback needs a clause in the employment contract. There's a practical issue, too, if the salary or bonus has already been paid. A 'can't pay, won't pay' response leaves the employer having to sue, a messy and time-consuming business with no guarantee of getting anything back at the end.

Clawback works better with deferred pay. This is when a cash bonus or share award earned in one year is held back for another couple of years or so. Then, before it's been paid, it can be forfeited if the executive resigns or clawed back if it later turns out to have been made under false pretences (such as employee misconduct or financial miscalculations).

RSA bases its bonuses for divisional regional leaders in part on the ratio of claims paid against premiums received during the year. If claims in Ireland, for example, turn out to have been booked late and premiums turn out to have been booked early, there could be grounds to claw back part of the bonus. Except for one thing: RSA only introduced clawback last year and the group is not applying it retrospectively (probably for legal reasons).

So is RSA's pay policy at fault? Well, don't blame the current board for, in 2013, they overhauled how RSA pays its senior executives. Annual bonuses were no longer based on premiums, but on return on equity - the preferred measure of many value investors. They introduced a more enlightened performance condition for share awards. And they introduced clawback, just in case. Shareholders approved all of these at the last annual meeting.

In other words, the board did the right things; it's just that events got in the way before the new pay regime could take effect. This seems to have been lost on some of RSA's large shareholders who, in the aftermath of the profit warnings, were quoted as questioning the very pay arrangements that they'd approved just a few months before.

But those responsible have hardly got away scot-free.

In Ireland, where it might have helped to claw back past bonuses from senior executives, the Irish regulator could still end up fining them up to a million euros each.

As for Simon Lee, about half of his headline annual pay of £2m depended on performance, paid part in cash and part in shares. The profit warnings must have placed his cash bonus in jeopardy; and over the years he'd built up almost 4m matching and performance shares, all subject to performance conditions. These are unlikely to be passed, leaving the shares unvested and participants with nothing. So, even without clawback, he'd been dealt financial blows. He also owned outright 1.5m RSA shares - on these, he's suffered exactly as other investors have from the drop in the share price.

Simon Lee resigned because chief executives have ultimate responsibility for applying internal governance. The new chief executive, Stephen Hester, lacks direct experience of insurance operations, although his brief stint when he was chief executive of RBS would have included its insurance activities. Despite this, his salary of £950,000 will be 20 per cent more than Mr Lee's (as stated in the RSA's last annual report). No doubt this is justified by Mr Hester's other qualities, but it illustrates one reason why chief executive's pay always seems to go up from year to year.

Mr Hester's main challenges, assuming RSA can fend off predators, are to get the right balance of risk in an intensively competitive environment and to plug RSA's capital hole. It would be daring to have a rights issue and expand in emerging markets, but Mr Hester may prefer to play safe and sell off businesses. After all, that's what he did at RBS.

In the meantime, RSA's troubles are a reminder to investors in other companies to check how much divisional senior executives are held financially accountable through being paid for performance with deferred cash or share awards. And that there's clawback as a backstop.