Audit: Pinnacol shows abuses

Legislative audit committee blasts travel expenses, bonuses

By Marianne Goodland
THE COLORADO STATESMAN

A state-ordered audit of Pinnacol Assurance, the quasi-state worker’s compensation provider, reported that travel expenses and bonus payments are out of line with industry standards and border on abuse.

Sen. Morgan Carroll questions Pinnacol reps at the audit.
Photo by Jamie Cotten/The Colorado Statesman

The audit released by the Legislative Audit Committee and reviewed by that committee on June 7 was ordered by the General Assembly in 2009. The same legislation, SB 09-281, also ordered that an interim committee be established to look at Pinnacol’s operations, including whether it was feasible to allow the insurance provider to be privatized.

Pinnacol Assurance is a political subdivision of the state. It was established in 1915 as the State Compensation Insurance Fund (SCIF), a state agency and the “insurer of last resort,” which means Pinnacol must provide insurance coverage to employers that can’t get it from private insurers. The SCIF became a political subdivision in 1987, which meant it was no longer under the jurisdiction of a state agency and could operate as a mutual insurance company. At that time the name was changed to The Colorado Compensation Insurance Authority. The name change to Pinnacol Assurance took place in 2002.

President of Pinnacol Assurance board of directors Gary Johnson listens during the company’s audit on June 7 in front of state legislators.
Photo by Jamie Cotten/The Colorado Statesman

As a political subdivision, Pinnacol is not subject to federal income taxes, state corporate income taxes, state sales and use taxes, property taxes, and the state premium tax.

In 2009, facing a growing budget crisis, legislators began looking at ways to shore up the state budget, and they set their sights on $587 million in reserves held by Pinnacol. When introduced, the 2009 Long Appropriations Bill, SB 09-259, cut $300 million from higher education and that was to be backfilled with the Pinnacol reserve. But legislators abandoned the idea, in the wake of furious lobbying by Pinnacol and different solutions proposed to solve the budget shortfall. The Legislature instead passed SB 09-281, ordering the audit and establishing the interim committee.

This year, Pinnacol made two offers to the state for cash in exchange for privatization. In February, they offered $200 million; a month later Pinnacol upped that proposal to $330 million, following the release of a March 8 analysis by Morgan Stanley that estimated Pinnacol‘s value at $374 million. That analysis said Pinnacol had gotten a tax benefit of $51 million; had a surplus at the beginning of 2002 of $151 million, and had received capital support of $167 million. Both of those offers were rejected by Senate President Brandon Shaffer, D-Longmont, and other legislators, who said they wanted to wait for the results of the audit.

Pinnacol Assurance CEO Ken Ross looks toward auditors during a June 7 audit of the company. Pinnacol is under scrutiny because the company’s executive bonuses are significantly higher and more extravagant than any other state agency.
Photo by Jamie Cotten/The Colorado Statesman

Under SB 09-281, the state auditor was to look at Pinnacol’s executive compensation, premium rate structure, loss reserves and injured workers’ claims experience.

The audit noted that Pinnacol has been the state’s largest worker’s compensation insurance carrier since at least 1996. In 2009 Pinnacol held more than 53 percent of the worker’s compensation insurance market in Colorado; the next highest percent of the market was held by National Union Fire Insurance of Pittsburgh, PA, which had less than 3 percent.

The audit reported that while Pinnacol’s executive compensation is at the high end of the range among the entities reviewed by the auditors, it was not necessarily unreasonable. Pinnacol’s compensation was compared to other political subdivisions of the state, such as PERA and the Regional Transportation District; worker’s compensation funds operated by other states and Pinnacol’s private competition. The audit noted that unlike Pinnacol, the CEOs of other state funds took a reduction in pay or earned a smaller performance bonus in one or more of the years used in comparison — 2007 through 2009.

But it was the executive bonus program that drew concerns from the auditors. For the CEO, Ken Ross, the audit noted that the bonus he earned in 2009 represented one-third of his total salary, bonuses and perqs, while bonuses for CEOs of other state funds represented anywhere from zero to 30 percent. The CEO’s compensation was substantially less than that of other private insurers, which the audit said was not surprising, given that the other companies were much larger and more complex than Pinnacol.

Pinnacol auditor Anna Reinert confers with the legislative audit manager.
Photo by Jamie Cotten/The Colorado Statesman

Bonuses for vice presidents were substantially higher than at other state funds and Colorado political subdivisions, the audit said. The average in 2009 was $102,000; vice presidents at other state funds drew bonuses of $1,000 to $58,000 each, the audit said.

Because of the large impact the bonuses have on executive compensation, the auditors reviewed in greater detail Pinnacol’s two executive bonus programs. Under the Executive Performance Plan, which is a formula-based program, executives received the maximum bonus allowable almost every year, which the audit said was because the Plan set targets below the prior year’s actual results. The Plan also allows for bonuses to be paid for superior performance but does not document how that is defined. The audit noted that they could not determine whether the Pinnacol board used a sound methodology to set those targets because Pinnacol did not provide that documentation or they provided incomplete information.

The audit recommended that Pinnacol fully document the Plan’s methodology for setting targets, rationales for the methodology and how that rationale should be applied. Superior performance should also be defined, as well as how it will be evaluated, the audit said.

Pinnacol also has a discretionary pay program for its executive team, and auditors found problems with it, too. There is no written policy for the program that describes its purposes or critical elements and no definition of extraordinary performance or special projects for which bonuses could be paid. The audit said this could lead to duplication between the Executive Performance Plan and the discretionary bonus program. For example, one executive got a Plan bonus of $3,900 in 2008 for developing a “new vision and values program,” and that executive got a discretionary bonus of $13,600 for the same thing.

Until December 2008, the CEO could award discretionary bonuses without reporting them to the board. The board changed that policy in 2009, and while the audit said this was good oversight by the board it was not formally documented in policy.

The audit questioned whether the discretionary program was in the best interests of Pinnacol and its policyholders, noting that it is uncommon for state funds to have both a discretionary and a formula-based bonus program.

In the meantime, the audit said, if the board decides to keep the discretionary program, it needs to better document in written policy its purpose and how it is distinct from the purpose of the Executive Performance Plan. The policy needs to define extraordinary performance and special projects, and how it is distinct from normally assigned duties or goals in the Executive Performance Plan. Finally, the CEO should report all discretionary bonuses to the board before the bonuses are paid, the audit said.

Pinnacol has a gain-sharing program for non-executive employees, and it shared some of the same problems that the executive pay plan had. Specifically, targets set for employees were set below previous year’s performances. For example, in order for employees to get a bonus Pinnacol had to earn $15.6 million in the first quarter of 2009, which was almost $9 million below what Pinnacol had earned in the first quarter of 2008. Pinnacol officials told the auditors that the targets were set below the previous year’s performance because they had reduced premium rates to policyholders, leading to a projected decline in net income. However, since Pinnacol did not document the rationale for gain-sharing target setting, auditors could not determine how the targets were set. The audit recommended better documentation for target setting and the rationale for the program.

The auditors contracted with an outside company, Regulatory Consultants Inc., to review Pinnacol’s processes for setting rates, establishing reserves and managing its surplus. The audit noted that RCI has extensive experience in evaluating worker’s compensation.

Pinnacol is required to file all rate-setting information with the Division of Insurance, and that can happen at any time throughout the year. RCI identified problems with Pinnacol’s rate-setting method and its filing of rating information with the Division, which raised concerns that Pinnacol’s rates might not be fair and could be excessive. In an addendum to the RCI findings, the auditor said the practices resulted in higher-risk employers paying premiums that subsidized the premiums charges to lower-risk employers. “This is an issue of fairness in rate-setting and could be discriminatory under state law,” the auditor said.

Of more concern was Pinnacol’s practice of using rate-setting information that wasn’t filed with the Division of Insurance, a practice that went on for 13 years, between 1995 and 2008. In addition, Pinnacol did not file risk factors and percentages used in its Schedule Rate Plan until December 2009, seven years after the company began using those factors, which the audit said violated state law as well as insurance regulations.

State Auditor Monica Bower said that when RCI started asking questions, Pinnacol started filing all of the rate-setting information required by law.

Pinnacol CFO Jeff Tetrick said failure to file that information was a “mistake” and an “oversight.” Sen. Morgan Carroll, D-Aurora, pointed out that one year is a mistake. “Thirteen years is not,” she said.

LAC Chair Sen. David Schultheis, R-Colorado Springs, asked if there was any culpability by the Division of Insurance over this issue; Bowers said that the division has no way to know what information Pinnacol is using and not filing.

The audit recommended that the company ensure that any changes to its Schedule Rating Plan be filed before those changes are implemented, and that its files be complete and accurate. And although the audit said that Pinnacol had violated the law by not making complete filings, no other action was recommended.

The one bright light in the audit for Pinnacol was the audit’s review of the company’s reserve and surplus. Pinnacol’s reserves through Dec. 31, 2009 are more than $1 billion, and its surplus as of Dec. 31, 2009, is $733 million. At the same time, Pinnacol has been paying out policyholder dividends for the past five years, ranging from $54 million in 2007 to $123 million in 2008. Pinnacol’s surplus is adequate to meet its obligations, RCI said in the audit.

With regard to workers’ claims experience, the audit recommended that Pinnacol incorporate its injured worker survey into the gain-sharing and Executive Performance Plan; currently the two plans only use satisfaction surveys conducted of its policyholders.

The audit’s harshest criticism was reserved for Pinnacol’s policies on travel and entertainment. The auditors reviewed samples of travel and entertainment expenses, and found that 75 percent of the samples violated company policy. That included expenses that were not allowed and expenses that were reimbursed without receipts. “In our opinion,” the audit said,” the fact that 75 percent of the sample we tested [violated company policies] borders on abuse under Government Auditing Standards.”

Pinnacol employees also ignored company policies regarding expenses regarding lodging and meals. Pinnacol policies regarding lodging state that the expenses should be “moderate” and based on federal guidelines. However, the samples reviewed by auditors showed that nightly lodging rates exceeded federal guidelines by as much as $421 per night. Meal expenses also exceeded company guidelines, the audit said. Pinnacol’s initial response was to say it planned to remove all references to federal guidelines since they weren’t being used in practice. The auditor disagreed with that decision, stating Pinnacol should strengthen its controls over lodging and meal expenses by either using the federal guidelines or establishing other clear guidelines as it deems appropriate.

Schultheis said that when he read that section of the report “you could have heard me from three miles away. These are not appropriate policies when individuals can spend $500 per night in Colorado Springs.” Controls need to be tightening and before Dec. 31, 2010, as is outlined in Pinnacol’s response, he said.

The deadline for implementing all audit recommendations is Dec. 31, 2010, but that isn’t soon enough for some legislators.

Rep. Dianne Primavera, D-Broomfield, told Pinnacol officials the audit showed a lack of accountability and transparency. “Businesses are tightening their belts. Pinnacol should, too,” she said, asking that Pinnacol officials come back in September to report on the progress on audit recommendations made by the company. Pinnacol officials said most of the audit recommendations should be implemented well in advance of the December 31 deadline.

Following the audit, Pinnacol officials talked to reporters but they were often tight-lipped in their responses. CEO Ken Ross responded to many of the questions by saying their answers were in the report.

With regard to how the audit would affect Pinnacol’s desire to privatize, Ross said he had not given that any thought and that the company’s goal was to get the audit to improve its business practices.

But Carroll, who chaired the 2009 interim committee, said the results of the audit showed that it would be a bad idea for Pinnacol to be privatized. Pinnacol lacks sufficient controls, she told The Colorado Statesman, adding that its rates are discriminatory. “To eliminate what existing oversight is there would be a bad idea,” she said. “Privatizing means removing state oversight; this audit [says] the state should have been looking at Pinnacol sooner.”

Board Chair Gary Johnson also spoke to reporters, including responding to questions on a recent KMGH report regarding employee and board member trips to Pebble Beach, Calif., for a $500 per-person golf outing. Johnson said Pinnacol has to compete with other private insurers, and those companies send their employees on “extremely lavish” trips to France and England.

That drew the ire of Rep. Su Ryden, D-Aurora, who told The Statesman that Ross had testified last year that Pinnacol was not interested in increasing its market share. If that’s true, she said, why would they have to do things to be competitive with private insurers that don’t get the same tax breaks? Ryden also said people have been led to believe that Pinnacol is doing a good job, and she isn’t so sure of that.

Sen. Shawn Mitchell, R-Broomfield, criticized the audit frequently during the hearing, stating that it did not take into account Pinnacol’s performance or that the company offers the lowest worker’s compensation premium rates in the state. The state “is running huge deficits yet we presume to tell Pinnacol how to run the company,” he said. Mitchell said the audit was not useful to the Legislature, but said he blamed that on the charge made to the auditors by SB 09-281 and he did not blame the auditors’ work.

Marianne@coloradostatesman.com