CASUALTY LOSS RESERVE SEMINARCASUALTY LOSS RESERVE SEMINARSeptember 10-11, 2007September 10-11, 2007

Chap Cook, FCAS FCA, MAAA, CPCUChap Cook, FCAS FCA, MAAA, CPCUConsulting Actuary, MBA Actuaries, Inc.Consulting Actuary, MBA Actuaries, Inc.

RMAD -- RISK OF MATERIAL RMAD -- RISK OF MATERIAL ADVERSE DEVIATIONADVERSE DEVIATION

A Practitioner’s ViewpointA Practitioner’s Viewpoint

RMAD Requirements: StatutoryRMAD Requirements: Statutory

NAIC Instructions require the Appointed Actuary NAIC Instructions require the Appointed Actuary to provide specific relevant comment paragraphs to provide specific relevant comment paragraphs to address the risk of material adverse deviationto address the risk of material adverse deviation

Identify the standard, disclose amount in $USIdentify the standard, disclose amount in $US Explicitly state if actuary reasonably believes Explicitly state if actuary reasonably believes

there are significant risks that could result in MADthere are significant risks that could result in MAD If risk exists, include an explanatory paragraph to If risk exists, include an explanatory paragraph to

describe the major risk factors (exclude general describe the major risk factors (exclude general broad statements)broad statements)

RMAD Requirements: ASOP 36RMAD Requirements: ASOP 36 Requires an additional explanatory paragraph Requires an additional explanatory paragraph

when the actuary reasonably believes that there when the actuary reasonably believes that there are significant risks and uncertainties that could are significant risks and uncertainties that could result in material adverse deviation. This result in material adverse deviation. This paragraph should contain the following:paragraph should contain the following:

The amount of adverse deviation that the actuary The amount of adverse deviation that the actuary judges to be material with respect to the judges to be material with respect to the Statement of Actuarial Opinion; andStatement of Actuarial Opinion; and

A description of the major factors or particular A description of the major factors or particular conditions underlying risks and uncertainties that conditions underlying risks and uncertainties that the actuary believes could result in material the actuary believes could result in material adverse deviation.adverse deviation.

RMAD Requirements: Practice NoteRMAD Requirements: Practice Note

Regulatory Guidance: Actuary is Regulatory Guidance: Actuary is encouraged to comment on the risks and encouraged to comment on the risks and other factors even when no RMAD is other factors even when no RMAD is judged to existjudged to exist

Stresses importance of considering the unique Stresses importance of considering the unique characteristics of each company vs. ‘cookie characteristics of each company vs. ‘cookie cutter’ languagecutter’ language

Expects the actuary to disclose risks and Expects the actuary to disclose risks and uncertainties even when the carried reserve is uncertainties even when the carried reserve is within the actuary’s reasonable rangewithin the actuary’s reasonable range

RMAD Requirements: RMAD Requirements: Bright Line IndicatorBright Line Indicator

Regulatory tool: Bright Line Indicator Test (BLI) – Regulatory tool: Bright Line Indicator Test (BLI) – outside bound of what is considered materialoutside bound of what is considered material

Used to be part of the Practice Note Regulatory Used to be part of the Practice Note Regulatory Guidance just discussed, now included only for Guidance just discussed, now included only for regulators in the Financial Analysis Handbookregulators in the Financial Analysis Handbook

BLI is triggered when 10% of the Net Reserves are BLI is triggered when 10% of the Net Reserves are greater than the difference between the Total Adjusted greater than the difference between the Total Adjusted Capital and Company Action Level Capital (RBC level)Capital and Company Action Level Capital (RBC level)

It is highly likely that RMAD exists – regulator expects It is highly likely that RMAD exists – regulator expects to see extensive commentsto see extensive comments

Material Adverse Deviation vs. a Material Adverse Deviation vs. a Range of Reasonable EstimatesRange of Reasonable Estimates

Don’t confuse a range with an RMAD standard Don’t confuse a range with an RMAD standard One approach is to compare the selected materiality standard to One approach is to compare the selected materiality standard to

the difference between the carried reserve and the high end of a the difference between the carried reserve and the high end of a reasonable range of reserve estimatesreasonable range of reserve estimates

The range of reasonable estimates relates to a range of The range of reasonable estimates relates to a range of estimates of aggregate resultsestimates of aggregate results

Narrower than the range of possible outcomesNarrower than the range of possible outcomes The adverse deviation is an outcome; not The adverse deviation is an outcome; not tootoo far out in the far out in the

tail, but not an expected result, eithertail, but not an expected result, either If the dollar distance from the carried reserve to the top of the If the dollar distance from the carried reserve to the top of the

range (in dollars) exceeds the materiality standard, it would seem range (in dollars) exceeds the materiality standard, it would seem that there that there must bemust be RMAD RMAD

But if the dollar distance from the carried reserve to the top of the But if the dollar distance from the carried reserve to the top of the range is less than the materiality standard, there may still be range is less than the materiality standard, there may still be RMADRMAD

Materiality for MADMateriality for MAD If the ultimate losses were to be different If the ultimate losses were to be different

by the amount of the materiality standard, by the amount of the materiality standard, then the regulator would be likely to do then the regulator would be likely to do something different.something different.

The regulator expects the actuary to The regulator expects the actuary to consider the relationship of surplus to the consider the relationship of surplus to the exposure incurred, the lines written, and exposure incurred, the lines written, and the volatility of development patterns (or the volatility of development patterns (or less obvious criteria, e.g. key management less obvious criteria, e.g. key management changes) when establishing materiality changes) when establishing materiality and determining the presence or absence and determining the presence or absence of risk of material adverse deviation.of risk of material adverse deviation.

Is there a Risk of Is there a Risk of

Material Adverse Deviation?Material Adverse Deviation?

Does RMAD exist?: Does RMAD exist?: Significant Risks and UncertaintiesSignificant Risks and Uncertainties

Significant risks and uncertainties are specific Significant risks and uncertainties are specific issues affecting ultimate claim liabilities such as:issues affecting ultimate claim liabilities such as:

Position of carried reserve relative to actuarial Position of carried reserve relative to actuarial indicationsindications

LeverageLeverage Volatility – Inherent, ExternalVolatility – Inherent, External Extent of applicable historical dataExtent of applicable historical data Operational changesOperational changes Dependence on reinsuranceDependence on reinsurance Other contingenciesOther contingencies

Does RMAD exist?: Does RMAD exist?: Significant Risks and UncertaintiesSignificant Risks and Uncertainties

Risky business; malpractice or excess & surplusRisky business; malpractice or excess & surplus

Poor spread; one line or one statePoor spread; one line or one state

Little experience; new line or state or young Little experience; new line or state or young carriercarrier

Historical volatility of reserves: chronic IRIS Historical volatility of reserves: chronic IRIS problemproblem

Low surplus or serious losses; small change in Low surplus or serious losses; small change in reserves may be very harmful to the carrierreserves may be very harmful to the carrier

On the edge; if the carrier is very near to break-On the edge; if the carrier is very near to break-even on profit or loss, or to a RBC break pointeven on profit or loss, or to a RBC break point

Does RMAD exist?: Does RMAD exist?: DisclosuresDisclosures

Yes/No explicit statement of the existence Yes/No explicit statement of the existence of RMADof RMAD

Per the Practice Note guidance, need Per the Practice Note guidance, need discussion of risk factors that led to the discussion of risk factors that led to the conclusionconclusion

Conclusion based on specific risk factors Conclusion based on specific risk factors for that entityfor that entity

Avoid generalized commentsAvoid generalized comments Avoid “Attorney approved” languageAvoid “Attorney approved” language

Does RMAD exist?: Does RMAD exist?: A Horror StoryA Horror Story

Small Company – 96% in two statesSmall Company – 96% in two states 98% Long-tail Commercial Casualty98% Long-tail Commercial Casualty Over half had large deductiblesOver half had large deductibles 95% of accounts in one industry95% of accounts in one industry 100% of business from one MGA – 100% of business from one MGA –

owned and managed by the same 3 peopleowned and managed by the same 3 people Reinsurance Recoverables exceed surplusReinsurance Recoverables exceed surplus

$350,000 xs 150,000 layer RI retro rated$350,000 xs 150,000 layer RI retro rated

How Many RMADS?How Many RMADS?

Does RMAD Exist?Does RMAD Exist?Bad Example #1Bad Example #1

“ “Although the carried reserves as of 12/31/05 are Although the carried reserves as of 12/31/05 are within my reasonable range, I within my reasonable range, I do believe that do believe that there is a substantial risk of material adverse there is a substantial risk of material adverse deviationdeviation in the Company’s reserves as measured in the Company’s reserves as measured against a materiality standard of 10% of surplus. …against a materiality standard of 10% of surplus. …Carried reserves are about 110% of surplus, so a Carried reserves are about 110% of surplus, so a 10% deficiency in reserves would results in a loss 10% deficiency in reserves would results in a loss of more than 10% of surplus. A deviation of this of more than 10% of surplus. A deviation of this magnitude, while not anticipated, is not a magnitude, while not anticipated, is not a statistically insignificant possibility.”statistically insignificant possibility.”

WhatWhat are the risk factor(s)? are the risk factor(s)?

Does RMAD Exist?Does RMAD Exist?Bad Example #2Bad Example #2

““The Materiality Standard is established as The Materiality Standard is established as 10% of reported statutory surplus, or 10% of reported statutory surplus, or $XXX,000 as shown in Exhibit B: Disclosures. $XXX,000 as shown in Exhibit B: Disclosures. I estimate the likelihood of material adverse I estimate the likelihood of material adverse deviation arising from normal variations in deviation arising from normal variations in expected results to be about 16%. I estimate expected results to be about 16%. I estimate the likelihood of material favorable the likelihood of material favorable development to exceed 50%.”development to exceed 50%.”

Is 16% significant? Is 16% significant? What might cause it to occur?What might cause it to occur?

Does RMAD Exist?Does RMAD Exist?No RMAD Example #1No RMAD Example #1

“ “Based on my actuarial calculations, the Based on my actuarial calculations, the lines of business written by the lines of business written by the company, the company’s participation in company, the company’s participation in the intercompany pool, and my the intercompany pool, and my consideration of other relevant factors, I consideration of other relevant factors, I reasonably believe there are no known reasonably believe there are no known significant risk factors or uncertainties significant risk factors or uncertainties that could cause material adverse that could cause material adverse deviation. While adverse development in deviation. While adverse development in excess of the materiality standard is excess of the materiality standard is possible, I consider it unlikely.”possible, I consider it unlikely.”

Does RMAD Exist?Does RMAD Exist?No RMAD Example #2No RMAD Example #2

““The company writes a variety of coverages The company writes a variety of coverages whose risk factors expose the company’s whose risk factors expose the company’s reserves to significant variability. I do not reserves to significant variability. I do not believe that there are any such factors that believe that there are any such factors that are unusual to the lines of business written.are unusual to the lines of business written.

Not “unusual” – but Not “unusual” – but WHAT ARE THEY?WHAT ARE THEY? IS there an RMAD or NOT?IS there an RMAD or NOT?

Does RMAD Exist?Does RMAD Exist?Better Examples #1Better Examples #1

““A major risk factor underlying the recorded reserves A major risk factor underlying the recorded reserves is the inherent uncertainty associated with the long-tail is the inherent uncertainty associated with the long-tail business written by the company. I have considered business written by the company. I have considered this uncertainty by estimating a range of reasonable this uncertainty by estimating a range of reasonable reserves. The difference between the recorded reserves. The difference between the recorded reserves and the high end of my range of reasonable reserves and the high end of my range of reasonable estimates is X. I have selected a materiality standard estimates is X. I have selected a materiality standard of Y, which is Z percent of the company’s year-end of Y, which is Z percent of the company’s year-end policyholder surplus. Since the difference between the policyholder surplus. Since the difference between the recorded reserves and the high end of my range of recorded reserves and the high end of my range of reasonable estimates exceeds this standard, I believe reasonable estimates exceeds this standard, I believe there are significant risks and uncertainties that could there are significant risks and uncertainties that could result in material adverse deviation from the recorded result in material adverse deviation from the recorded reserves.”reserves.”

Does RMAD Exist?Does RMAD Exist?Better Examples #2Better Examples #2

““In my opinion there is a risk of material In my opinion there is a risk of material adverse deviation…including uncertainties adverse deviation…including uncertainties associated with the company’s changing mix associated with the company’s changing mix of business and operations,…liabilities of business and operations,…liabilities relating to the company’s discontinued relating to the company’s discontinued operations, potential reinsurance collectibility operations, potential reinsurance collectibility issues and estimates of liability for the issues and estimates of liability for the company’s A&E exposure.”company’s A&E exposure.”

I would like to see a paragraph on each oneI would like to see a paragraph on each one

Does RMAD Exist?Does RMAD Exist?Better Examples #3Better Examples #3

““There are points within my reasonable There are points within my reasonable range of reserve estimates that … would range of reserve estimates that … would materially reduce the company’s surplus… materially reduce the company’s surplus… Certain points nearer the high end of my Certain points nearer the high end of my range would… change the company’s RBC range would… change the company’s RBC status to company action level.”status to company action level.”

Good start, but …Good start, but … What What specificspecific events or risks might events or risks might

cause it?cause it?

Does RMAD Exist?Does RMAD Exist?Better Examples #4Better Examples #4

. . “There is a Risk of Material Adverse Deviation “There is a Risk of Material Adverse Deviation because of claims counting issues found in the audit. because of claims counting issues found in the audit. For at least 2 years, some open claims for the XX line For at least 2 years, some open claims for the XX line of business were incorrectly coded as closed. So far of business were incorrectly coded as closed. So far the 2007 data appears to have been corrected. This the 2007 data appears to have been corrected. This line shows unusually large loss development in 2007, line shows unusually large loss development in 2007, especially in claims count. We are uncertain of the especially in claims count. We are uncertain of the amount of reopened claims, both past and future, and amount of reopened claims, both past and future, and are not sure that there are not some remaining open are not sure that there are not some remaining open claims coded as closed. Because of a small volume claims coded as closed. Because of a small volume of large volatile claims, we have historically given of large volatile claims, we have historically given significant weight to the number of open cases. We significant weight to the number of open cases. We did not give that any weight this year because of the did not give that any weight this year because of the error issue, which is a significant change in method.”error issue, which is a significant change in method.”

Does RMAD Exist?Does RMAD Exist?Better Examples #5Better Examples #5

. . “There is a Risk of Material Adverse Deviation “There is a Risk of Material Adverse Deviation because of a claim department reorganization. In the because of a claim department reorganization. In the past, the claim department had been centralized at the past, the claim department had been centralized at the head office, but during late 2006 it was decentralized head office, but during late 2006 it was decentralized to eight regional claim offices. Many examiners and to eight regional claim offices. Many examiners and adjusters did not accept transfers and were replaced, adjusters did not accept transfers and were replaced, so there are many new staff members. We are also so there are many new staff members. We are also not certain that expertise may not have been diluted not certain that expertise may not have been diluted for smaller lines and unusual claims: it is difficult to for smaller lines and unusual claims: it is difficult to have a product liability expert in every office. have a product liability expert in every office. Management is confident that the geographic Management is confident that the geographic specialization will improve local knowledge and reduce specialization will improve local knowledge and reduce travel expenses, but we are concerned that for at least travel expenses, but we are concerned that for at least two years there will be some uncertainty as to both two years there will be some uncertainty as to both adjustment quality and development patterns.”adjustment quality and development patterns.”

Does RMAD Exist?Does RMAD Exist?Better Examples #6Better Examples #6

“ “There is a Risk of Material Adverse Deviation There is a Risk of Material Adverse Deviation because the company is in runoff. The because the company is in runoff. The company has been in runoff since 2004. company has been in runoff since 2004. Business volume written in the latest 3 years Business volume written in the latest 3 years is small, declining, and essentially is small, declining, and essentially involuntary. There is not enough data to be involuntary. There is not enough data to be confident of recent years’ development confident of recent years’ development patterns: it is quite certain that mix within line patterns: it is quite certain that mix within line has changed substantially, and highly likely has changed substantially, and highly likely that there has been significant adverse that there has been significant adverse selection because better business and better selection because better business and better agents have moved on, while poorer risks and agents have moved on, while poorer risks and agents are hanging on as long as they can agents are hanging on as long as they can legally hold the company on the risk.” legally hold the company on the risk.”

Does RMAD Exist?Does RMAD Exist?Better Examples #6 (continued)Better Examples #6 (continued)

““Expected loss ratios for budgetary methods are Expected loss ratios for budgetary methods are assumed to be higher, but how much higher? We assumed to be higher, but how much higher? We have also made pessimistic assumptions about have also made pessimistic assumptions about deterioration in development factors, but how bad? deterioration in development factors, but how bad? Because of the declining volume of new claims, it is Because of the declining volume of new claims, it is certain that A&O expenses will increase as a % of certain that A&O expenses will increase as a % of incurred losses because payments and handling will incurred losses because payments and handling will continue even as incurred losses decline toward zero. continue even as incurred losses decline toward zero. The absence of underwriting revenues means that The absence of underwriting revenues means that operations such as general management, data operations such as general management, data processing, actuarial and accounting lay a larger processing, actuarial and accounting lay a larger portion of overhead expenses on the claims side of portion of overhead expenses on the claims side of the business. Finally, the ability to retain the best the business. Finally, the ability to retain the best adjusters may affect the quality of the claims settling. ” adjusters may affect the quality of the claims settling. ”

Risks and Uncertainties DiscussedRisks and Uncertainties DiscussedEven if no RMAD?Even if no RMAD?

““But the NAIC Instructions But the NAIC Instructions don’t require me, as an don’t require me, as an appointed actuary to provide appointed actuary to provide a discussion of risk factors a discussion of risk factors when Risk of MAD is not when Risk of MAD is not present.”present.”

Statistics shown: % of Statistics shown: % of Opinions that discuss Opinions that discuss company specificcompany specific risk factors, risk factors, after actuary concluded no after actuary concluded no Risk of MAD.Risk of MAD. 0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

PA TX

20042005

Risks and Uncertainties Discussed Risks and Uncertainties Discussed Even if no RMAD?Even if no RMAD?

Company specific risk factors cited for “No Company specific risk factors cited for “No RMAD”:RMAD”: Growth in long-tailed linesGrowth in long-tailed lines Medical cost inflation trendsMedical cost inflation trends A&E, claims initiatives, construction defect liabilitiesA&E, claims initiatives, construction defect liabilities XS over large deductible and self-insured exposuresXS over large deductible and self-insured exposures

Regulators view this type of disclosure very Regulators view this type of disclosure very positively.positively.

These same factors could possibly lead to These same factors could possibly lead to RMAD for the Company in the future.RMAD for the Company in the future.

Again, keep up the good work!Again, keep up the good work!

Special Considerations: Special Considerations: Discussion with ManagementDiscussion with Management

Discuss risk of material adverse deviation Discuss risk of material adverse deviation disclosure requirements with managementdisclosure requirements with management

Discuss risks and uncertainties with Discuss risks and uncertainties with managementmanagement

Consider risks and uncertainties in Consider risks and uncertainties in developing a range of reasonable estimatesdeveloping a range of reasonable estimates

Discuss comparison with management the Discuss comparison with management the difference between the carried reserve and difference between the carried reserve and the indicated reserve or range of reserve with the indicated reserve or range of reserve with managementmanagement

Discuss draft disclosures with managementDiscuss draft disclosures with management

Special Considerations: Special Considerations: Managing ExpectationsManaging Expectations

Why not always include a risk of material Why not always include a risk of material adverse deviation disclosure?adverse deviation disclosure?

CommunicationCommunication Clear and unmistakableClear and unmistakable Non-technicalNon-technical Early and oftenEarly and often ReasonableReasonable

QUESTIONSQUESTIONS ? ?????????