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Considerations Regarding Materiality and Range of Reserves

In Connection With Actuarial Standard of Practice # 36

George M. Levine, FCAS, MAAASenior Manager, KPMG LLP

September 24, 2002Arlington, Virginia

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ASOP36: Comments on 1999 3rd Exposure Draft (Appendix

2) Comment Letters Included:» Request that ASOP #36 Provide More Guidance

by Giving Various Examples in the ASOP» Concern that Many Actuaries are not aware of

the ASOP

This Paper 1) Provides Examples and 2) Based on Author’s experience, provides Areas that many actuaries have been unaware of since 12/00

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General Overview of ASOP # 36 (Effective October 15,

2000)Some Important New Requirements:

» Actuary Evaluate Risks and Uncertainties which Could Result in Material Adverse Deviation in Loss Reserves (Section 3.3.3)

» Actuary Evaluate Materiality in Loss Reserves, Considering the Intended Use of the Statements (Section 3.4)

» Specific Guidance as to Nature and Extent of Disclosures for Statement of Actuarial Opinion [“SAO”] (Section 4)

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Five Types of Opinions(Section 3.3.2)

1) Reasonable

2) Deficient or Inadequate (Not Reasonable)

3) Redundant or Excess Provision (Not Reasonable)

4) Qualified

5) No Opinion

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Comments Regarding Types of Actuarial Opinion

1) COPLFR Practice Note— Only Available Guidance prior to

ASOP36, but not Binding

2) Precision Introduced that Did Not Exist Before

» Prior: Carried Reserve > High End of Range is “Conservative”

» After SOP #36: Opine “Redundant” or “Excessive”, and State Amount

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Comments Regarding Types of Actuarial Opinion (cont.)

3) Disappearance of “Reasonable but Conservative”

4) Changes in Work Processes for NAIC Opinions

Conservative Opinion, with Amount of Conservatism Stated, necessitates range to be completed by date of opinion, not actuarial report completion date

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Range of Reasonable Reserve Estimates

» Range Defined in Section 3.6.4– Range of Estimates that could be

produced by appropriate actuarial methods or alternative sets of assumptions that the actuary judges to be reasonable

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Range of Reasonable Reserve Estimates (cont.)

» Accounting Literature: Financial Accounting Standards No. 5: “Accounting for Contingencies”—Accrue Loss When1) Probable Asset Impaired or Liability Incurred2) Amount of Loss Can be Reasonably Estimated

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Range of Reasonable Reserve Estimates (cont.)» “FASB Interpretation # 14: Reasonable

Estimation of the Amount of a Loss—An Interpretation of FASB 5”1) When an Amount In Range Appears Better

than Another, Accrue that Amount2) When No Amount is Better than any Other

Amount, Accrue the Minimum Amount in the Range

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Range of Reasonable Reserve Estimates (cont.)» Illustrates Difference Between Actuary’s and

Accountant’s View of Best Estimate and Range1) Actuary: Point Estimate is More Probable than other

points//Accountant: Book It (Under FASB5)2) Accountant: All Points in A Reasonable Range are

equally Likely, so Book the Minimum {In Spite of the Existence of A Point Estimate}

» SSAP #55: Statutory Accounting Management’s Best Estimate

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Disclosure of Range of Reasonable Reserve

Estimates» ASOP # 36 Does Not Require that Range of Reserves be Disclosed in Statement of Actuarial Opinion

» Observation: Many Actuaries do not disclose the Range in the Actuarial Report, even when Carried Reserve is some distance (>5%) away from the Point Estimate– Actuarial Standard of Practice #9 would appear to

require the documentation of the range in the actuarial workpapers, if not the report

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Materiality Discussed in Section 3.4 of ASOP36

» No Definition in Section 3.4, only Discussion

» Section 312.10 of AICPA Code Defines Materiality: “The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

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The Actuary Should Evaluate Materiality Based On:

1) Professional Judgment 2) Materiality Guidelines or Standards

Applicable to the Statement of Actuarial Opinion

3) Actuary’s Intended Purpose for the Statement of Actuarial Opinion—which values are important for the user

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Sec. 3.4: 3 Examples of Materiality to Reference

1) Specified Reserve Amount (% Loss Reserves)

2) The Company’s Reported Surplus

3) The Company’s Net Worth and Annual Net Income (for an Evaluation)

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Quantitative Percentages of Materiality: Observations

1) Specified Reserve Amount: 5% and 10% seen in practice [Note: The “Average” Range of Reserves implies which figures to use]

2) The Company’s Reported Surplus: If Reserves/Surplus at 2:1, would imply 10% and 20% of Surplus

3) Net Income: 5% and 10% under certain limited circumstances according to SEC’s SAB 99

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Professional Guidance Regarding Materiality

1) CAS Valuations, Finance and Investment Committee: “Materiality and ASOP No. 36: Considerations for the Practicing Actuary” with 12/31/01 Practice Note;3 additional quantitative measures:a) Absolute magnitude of correction/difference itemb) Absolute magnitude of item for which data is not

availablec) Impact of Item on IRIS or RBC Capital Results

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Professional Guidance Regarding Materiality (cont.)

2) SEC Staff Accounting Bulletin #991) Numerical Quantitative Values have no basis

in Law or Accounting Literature2) Misstatements are not immaterial simply

because they fall below minimum value

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Material Adverse Deviation in Relation to Range

Risk of Material Adverse Deviation Exists If:

1) High End of Range – Carried Reserves >2) Materiality Amount

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Material Adverse Deviation in Relation to Range (cont.)

Risk of Material Adverse Deviation Exists If:

1) High End of Range – Carried Reserves >2) Materiality Amount, or

1) High End of Range > 2) Carried Reserves +Materiality Amount

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Expected Policyholder Deficit vs. Expected Material Deviation

Risk Based Capital Concept, from 1994 Butsic 1) Expected Policyholder Deficit (“EPD”)2) Where A=Assets, L=Loss Reserves

DL = p(x) (x-A) x>A

3) Expected Material Deviation (“EMD”)4) Where L=Loss Reserves, M=Materiality

Amount DMD = p(x) (x-(L+M))x>L+M

Material Adverse Deviation is Related to Concept of Capital

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EPD Ratio vs. EMD Ratio

1) EPD Ratio= DL/L

2) Where A=Assets, L=Loss ReservesDL = p(x) (x-A)

x>A 3) EMD Ratio= DMD /L

4) Where L=Loss Reserves, M=Materiality Amount DMD = p(x) (x-(L+M))

x>L+M

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Material Adverse Deviation in Relation to Range (Example)

Low Medium High CarriedMateriality

90 100 110 105 10.5 (10%)

Since High End (110) < Carried + Materiality (115.5), Risk of Material Adverse Deviation Does Not Exist

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Material Adverse Deviation in Relation to Range (Example)

Low Medium High Carried Materiality90 100 110 95 9.5 (10%)

Since High End (110) > Carried + Materiality (104.5), Risk of Material Adverse Deviation Does Exist

ASOP # 36 Mandates that Risk of Material Adverse Deviation be Disclosed; not the amount of 5.5 = (110-104.5)

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Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

Line Low Medium HighCarried

MedMal (+/-14.1%) 7.6 8.8 10.1 8.1WC(+/-7.8%) 48.6 52.7 56.8 51.1PAL (+/-6.7%) 52.8 56.6 60.4 63.5GL (+/-9.2%) 34.1 37.6 41.0 34.0CAL (+/-7.9%) 18.8 20.4 22.1 18.9

All (+/-6.1%) 286.2 304.7 323.2 297.0

Using Murphy’s 1994 Paper for Confidence Levels, and assuming 5th and 95th Percentiles are Low and High End of Range

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Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

MaterialityLine High Carried High-Carried 10% Reserves

Risk?MedMal 10.1 8.1 1.9 0.8 YesWC 56.8 51.1 5.7 5.1 YesPAL 60.4 63.5 (3.2) 6.4

NoGL 41.0 34.0 7.0 3.4 YesCAL 22.1 18.9 3.2 1.9 Yes

All 323.2 297.0 26.229.7 No

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Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

MaterialityLine High Carried High-Carried 20% Reserves

Risk?MedMal 10.1 8.1 1.9 1.6 YesWC 56.8 51.1 5.7 10.2 NoPAL 60.4 63.5 (3.2) 12.8

NoGL 41.0 34.0 7.0 6.8 YesCAL 22.1 18.9 3.2 3.8 No

All 323.2 297.0 26.259.4 No

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Expected Material Deviation and EMD Ratios, by LOB: A.M. Best’s

2000High- Materiality EMD

Line Carried 10% ReservesEMD Reserve sRatio

MedMal 1.9 0.8 1.1 8.114%

WC 5.7 5.1 0.6 51.1 1%GL 7.0 3.4 3.7 34.0

11%CAL 3.2 1.9 1.3 18.9

7%

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Conclusions

1) Range of Reasonable Reserves and Amount of Material Adverse Deviation are Related

2) Amount of Material Adverse Deviation can be quantified, as the high end of the range – (carried reserves plus the materiality standard)

3) Width of the “average” reasonable range of reserves may be an additional factor to be considered when selecting the materiality amount, and range will influence the “average” frequency that the risk of material adverse deviation will exist

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Conclusions (continued)

4) Although ASOP # 36 implies the range of reasonable reserves need not be disclosed in the opinion, ASOP9 under certain circumstances could imply the necessity to disclose the range in the actuarial report

5) The risk of material adverse deviation can be supported by qualitative as well as quantitative tests.