The Actuary &Earnings Management

Casualty Actuarial Society-Annual Meeting

November 14, 2000Moderated by:

Marc F. Oberholtzer, FCAS

Principal Consultant, PricewaterhouseCoopers LLP

The Actuary & Earnings Management-Why Now?

• Increased scrutiny by SEC, press. Past history is not indicative of current or future environment

• Message: Awareness needs Heightened for Actuaries– Understand how actuarial work is incorporated into

quarterly financial reporting– Be congizant of SEC’s, press’ and others’

perception of actions

The Actuary & Earnings Management-Opening Ideas

• ABC Ins Co typically reserves 3%-5% above internal actuary estimate. In a quarter, ABC reserved 1% above estimate.– Do you construe this as (a) normal volatility or

(b) earnings management?– Same situation, but ABC now exceeds

expectations; reserving at 3% redundant, ABC would have fallen short.

The Actuary & Earnings Management-Opening Ideas

• ABC Ins Co purchases a finite aggregate reinsurance cover. Contract barely transfers enough risk transfer to qualify. ABC is now very likely to meet its publicized goal of a combined ratio below 105%.– Do you construe this as (a) earnings

management or (b) a shrewd business decision?

The Actuary & Earnings Management-Defined

• Actions taken without a specific event to justify the accounting to alter results where the perceived motivation is to comply with certain expectations– Or the lack of action with a specific event

• P&C insurers are susceptible to scrutiny; timing of earnings are heavily dependent on estimates

The Actuary & Earnings Management-Panelists

• Matthew Adams, CPAPartner, PricewaterhouseCoopers LLP

• Albert D. Ciavardelli, CPAVice President-Finance, PMA Capital Corp

• William M. Wilt, FCASVice President, Moody’s Investor Services

The Actuary & Earnings Management

An Auditor’s Perspective

Matthew Adams, PricewaterhouseCoopers LLP

The Actuary &Earnings Management

Wall Street’s Expectations - How Does Your Company Measure Up?

Al Ciavardelli

PMA Capital Corporation

Earnings Management: Has there always been a strong focus on

“Hitting the Numbers”?

500

2500

4500

6500

8500

10500

1965 1970 1975 1980 1985 1990 1995 1999 Today

50

300

550

800

1050

1300

DJIA S&P 500

•As stock values rise, the negative repercussions of not “Hitting the Numbers” are magnified.

•Greater number of significant one day declines in stock values due to one quarter’s earnings disappointment.

Wall Street’s Views on “Earnings”

• Measured Quarterly

• Earnings Quality

• Earnings Visibility/Stability

• Growth

• Hit the Numbers

• Uniqueness of Insurance Companies

Quarterly Earnings: Short-term Performance Measure

• Benchmark for Portfolio Managers

• Predictive value is over-rated

• Consistent results comfort investors

• Stock price performance key management focus

Management’s Views on Earnings

• Value Creation• Short-term earnings focus is the basis for a poor

business plan• Earnings Quality• Earnings Visibility/Stability• Balance Sheet Strength• Sound business plan, good execution on pricing

and underwriting discipline will drive the earnings

Stock Price Valuation:It’s more than “Meeting Expectations”

Internal Factors• Performance metrics - return on equity, PTOI

• Improving revenue, loss and earnings trends

• Consistent performer - no surprises

• Management credibility

• Dividend yield

External Factors• Interest rate environment

• General stock market trends

• Competitors’ earnings surprises

• Sector weighting

• New vs. old economy

• Regulatory environment (A&E, tobacco)

Stock Price Valuation:It’s more than “Meeting Expectations”

Variety of Ways to Measure “Earnings”

Economic Income

Comprehensive Income

Operating Income excluding

XXXX

Book Value Per Share

Core Operating Income

Operating Income

Wall Street’s Current Views on Loss Reserves

• Companies will have to continue to strengthen reserves during the year.

• Standard commercial lines reserves may be as much as $30 billion deficient. Virtually all reserve problems are in the major casualty lines with workers’ compensation, commercial, auto and general liability (occurrence) significantly under-reserved.

• Annual Loss Reserve Survey reported continued deterioration. Industry has been creating an ugly past that will have to be paid for in the future - and the future is close at hand.

• We believe that the industry may have under-reserved in the 1998 and 1999 accident years by as much as 10 points each.

• The past two years (and possibly three) have been under-reserved.

• Industry has essentially set reserves based on a decade of disinflation and favorable claims experience. Unfortunately, this benign claims environment appears to be changing owing to increased litigation, rising medical cost trends and rising inflationary pressures.

Wall Street’s Current Views on Loss Reserves

• AY CR are under pressure with diminished ability to harvest what once were redundant reserves without significant price increases.

Wall Street’s Current Views on Loss Reserves

• Companies will choose whether or not they wish to provide explicit forecasted earnings for upcoming quarter and year.

Regulation FD and Earnings Expectations

If they decide to provide earnings guidance....• It must be to everyone at the same time• No longer can analysts get more than anyone else• Creates very narrow band of earnings estimates

confirmed explicitly by management• Pressures management to explain differences when

earnings do not achieve expected levels

Regulation FD and Earnings Expectations

If they decide not to provide earnings guidance....• More marketplace uncertainty will lead to wider

range of analysts’ estimates.• Much tougher for Company to respond to analysts

who want to reconcile the Company’s actual result to the analyst’s expectation.

• Companies “missing the numbers” may see more or less stock price volatility.

Regulation FD and Earnings Expectations

Earnings Management -- A Rating Agency Perspective

November 14, 2000

Bill WiltMoody’s Investors Service

Discussion Topics

• Operating earnings -- role of loss reserves

• Impact of change in reserve estimate -- material?

• Moody’s view of a ‘one-time’ charge

• Additional analytical obstacles

• Credibility -- the most important currency in capital markets

Operating Earnings

• Crux of work done by financial analysts

• Exclude all non-recurring items– Sale of subsidiary– Discontinued operations– Change in accounting practices– Haircut realized capital gains

• Less obvious -- change in reserve estimates

A Look Through the Industry’s Earnings

0

10,000

20,000

30,000

40,000

$

1994 1995 1996 1997 1998 1999

Operating Earnings

Operating Earnings Adjusted Operating Earnings

Changes in Reserve Estimates -- Material?

XYZ Holding Company

Investment in Affiliate $1,000 Senior Debt: $350Equity: $650

XYZ Operating Company

Total Assets: $4,500 Loss Reserves: $3,000 Other Liab. $500 Surplus: $1,000

Changes in Reserve Estimates -- Material?

Assumption: Within a Reasonable Reserve Range of +5% or -5%

Midpoint +5% -5%

Premiums 2,500 2,500 2,500 Losses & Expenses 2,675 2,825 2,525 Underwriting Loss (175) (325) (25)

Net Investment Income 335 330 341

Income before Income Taxes 160 5 316

Net Income 103 3 202

Return on Surplus 10.3% 0.3% 20.2%Return on Equity 13.0% -2.3% 28.4%

Pretax earnings could fluctuate by $300 million in a given year.

Moody’s View of a “One Time” Reserve Charge

XYZ Projections

($200)($150)($100)

($50)$0

$50$100$150$200

1996 1997 1998 1999 2000 2001 2002 2003

Pretax Operating Income Proforma Operating Income

Moody’s View of a “One Time” Reserve Charge

XYZ Projections

($200)($150)($100)

($50)$0

$50$100$150$200

1996 1997 1998 1999 2000 2001 2002 2003

Pretax Operating Income Proforma Operating Income

Additional Analytical Obstacles

• “Leveraged” effect of reserves• Merger and acquisition activity• Increased utilization of finite reinsurance

– Low risk transfer threshold create many financing arrangements

– Cheap reinsurance -- sustainable?

• Restructuring / reorganization charges• Other non recurring revenue and expenses

Credibility -- The Best Currency

• Managing earnings -- a dangerous game– Restatement alters perception of past -- and future

earnings– Degree of skepticism very high

• Issues more than immediate shareholder value– Rx of stock price to reserve charge– Access to funds -- equity, debt, bank market

• Financial flexibility is critical rating factor

The Actuary &Earnings Management

Q&A