Casualty Loss Reserve Seminar

1. Casualty Loss Reserve Seminar Considerations of ASOP #36 and NAIC Codification in Issuing Actuarial Opinions September 24, 2002Arlington, Virginia

2. Today’s Discussion Facilitated by: • Mary D. Miller, Moderator, Ohio Department of Insurance • Wendy Germani, Texas Department of Insurance • David S. Powell, Tillinghast – Towers Perrin • Robert H. Wainscott, Ernst & Young, LLP

3. Evolution of Loss Reserve Opinions • Statement of Actuarial Opinion arose from insolvencies of the 1970’s • Primary statutory concern is solvency • “Good and Sufficient Provision” • By 1990 the SAO was required in every state

4. Today’s Statement of Actuarial Opinion • “Good and Sufficient” has become “Reasonable” • Certain unearned premiums are included within the scope of the opinion • Commentary is required on such items as: • Anticipated salvage and subrogation • Discount for time value of money • Reinsurance collectibility • Retroactive reinsurance • …and more • Documentation report is required Continued…

5. Today’s Statement of Actuarial Opinion • ASOP #36 • Codification • NAIC changes

6. Who’s Signing Opinions Today?Texas, Illinois and Ohio domestics Texas Illinois Ohio Consultants Company 62% 38% 60% 40% 46% 54% FCAS 73% 70% 84% New Actuary in 2001 26% 21% 16%

7. What’s Covered Today?Texas, Illinois and Ohio domestics Texas Illinois Ohio Number of companies 209 178 121 Loss and LAE Reserves Direct Net 13.80 B 7.10 B 92.30 B 63.30 B 28.70 B 20.80 B Total Surplus 11.91 B 76.25 B 20.04 B

8. Distribution of Texas, Ohio and Illinois Domestics by Surplus Size (in Millions) Lessthan $1 $1 to$5 $5 to$10 $10 to$50 $50 to$100 $100 to$500 Over$500

9. New In 2001 Opinion Retroactive Reinsurance Assumed • Why — Liability for loss on insurer’s balance sheet not previously in Opinion Scope • Result — Many companies strengthened these reserves in 2001

10. New In 2001 Opinion Codification • Eliminated Schedule P penalty — little impact • Best estimate by line of business and in total — some movement toward adjusting imbalances • Added balance sheet liability for premium deficiency reserve, if any — not yet addressed by Opinion Instructions

11. New in 2001 Annual Statement:Notes to Financial Statement No. 24 • Explain change in incurred losses and LAE for prior years: • Example 1: Note 24 detailed adverse loss development of more than 1.5% (>$25M) on prior years reserves. Schedule P one-year development was 0 • Example 2: Note 24 said adverse development was 12%, Schedule P said 2%

12. Actuarial Standard of Practice No. 36 • For all Statements of Actuarial Opinion provided for reserves with a valuation date on or after October 15, 2000 • Types of Statements of Actuarial Opinion • Range of Reasonable Reserve Estimates • Materiality • Risk of Material Adverse Deviation

13. Types of Statements of Actuarial Opinion • Determination of reasonable provision • Determination of deficient or inadequate provision • Determination of redundant or excessive provision • Qualified Opinion (new definition) • No Opinion

14. NOTE! • Very few Opinions say reserves are at low end of a range or optimistic • Even fewer say they are deficient • But…there has been significant reserve strengthening in recent years

15. What is a Qualified Opinion? ASOP No. 36 says: • Reserves for item(s) in question because they cannot be reasonably estimated or actuary is unable to render an opinion on them • The actuary is not required to issue a qualified opinion if he reasonably believes the item(s) are not likely to be material Continued…

16. What is a Qualified Opinion? NAIC view(s): • Annual Statement Instructions do not define but say actuary must explicitly state reasons for issuing • Some regulators view any exclusion as being in qualified category Continued…

17. What is a Qualified Opinion? • These relevant comments may provide information leading the regulator to say the Opinion is qualified: • Risk of Material Adverse Deviation (ASOP #36) • Asbestos and Environmental Reserves • Retroactive Reinsurance

18. Loss Reserve Opinions • Statutory Annual Statement • GAAP • Workers Compensation Self Insured Funding • Self Insured Groups • Special Purpose

19. Examples of Special Purpose • Reinsurance Commutation • M&A Valuation • Litigation

20. Range of Reasonable Reserve Estimates • A range of reasonable estimates is a range of estimates that could be produced by appropriate actuarial methods or alternative sets of assumptions that the actuary judges to be reasonable • Actuary is NOT required to calculate a range, in most circumstances

21. Definition of a Reserve Range • Reasonable/credible low and high estimates of expected values of unpaid losses and loss adjustment expenses, given information currently available • All reserve estimates within the range should be considered “actuarially sound” — that is, all reserves in the range should be based on estimates derived from reasonable assumptions and appropriate actuarial methods Continued…

22. Definition of Reserve Range • The range should reflect the uncertainty in estimating expected values and should not be meant to encompass all possible outcomes or the possibility that future payments may differ from expected due to unforeseen events • The lower bound of the range should not be lower than that amount to which the actuary would give a reasonable provision opinion

23. Materiality — a WorkingDefinition for Loss Reserve Opinions • An item is material if it would alter the perception of a reasonable reader related to the intended purpose of the opinion

24. Statutory Solvency/viability GAAP Income/viability WC Funding Sufficiency Self-insured Group Dividend/comfort Special Purpose ???????? Purposes of Opinions Type of Opinion Primary Purpose

25. Materiality • Size as a percent of reserve, surplus, other • Some natural thresholds are important regardless of size

26. Natural Thresholds Primary Purpose Threshold • Solvency • Income • Solvency • RBC triggers • IRIS tests • Gain/loss • Earnings target • Performance bonus

27. Less Common Thresholds • Particularly under GAAP there may be other thresholds related to the company’s financial structure such as loan covenants

28. Key Point! • If a change in reserve estimate causes a natural threshold to be crossed, it is material — no matter how small

29. Who’s Commenting on Risk ofMaterial Adverse Deviation (MAD)Texas, Illinois and Ohio domestics only Texas Illinois Ohio Number of opinions Surplus as measure Reserves as measure Dollar amount 31 52% 29% 13% 20 91% 7% 2% 45 55% 10% 30%

30. Sources of Potential Material Adverse Deviation • Various mass exposures • Asbestos • Pollution • Construction defect • Uninsured/underinsured motorist • Mold • Diminution of value Continued…

31. Sources of Potential Material Adverse Deviation • Reserves in low end of range • Reinsurance collections — can’t/wouldn’t pay • Volatile lines of business • High reserve/surplus ratio • High policy limits relative to surplus • Increased uncertainty due to changes in claims operations

32. Other Topics Addressed in ASOP #36 • Gross vs. Net Reserves • Discounting • Risk Margin • Reliance • Second Opinions

33. Codification of Statutory Accounting • Effective January 1, 2001 • Actuarial implications include: • Management’s best estimate of loss reserves • Premium deficiency reserves

34. Statement of Statutory Accounting Principles No. 55 • For each line of business and for all lines of business in the aggregate, management shall record its best estimate of its liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses • If, for a particular line of business, management develops its estimate considering a range… management’s best estimate of the liability within that range shall be recorded. • Management’s range shall be realistic and, therefore, shall not include the set of all possible outcomes but only those that are considered reasonable Continued…

35. SSAP # 55 • In the rare instances when…it is determined that no point within management’s estimate of the range is a better estimate than any other point, the midpoint… shall be accrued • If management determines that the high end of the range cannot be quantified, then a range does not exist, and management's best estimate shall be accrued

36. Codification and The Actuary • Management records (and supports) • Best estimate of reserves • Actuary continues to opine upon • Reasonableness of reserves

37. Management’s Best Estimate • Many auditors/examiners equate with actuary’s best estimate • Can it be in the low end of actuary’s range and still be management’s best estimate? • Management may be required to document why their estimate is different from the actuary’s

38. Ongoing Issues and Interpretations How does the “best estimate” reconcile with a “reasonable estimate”? What constitutes management’s “Best Estimate”? Who is “management”? Who owns the estimate? Role of the Actuary • Set reserves or review management’s reserves?

39. Opinion Problems • The actuary has “low confidence in the reserves booked” • Reserves are at the “low end of a reasonable range of estimates” • Schedule P errors/reconciliation • Exclusion of a line of business and/or block of reserves • Large surplus decreases

40. Minor Opinion Problems • Reconciliation of numbers in Actuarial Opinion vs. Annual Statement • Opinion was not included with Annual Statement filing • Incorrect date, state • No reconciliation • Frequent change in Opining Actuary • Reinsurance with carriers rated C or worse byA.M. Best

41. New In 2002 Opinion • General cleanup of inadvertent errors • Removes reference to not accruing for reporting lags for pools and associations • Major changes for 2004 Opinions issued in 2005