Materiality and Statements of Actuarial Opinion

1. Materiality and Statements of Actuarial Opinion Presentation to Casualty Loss Reserve Seminar September 24, 2002 Joseph A. Herbers, ACAS, MAAA Principal & Consulting Actuary Miller, Herbers, Lehmann, & Associates, Inc.

2. Materiality and Statements of Actuarial Opinion • Comments relate only to statutory SAO, not to other SAO’s • Materiality in context of required disclosures • Assume working knowledge of NAIC Instructions for SAO and ASOP 36

3. Materiality and ASOP 36 • “Material” or “materiality” is mentioned at least 13 times in ASOP 36 • Section 3.4 devoted to “Materiality”

4. ASOP Section 3.4 • In evaluating materiality within the context of a reserve opinion, the actuary should consider the purposes and intended uses for which the actuary prepared the statement of actuarial opinion • Evaluate materiality based on professional judgment, materiality guidelines or standards applicable to SAO and actuary’s intended purpose for the SAO

5. Materiality Standard • Need for separate ASOP on Materiality? • Subcommittee on Reserving agreed that it would be better to already have a materiality standard, but lack of such standard is not critical to use of ASOP 36 • Principal uses of materiality in ASOP are for the actuary to decide if explanatory paragraph is needed

6. Where Do We Look for Guidance? • SEC • FASB • Supreme Court • NAIC Financial Examiners Handbook • VFIC • NAIC Accounting Practices and Procedures Manual

7. SEC Staff Accounting Bulletin No. 99 • Exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements … is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold • Days of relying simply on +/-5% are over • However, SEC has no objection to such rules of thumb as an initial step in assessing materiality

8. FASB No. 2 • The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of item • Management must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality

9. U. S. Supreme Court • TSC Industries v. Northway, Inc., 426 U.S. 438,449 (1976) • A fact is material if there is a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available • Determinations of materiality require “delicate assessments of inferences a reasonable shareholder would draw from a given set of facts and the significance of those inferences to him”

10. NAIC Financial Examiners Handbook • Dollar amount above which the examiner’s perspective of the company’s financial position will be influenced • Overall Materiality • Individual Balance Sheet items • Planning Materiality (PM) – starting point is 1% to 5% of surplus

11. VFIC • Appendix 7 to P/C Practice Note developed by COPLFR • Discussion of materiality and ASOP 36 • Specific citations of the words material, materially, materiality • Discussion of guidance from NAIC and SEC

12. NAIC Accounting Practices and Procedures Manual • Materiality judgments are primarily quantitative in nature • Is this item large enough for users of the information to be influenced by it? • Magnitude of the items is such that it is probable that the judgment of a reasonable person relying upon the statutory financial statement would have been changed or influenced by the inclusion or correction of the item

13. Regulator Statutory Surplus Risk Based Capital Loss, LAE, Unearned Premium Reserves IRIS Tests Appraisal New Worth (GAAP) Net Income Earning per Share Which financial values are important to the intended user?

14. Regulators Management Investors Auditors Reinsurers Rating Agencies Policyholders Claimants ABCD Who are Intended Users?

15. Crux of the Problem • With all these intended users, how do I determine what a reasonable person will view as material?

16. Regulatory View • MHL Survey of Regulators’ view of materiality threshold (Fall 2000) “It all depends” (7) 1% to 5% of Surplus (6) “It’s up to you” (2) 10% of surplus (1)

17. View of Practicing Actuaries • Informal Survey subsequent to year-end 2000 opinion season (mostly consultants) 10% of reserves/20% of surplus (3) 15% of surplus (2) 15% of reserves/25% of surplus (1) 1% - 5% of surplus (1)

18. Suggested Multiple Trigger Approach • Difference between held reserves and high end of range of indicated reserves • Impact of indicated reserves on IRIS Tests 10-12 • Impact of indicated reserves on RBC

19. Materiality Considerations • Single vs. multiple line company • Net Retention • Single Company vs. Member of Group • Access to Capital • Management • Prior loss reserve runoff • Financial Strength

20. Management as User of SAO • Viewed as regulatory requirement • Disclose as little as possible • Boilerplate Language • Materiality viewed relative to surplus or total reserves

21. Case Studies • Mutual Auto Insurance Company • Multi-Line Casualty Company • Lawyers Prof. Liab. Mutual Ins Co • Reinsurance Company

22. Mutual Auto Insurance Co.

23. Multi-line Casualty Insurance Co.

24. Lawyers Prof. Liability Mutual Insurance Co.

25. Reinsurance Company

26. Quantitative Approaches to Materiality • Stochastic Modeling • “Murphy” method – regression techniques • “Mack” method – distribution free statistical approach • “Renshaw & Vernall” – generalized linear models

27. Conclusions • Must consider viewpoint of Intended Users • Many “unintended” users because SAO is a public document • Use reasonable person test • Our view of materiality is typically much broader/wider than that of our audiences • Suggest a multiple trigger approach for assessing materiality • Consider totality of information, and give it “thoughtful consideration”