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George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 24, 2002 Arlington, Virginia

Considerations Regarding Materiality and Range of Reserves In Connection With Actuarial Standard of Practice # 36. George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 24, 2002 Arlington, Virginia. Comment Letters Included:

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George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 24, 2002 Arlington, Virginia

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  1. Considerations Regarding Materiality and Range of ReservesIn Connection With Actuarial Standard of Practice # 36 George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 24, 2002 Arlington, Virginia

  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 ASOP36: Comments on 1999 3rd Exposure Draft (Appendix 2)

  3. 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) General Overview of ASOP # 36 (Effective October 15, 2000)

  4. Reasonable Deficient or Inadequate (Not Reasonable) Redundant or Excess Provision (Not Reasonable) Qualified No Opinion Five Types of Opinions(Section 3.3.2)

  5. COPLFR Practice Note— Only Available Guidance prior to ASOP36, but not Binding 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 Comments Regarding Types of Actuarial Opinion

  6. Disappearance of “Reasonable but Conservative” 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 Comments Regarding Types of Actuarial Opinion (cont.)

  7. 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 Range of Reasonable Reserve Estimates

  8. Accounting Literature: Financial Accounting Standards No. 5: “Accounting for Contingencies”—Accrue Loss When Probable Asset Impaired or Liability Incurred Amount of Loss Can be Reasonably Estimated Range of Reasonable Reserve Estimates (cont.)

  9. “FASB Interpretation # 14: Reasonable Estimation of the Amount of a Loss—An Interpretation of FASB 5” When an Amount In Range Appears Better than Another, Accrue that Amount When No Amount is Better than any Other Amount, Accrue the Minimum Amount in the Range Range of Reasonable Reserve Estimates (cont.)

  10. Illustrates Difference Between Actuary’s and Accountant’s View of Best Estimate and Range Actuary: Point Estimate is More Probable than other points//Accountant: Book It (Under FASB5) 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 Range of Reasonable Reserve Estimates (cont.)

  11. 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 Disclosure of Range of Reasonable Reserve Estimates

  12. 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. Materiality Discussed in Section 3.4 of ASOP36

  13. Professional Judgment Materiality Guidelines or Standards Applicable to the Statement of Actuarial Opinion Actuary’s Intended Purpose for the Statement of Actuarial Opinion—which values are important for the user The Actuary Should Evaluate Materiality Based On:

  14. Specified Reserve Amount (% Loss Reserves) The Company’s Reported Surplus The Company’s Net Worth and Annual Net Income (for an Evaluation) Sec. 3.4: 3 Examples of Materiality to Reference

  15. Specified Reserve Amount: 5% and 10% seen in practice [Note: The “Average” Range of Reserves implies which figures to use] The Company’s Reported Surplus: If Reserves/Surplus at 2:1, would imply 10% and 20% of Surplus Net Income: 5% and 10% under certain limited circumstances according to SEC’s SAB 99 Quantitative Percentages of Materiality: Observations

  16. 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: Absolute magnitude of correction/difference item Absolute magnitude of item for which data is not available Impact of Item on IRIS or RBC Capital Results Professional Guidance Regarding Materiality

  17. SEC Staff Accounting Bulletin #99 Numerical Quantitative Values have no basis in Law or Accounting Literature Misstatements are not immaterial simply because they fall below minimum value Professional Guidance Regarding Materiality (cont.)

  18. Risk of Material Adverse Deviation Exists If: High End of Range – Carried Reserves > Materiality Amount Material Adverse Deviation in Relation to Range

  19. Risk of Material Adverse Deviation Exists If: High End of Range – Carried Reserves > Materiality Amount, or High End of Range > Carried Reserves +Materiality Amount Material Adverse Deviation in Relation to Range (cont.)

  20. Risk Based Capital Concept, from 1994 Butsic Expected Policyholder Deficit (“EPD”) Where A=Assets, L=Loss Reserves DL = p(x) (x-A)x>A Expected Material Deviation (“EMD”) 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 Expected Policyholder Deficit vs. Expected Material Deviation

  21. EPD Ratio= DL/L Where A=Assets, L=Loss Reserves DL = p(x) (x-A)x>A EMD Ratio= DMD /L Where L=Loss Reserves, M=Materiality Amount DMD = p(x) (x-(L+M))x>L+M EPD Ratio vs. EMD Ratio

  22. Low Medium High Carried Materiality 90 100 110 105 10.5 (10%) Since High End (110) < Carried + Materiality (115.5), Risk of Material Adverse Deviation Does Not Exist Material Adverse Deviation in Relation to Range (Example)

  23. Low Medium High Carried Materiality 90 100 110 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) Material Adverse Deviation in Relation to Range (Example)

  24. LineLowMediumHighCarried MedMal (+/-14.1%) 7.6 8.8 10.1 8.1 WC(+/-7.8%) 48.6 52.7 56.8 51.1 PAL (+/-6.7%) 52.8 56.6 60.4 63.5 GL (+/-9.2%) 34.1 37.6 41.0 34.0 CAL (+/-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 Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

  25. Materiality LineHighCarriedHigh-Carried10% ReservesRisk? MedMal 10.1 8.1 1.9 0.8 Yes WC 56.8 51.1 5.7 5.1 Yes PAL 60.4 63.5 (3.2) 6.4 No GL 41.0 34.0 7.0 3.4 Yes CAL 22.1 18.9 3.2 1.9 Yes All 323.2 297.0 26.2 29.7 No Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

  26. Materiality LineHighCarriedHigh-Carried20% ReservesRisk? MedMal 10.1 8.1 1.9 1.6 Yes WC 56.8 51.1 5.7 10.2 No PAL 60.4 63.5 (3.2) 12.8 No GL 41.0 34.0 7.0 6.8 Yes CAL 22.1 18.9 3.2 3.8 No All 323.2 297.0 26.2 59.4 No Material Adverse Deviation in by Line of Business: A.M. Best’s 2000

  27. High-Materiality EMD LineCarried10% ReservesEMDReserve s Ratio MedMal 1.9 0.8 1.1 8.1 14% 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% Expected Material Deviation and EMD Ratios, by LOB: A.M. Best’s 2000

  28. Range of Reasonable Reserves and Amount of Material Adverse Deviation are Related Amount of Material Adverse Deviation can be quantified, as the high end of the range – (carried reserves plus the materiality standard) 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 Conclusions

  29. 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 The risk of material adverse deviation can be supported by qualitative as well as quantitative tests. Conclusions (continued)

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