Reserve Adequacy and the Underwriting Cycle

1. Reserve Adequacy and the Underwriting Cycle Stephen T. Morgan CAS 2004 ANNUAL MEETING Montreal – November 15, 16, 17 General Session

2. Reserve Adequacy and the Underwriting Cycle Moderator: Steve Morgan ACAS, MAAA Vice President Clarendon Insurance Group Panelists: Meyer Shields FCAS, MAAA Analyst Legg Mason Wood Walker, Inc. Mike Angelina ACAS, MAAA Consulting Actuary Towers Perrin

3. Reserve Adequacy and the Underwriting Cycle Key indicators that RAUC is significant issue: • Many companies issuing news releases noting significant reserve increases; • Many published reports on industry reserve inadequacy/adequacy (S&P, A.M. Best, Morgan Stanley, and Fitch); • Legislative enactments with implications for reserving (Sarbanes-Oxley); • Regulatory actions with implications for reserving (reserve opinions, data testing requirement, department audits and oversight); and • Actuarial response (training, improved reserving techniques, and software).

4. Reserve Adequacy and the Underwriting Cycle Key questions to be asked about reserving: • Have actuarial techniques kept up with the times? • Are current regulatory guidelines sufficient to ensure a reasonable probability of reserve adequacy? • Are current ethical guidelines and policing for actuaries sufficient? • Do companies have sufficient internal controls? and • Is data quality or lack thereof a hidden cause of missing the reserving mark?

5. Reserve Adequacy and the Underwriting Cycle Have actuarial techniques kept up with the times? • Techniques developed BC (Before Computers) may not be up to reasonably projecting reserves in such a complex environment; • Sampling theory teaches us how to determine the probability of pulling a red or blue ball from a population of what we think only includes red and blue balls. What happens when we pull a purple ball or even a black ball? How can we know ahead of time?; • Can actuarial techniques ever be successfully used to estimate reserves when they are impacted by factors like case law and legislation?; • Does history really ever repeat itself? and • Can all the things that go wrong with data be picked up in actuarial techniques?

6. Reserve Adequacy and the Underwriting Cycle What others are saying: A.M. Best (October 4, 2004) • “Despite the considerable reserve charges [through year-end 2003], which totaled almost $47 billion over the past three calendar years, A.M. Best believes the industry’s overall carried reserve position remains deficient.” • “….reserves are up to $67 billion deficient….$38.5 billion is related to unfunded asbestos and environmental….” • “While actuaries use their best professional judgment in estimating reserves, there is a wide degree of variability inherent in loss reserves.” • “Management teams may weaken reserves… with the intention of strengthening reserves….when conditions improve.”

7. Reserve Adequacy and the Underwriting Cycle What others are saying (continued): Morgan Stanley (May 12, 2004) • ….we think the days of big-bath reserve charges are quickly fading.” • “At $80 billion, our estimated industry shortfall is at its lowest level in several years.” • “….insurers have been harvesting the gains of the hard market more quickly than in cycles past.” • “….nearly $5 billion of reserves from accident year 2002 were released in calendar year 2003.” Fitch Ratings (November 19, 2003) • “….that property/casualty was sharply underpriced….[and]…..companies do not have a firm handle on underwriting loss costs….” • “Fitch believes….reserving shortfalls….are attributable to a failure in the actuarial process as opposed to purposeful “cheating”……” • “Often despite best efforts, management is simply wrong because current established actuarial processes are unable to assess ultimate loss costs…..” • “Although “cheating” is highly troublesome,….reserving shortfalls have increasingly been the result of the actuaries simply being wrong,…and that generally actuaries do a relatively poor job in predicting future trends not yet evident in historical loss patterns.”

8. Reserve Adequacy and the Underwriting Cycle What others are saying (continued): Standard & Poors (May 10, 2004) • “Insurers tend to under-report reserves during soft pricing periods and then build up reserves as markets harden.” • “While some reserving error is explained by simple uncertainty, a good deal is caused by deliberate earnings management.” • “….cycle-driven reserving management ‘is a longstanding phenomenon,’….. • “Insurance companies also often swap fund between reserves.…to manage earnings rather than establish adequate reserves.” Standard & Poors (November 19, 2003) • “Actuaries are signing off on reserves that turn out to be wildly inaccurate…It’s an abysmal record.” • “But reserve shortfalls don’t just happen overnight. What happened to all of those reserve opinions….?” • “Analysts also point to the convenient discovery….of a reserve surplus in one line of business that masks deficiencies in another.” • “It [S&P] has also generally found its own “relatively simplistic models are more reliable than legions of actuaries.”

9. Reserve Adequacy and the Underwriting Cycle “The data is in the details.” Apologies to Anonymous