RMAD -- RISK OF MATERIAL ADVERSE DEVIATION A Practitioner’s Viewpoint

1. RMAD -- RISK OF MATERIAL ADVERSE DEVIATIONA Practitioner’s Viewpoint CASUALTY LOSS RESERVE SEMINAR September 10-11, 2007 Chap Cook, FCAS FCA, MAAA, CPCU Consulting Actuary, MBA Actuaries, Inc.

2. RMAD Requirements: Statutory • NAIC Instructions require the Appointed Actuary to provide specific relevant comment paragraphs to address the risk of material adverse deviation • Identify the standard, disclose amount in $US • Explicitly state if actuary reasonably believes there are significant risks that could result in MAD • If risk exists, include an explanatory paragraph to describe the major risk factors (exclude general broad statements)

3. RMAD Requirements: ASOP 36 • Requires an additional explanatory paragraph when the actuary reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation. This paragraph should contain the following: • The amount of adverse deviation that the actuary judges to be material with respect to the Statement of Actuarial Opinion; and • A description of the major factors or particular conditions underlying risks and uncertainties that the actuary believes could result in material adverse deviation.

4. RMAD Requirements: Practice Note • Regulatory Guidance: Actuary is encouraged to comment on the risks and other factors even when no RMAD is judged to exist • Stresses importance of considering the unique characteristics of each company vs. ‘cookie cutter’ language • Expects the actuary to disclose risks and uncertainties even when the carried reserve is within the actuary’s reasonable range

5. RMAD Requirements: Bright Line Indicator • Regulatory tool: Bright Line Indicator Test (BLI) – outside bound of what is considered material • Used to be part of the Practice Note Regulatory Guidance just discussed, now included only for regulators in the Financial Analysis Handbook • BLI is triggered when 10% of the Net Reserves are greater than the difference between the Total Adjusted Capital and Company Action Level Capital (RBC level) • It is highly likely that RMAD exists – regulator expects to see extensive comments

6. Material Adverse Deviation vs. a Range of Reasonable Estimates • Don’t confuse a range with an RMAD standard • One approach is to compare the selected materiality standard to the difference between the carried reserve and the high end of a reasonable range of reserve estimates • The range of reasonable estimates relates to a range of estimates of aggregate results • Narrower than the range of possible outcomes • The adverse deviation is an outcome; not too far out in the tail, but not an expected result, either • If the dollar distance from the carried reserve to the top of the range (in dollars) exceeds the materiality standard, it would seem that there must be RMAD • But if the dollar distance from the carried reserve to the top of the range is less than the materiality standard, there may still be RMAD

7. Materiality for MAD • If the ultimate losses were to be different by the amount of the materiality standard, then the regulator would be likely to do something different. • The regulator expects the actuary to consider the relationship of surplus to the exposure incurred, the lines written, and the volatility of development patterns (or less obvious criteria, e.g. key management changes) when establishing materiality and determining the presence or absence of risk of material adverse deviation.

8. Is there a Risk of Material Adverse Deviation?

9. Does RMAD exist?: Significant Risks and Uncertainties Significant risks and uncertainties are specific issues affecting ultimate claim liabilities such as: • Position of carried reserve relative to actuarial indications • Leverage • Volatility – Inherent, External • Extent of applicable historical data • Operational changes • Dependence on reinsurance • Other contingencies

10. Does RMAD exist?: Significant Risks and Uncertainties • Risky business; malpractice or excess & surplus • Poor spread; one line or one state • Little experience; new line or state or young carrier • Historical volatility of reserves: chronic IRIS problem • Low surplus or serious losses; small change in reserves may be very harmful to the carrier • On the edge; if the carrier is very near to break-even on profit or loss, or to a RBC break point

11. Does RMAD exist?: Disclosures • Yes/No explicit statement of the existence of RMAD • Per the Practice Note guidance, need discussion of risk factors that led to the conclusion • Conclusion based on specific risk factors for that entity • Avoid generalized comments • Avoid “Attorney approved” language

12. Does RMAD exist?: A Horror Story • Small Company – 96% in two states • 98% Long-tail Commercial Casualty • Over half had large deductibles • 95% of accounts in one industry • 100% of business from one MGA – • owned and managed by the same 3 people • Reinsurance Recoverables exceed surplus • $350,000 xs 150,000 layer RI retro rated How Many RMADS?

13. Does RMAD Exist?Bad Example #1 “Although the carried reserves as of 12/31/05 are within my reasonable range, I do believe that there is a substantial risk of material adverse deviation in the Company’s reserves as measured against a materiality standard of 10% of surplus. …Carried reserves are about 110% of surplus, so a 10% deficiency in reserves would results in a loss of more than 10% of surplus. A deviation of this magnitude, while not anticipated, is not a statistically insignificant possibility.” • What are the risk factor(s)?

14. Does RMAD Exist?Bad Example #2 “The Materiality Standard is established as 10% of reported statutory surplus, or $XXX,000 as shown in Exhibit B: Disclosures. I estimate the likelihood of material adverse deviation arising from normal variations in expected results to be about 16%. I estimate the likelihood of material favorable development to exceed 50%.” • Is 16% significant? • What might cause it to occur?

15. Does RMAD Exist?No RMAD Example #1 “Based on my actuarial calculations, the lines of business written by the company, the company’s participation in the intercompany pool, and my consideration of other relevant factors, I reasonably believe there are no known significant risk factors or uncertainties that could cause material adverse deviation. While adverse development in excess of the materiality standard is possible, I consider it unlikely.”

16. Does RMAD Exist?No RMAD Example #2 “The company writes a variety of coverages whose risk factors expose the company’s reserves to significant variability. I do not believe that there are any such factors that are unusual to the lines of business written. • Not “unusual” – but WHAT ARE THEY? • IS there an RMAD or NOT?

17. Does RMAD Exist?Better Examples #1 “A major risk factor underlying the recorded reserves is the inherent uncertainty associated with the long-tail business written by the company. I have considered this uncertainty by estimating a range of reasonable reserves. The difference between the recorded reserves and the high end of my range of reasonable estimates is X. I have selected a materiality standard of Y, which is Z percent of the company’s year-end policyholder surplus. Since the difference between the recorded reserves and the high end of my range of reasonable estimates exceeds this standard, I believe there are significant risks and uncertainties that could result in material adverse deviation from the recorded reserves.”

18. Does RMAD Exist?Better Examples #2 “In my opinion there is a risk of material adverse deviation…including uncertainties associated with the company’s changing mix of business and operations,…liabilities relating to the company’s discontinued operations, potential reinsurance collectibility issues and estimates of liability for the company’s A&E exposure.” I would like to see a paragraph on each one

19. Does RMAD Exist?Better Examples #3 “There are points within my reasonable range of reserve estimates that … would materially reduce the company’s surplus… Certain points nearer the high end of my range would… change the company’s RBC status to company action level.” • Good start, but … • What specific events or risks might cause it?

20. Does RMAD Exist?Better Examples #4 . “There is a Risk of Material Adverse Deviation because of claims counting issues found in the audit. For at least 2 years, some open claims for the XX line of business were incorrectly coded as closed. So far the 2007 data appears to have been corrected. This line shows unusually large loss development in 2007, especially in claims count. We are uncertain of the amount of reopened claims, both past and future, and are not sure that there are not some remaining open claims coded as closed. Because of a small volume of large volatile claims, we have historically given significant weight to the number of open cases. We did not give that any weight this year because of the error issue, which is a significant change in method.”

21. Does RMAD Exist?Better Examples #5 . “There is a Risk of Material Adverse Deviation because of a claim department reorganization. In the past, the claim department had been centralized at the head office, but during late 2006 it was decentralized to eight regional claim offices. Many examiners and adjusters did not accept transfers and were replaced, so there are many new staff members. We are also not certain that expertise may not have been diluted for smaller lines and unusual claims: it is difficult to have a product liability expert in every office. Management is confident that the geographic specialization will improve local knowledge and reduce travel expenses, but we are concerned that for at least two years there will be some uncertainty as to both adjustment quality and development patterns.”

22. Does RMAD Exist?Better Examples #6 “There is a Risk of Material Adverse Deviation because the company is in runoff. The company has been in runoff since 2004. Business volume written in the latest 3 years is small, declining, and essentially involuntary. There is not enough data to be confident of recent years’ development patterns: it is quite certain that mix within line has changed substantially, and highly likely that there has been significant adverse selection because better business and better agents have moved on, while poorer risks and agents are hanging on as long as they can legally hold the company on the risk.”

23. Does RMAD Exist?Better Examples #6 (continued) “Expected loss ratios for budgetary methods are assumed to be higher, but how much higher? We have also made pessimistic assumptions about deterioration in development factors, but how bad? Because of the declining volume of new claims, it is certain that A&O expenses will increase as a % of incurred losses because payments and handling will continue even as incurred losses decline toward zero. The absence of underwriting revenues means that operations such as general management, data processing, actuarial and accounting lay a larger portion of overhead expenses on the claims side of the business. Finally, the ability to retain the best adjusters may affect the quality of the claims settling. ”

24. Risks and Uncertainties DiscussedEven if no RMAD? • “But the NAIC Instructions don’t require me, as an appointed actuary to provide a discussion of risk factors when Risk of MAD is not present.” • Statistics shown: % of Opinions that discuss company specific risk factors, after actuary concluded no Risk of MAD.

25. Risks and Uncertainties Discussed Even if no RMAD? • Company specific risk factors cited for “No RMAD”: • Growth in long-tailed lines • Medical cost inflation trends • A&E, claims initiatives, construction defect liabilities • XS over large deductible and self-insured exposures • Regulators view this type of disclosure very positively. • These same factors could possibly lead to RMAD for the Company in the future. • Again, keep up the good work!

26. Special Considerations: Discussion with Management • Discuss risk of material adverse deviation disclosure requirements with management • Discuss risks and uncertainties with management • Consider risks and uncertainties in developing a range of reasonable estimates • Discuss comparison with management the difference between the carried reserve and the indicated reserve or range of reserve with management • Discuss draft disclosures with management

27. Special Considerations: Managing Expectations • Why not always include a risk of material adverse deviation disclosure? • Communication • Clear and unmistakable • Non-technical • Early and often • Reasonable

28. QUESTIONS ?????