ASOP’s FABLES:How Plaintiffs and Actuaries

Use the Actuarial Standards of Practice in Litigation

By

R. Timothy Muth

Sandra Zunker BrownReinhart Boerner Van Deuren s.c.

1000 North Water StreetMilwaukee, WI 53202

414-298-1000www.reinhartlaw.com

Overview

• Standards of Practice and Their Role in Malpractice Litigation

• Recent Cases Involving Actuarial Standards

• A Courtroom Example• The Standards Most Likely to Be Involved

in Litigation• Some Conclusions

Code of Professional Conduct:

• “An Actuary shall ensure that Actuarial Services performed by or under the direction of the Actuary satisfy applicable standards of practice.”

Precept 3

MALPRACTICE

WORK THAT FALLS BELOW THE

AVERAGE PROFESSIONAL

STANDARD OF CARE

How Does the Jury Know the Standard of Care?

• Expert Testimony

• Standards of Practice» ASOPs

» Code of Conduct

» CAS Statement of Principles

» NAIC Annual Statement Requirements

ASOP 23 means the actuary must ...

A Fable -- The Lion, the Fox, and the Ass

“Happy is the person who learns from the

misfortunes of others.”

ASOP FABLE #1:

“The Actuary and the Non-Existent Duties of Solvency and

Risk Transfer Certification”

Once upon a time….

• YE 1988: Actuary provides unqualified SOAO for Life Company (“LifCo”).

• 1989: Former LifCo officer “blows the whistle” to DOI.

• January 19, 1990: DOI concludes LifCo was underreserved and insolvent as of YE 1988 . . . but does not tell the Actuary.

Our story continues...

• YE 1989: Actuary provides unqualified SOAO for LifCo.

• DOI allows LifCo to continue to write new business until October 1991.

• DOI becomes the Receiver for the insolvent LifCo in 1992.

DOI Sues the Actuary

• Actuary allegedly did not read reinsurance agreements and allowed LifCo to take a reserve credit based on treaties that did not transfer risk.

• Actuary allegedly understated LifCo’s reserves, which “masked” LifCo’s insolvency.

The Trial Court Agrees

• Awards $17.5M to DOI in 2001.

• Rules that Actuary “should have certified that LifCo was insolvent” and that Actuary’s “failure to properly calculate reserves and advise LifCo and the regulators that the company was insolvent beginning in 1988” constituted negligence.

The Court’s Reasoning:

• LifCo was “totally dependent” on Actuary “for advice on its financial solvency” because of the “constant turnover” in LifCo treasurers.

• Actuary’s failure to review the reinsurance treaties was negligent; Actuary “fully participated in these sham treaties” by certifying reserves.

More Reasoning:

• The DOI did not have to prove that it relied upon or even read Actuary’s SOAOs.

• “The Court presumes that the certification was reviewed because no regulatory action was taken.”

This case is currently on appeal. It is fully briefed and will be argued on September

18, 2003.

Why the Trial Court was Wrong:

• Actuaries do not certify solvency.• Court looked to an ASOP that did not exist

when the Actuary provided SOAO.

» ASOP 11, “The Treatment of Reinsurance Transactions in Life and Health Insurance Company Financial Statements,” was effective for fiscal periods beginning after December 15, 1989.

ASOP 11• Provided that actuaries “must undertake

review of all material reinsurance agreements.”

• Provided that actuaries “should be familiar with all financial features of material reinsurance agreements.”

• Provided that “the actuary must ensure that all risks transferred, and only the risks transferred, are recognized in determining the reinsurance credits.”

ASOP 11

• Provided for a future effective date because “very little guidance is currently available to actuaries in accounting for reinsurance….practices have varied. The level of attention given to reinsurance transactions has ranged from perfunctory to detailed cash flow analysis.”

Current Exposure Draft of ASOP 11

• “The actuary should consider the material financial features of relevant reinsurance agreements.”

• “The actuary may rely on reinsurance information, including data, supplied by others.”

The Moral:

• In the absence of an ASOP, courts will determine what the duty of care is.

• Courts may apply ASOPs retroactively despite clear directions that the ASOPs are creating new and/or higher duties that should not be applied retroactively.

ASOP FABLE #2:

“Mission Impossible: The Actuary and the Duty to Prevent Misuse”

Once upon a time….

• Actuary estimates Seller’s YE reserves.

• Potential Buyer reviews Actuary’s estimate and computes its own reserve estimate during due diligence.

• Potential Buyer signs a binding contract to purchase Seller.

• The deal closes six months later.

The Plot Thickens

• During the six months between contract and closing, Seller asks Actuary to update her reserve estimate.

• Data issues hinder Actuary’s work.

• Shortly before closing, Actuary tells Seller that reserves have developed adversely.

New estimate is not shared

• Seller never requests the new estimate.

• Buyer never informs Seller of the new reserve estimate.

• Deal is concluded and reserves continue to deteriorate.

• Buyer becomes insolvent.

Buyer Sues Actuary

• Buyer alleges that Seller misused Actuary’s report to mislead Buyer and Actuary had duty to “prevent misuse.”

• Buyer cites ASOP 9, “Documentation and Disclosure in PC Insurance Ratemaking, Loss Reserving, and Valuations.”

Prevention of Misuse:

• “Information prepared by an actuary may be used by another person in a way that may influence the actions of a third party. If someone other than an actuary might convey such information to any such indirect users, the actuary should recognize the risk of misquotation, misinterpretation, or other misuse of its actuarial aspects.”

ASOP 9, sec. 5.3.

Buyer’s other allegations:

• Using data that was not available when Actuary estimated reserves, Buyer alleges that Actuary was “wrong” in its estimate by millions of dollars and thus was negligent.

• Buyer claims Actuary had a duty to tell Buyer of updated analysis.

Why Buyer is wrong:

• The Actuary took reasonable steps to prevent misuse.

• The Actuary had a duty of confidentiality.

• Hindsight is improper.

The ASOPs Explain How to prevent “misuse”

• “The actuary should take reasonable steps to ensure that an actuarial work product is presented fairly.”

ASOP 9, sec. 5.3.

Actuarial work product is presented fairly if it describes:

• the data

• the material assumptions

• the methods, and

• any material changes in these three items from the last analysis.

ASOP 9, sec. 5.3.

The description must be made “with sufficient clarity that

another actuary practicing in the same field could make an

appraisal of the reasonableness and validity of

the report.”

The Code Describes the Duty of Confidentiality:

• “An actuary shall not disclose to another party any Confidential information unless authorized to do so by the Principal or required to do so by law.”

Precept 9, Code of Professional Conduct.

Experts describe the flaws and fundamental unfairness of

“hindsight” analysis

• ASOPs do not caution against use of hindsight (but should).

The Moral:

• These cases have settled; we do not yet know how a judge will rule on these issues.

• Document everything clearly so your work is “fairly presented”!

ASOP FABLE #3:

“The Actuary and the Negligent Attorneys”

Once upon a time….

• An attorney tells pension trustees that a proposed benefit change is legal.

• An actuary estimates the cost of the proposed change.

• The pension plan negotiates the change with the union.

• The attorney restates the Plan.

The Plot Thickens….

• Attorney’s secretary mistakenly deletes a set-off provision from the Plan document that no one wants deleted.

• A court rules that the negotiated change was not permissible.

• The Plan becomes underfunded.

The Trustees Sue the Actuary

• Trustees allege Actuary was negligent in continuing to value Plan as the Trustees intended, instead of as the typographically incorrect Plan read.

• Trustees allege Actuary was negligent in “recommending” the proposed change by estimating that it would save money.

The Moral:

• Some attorneys have no morals.

• Disclose reliance on others--even if it seems obvious.

• Limit the scope of your engagement, in writing if possible.

An Example of Possible Trial Testimony Around the ASOPS

Concerning Data

Standards of Practice

• The average level of practice?

• The minimum level of practice?

• A goal which all actuaries should strive for?

• Set to lift the average level of practice of the profession?

Standards of Practice

• Sword -- The jury should find the actuary negligent because she failed to comply with the standard of practice

• Shield -- The jury should NOT find the actuary negligent because she complied with all the applicable standards of practice

A Fable--The Eagle and the Arrow

"We often give our enemies the means for our own destruction."

Plaintiffs’ Top 10 List

Plaintiffs’ Top 10 List

Helpful ASOPs for Actuaries Under Attack

Uncertainty

• “Actuarial estimates are inherently uncertain…Even when appropriate actuarial techniques and assumptions indicate that the stated reserve amount is reasonable, the actual amount necessary to settle the unpaid claims can be significantly different from the stated reserve amount.”

ASOP 36, sec. 3.6

Range

• “A range of reasonable estimates usually does not represent the range of all possible outcomes.”

ASOP 36, sec. 3.6.4.

Communications to Third Parties

• “Nothing in this standard creates an obligation for the actuary to communicate with any person other than the intended audience.”

ASOP 41, sec. 3.5.2

Reliance

• “The actuary may rely on data, projections, and supporting analysis supplied by others. In doing so, the actuary should disclose both the fact and the extent of such reliance.”

ASOP 7, sec. 4.1

External Conditions

• “the actuary should consider forces in the environment that are likely to have a material effect on the results of the actuary’s reserve analysis. However, the actuary is not required to have detailed knowledge of all the economic changes, regulatory actions, judicial decisions, political or social forces, etc., that may affect the settlement values.”

ASOP 36, sec. 3.5.3

Judgment

• “Any credibility procedure requires the actuary to exercise informed judgment, using relevant information. The use of credibility procedures is not always a precise mathematical process.”

ASOP 25, sec. 3.4

ALWAYS INSERT THIS:

• “If the actuary reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation, an explanatory paragraph…should be included.”

ASOP 36, sec. 4.6(g)

You Can Deviate from the ASOP Standards

• “An actuary must be prepared to justify the use of any procedures that depart materially from those set forth in this standard and must include, in any actuarial communication disclosing the results of the procedures, an appropriate statement with respectto the nature, rationale, and effect of such departures.”

But Beware…Disclosure is required!

• Disclose nature of deviation: what you did differently.

• Disclose rationale: why you did it differently.

• Disclose the effect: how the deviation impacts your results.

ASOPs we’d like to see• Actuaries are not regulators.• Actuaries are not auditors.• Actuaries are not attorneys.• Actuaries are not responsible for

management of insurance companies.• Actuaries do not opine on solvency.• Actuaries can rely on management,

regulators, auditors and attorneys to do their jobs correctly.