IRS/ActuaryIRS/Actuary

Actuary’s Perspectiveby

Alan E. Kaliski, FCAS, MAAA

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Sensitivity to Loss Cost Inflation

Loss reserves at 12/31/98 = $ X These are estimates of what future payments will be on

outstanding reported and unreported claims as of 12/31/98.

There is an implied or imbedded assumption regarding loss cost inflation from 12/31/98 to dates of payments

Average payment date on the loss reserves @ 12/31/98 may be 4 years out for some casualty lines

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Sensitivity to Loss Cost Inflation

Hence, for every 1% of error in annual inflation, loss reserve estimate will be off by 4%

Reserves are leveraged to loss cost inflation on casualty lines with lengthy pay-out periods

Leverage compounds to extent loss reserves leveraged to surplus (if reserves = 2x surplus, then 1% error in inflation equals 8% of surplus).

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Sensitivity to Tail

Workers’ compensation has significant loss development beyond 20 years

Error in estimate of tail factor compounds itself over 20+ years

Example: For each error of 1% in tail factor, loss reserves could be off by 7%

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Asbestos & Environmental

Greater than normal uncertainty Existence of coverage Definition of occurrence Ultimate damages Allocation to potentially responsible parties No historical information

Early Estimates of Industry Liabilities (1994 study)

$50 billion - $600 billion

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“Make a reasonable provision for all unpaid loss and loss expense

obligations of the Company under the terms of its policies

and agreements.”

— NAIC Annual Statement Instructions —

Statement of Actuarial Opinion

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Committee on Property and Liability Financial Reporting (COPLFR) of the

American Academy of Actuaries (AAA)

“Reserve makes a reasonable provision if it is within the range of reasonable estimates …”

“The range of reasonable estimates is a range of estimates that would be produced by alternative sets of assumptions that the actuary judges to be reasonable…”

“The range of reasonable estimates is narrower, perhaps considerably, than the range of possible outcomes…”

“When exceptionally high degree of variability…, the actuary may choose to discuss this in the opinion.”

Property and Casualty Practice Note - December 1998

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(February 1998 Exposure Draft)

Actuarial Standards Board –Proposed Actuarial Standard of Practice

on Statements of Actuarial Opinion

Uncertainty Requires actuary to evaluate the uncertainty in the

reserve in determining range of reasonable estimates Requires actuary to comment on risk of material

adverse deviation Sets forth sources of uncertainty:

Random chance, changes in operations, changes in external environment, changes in data trends, etc.

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Evolution of Uncertainty Considerations

Reasonable Reserves

Range of Estimates

Reasonable sets of Assumptions

Evaluate Uncertainty, Risk ofMaterial Adverse Deviation

Identify Sources of Uncertainty

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Range of Reasonable Estimates

Example #1Reasonable

$400M

–2% inflation

$450M

2% inflation

$550M

8% inflation

$600M

12% inflation

??$500M

Possible - YesReasonably Likely - No

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Loss Development Factors

Example #212-241.501.801.851.80

. . . . . . . . . . . . . 24-361.201.501.55

Selected 1.50 1.20

Selections are lowest points in each intervalPossible - Yes

Reasonably Likely - No

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Example #3

Possible - YesReasonably Likely - No

Incurred Loss Development Method = $500M(No adjustments)

Know that case reserves weakened on latest diagonal

Select $500M as being in range

IRS/Actuary

Independent Public Accountant’s Perspective

byMichael R. Hazel, CPA, FLMI

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Auditing Literature

SAS 57 - Auditing Estimates SAS 47 - Audit Risk and Materiality in Conducting

an Audit SAS 73 - Use of a Specialist

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SAS 57 - Auditing Estimates

Adjustment of reserves in future periods as a result of future events is not indicative of poor reserving

Relates to the SFAS 5 concept of accrual of loss contingencies

Auditor’s assessment is of the reasonableness of the reserve estimate

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SAS 57 - Auditing Estimates

The audit approach developed should address the inherent variability of loss reserve estimates an the impact of that variability in developing the estimate

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AICPA Audit Guide for Property and Liability Insurers

Provides guidance to the auditor in auditing and analyzing loss reserves

Suggests two methods for analyzing variability: To consider a range of estimates bounded by a

reasonable high and low estimate Develop a best estimate and supplement with a

qualitative analysis to address the variability in the estimate. Factors to consider are the mix of the business, historical volatility, etc.

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AICPA Audit Guide for Property and Liability Insurers

Factors affecting the reasonableness of the size of the reserve range:

History of the line of business (or lack thereof) Volatility of the underlying product Surplus levels of the Company Volatility in other lines of business underwritten by

the Company Volatility of other account balances in the financial

statements

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SAS 47 Audit Risk and Materiality in Conducting an Audit

“If the auditor believes the estimated amount included in the financial statements is unreasonable, he should treat the difference between the estimate and the closest reasonable estimate as a likely misstatement and aggregate it with other likely misstatements.”

If the recorded reserve is outside the reasonable range, an adjustment should be proposed to bring the reserve to the closest end of the reasonable range

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SAS 47 Audit Risk and Materiality in Conducting an Audit

Gives credence to the reasonability of recording any amount so long as it is within the reasonable range

“since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered a likely misstatement”

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Management’s Responsibility

Management must select a single loss reserve estimate that represents its judgement about the most likely scenario

If a reasonable range is developed, the recorded balance should be the best estimate within that range

Auditor’s responsibility is to ensure there is adequate disclosure of the uncertainty of the estimate in the financial statements

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SAS 73 Auditors Use of a Specialist to Evaluate Loss Reserves

Auditor is not expected to have the expertise of a person trained for or qualified to engage in the practice of another profession

Where a specialist is creating audit evidence, the auditor must consider the specialists relationship with the client

Assess whether the judgement of the specialist could be impaired

The auditor is not precluded from using the work of a specialist who has a relationship with the client

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SAS 73 Auditors Use of a Specialist to Evaluate Loss Reserves

In-house actuary only develops loss reserve estimate Auditor is required to use the services of an outside

specialist to evaluate the reasonableness of the loss reserve estimate

Outside actuary only develops loss reserve estimate Auditor must evaluate the relationship between the

external actuary and management, to the extent the actuary is deemed related, the auditor should consider the use of an outside specialist

In-house actuary develops reserves, outside specialist reviews estimate

The auditor can use the outside review

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SAS 73 Auditors Use of a Specialist to Evaluate Loss Reserves

Testing the work of a specialist Obtain an understanding of the methods and

assumptions used by the specialist Test the accuracy of the data provided to the

specialist Assure the specialists conclusions support the

related financial statement assertions