Casualty Loss Reserve Seminar September 2006 Dancin With

Casualty Loss Reserve Seminar, September 2006 Dancin’ With the Devil Ranges and Adverse Deviation Charles L. Mc. Clenahan 10 South Wacker Drive, Chicago, IL 60606

Dancin’ With the Devil n Range of Reasonable Estimates n Risk of Material Adverse Deviation n Some Suggestions for Consideration Casualty Loss Reserve Seminar, September 2006 2

Range of Reasonable Estimates n History n Purpose n Misuse of Ranges n New Actuarial Opinion Summary Casualty Loss Reserve Seminar, September 2006 3

Range of Reasonable Estimates n History – 1973 - Bob Anker discusses reserve ranges – 1988 - CAS Statement of Principles - “a range of reserves can be actuarially sound” – 1994 - COPLFR – “reasonable provision” if within the “range of reasonable estimates” – 2000 - ASOP #36 Casualty Loss Reserve Seminar, September 2006 4

Range of Reasonable Estimates n ASOP #36 Definition (Section 3. 6. 4) A range of reasonable estimates is a range of estimates that could be produced by appropriate actuarial methods or alternative sets of assumptions that the actuary judges to be reasonable. Appropriate methods Reasonable Assumptions Casualty Loss Reserve Seminar, September 2006 5

Range of Reasonable Estimates Casualty Loss Reserve Seminar, September 2006 6

Range of Reasonable Estimates n Purpose – The range reflects the fact that different actuaries using different reasonable methods and different appropriate assumptions will produce different reasonable estimates of reserves – The range is NOT permission to carry 95% Casualty Loss Reserve Seminar, September 2006 7

Range of Reasonable Estimates n Misuse of Ranges – The “Actuarial Limbo” or “How Low Can You Go? ” – The “Actuarial Two-Step” – The “Actuarial Tango” or “It Takes Two” – The “Actuarial Waltz” or “It’s as Easy as 1 -2 -3” Casualty Loss Reserve Seminar, September 2006 8

Exhaustive Research Reveals … n 7. 3% of actuaries are using inappropriate methods n Of the remaining 92. 7%, 8. 4% are using unreasonable assumptions n We have identified the 84. 9% who are using appropriate methods and reasonable assumptions Casualty Loss Reserve Seminar, September 2006 9

Exhaustive Research Reveals … n Highest Best Estimate – Consultant named Max (last name withheld for privacy) – Max left his firm last month – Currently working in DC n Lowest Best Estimate – Consultant named Minnie (last name withheld to avoid being sued) – Currently swamped with work Casualty Loss Reserve Seminar, September 2006 10

Exhaustive Research Reveals … Casualty Loss Reserve Seminar, September 2006 11

The “Actuarial Limbo” or: “How Low Can You Go? ” n Minnie doesn’t know her best estimate is lowest Casualty Loss Reserve Seminar, September 2006 12

The “Actuarial Limbo” or: “How Low Can You Go? ” n So she establishes a range Casualty Loss Reserve Seminar, September 2006 13

The “Actuarial Limbo” or: “How Low Can You Go? ” n And signs off at the low end Casualty Loss Reserve Seminar, September 2006 14

The “Actuarial Limbo” or: “How Low Can You Go? ” n Another clean opinion for Minnie Casualty Loss Reserve Seminar, September 2006 15

The “Actuarial Two-Step” n Step 1 – Appointed Actuary Determines Range Casualty Loss Reserve Seminar, September 2006 16

The “Actuarial Two-Step” n Step 2 – Company Books to (or Near) Low Casualty Loss Reserve Seminar, September 2006 17

The “Actuarial Tango” or: “It Takes Two” n Company Books at Low End of Its Own Range Casualty Loss Reserve Seminar, September 2006 18

The “Actuarial Tango” or: “It Takes Two” n Appointed Actuary Sees Reserve Within Range Casualty Loss Reserve Seminar, September 2006 19

The “Actuarial Tango” or: “It Takes Two” n Clean Opinion on what both agree is low reserve Casualty Loss Reserve Seminar, September 2006 20

The “Actuarial Waltz” or: “It’s as easy as 1 -2 -3” n Appointed Actuary Prepares Analysis Casualty Loss Reserve Seminar, September 2006 21

The “Actuarial Waltz” or: “It’s as easy as 1 -2 -3” n n Appointed Actuary Shares Analysis with Company Selectively Critiques Analysis – Focus on areas where Appointed Actuary may be too high See? Claims are closing faster! – Ignore areas where Appointed Actuary may be too low Casualty Loss Reserve Seminar, September 2006 22

The “Actuarial Waltz” or: “It’s as easy as 1 -2 -3” n Appointed Actuary Amends Analysis Casualty Loss Reserve Seminar, September 2006 23

The “Actuarial Waltz” or: “It’s as easy as 1 -2 -3” 2 1 3 Repeat as necessary Casualty Loss Reserve Seminar, September 2006 24

New Actuarial Opinion Summary n n n Signed and dated by the Appointed Actuary AOS should include the Appointed Actuary’s range of reasonable estimates and/or point estimates Where there has been one-year adverse development in excess of 5% of surplus, in at least three of the past five calendar years, include explicit description of the reserve elements or management decisions which were the major contributors. Casualty Loss Reserve Seminar, September 2006 25

New Actuarial Opinion Summary n Disclosure of best estimate and/or range will be helpful to regulators, not available to consumers – Confidentiality likely to be litigated – Bases for ranges will receive additional attention – May be client pressure for wider (lower) ranges – If reserve is near bottom of range, best estimate alone will be disclosed Casualty Loss Reserve Seminar, September 2006 26

New Actuarial Opinion Summary n 5% of Surplus Test Casualty Loss Reserve Seminar, September 2006 27

New Actuarial Opinion Summary n 5% of Surplus Test – Penalizes strengthening – Constant 5% benchmark – inflation will have major impact – Single test point: 5% in 3 of 5 years o No disclosure required for: 4 th prior (1%) 3 rd prior 2 nd prior 1 st prior Current Casualty Loss Reserve Seminar, September 2006 (2%) (4%) (8%) (22%) 28

Risk of Material Adverse Deviation n ASOP #36 3. 3. 3 Significant Risks and Uncertainties (Explanatory Paragraph) - When the actuary reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation, the actuary should also include an explanatory paragraph in the statement of actuarial opinion. (See sections 3. 4 and 3. 6. 5 for guidance on evaluating materiality and considering risks and uncertainties. ) The explanatory paragraph should contain the following: a. the amount of adverse deviation that the actuary judges to be material with respect to the statement of actuarial opinion; and b. a description of the major factors or particular conditions underlying risks and uncertainties that the actuary believes could result in material adverse deviation. Casualty Loss Reserve Seminar, September 2006 29

Risk of Material Adverse Deviation n 2005 Practice Note – The actuary should include within the Actuarial Report some detail on how the materiality threshold was chosen, including commentary on what items were considered in choosing the threshold. In addition, the Actuarial Report should include extended commentary on the risks considered in the actuary’s determination of whether a risk of material adverse deviation exists. Casualty Loss Reserve Seminar, September 2006 30

Risk of Material Adverse Deviation n Materiality Threshold – Possible factors to consider: o o o % of reserves % of surplus impact on income/earnings-per-share impact on IRIS tests impact on RBC impact on Best’s or S&P ratings Casualty Loss Reserve Seminar, September 2006 31

Risk of Material Adverse Deviation n Difficult Questions – If the difference between the Appointed Actuary’s best estimate and the booked reserve exceeds the materiality threshold, is that a prima facie risk of material adverse deviation? – Are there so many potential risks that the important ones are likely to get lost in the boilerplate? – How do you quantify effects of: o o o Adverse judicial decisions? Future inflation? Currency fluctuation? Casualty Loss Reserve Seminar, September 2006 32

Some Suggestions for Consideration n Ownership of Reserve Estimate – Company must select carried reserve before independent Appointed Actuary estimates range (“untutored” reserve) – If untutored reserve is within range it is reasonable – If untutored reserve is below range, Appointed Actuary now “owns” the estimate (is establishing reserve) and a clean opinion requires reserve of at least AA’s best estimate Casualty Loss Reserve Seminar, September 2006 33

Some Suggestions for Consideration n Disclosure of position within range – If Appointed Actuary calculates range it should be disclosed – If Appointed Actuary calculates best estimate it should be disclosed – If Company has calculated range different from AA it should be disclosed Casualty Loss Reserve Seminar, September 2006 34

Some Suggestions for Consideration n Definition of “reasonable provision” – Current ASOP #36 – “if it is within the actuary’s range of reasonable reserve estimates” – Proposed – “if it is greater than or equal to the best estimate of a qualified actuary and it is within the opining actuary’s range of reasonable estimates. ” Casualty Loss Reserve Seminar, September 2006 35

Some Suggestions for Consideration n Reserve Development Test – Scrap the 5% in 3 of 5 test – Development should be measured at equivalent point in range to avoid penalty for strengthening – Benchmark should reflect change in CPI Casualty Loss Reserve Seminar, September 2006 36

Some Suggestions for Consideration n Risk of Material Adverse Deviation – Universal risks should be enumerated and excluded from disclosure o o o Judicial interpretations Retroactive legislation Inflation Currency fluctuation or revaluation Theories of litigation Emergence of previously unknown damage or disease Casualty Loss Reserve Seminar, September 2006 37

Some Suggestions for Consideration n Ranges of Reasonable Estimates – Avoid benchmarks based upon best estimate (i. e. ±x%) o Cannot assume every b. e. is at midpoint – Experience-based studies should correct for general under- estimation of ultimates o Widening the range tends to increase deficiency Casualty Loss Reserve Seminar, September 2006 38