George M' Levine, FCAS, MAAA

1
Considerations Regarding Materiality and Range of
ReservesIn Connection With Actuarial Standard of
Practice 36

• George M. Levine, FCAS, MAAA
• Senior Manager, KPMG LLP
• September 24, 2002
• Arlington, Virginia

2
ASOP36 Comments on 1999 3rd Exposure Draft
(Appendix 2)

• Comment Letters Included
• Request that ASOP 36 Provide More Guidance by
  Giving Various Examples in the ASOP
• Concern that Many Actuaries are not aware of the
  ASOP
• This Paper 1) Provides Examples and 2) Based on
  Authors experience, provides Areas that many
  actuaries have been unaware of since 12/00

3
General Overview of ASOP 36 (Effective October
15, 2000)

• Some Important New Requirements
• Actuary Evaluate Risks and Uncertainties which
  Could Result in Material Adverse Deviation in
  Loss Reserves (Section 3.3.3)
• Actuary Evaluate Materiality in Loss Reserves,
  Considering the Intended Use of the Statements
  (Section 3.4)
• Specific Guidance as to Nature and Extent of
  Disclosures for Statement of Actuarial Opinion
  SAO (Section 4)

4
Five Types of Opinions(Section 3.3.2)

• Reasonable
• Deficient or Inadequate (Not Reasonable)
• Redundant or Excess Provision (Not Reasonable)
• Qualified
• No Opinion

5
Comments Regarding Types of Actuarial Opinion

• COPLFR Practice Note
• Only Available Guidance prior to ASOP36, but not
  Binding
• Precision Introduced that Did Not Exist Before
• Prior Carried Reserve gt High End of Range is
  Conservative
• After SOP 36 Opine Redundant or Excessive,
  and State Amount

6
Comments Regarding Types of Actuarial Opinion
(cont.)

• Disappearance of Reasonable but Conservative
• Changes in Work Processes for NAIC Opinions
• Conservative Opinion, with Amount of Conservatism
  Stated, necessitates range to be completed by
  date of opinion, not actuarial report completion
  date

7
Range of Reasonable Reserve Estimates

• Range Defined in Section 3.6.4
• Range of Estimates that could be produced by
  appropriate actuarial methods or alternative sets
  of assumptions that the actuary judges to be
  reasonable

8
Range of Reasonable Reserve Estimates (cont.)

• Accounting Literature Financial Accounting
  Standards No. 5 Accounting for
  ContingenciesAccrue Loss When
• Probable Asset Impaired or Liability Incurred
• Amount of Loss Can be Reasonably Estimated

9
Range of Reasonable Reserve Estimates (cont.)

• FASB Interpretation 14 Reasonable Estimation
  of the Amount of a LossAn Interpretation of FASB
  5
• When an Amount In Range Appears Better than
  Another, Accrue that Amount
• When No Amount is Better than any Other Amount,
  Accrue the Minimum Amount in the Range

10
Range of Reasonable Reserve Estimates (cont.)

• Illustrates Difference Between Actuarys and
  Accountants View of Best Estimate and Range
• Actuary Point Estimate is More Probable than
  other points//Accountant Book It (Under FASB5)
• Accountant All Points in A Reasonable Range are
  equally Likely, so Book the Minimum In Spite of
  the Existence of A Point Estimate
• SSAP 55 Statutory Accounting Managements Best
  Estimate

11
Disclosure of Range of Reasonable Reserve
Estimates

• ASOP 36 Does Not Require that Range of Reserves
  be Disclosed in Statement of Actuarial Opinion
• Observation Many Actuaries do not disclose the
  Range in the Actuarial Report, even when Carried
  Reserve is some distance (gt5) away from the
  Point Estimate
• Actuarial Standard of Practice 9 would appear
  to require the documentation of the range in the
  actuarial workpapers, if not the report

12
Materiality Discussed in Section 3.4 of ASOP36

• No Definition in Section 3.4, only Discussion
• Section 312.10 of AICPA Code Defines Materiality
  
• The magnitude of an omission or misstatement of
  accounting information that, in the light of
  surrounding circumstances, makes it probable that
  the judgment of a reasonable person relying on
  the information would have been changed or
  influenced by the omission or misstatement.

13
The Actuary Should Evaluate Materiality Based On

• Professional Judgment
• Materiality Guidelines or Standards Applicable to
  the Statement of Actuarial Opinion
• Actuarys Intended Purpose for the Statement of
  Actuarial Opinionwhich values are important for
  the user

14
Sec. 3.4 3 Examples of Materiality to Reference

• Specified Reserve Amount ( Loss Reserves)
• The Companys Reported Surplus
• The Companys Net Worth and Annual Net Income
  (for an Evaluation)

15
Quantitative Percentages of Materiality
Observations

• Specified Reserve Amount 5 and 10 seen in
  practice Note The Average Range of Reserves
  implies which figures to use
• The Companys Reported Surplus If
  Reserves/Surplus at 21, would imply 10 and 20
  of Surplus
• Net Income 5 and 10 under certain limited
  circumstances according to SECs SAB 99

16
Professional Guidance Regarding Materiality

• CAS Valuations, Finance and Investment Committee
  Materiality and ASOP No. 36 Considerations for
  the Practicing Actuary with 12/31/01 Practice
  Note
• 3 additional quantitative measures
• Absolute magnitude of correction/difference item
• Absolute magnitude of item for which data is not
  available
• Impact of Item on IRIS or RBC Capital Results

17
Professional Guidance Regarding Materiality
(cont.)

• SEC Staff Accounting Bulletin 99
• Numerical Quantitative Values have no basis in
  Law or Accounting Literature
• Misstatements are not immaterial simply because
  they fall below minimum value

18
Material Adverse Deviation in Relation to Range

• Risk of Material Adverse Deviation Exists If
• High End of Range Carried Reserves gt
• Materiality Amount

19
Material Adverse Deviation in Relation to Range
(cont.)

• Risk of Material Adverse Deviation Exists If
• High End of Range Carried Reserves gt
• Materiality Amount, or
• High End of Range gt
• Carried Reserves Materiality Amount

20
Expected Policyholder Deficit vs. Expected
Material Deviation

• Risk Based Capital Concept, from 1994 Butsic
• Expected Policyholder Deficit (EPD)
• Where AAssets, LLoss Reserves
• DL ? p(x) (x-A) xgtA
• Expected Material Deviation (EMD)
• Where LLoss Reserves, MMateriality Amount DMD
  ? p(x) (x-(LM)) xgtLM
• Material Adverse Deviation is Related to
  Concept of Capital

21
EPD Ratio vs. EMD Ratio

• EPD Ratio DL/L
• Where AAssets, LLoss Reserves
• DL ? p(x) (x-A) xgtA
• EMD Ratio DMD /L
• Where LLoss Reserves, MMateriality Amount DMD
  ? p(x) (x-(LM)) xgtLM

22
Material Adverse Deviation in Relation to Range
(Example)

• Low Medium High Carried Materiality
• 90 100 110 105 10.5 (10)
• Since High End (110) lt Carried Materiality
  (115.5), Risk of Material Adverse Deviation Does
  Not Exist

23
Material Adverse Deviation in Relation to Range
(Example)

• Low Medium High Carried Materiality
• 90 100 110 95 9.5 (10)
• Since High End (110) gt Carried Materiality
  (104.5), Risk of Material Adverse Deviation Does
  Exist
• ASOP 36 Mandates that Risk of Material Adverse
  Deviation be Disclosed not the amount of 5.5
  (110-104.5)

24
Material Adverse Deviation in by Line of
Business A.M. Bests 2000

• Line Low Medium High Carried
• MedMal (/-14.1) 7.6 8.8 10.1 8.1
• WC(/-7.8) 48.6 52.7 56.8 51.1
• PAL (/-6.7) 52.8 56.6 60.4 63.5
• GL (/-9.2) 34.1 37.6 41.0 34.0
• CAL (/-7.9) 18.8 20.4 22.1
  18.9
• All (/-6.1) 286.2 304.7 323.2 297.0
• Using Murphys 1994 Paper for Confidence Levels,
  and assuming 5th and 95th Percentiles are Low and
  High End of Range

25
Material Adverse Deviation in by Line of
Business A.M. Bests 2000

• Materiality
• Line High Carried High-Carried 10 Reserves
  Risk?
• MedMal 10.1 8.1 1.9 0.8 Yes
• WC 56.8 51.1 5.7 5.1 Yes
• PAL 60.4 63.5 (3.2) 6.4 No
• GL 41.0 34.0 7.0 3.4 Yes
• CAL 22.1 18.9 3.2 1.9 Yes
• All 323.2 297.0 26.2 29.7 No

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Material Adverse Deviation in by Line of
Business A.M. Bests 2000

• Materiality
• Line High Carried High-Carried 20 Reserves
  Risk?
• MedMal 10.1 8.1 1.9 1.6 Yes
• WC 56.8 51.1 5.7 10.2 No
• PAL 60.4 63.5 (3.2) 12.8 No
• GL 41.0 34.0 7.0 6.8 Yes
• CAL 22.1 18.9 3.2 3.8 No
• All 323.2 297.0 26.2 59.4 No

27
Expected Material Deviation and EMD Ratios, by
LOB A.M. Bests 2000

• High- Materiality EMD
• Line Carried 10 Reserves EMD Reserve s Ratio
• MedMal 1.9 0.8 1.1 8.1 14
• WC 5.7 5.1 0.6 51.1 1
• GL 7.0 3.4 3.7 34.0 11
• CAL 3.2 1.9 1.3 18.9 7

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Conclusions

• Range of Reasonable Reserves and Amount of
  Material Adverse Deviation are Related
• Amount of Material Adverse Deviation can be
  quantified, as the high end of the range
  (carried reserves plus the materiality standard)
• Width of the average reasonable range of
  reserves may be an additional factor to be
  considered when selecting the materiality amount,
  and range will influence the average frequency
  that the risk of material adverse deviation will
  exist

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Conclusions (continued)

• Although ASOP 36 implies the range of
  reasonable reserves need not be disclosed in the
  opinion, ASOP9 under certain circumstances could
  imply the necessity to disclose the range in the
  actuarial report
• The risk of material adverse deviation can be
  supported by qualitative as well as quantitative
  tests.