Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes Chris Nyce KPMG LLP September 2006

2 Disclaimer Views and opinions expressed in this presentation and the underlying paper are those of the authors. Needless to say then, they do not represent the opinions of the CAS, nor any employer of the presenters, nor any sponsors of the meeting. Anyone who says otherwise is not only wrong, but is clearly itching for a fight.

3 Note Risks to financial reporting are unique to each company The following discussion highlights things that should commonly be considered, but companies may need to consider other types of controls, and do not necessarily need all types of controls discussed. Companies should consider their unique risk profile and consult professional advisors when implementing and evaluating their own controls.

4 Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes Background COSO Framework Scope for Actuarial Processes Issues n Information Integrity & Availability n Analysis n End User Applications n Management’s Best Estimate Documentation Considerations by Size of Company Status

5 Comments by Harvey Pitt (SEC Chairman when SOX was Passed) Question: How is SOX like the weather Answer: Everyone talks about it, but no-one does anything about it Quote from Mr. Pitt “The statute was hastily – and, therefore, badly – drafted; but it was and remains, necessary Source: Wall Street Journal, April 13, 2006

6 Background

7 n SOX Section 404 Company Requirements: –State management’s role in establishing and maintaining an adequate central structure and procedures for financial reporting; –Report on the effectiveness of their internal controls over financial reporting procedures Including supporting documentation of controls, and testing of their effectiveness. n SOX Section 404 Auditor Requirements: –Attest to and report on management’s assessment of internal controls; –Attest to the effectiveness of internal controls.

8 Background n Deficiency = situation arises where internal controls are identified as not effective n Responses –Identify and implement remediation steps –Evaluate seriousness of the deficiency Type of DeficiencyCriteriaReporting Requirement DeficiencyDoesn’t rise to a more serious level. Auditor to management. Significant DeficiencyResults in a more than remote likelihood of a misstatement that is more than inconsequential. Auditor to Audit Committee Material WeaknessResults in a more than remote likelihood of a material misstatement. Auditor to Audit Committee and in Audit Opinion (a public document).

9 The COSO Framework

10 The COSO Framework Committee of Sponsoring Organizations issued in 1992 n AKA The Treadway Commission; n Provides a basic framework for all internal controls; n Implementers not required to use this framework– But most do. What is the framework n Control Environment; n Risk Assessment; n Control Activities; n Information and Communication; n Monitoring.

11 Diagram of COSO Based Internal Control Structure *Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors

Elements of COSO Based Internal Control Structure *Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors

Scope for Actuarial Processes

Property/Casualty Insurance Operations Chain: Producer solicits/binds coverage, or policy renews Underwriting Process Policy expires and may be renewed or audited Claims are received or estimated Underwriter verifies risk acceptability and price Policy is submitted to Underwriter Underwriting/Claims Transaction Underwriting Guides Product Rate Plan and Coverage Premiums Written and Earned Resulting Financial Flows Losses received, recorded, estimated Business Design Markets Targeted Underwriting Expenses result Transactional Data Systems 14

Producer solicits/binds coverage, or policy renews Underwriting Process Policy expires and may be renewed or audited Claims are received or estimated Underwriter verifies risk acceptability and price Policy is submitted to Underwriter Underwriting/Claims Transaction Underwriting Guides Product Rate Plan and Coverage Premiums Written and Earned Resulting Financial Flows Losses received, recorded, estimated Business Design Markets Targeted Underwriting Expenses result Transactional Data Systems Traditional Financial Statement Audit Focus Property/Casualty Insurance Operations Chain: 15

Property/Casualty Insurance Internal Controls affecting Estimated Balance Sheet and Income Statement Items 16 Producer solicits/binds coverage, or policy renews Underwriting Process Policy expires and may be renewed or audited Claims are received or estimated Underwriter verifies risk acceptability and price Policy is submitted to Underwriter Underwriting/Claims Transaction Underwriting Guides Product Rate Plan and Coverage Premiums Written and Earned Resulting Financial Flows Losses received, recorded, estimated Business Design Markets Targeted Underwriting Expenses result Transactional Data Systems Additional Focus Areas for Internal Controls

17 Estimated Balances Must Properly Reflect the Following Company Operations Source A Source B Source C Company Risk Assumption/ Underwriting Practices Company Claims Handling and Settlement Practices Company IT/ Data Design and Collection Process Perform Estimates and Analysis Review and Communication Process Committee Process Input into Accounting System & Review Source Z Information and Communication

18 Estimated Balances Must Properly Reflect the Following Company Operations Source A Source B Source C Company Risk Assumption/ Underwriting Practices Company Claims Handling and Settlement Practices Company IT/ Data Design and Collection Process Perform Estimates and Analysis Review and Communication Process Committee Process Input into Accounting System & Review Source Z Information and Communication Underwriting and Claims Data Analysis Management Review Process

19 Comments on Operational Internal Controls and Sarbanes-Oxley, Section 404 n AICPA gives guidance as to how Sarbanes- Oxley applies to Internal controls in operational areas –Only controls which affect financial statement reporting are subject to Sarbanes-Oxley; –Includes items with significant input to financial reporting; –Should be taken to include disclosures. n Examples and the AICPA guidance are in the following table.

20 Operational Controls; Management Responsibility Contrasted with Section 404 Goals Area of Control Section 404 Internal Controls Include: Examples of Additional Management Responsibilities, not section 404 In General (from AICPA 319, item 40) Address “Inherent and control risks to evaluate the likelihood that material misstatement could occur in the financial statements” Address “identify, analyze, and manage risks that affect entity objectives” UnderwritingCompany intent around which exposures to insure, at what prices, terms and conditions is clear, is followed, and consistent with assumptions underlying balance sheet and income statement estimates Management executes an underwriting strategy that provides appropriate returns with reasonable risk to capital providers. Staffing resource is appropriate to the volume of business. ClaimsCase reserving philosophy, and claims processes are understood, impacts of changes are understood, and consistent with assumptions underlying profit, loss, and balance sheet estimates Claim settlements are fair to both claimants and capital providers. Appropriate legal strategies are pursued to defend policyholders. Claims staffing resource is appropriate to the volume of claims.

21 Industry Track Record

22 Industry Track Record

Information Integrity and Availability

24 Data Controls to ensure data is accurate and complete Data is available to enable comprehensive analysis Data is available to monitor compliance with Claims and Underwriting controls Data is available to support management review needs, including tracking of trends Information Integrity and Availability Data Analysis Underwriting and Claims

25 Actuarial Analysis Analysis Access to data is sufficiently convenient to analysts Available information is incorporated in analysis Communication process with underwriting, claims, management is sufficient Appropriate methods are used Communication of results to management is clear Data Analysis Underwriting and Claims

26 End User Applications Spreadsheets, databases, word documents,…. One of the most problematic pieces of control documentation There is a group dedicated to spreadsheet risks, lots of stories available n See Website University of Hawaii research that error rates on spreadsheets near 90% n And this goes near 100% if more than 200 lines

27 Priority of Spreadsheet Controls Complex Simple Operational Analytical Financial Reporting Simple Controls Extensive Controls Moderate Controls For more information see “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley Act” Available at

28 What Controls to Consider Backups Archiving Security n Controls over Access Change Control and Version Control n Such as Formula Locking Baselining – In depth review of calculations and functions Internal Data Reconciliations Peer Review – Sometimes outside the chain of reporting Documentation

Management’s Best Estimate vs. Actuarial Best Estimate

30 Management’s Best Estimate vs. Actuarial Best Estimate Management Review Process Process to determine booked reserves is reasonable Reserve Committee and management review is effective Underlying assumptions, such as trends, are validated Data Analysis Underwriting and Claims Review controls to ensure the estimate selection process is consistent with the outcome of the underlying estimates, or reasons for departure are documented – including quantification of reasons;

31 n Reserve Committee Process (best practices) –Charter spelling out charge and operation of Committee; –Participation by Senior Management, Finance, Claims, Underwriting, Actuarial; –Access to a well documented actuarial estimate and range prepared prior to the Committee meeting; –Active questioning by Committee; –Well documented outcome of Committee meetings, including approved reserve amount; –Documentation of differences between management’s best estimate and actuarial best estimate. CompletenessAccuracyJudgmental Areas Management Review Process Control Activities, Information and Communication, Monitoring Data Analysis Underwriting & Claims

Documentation Issues

33 Documentation While SOX has changed the documentation commonly used in Actuarial work, Accounting documentation requirements are similar to common standards prior to SOX. Most Common Pitfalls n Controls should be specific –What is the control?, who performs?, who reviews?, what is the documentation?, how often?, where maintained? n Informal processes do not fully replace controls; n Conservatism doesn’t take the place of controls; n Lack of misstatement in the past doesn’t obviate the need for controls.

34 Documentation (continued) Most Common Pitfalls n Controls over reserves usually just at year end, but release of results to markets quarterly; n Controls over processes with significant input to financial statement balances missing; n “Common knowledge” instead of rigorous analysis; n Considering the auditor as part of the control process; n Forgetting controls over significant actuarial balances other than reserves.

Considerations by Size of Company

36 Considerations by Size of Company All companies need to weight costs and benefits associated with implementation of SOX 404. Management may consider some deficiencies acceptable relative to costs associated with remediation. Larger companies generally have the actuarial resources to implement internal controls effectively. Smaller companies likely have resource constraints, most apparently relative to peer review. n Third party actuarial analysis; n Thorough review (and documentation) of reserves by all professionals in the organization that would be best versed in reasonability of reserves --- senior claims, underwriting, and finance management.

Status of Implementation

38 Status – Recent Events For most large domestic entities; Implemented 2004 Large foreign filers; Implementation in 2006 NAIC considering statutory rules n Current form would affect large entities, newly impacting about 190 Companies; n Proposed effective for 2009; n No external audit requirement. Canadian Securities Administrator has proposed SOX type requirements n No external audit requirement.