1. MATERIALITY AND THE RISK OF MATERIAL ADVERSE DEVIATION: A REGULATORY PERSPECTIVE CASUALTY LOSS RESERVE SEMINAR September 11-12, 2006 Moderator:Kris DeFrain, FCAS, MAAA NAIC, Chief Managing Actuary - Property/Casualty Panelists:Wendy Germani, FCAS, MAAA (retired) Texas Department of Insurance Melissa Greiner P&C Actuary, Pennsylvania Insurance Department

2. Topics Within the context of Statutory Statements of Actuarial Opinion: What is materiality? What is materiality? What are acceptable standards of materiality? What are acceptable standards of materiality? Is there a Risk of Material Adverse Deviation? Is there a Risk of Material Adverse Deviation? Risks and Uncertainties Risks and Uncertainties Other observations Other observations

3. Why is Materiality Important for Opinion Writers ? NAIC Annual Statement Instructions require the opining actuary to: NAIC Annual Statement Instructions require the opining actuary to: Provide specific paragraphs to address the risk of material adverse deviation (RMAD). Provide specific paragraphs to address the risk of material adverse deviation (RMAD). Identify the materiality standard and the basis for establishing this standard. Identify the materiality standard and the basis for establishing this standard. Must explicitly state whether or not there is RMAD. Must explicitly state whether or not there is RMAD. If there is RMAD, describe the major factors, etc. that could result in MAD. If there is RMAD, describe the major factors, etc. that could result in MAD.

4. Who Cares about Materiality and WHY? Regulators Regulators Rating Agencies Rating Agencies SEC? SEC? Others Others

5. WHAT IS MATERIALITY? AAA Task Force on Materiality – developed a generalized description of the concept of Materiality. AAA Task Force on Materiality – developed a generalized description of the concept of Materiality. ASOP 36 and other Standards of Practice don’t define it per se. ASOP 36 and other Standards of Practice don’t define it per se. “Materiality & ASOP 36; Considerations for the Practicing Actuary” - CAS “Materiality & ASOP 36; Considerations for the Practicing Actuary” - CAS NAIC APPM has a definition. NAIC APPM has a definition. SEC’s definition is similar to the NAIC’s. SEC’s definition is similar to the NAIC’s.

6. Materiality Concepts on Professionalism Paper by AAA’s Task Force on Materiality Paper by AAA’s Task Force on Materiality “An omission, understatement or overstatement in a work product is material if it is likely to affect either the intended principal user’s decision-making or the intended principal user’s reasonable expectations.” “An omission, understatement or overstatement in a work product is material if it is likely to affect either the intended principal user’s decision-making or the intended principal user’s reasonable expectations.” “Reflecting on Materiality: The User is Key” “Reflecting on Materiality: The User is Key”

7. According to NAIC Accounting Practices & Procedures Manual A omission or misstatement of an item in a statutory financial statement may be material if it is of such a magnitude that it is probable that the judgment of a reasonable person relying upon the statutory financial statement would be changed or influenced by the inclusion or correction of the item. A omission or misstatement of an item in a statutory financial statement may be material if it is of such a magnitude that it is probable that the judgment of a reasonable person relying upon the statutory financial statement would be changed or influenced by the inclusion or correction of the item.

8. ASOP 36 Section 3.4:….”The actuary should consider the purposes and intended uses for which the actuary prepared the Statement of Actuarial Opinion. The actuary should evaluate materiality based on professional judgment, materiality guidelines or standards applicable to the Statement of Actuarial Opinion and the actuary’s intended purpose for the Statement of Actuarial Opinion.” Section 3.4:….”The actuary should consider the purposes and intended uses for which the actuary prepared the Statement of Actuarial Opinion. The actuary should evaluate materiality based on professional judgment, materiality guidelines or standards applicable to the Statement of Actuarial Opinion and the actuary’s intended purpose for the Statement of Actuarial Opinion.”

9. Know Your User !!! Principal User Principal User Intended User Intended User Unintended User Unintended User Different Users have different expectations regarding materiality. Different Users have different expectations regarding materiality.

10. Identify the Materiality Standard and the Basis for Establishing This Standard

11. Considerations in Materiality Standard for Reserves From Materiality & ASOP 36 Would the misstatement put the insurer in danger of a breach of covenant or regulatory requirement? Would the misstatement put the insurer in danger of a breach of covenant or regulatory requirement? RBC Trigger? RBC Trigger? Minimum Capital Requirement Minimum Capital Requirement IRIS ratio failure IRIS ratio failure Turn profit into loss? Turn profit into loss? Relative size is usually more important than absolute size. Relative size is usually more important than absolute size. Lines of business written by company Lines of business written by company

12. Possible Standards of Materiality % of Surplus % of Surplus % of Reserves % of Reserves Reinsurance (Zero Net Reserve Companies) Reinsurance (Zero Net Reserve Companies) Minimum of % of Surplus, % of Reserves and Amount to trigger an RBC action level. Minimum of % of Surplus, % of Reserves and Amount to trigger an RBC action level. Other Other

13. Standards Used for Texas Domestics - 2005 TypeCountPercentage Surplus12661% Loss & LAE Reserves 2010% Combination2110% Reinsurance136% Other2512%

14. Standards Used for Texas Domestics 2004 over 2005 Type % 2004 % 2005 Surplus64%61% Loss & LAE Reserves 9%10% Combination5%10% Reinsurance1%6% Other20%12%

15. Standards Used for Pennsylvania Domestics – 2005 TypeCountPercentage Surplus9768% Loss & LAE Reserves 128% Combination2820% Other54%

16. Standards Used for Pennsylvania Domestics – 2005 over 2004 Type % 2004 % 2005 Surplus63.8%68.3% Loss & LAE Reserves 14.5%8.5% Combination17.4%19.7% Other4.3%3.5%

17. Standards Used for Pennsylvania Domestics – 2005 over 2004 Type % 2004 % 2005 Surplus63.8%68.3% Loss & LAE Reserves 14.5%8.5% Combination17.4%19.7% Other4.3%3.5%

18. Combination of Standards PA Domestic Data 2004 2005

19. General Observations Materiality Standards Regulatory actuaries generally observed a more thorough discussion of the consideration of materiality standards in Opinions from 2004 to 2005 Regulatory actuaries generally observed a more thorough discussion of the consideration of materiality standards in Opinions from 2004 to 2005 Appears to be a general trend to consider multiple measures of materiality: Appears to be a general trend to consider multiple measures of materiality: More “combinations” of materiality bases in Opinions. More “combinations” of materiality bases in Opinions. Less Opinions with a single basis of materiality. Less Opinions with a single basis of materiality. Here are a few examples: Here are a few examples:

20. Combination – Example #1 “In determining the materiality standard, I note the Opinion is a tool of solvency regulation. Thus, the selected standard is oriented towards the potential impact a misstatement of reserves would have on surplus levels…and is a minimum of three values: (1) 20% of surplus, (2) 10% of loss and LAE reserves after pooling and (3) difference between surplus less Company Action Level RBC.” “In determining the materiality standard, I note the Opinion is a tool of solvency regulation. Thus, the selected standard is oriented towards the potential impact a misstatement of reserves would have on surplus levels…and is a minimum of three values: (1) 20% of surplus, (2) 10% of loss and LAE reserves after pooling and (3) difference between surplus less Company Action Level RBC.”

21. Combination – Example #2 “Based on my understanding of the use of this (Opinion), I evaluated materiality in the context of 15% of loss and LAE reserves, 25% of surplus, and action/control level from RBC, of the minimum was selected…The minimum was adjusted to reflect where within the range of reasonable estimates the Company’s reserves fell.” “Based on my understanding of the use of this (Opinion), I evaluated materiality in the context of 15% of loss and LAE reserves, 25% of surplus, and action/control level from RBC, of the minimum was selected…The minimum was adjusted to reflect where within the range of reasonable estimates the Company’s reserves fell.”

22. Combination – Example #3 “Based on my review I consider a deviation greater than $xxx,000 to represent a material adverse deviation. This standard is based on my professional judgment with consideration as to Company’s surplus, liquid assets, reserve balance and authorized control level of the Company.” “Based on my review I consider a deviation greater than $xxx,000 to represent a material adverse deviation. This standard is based on my professional judgment with consideration as to Company’s surplus, liquid assets, reserve balance and authorized control level of the Company.”

23. Combination – Example #4 “In developing the threshold for the risk of material adverse deviation, I considered the company’s loss and LAE reserves, statutory surplus and RBC position as of (year-end). Based on review of these considerations, I selected a materiality standard of $xxx,000, which is about 10% of carried loss and LAE reserves.” “In developing the threshold for the risk of material adverse deviation, I considered the company’s loss and LAE reserves, statutory surplus and RBC position as of (year-end). Based on review of these considerations, I selected a materiality standard of $xxx,000, which is about 10% of carried loss and LAE reserves.”

24. Consideration of RBC Position “I have considered a MAD to be one in which the actual net outstanding loss and LAE exceed carried reserves by an amount greater than 10% of surplus... I also verified that a 10% deviation in the Company’s net reserves would not reduce the Company’s Total Adjusted Capital to below the Company Action Level Capital.” “I have considered a MAD to be one in which the actual net outstanding loss and LAE exceed carried reserves by an amount greater than 10% of surplus... I also verified that a 10% deviation in the Company’s net reserves would not reduce the Company’s Total Adjusted Capital to below the Company Action Level Capital.” May be MORE appropriate to include this for companies with RBC scores at lower end of spectrum vs. healthy RBC scores. May be MORE appropriate to include this for companies with RBC scores at lower end of spectrum vs. healthy RBC scores. Regulators do not necessarily have to see this in all Opinions. Regulators do not necessarily have to see this in all Opinions.

25. What is the Bright Line Indicator? Outside bound of what is material. Outside bound of what is material. If 10% of the Net Reserves are greater than the difference between the Total Adjusted Capital and Company Action Level Capital, If 10% of the Net Reserves are greater than the difference between the Total Adjusted Capital and Company Action Level Capital, Then regulators expect to see explicit Relevant Comment paragraphs discussing the factors giving rise to the presence or absence of RMAD. Then regulators expect to see explicit Relevant Comment paragraphs discussing the factors giving rise to the presence or absence of RMAD.

26. Consideration of RBC Position “YES” if the Bright Line Indicator is crossed “YES” if the Bright Line Indicator is crossed Although reference to the BLI test is removed from the 2006 Regulatory Guidance Draft document, the test is still part of the NAIC’s Financial Analysis Handbook. Although reference to the BLI test is removed from the 2006 Regulatory Guidance Draft document, the test is still part of the NAIC’s Financial Analysis Handbook. We will discuss Guidance briefly at the end of our presentation. We will discuss Guidance briefly at the end of our presentation. Should appointed actuaries be expected to comment on the Bright Line Indicator in Opinions?

27. Is there a Risk of Material Adverse Deviation?

28. I do not believe that there are significant risks and uncertainties that could result in material adverse deviation in the loss and loss adjustment expense reserves.

29. Relevant Comments should allow a regulator to answer these questions: Is there a Risk of Material Adverse Deviation? Is there a Risk of Material Adverse Deviation? What amount of adverse deviation does the actuary consider material? What amount of adverse deviation does the actuary consider material? Why does the actuary consider that amount to be material for this company? Why does the actuary consider that amount to be material for this company? Do I understand why the actuary believes that material adverse deviation is or is not a risk for this company? Do I understand why the actuary believes that material adverse deviation is or is not a risk for this company? Given this guidance, what are your thoughts on the following language: Given this guidance, what are your thoughts on the following language:

30. Example #1 – Unclear “The Materiality Standard is established as 10% of reported statutory surplus, or $xxx,000 as shown in Exhibit B: Disclosures. I estimate the likelihood of material adverse deviation arising from normal variations in expected results to be about 16%. I estimate the likelihood of material favorable development to exceed 50%.” Thoughts from audience?? Thoughts from audience??

31. Example #1 - Improved “The Materiality Standard is established as 10% of reported statutory surplus, or $xxx,000 as shown in Exhibit B: Disclosures. I estimate the likelihood of material adverse deviation arising from normal variations in expected results to be about 16%, not a significant likelihood. I estimate the likelihood of material favorable development to exceed 50%.”

32. Example #2 – Unclear I have established a materiality standard of ±5% from my point estimate…In my opinion, the Company’s reserves is $1.xxx million in excess of my point estimate. I have established a materiality standard of ±5% from my point estimate…In my opinion, the Company’s reserves is $1.xxx million in excess of my point estimate. Actuary provides lengthy paragraph on changes to actuarial assumptions and approach. Actuary provides lengthy paragraph on changes to actuarial assumptions and approach. In addition to knowing the reinsurance arrangements, actuary determined adequacy of Gross reserves, from which Net results were determined. In addition to knowing the reinsurance arrangements, actuary determined adequacy of Gross reserves, from which Net results were determined. Thoughts from audience?? Thoughts from audience??

33. Example # 3 – Unclear Actuary did not believe there was RMAD. 15% of Statutory Surplus was used as a materiality standard. Actuary did not believe there was RMAD. 15% of Statutory Surplus was used as a materiality standard. The Company’s RBC ratio was 200.6%; dropping from about 300% from previous year. The Company’s RBC ratio was 200.6%; dropping from about 300% from previous year. Is this a suitable standard? Is this a suitable standard? Should the actuary check the Company’s RBC ratio, when deciding on a materiality standard? Should the actuary check the Company’s RBC ratio, when deciding on a materiality standard? Thoughts from audience?? Thoughts from audience??

34. So, is there RMAD? Pennsylvania domestics Pennsylvania domestics More appointed actuaries concluded “No RMAD” in 2005 from 2004. More appointed actuaries concluded “No RMAD” in 2005 from 2004. Statements on RMAD were more clear (or less vague) in interpretation. Statements on RMAD were more clear (or less vague) in interpretation. Regulators want appointed actuaries to be clear in their position on RMAD Regulators want appointed actuaries to be clear in their position on RMAD

35. So, is there RMAD? Texas Domestics Texas Domestics “No RMAD” for 81% of total companies. “No RMAD” for 81% of total companies. “No RMAD” for 70% of companies with net reserves greater than zero. “No RMAD” for 70% of companies with net reserves greater than zero. Texas has a high concentration of companies that carry $0 in net reserves…then what? Texas has a high concentration of companies that carry $0 in net reserves…then what? To be continued To be continued

36. General Observations RMAD Discussion Regulatory actuaries generally observed a more thorough consideration and discussion of RMAD from 2004 to 2005 Regulatory actuaries generally observed a more thorough consideration and discussion of RMAD from 2004 to 2005 Improvements likely due to combination of: Improvements likely due to combination of: Increased regulatory actuary review and feedback on Opinions Increased regulatory actuary review and feedback on Opinions AAA Opinion Writers Symposium AAA Opinion Writers Symposium Better understanding from appointed actuary community on regulator’s expectations Better understanding from appointed actuary community on regulator’s expectations Keep up the good work! Keep up the good work!

37. Net-Zero Companies Now, let’s switch gears Now, let’s switch gears What if the Company has $0 carried net reserves, due to a pooling arrangement or cession to the parent? What if the Company has $0 carried net reserves, due to a pooling arrangement or cession to the parent? What are the options to the opining actuary? What are the options to the opining actuary?

38. Risk of MAD on Zero Net Reserves – TX Domestics About 90 “net-zero” companies About 90 “net-zero” companies 97% of Opinion writers concluded no RMAD 97% of Opinion writers concluded no RMAD Comments: remote or no risk since company cedes 100% Comments: remote or no risk since company cedes 100% 13 included additional comments on Reinsurance 13 included additional comments on Reinsurance there exists a contingent net liability with respect to ceded reinsurance in the event that reinsurers become unable to meet obligations under existing reinsurance agreements. there exists a contingent net liability with respect to ceded reinsurance in the event that reinsurers become unable to meet obligations under existing reinsurance agreements. 2 concluded “yes” to RMAD, citing Reinsurance & Rapid Growth as risk factors. 2 concluded “yes” to RMAD, citing Reinsurance & Rapid Growth as risk factors. 1 conclusion about RMAD indeterminable. 1 conclusion about RMAD indeterminable.

39. Risk of MAD on Zero Net Reserves – PA Domestics 8 “net-zero” companies 8 “net-zero” companies 7 of 8 Opinion writers concluded no RMAD 7 of 8 Opinion writers concluded no RMAD Comments: remote or no risk since company cedes 100% Comments: remote or no risk since company cedes 100% 4 of 8 included additional comment that there exists a contingent net liability with respect to ceded reinsurance in the event that reinsurers become unable to meet obligations under existing reinsurance agreements. 4 of 8 included additional comment that there exists a contingent net liability with respect to ceded reinsurance in the event that reinsurers become unable to meet obligations under existing reinsurance agreements. 1 of 8 concluded “yes” to RMAD, as the Company was in Action Level RBC at year-end, citing Reserve Variability in medical malpractice and Reinsurance Collectibility as risk factors. 1 of 8 concluded “yes” to RMAD, as the Company was in Action Level RBC at year-end, citing Reserve Variability in medical malpractice and Reinsurance Collectibility as risk factors.

40. Risks and Uncertainties

41. Appointed actuaries are expected to describe the major factors that could result in Material Adverse Deviation

42. Risks and Uncertainties Opinion writers need to discuss in this section, why or why not there is RMAD and the factors that would lead to RMAD. Opinion writers need to discuss in this section, why or why not there is RMAD and the factors that would lead to RMAD. Explanation should not include general, broad statements about risks and uncertainties due to economic changes, judicial decisions, regulatory actions, political or social forces, etc. Explanation should not include general, broad statements about risks and uncertainties due to economic changes, judicial decisions, regulatory actions, political or social forces, etc. List does not need to be exhaustive. List does not need to be exhaustive. Should be specific to the Company’s book of business and operations. Should be specific to the Company’s book of business and operations. We offer the following as good and bad examples: We offer the following as good and bad examples:

43. Risk Factor Discussion Good Example #1 The major factors underlying the risks and uncertainties which could result in MAD include: The major factors underlying the risks and uncertainties which could result in MAD include: The significant concentration in premium volume in 2003 through 2005 from business that is relatively new to the Company. The significant concentration in premium volume in 2003 through 2005 from business that is relatively new to the Company. Lack of data available for reserve analysis on Company’s financial guaranty exposure. Lack of data available for reserve analysis on Company’s financial guaranty exposure. Significant reliance on the use of judgment by the Company in selecting factors for setting loss reserves. Significant reliance on the use of judgment by the Company in selecting factors for setting loss reserves.

44. Risk Factor Discussion Good Example #2 I have identified the major risks and uncertainties as: I have identified the major risks and uncertainties as: Significant changes in claims operations over the last xx years, which creates volatility in the development patterns and therefore necessitates considerable reliance on benchmark development patterns. Significant changes in claims operations over the last xx years, which creates volatility in the development patterns and therefore necessitates considerable reliance on benchmark development patterns. Rapid growth with net premium increasing six fold over the last xx years. Rapid growth with net premium increasing six fold over the last xx years. Company’s cession of an amount of loss and LAE reserves that exceeds its surplus to an unrated (offshore) affiliate. Company’s cession of an amount of loss and LAE reserves that exceeds its surplus to an unrated (offshore) affiliate.

45. Risk Factor Discussion Good Example #3 “There are a variety of risk factors that expose the Company’s reserves to significant variability. I have identified the major risk factors: “There are a variety of risk factors that expose the Company’s reserves to significant variability. I have identified the major risk factors: Significant increase in policyholders in 2002; Significant increase in policyholders in 2002; New coverages offered beginning in 2002; New coverages offered beginning in 2002; Increases in the policy limit; Increases in the policy limit; The long-tail nature of medical professional liability coverage.” The long-tail nature of medical professional liability coverage.”  The opining actuary includes a detailed paragraph on EACH of these points within the body of the Opinion.

46. Risk Factor Discussion Bad Example #1 “Although the carried reserves as of 12/31/05 are within my reasonable range, I do believe that there is a substantial risk of material adverse deviation in the Company’s reserves as measured against a materiality standard of 10% of surplus. …Carried reserves are about 110% of surplus, so a 10% deficiency in reserves would results in a loss of more than 10% of surplus. A deviation of this magnitude, while not anticipated, is not a statistically insignificant possibility.” “Although the carried reserves as of 12/31/05 are within my reasonable range, I do believe that there is a substantial risk of material adverse deviation in the Company’s reserves as measured against a materiality standard of 10% of surplus. …Carried reserves are about 110% of surplus, so a 10% deficiency in reserves would results in a loss of more than 10% of surplus. A deviation of this magnitude, while not anticipated, is not a statistically insignificant possibility.” What are this risk factor(s) that could impact the reserve to surplus ratio? What are this risk factor(s) that could impact the reserve to surplus ratio?

47. Risk Factor Discussion Opinions that contained ONLY the general uncertainty comments for RMAD without consideration for company specific comments. Opinions that contained ONLY the general uncertainty comments for RMAD without consideration for company specific comments. PA: decrease from a few to none PA: decrease from a few to none TX: decrease from 18 to 16** TX: decrease from 18 to 16** Again, another positive trend for improved Opinion disclosure! Again, another positive trend for improved Opinion disclosure! **mostly from a single firm

48. Risks and Uncertainties Discussed Even if no RMAD? “But the NAIC Instructions don’t require me, as an appointed actuary to provide a discussion of risk factors when Risk of MAD is not present.” “But the NAIC Instructions don’t require me, as an appointed actuary to provide a discussion of risk factors when Risk of MAD is not present.” Statistics shown: % of Opinions that discuss company specific risk factors, after actuary concluded no Risk of MAD. Statistics shown: % of Opinions that discuss company specific risk factors, after actuary concluded no Risk of MAD.

49. Risks and Uncertainties Discussed Even if no RMAD? Company specific risk factors cited for “No RMAD”: Company specific risk factors cited for “No RMAD”: Growth in long-tailed lines Growth in long-tailed lines Medical cost inflation trends Medical cost inflation trends A&E, claims initiatives, construction defect liabilities A&E, claims initiatives, construction defect liabilities XS over large deductible and self-insured exposures XS over large deductible and self-insured exposures Regulators view this type of disclosure very positively. Regulators view this type of disclosure very positively. These same factors could possibly lead to RMAD for the Company in the future. These same factors could possibly lead to RMAD for the Company in the future. Again, keep up the good work! Again, keep up the good work!

50. Other Observations

51. Materiality and Link to Actuarial Opinion Summary What if actuary said “no” to RMAD, yet company carried reserves in lower end of actuarial range? What if actuary said “no” to RMAD, yet company carried reserves in lower end of actuarial range? Consideration given to surplus and RBC levels. If low, appointed actuaries should expect a call from the domestic regulator. Consideration given to surplus and RBC levels. If low, appointed actuaries should expect a call from the domestic regulator. Why is there no RMAD? Why is there no RMAD? Is the Materiality threshold possibly set too high? Is the Materiality threshold possibly set too high?

52. Regulatory Guidance - 2006 Separate Guidance for Actuarial Opinion and Actuarial Opinion Summary. Separate Guidance for Actuarial Opinion and Actuarial Opinion Summary. No longer need to attach (public) Opinion to the (confidential) Summary No longer need to attach (public) Opinion to the (confidential) Summary New Scope items actuary should be cognizant of: New Scope items actuary should be cognizant of: Coverage for Service Contracts Coverage for Service Contracts Prepaid loss adjustment expenses Prepaid loss adjustment expenses Draft document exposed at NAIC Fall meeting a few days ago – copies available. Draft document exposed at NAIC Fall meeting a few days ago – copies available.

53. QUESTIONS ?????