1. IRS/Actuary Actuary’s Perspective by Alan E. Kaliski, FCAS, MAAA

2. 1 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

3. 2 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).

4. 3 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%

5. 4 Asbestos & Environmental  Greater than normal uncertainty l Existence of coverage l Definition of occurrence l Ultimate damages l Allocation to potentially responsible parties l No historical information  Early Estimates of Industry Liabilities (1994 study) l $50 billion - $600 billion

6. 5 “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

7. 6 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

8. 7 (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: l Random chance, changes in operations, changes in external environment, changes in data trends, etc.

9. 8 Evolution of Uncertainty Considerations Reasonable Reserves Range of Estimates Reasonable sets of Assumptions Evaluate Uncertainty, Risk of Material Adverse Deviation Identify Sources of Uncertainty

10. 9 Range of Reasonable Estimates Example #1 Reasonable $400M –2% inflation $450M 2% inflation $550M 8% inflation $600M 12% inflation ?? $500M Possible - Yes Reasonably Likely - No

11. 10 Loss Development Factors Example #2 12-24 1.50 1.80 1.85 1.80............. 24-36 1.20 1.50 1.55 Selected 1.501.20 Selections are lowest points in each interval Possible - Yes Reasonably Likely - No

12. 11 Example #3 Possible - Yes Reasonably Likely - No  Incurred Loss Development Method = $500M (No adjustments)  Know that case reserves weakened on latest diagonal  Select $500M as being in range

13. IRS/Actuary Independent Public Accountant’s Perspective by Michael R. Hazel, CPA, FLMI

14. 13 Auditing Literature  SAS 57 - Auditing Estimates  SAS 47 - Audit Risk and Materiality in Conducting an Audit  SAS 73 - Use of a Specialist

15. 14 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

16. 15 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

17. 16 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: l To consider a range of estimates bounded by a reasonable high and low estimate l 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.

18. 17 AICPA Audit Guide for Property and Liability Insurers  Factors affecting the reasonableness of the size of the reserve range: l History of the line of business (or lack thereof) l Volatility of the underlying product l Surplus levels of the Company l Volatility in other lines of business underwritten by the Company l Volatility of other account balances in the financial statements

19. 18 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

20. 19 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”

21. 20 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

22. 21 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 l 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

23. 22 SAS 73 Auditors Use of a Specialist to Evaluate Loss Reserves  In-house actuary only develops loss reserve estimate l 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 l 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 l The auditor can use the outside review

24. 23 SAS 73 Auditors Use of a Specialist to Evaluate Loss Reserves  Testing the work of a specialist l Obtain an understanding of the methods and assumptions used by the specialist l Test the accuracy of the data provided to the specialist l Assure the specialists conclusions support the related financial statement assertions