RMAD _ RISK OF MATERIAL ADVERSE DEVIATION A Regulator’s Viewpoint Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 RMAD _ RISK OF MATERIAL ADVERSE DEVIATION A Regulator’s Viewpoint CASUALTY LOSS RESERVE SEMINAR September 10-11, 2007 Wendy Germani, FCAS, MAAA (retired) Texas Department of Insurance

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 WHAT IS 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. “Materiality & ASOP 36; Considerations for the Practicing Actuary” - CAS NAIC APPM has a definition. SEC’s definition is similar to the NAIC’s. Wendy AAA task force – has a number of definitions. AAA Council on Professionalism “Materiality – Concepts on Professionalism” prepared by Task Force of Materiality. See also Joseph Herbers paper on Materiality and Statements of Actuarial Opinion. Financial Examiners Handbook – has a standard for planning materiality and tolerable error for Financial Exams.

According to NAIC Accounting Practices & Procedures Manual Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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.” Here the user is a reasonable person. This is the standard a regulator would use.

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Know Your User !!! Principal User Intended User Unintended User Different Users have different expectations regarding materiality. Common theme the materiality standard depends on the user. For Actuarial Opinions/ Principal Users are the Company (CFO, board of directors) Regulator. Opinion is in the public domain. Therefore unintended users include reinsurers, financial analysts, investors, policyholders, claimants.

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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? RBC Trigger? Minimum Capital Requirement IRIS ratio failure Turn profit into loss? Relative size is usually more important than absolute size. Lines of business written by company Long tail or short tail lines Regulators are interested in financial health of company. Will the company be around to pay claims eventually? Should something be done NOW to prevent the company from being in trouble next year or down the road.

Possible Standards of Materiality Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Possible Standards of Materiality % of Surplus % of Reserves Reinsurance (Zero Net Reserve Companies) Minimum of % of Surplus, % of Reserves and/or Amount to trigger an RBC action level. Other These are the usual standards we see. Min of a % of Surplus and % of Reserves

Standards Used in 2006 For CT IL NY OH PA TX Domestics Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Standards Used in 2006 For CT IL NY OH PA TX Domestics Type Count Percentage Surplus 552 62% Loss & LAE Reserves 112 13% Combination 161 18% Reinsurance 28 3% Other 33 4% This is a total of 886 companies out of a total of 2,746 companies with opinions. Or 32% of total There are at least 480 members of the CAS signing opinion or 11% of the membership. Some companies do not fill out information ih The General Interrogatories with the name of the opining actuary. This will change with the 2007 opinion which require the name of the actuary and whether or not he/she is a company employee or consultant. This is in Exhibit B of the opinion and will be in electronic format.

Standards Used for Texas Domestics 2004 to 2006 Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Standards Used for Texas Domestics 2004 to 2006 Type 2004 2005 2006 Surplus 64% 61% 59% Reserves 9% 10% 5% Combination 21% Reinsurance 1% 6% 8% Others 20% 12% 7% .

Standards Used for Pennsylvania Domestics 2004 to 2006 Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Standards Used for Pennsylvania Domestics 2004 to 2006 Type 2004 2005 2006 Surplus 64% 68% 54% Reserves 15% 9% 10% Combination 17% 20% 31% Reinsurance 0% Others 4% 5% PA does not have as many net zero companies as a % as Texas

General Observations Materiality Standards Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 General Observations Materiality Standards Appears to be a general trend to consider multiple measures of materiality: More “combinations” of materiality bases in Opinions. Less Opinions with a single basis of materiality.

Combination – Example #1 Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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.”

Combination – Example #2 Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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 which the minimum was selected as a materiality standard.

Consideration of RBC Position Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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.” 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. Later will ask about should the actuary check the Company’s RBC ratio?

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Is there a Risk of Material Adverse Deviation?

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 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. We expect to see a specific statement. I do or do not believe there is a risk of MAD.

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Is there a risk of MAD “The actuary should explicitly state whether or not he or she reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation.” Exhibit B for 2007 Actuarial Opinions has a box to check Yes or No if there is RMAD. In Annual Statement Instructions for Actuarial Opinion 2007

So is there RMAD? Using data from CT, IL, NY, OH, PA, TX Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 So is there RMAD? Using data from CT, IL, NY, OH, PA, TX Count Percentage No 565 64% Yes 317 36% Undeterminable 5 1% This is a total of 886 companies out of a total of 2,746 companies with opinions. Or 32% of total. Same states of CT, IL, NY, OH, PA and TX.

Relevant Comments should allow a regulator to answer these questions: Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Relevant Comments should allow a regulator to answer these questions: Is there a Risk of Material Adverse Deviation? What amount of adverse deviation does the actuary consider material? 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? Wendy Missy is going to give us some examples of RMAD statements.

Is there a risk of MAD for Zero Net Reserve Companies? Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Is there a risk of MAD for Zero Net Reserve Companies? The opining actuaries concluded that 95% of the companies in Ohio, Pennsylvania and Texas with zero net reserves do not have a risk of RMAD. Reinsurance and/or rapid growth are cited as reasons for possibility of RMAD. Texas has a large % of zero net reserve companies, with about 40% of its total domestic companies. 84 out of 205. Most of this is in county mutual companies and Lloyds companies. Texas only companies that are frequently part of huge national companies.

Companies with zero net Reserves – 2006 OH PA TX Domestics Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Companies with zero net Reserves – 2006 OH PA TX Domestics Type Count Percentage Surplus 51 50% Loss & LAE Reserves 2 2% Combination 24 24% Reinsurance 15 15% Other 9 9% Texas has 205 domestic companies of which 84 are zero net companies. These states have 479 domestic companies of which 101 have zero net reserves. (Texas has 84 or 41% of its domestic companies.) Pooling

CRUSAP Report : Observations on Communication Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 CRUSAP Report : Observations on Communication “..many users of actuarial services don’t adequately understand the inherent variability and uncertainty that attach to actuarial opinions and projections.” This is “..one of the most significant communication problems the profession currently faces.” “… placing too much emphasis on the variability of actuarial results could undermine the perceived value of actuarial services in the eyes of the users.” Those who always state that there is RMAD may undermine the perceived value.

Materiality and Link to Actuarial Opinion Summary Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Materiality and Link to Actuarial Opinion Summary 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. Why is there no RMAD? Is the Materiality threshold possibly set too high? The AOS gives the regulators a better understanding of materiality standards. Remember range is not a materiality standard – range is about variability of reserve evaluation , uncertainty. Materiality is whether or not an omission, understatement or overstatement in a work product is likely to affect either the intended principal user’s decision-making or the intended principal user’s reasonable expectations.

Casualty Loss Reserve Seminar RMAD – Wendy Germani September 2007 Questions ?????