1 The Actuary’s Role in Due Diligence The Consultant’s Perspective Presented at the CAS Annual Meeting Washington, DC November 2000 by Gail M. Ross, FCAS, MAAA Am-Re Consultants, Inc.

2 Presentation Overview Actuary’s Involvement In:  Pre-Due Diligence  Sell Side  Buy Side  Due Diligence  Buy Side  Sell Side  Common Theme

3 Pre-Due Diligence - Sell Side Case Study: Seller - small privately held single state, mono-line carrier Buyer - regional multi-line carrier Buyer approached Seller stating their interest in acquiring them. Initial offer of 1.5 times book value. Seller was very interested but felt they needed help prior to proceeding.

4 Pre-Due Diligence - Sell Side Actuary’s Involvement In Providing Assistance to Seller:  Operational Review  Valuation

5 Pre-Due Diligence - Sell Side  Operational Review  Actuaries worked in conjunction with specialists from other functional disciplines.  Goal was to determine Seller’s operational areas of strength and weakness.  Based on findings, Seller implemented certain operational changes which ultimately enhanced its value.

6 Pre-Due Diligence - Sell Side  Operational Review  Claims consultants recommended changes in two major areas: Seller had poor medical cost containment controls and changes were recommended in the areas of bill review and nurse case management. Staffing was too low resulting in case loads being too high. By adding to staff, adjusters would be able to be more proactive in settling claims and use of outside adjusters could be reduced (lowering ALAE)

7 Pre-Due Diligence - Sell Side  Operational Review  Underwriters also recommended changes in two areas: Commission levels were unnecessarily higher than the market. Underwriting controls were in place but not being followed resulting in acceptance of high exposure risks.  Actuaries quantified the impact of changes in these areas on future loss, LAE and expense ratios.

8 Pre-Due Diligence - Sell Side  Valuation  Seller knew the book value of their company but did not know what range of values the market (and in particular, Buyer) might place on them.  Seller felt they would be in a better bargaining position with Buyer by getting an independent valuation.

9 Pre-Due Diligence - Sell Side  Valuation  Actuaries performed a number of different projections of market value. Discounted cash flow analyses under alternative scenarios with varying assumptions of growth, pricing, loss ratios, expense ratios, investment returns, etc. Price based upon multiples of book value and multiples of earnings using information from recent acquisitions of publicly held companies.

10 Pre-Due Diligence - Sell Side Case Study Outcome: Buyer acquired Seller for a price equal to 1.9 times book value.

11 Pre-Due Diligence - Buy Side Case Study: Buyer - financial group with multiple insurance company investments Seller - privately held national excess and surplus lines carrier Seller approached Buyer seeking an investment partner to finance a management buy-out of the company with ultimate goal of taking the company public. Buyer was somewhat interested but preferred conducting limited pre-due diligence before proceeding.

12 Pre-Due Diligence - Buy Side Actuary’s Involvement In Providing Assistance to Buyer:  Review of Seller’s most recent reserve study  Three day on-site meeting with Seller

13 Pre-Due Diligence - Buy Side  Reserve Review  Conducted a high level review of most recent independent actuarial report (supporting the reserve opinion).  Tested six month actual claim emergence and payments versus expected.  Goal was to assess level of adequacy of carried reserves and where potential problems areas might be.

14 Pre-Due Diligence - Buy Side  Reserve Review  Based on high level review, actuaries were able to inform claims and underwriting consultants that construction defect (CD) might be a problem area to focus on during on-site meeting.  Reserves appeared to be posted at the low end of the range.

15 Pre-Due Diligence - Buy Side  On-Site Meeting  Buyer’s consultants (actuaries, claims, underwriting, financial) met with Seller’s management to get a company overview.  Underwriters learned that the Seller had written a sizeable book of general contractors, subcontractors, and developers in California through mid 90s and corrective underwriting actions began in 1996.

16 Pre-Due Diligence - Buy Side  On-Site Meeting  Claims consultants learned that no formal tracking system for CD had yet been developed and all CD claims were being directed to outside counsel.  With no claim formal tracking system in place, actuaries could not segregate CD from liability triangles and were forced to make judgments regarding ultimate CD losses based upon ad hoc, manual claims department listings.

17 Pre-Due Diligence - Buy Side Case Study Outcome: Buyer elected to walk away from the transaction citing CD issue as the “deal breaker”.

18 Due Diligence - Buy Side Case Study: Buyer - large publicly held national multi-line writer Target - medium-sized publicly held regional multi-line writer Target wrote primarily middle-market personal and commercial lines business produced by independent agents. Seller had difficulty differentiating itself, had been losing market share and results had been deteriorating. Buyer saw a growth opportunity in acquiring Target. Transaction was directed by an investment banker working on behalf of Buyer.

19 Due Diligence - Buy Side Actuary’s Involvement In Providing Assistance to Buyer:  Participated in full scope due diligence  Perform independent reserve review  Interface with other members of due diligence team  Assisted bankers with valuation assumptions  Provided Buyer with post-acquisition insights

20 Due Diligence - Buy Side  Independent Reserve Review  Met with Target’s Chief Actuary and Senior Reserve Actuary to discuss data availability, data segmentation, and reserving issues.  Due to time constraints we focused on the lines of business that reflected the major portion of the reserves and had the most potential for variability.  Segregated into on-going and discontinued (e.g. asbestos and environmental) operations.

21 Due Diligence - Buy Side  Independent Reserve Review  Performed analysis on both a gross and net basis separately for loss, ALAE, ULAE.  A point estimate and a range of results was calculated.  Relied on interface with the other members of the due diligence team for the qualitative aspects of the analysis.

22 Due Diligence - Buy Side  Interface with Due Diligence Team  Underwriters’ review indicated that although regular (inflationary) rate changes had been taken, rate levels had actually been deteriorating due to increased use of discretionary pricing. The actuaries factored this into our loss ratio picks.

23 Due Diligence - Buy Side  Interface with Due Diligence Team  Systems consultants documented the timing of the implementation of a new claims system. Claims consultants confirmed a slowdown then speed-up of claims closures during this time period. Actuaries used the Berquist-Sherman method to adjust development factors for these changes.

24 Due Diligence - Buy Side  Interface with Due Diligence Team  Financial consultants assessed the credit worthiness of reinsurers. Actuaries used this information to test the adequacy of the reserve for uncollectible reinsurance recoverable.

25 Due Diligence - Buy Side  Valuation Assumptions  The investment bankers were modeling the transaction. They relied heavily on the actuaries for the assumptions they used in the valuation. Calendar year payout of reserves (separately for A&E). Loss and LAE ratios for new AYs by line. Claim payment and emergence patterns by line for new AYs.

26 Due Diligence - Buy Side  Post-Acquisition Insights  Since the Buyer was planning to integrate the Target with their ongoing operations they were interested in our insights in the following areas. Opportunities for expense savings (e.g., staffing levels, offices). Compatibility of systems. Competency of senior management.

27 Pre-Due Diligence - Buy Side Case Study Outcome: Reserves were deficient by approximately 20%, primarily from the core (on-going) book of business. The actuaries acted as overall coordinators in compiling the team’s findings for presentation to the Buyer. The reserve deficiency was factored into the pricing of the transaction and the acquisition was made.

28 Due Diligence - Sell Side Case Study: Same case study as Due Diligence - Buy Side The Seller’s actuarial team played an important role during due diligence.

29 Due Diligence - Sell Side  Impact of Seller’s Actuarial Team  In order to maintain confidentiality, only senior managers of Seller interacted with Buyer.  Chief Actuary and Senior Reserve Actuary were fully informed on details of the functions they managed.  Chief Actuary was a very good communicator to non-actuaries which was important in discussing some of the differences in the reserve projections.

30 Common Themes  The actuary’s role in due diligence is not just quantitative.  The technical skills taught in the Syllabus form the foundation of our knowledge base.  We need to be able to interpret how operational aspects of the insurance entity impacts the quantitative results.

31 Common Themes  We generally act as project managers and need to be able to coordinate the presentation of results (the “story telling”).  Because of this, as actuaries we need to continually enhance our communication skills (both written and verbal).