Loss Reserves from the Actuarial, Accounting and IRS Perspectives Actuary’s Perspective by Alan E. Kaliski, FCAS, MAAA

2 Sensitivity to Loss Cost Inflation n n Loss reserves at 12/31/00 = $X (undiscounted) n n These are estimates of what future payments will be on outstanding reported and unreported claims as of 12/31/00 n n There is an implied or imbedded assumption regarding loss cost inflation from 12/31/00 to dates of payments n n Average payment date on the loss 12/31/00 may be 4 years out for some casualty lines

3 Sensitivity to Loss Cost Inflation n n Hence, for every 1% of error in annual inflation, loss reserve estimate will be off by 4% n n Reserves are leveraged to loss cost inflation on casualty lines with lengthy pay-out periods n n Leverage compounds to extent loss reserves leveraged to surplus (if reserves = 2x surplus, then 1% error in inflation equals 8% of surplus)

4 Sensitivity to Tail n n Workers’ compensation has significant loss development beyond 20 years n n Error in estimate of tail factor compounds itself over 20+ years n n Example: For each error of 1% in tail factor, loss reserves could be off by 7%

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

– NAIC Annual Statement Instructions — Statement of Actuarial Opinion “Make a reasonable provision for all unpaid loss and loss expense obligations of the Company under the terms of its policies and agreements.”

7 Committee on Property and Liability Financial Reporting (COPLFR) of the American Academy of Actuaries (AAA) n n “Reserve makes a reasonable provision if it is within the range of reasonable estimates…” n n “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…” n n “The range of reasonable estimates is narrower, perhaps considerably, than the range of possible outcomes…” n n “When exceptionally high degree of variability…, the actuary may choose to discuss this in the opinion.” Property and Casualty Practice Note

8 Actuarial Standards Board – Actuarial Standard of Practice on Statements of Actuarial Opinion (ASOP #36) n n Requires actuary to consider the uncertainty in the reserve in determining range of reasonable estimates n n Requires actuary to comment on risk of material adverse deviation n n Sets forth sources of uncertainty: – –Random chance, changes in operations, changes in external environment, changes in data trends, etc. (Adopted March 2000) Uncertainty

9 NAIC Codification of Statutory Accounting (Effective January 1, 2001) n n Requires management to book its best estimate (by line) n n If no best estimate, requires mid-point of range to be booked

Evolution of Uncertainty Considerations Reasonable Reserves Range of Estimates Reasonable Sets of Assumptions Evaluate Uncertainty, Risk of Material Adverse Deviation Identify Sources of Uncertainty Book Management’s Best Estimate

Range of Reasonable Estimates Example #1 Reasonable $400M ?? $450M$500M$550M$600M -2% Inflation2% Inflation8% Inflation12% Inflation Possible - Yes Reasonably Likely - No

Loss Development Factors Example # Selections are lowest points in each interval Selected Possible - Yes Reasonably Likely - No

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