The Actuary & Earnings Management Casualty Actuarial Society-Annual Meeting November 14, 2000 Moderated by: Marc F. Oberholtzer, FCAS Principal Consultant, PricewaterhouseCoopers LLP

The Actuary & Earnings Management-Why Now? Increased scrutiny by SEC, press. Past history is not indicative of current or future environment Message: Awareness needs Heightened for Actuaries –Understand how actuarial work is incorporated into quarterly financial reporting –Be congizant of SEC’s, press’ and others’ perception of actions

The Actuary & Earnings Management-Opening Ideas ABC Ins Co typically reserves 3%-5% above internal actuary estimate. In a quarter, ABC reserved 1% above estimate. –Do you construe this as (a) normal volatility or (b) earnings management? –Same situation, but ABC now exceeds expectations; reserving at 3% redundant, ABC would have fallen short.

The Actuary & Earnings Management-Opening Ideas ABC Ins Co purchases a finite aggregate reinsurance cover. Contract barely transfers enough risk transfer to qualify. ABC is now very likely to meet its publicized goal of a combined ratio below 105%. –Do you construe this as (a) earnings management or (b) a shrewd business decision?

The Actuary & Earnings Management-Defined Actions taken without a specific event to justify the accounting to alter results where the perceived motivation is to comply with certain expectations –Or the lack of action with a specific event P&C insurers are susceptible to scrutiny; timing of earnings are heavily dependent on estimates

The Actuary & Earnings Management-Panelists Matthew Adams, CPA Partner, PricewaterhouseCoopers LLP Albert D. Ciavardelli, CPA Vice President-Finance, PMA Capital Corp William M. Wilt, FCAS Vice President, Moody’s Investor Services

The Actuary & Earnings Management An Auditor’s Perspective Matthew Adams, PricewaterhouseCoopers LLP

The Actuary & Earnings Management Wall Street’s Expectations - How Does Your Company Measure Up? Al Ciavardelli PMA Capital Corporation

Earnings Management: Has there always been a strong focus on “Hitting the Numbers”? As stock values rise, the negative repercussions of not “Hitting the Numbers” are magnified. Greater number of significant one day declines in stock values due to one quarter’s earnings disappointment.

Wall Street’s Views on “Earnings” Measured Quarterly Earnings Quality Earnings Visibility/Stability Growth Hit the Numbers Uniqueness of Insurance Companies

Quarterly Earnings: Short-term Performance Measure Benchmark for Portfolio Managers Predictive value is over-rated Consistent results comfort investors Stock price performance key management focus

Management’s Views on Earnings Value Creation Short-term earnings focus is the basis for a poor business plan Earnings Quality Earnings Visibility/Stability Balance Sheet Strength Sound business plan, good execution on pricing and underwriting discipline will drive the earnings

Stock Price Valuation: It’s more than “Meeting Expectations” Internal Factors Performance metrics - return on equity, PTOI Improving revenue, loss and earnings trends Consistent performer - no surprises Management credibility Dividend yield

External Factors Interest rate environment General stock market trends Competitors’ earnings surprises Sector weighting New vs. old economy Regulatory environment (A&E, tobacco) Stock Price Valuation: It’s more than “Meeting Expectations”

Variety of Ways to Measure “Earnings” Economic Income Comprehensive Income Operating Income excluding XXXX Book Value Per Share Core Operating Income Operating Income

Wall Street’s Current Views on Loss Reserves Companies will have to continue to strengthen reserves during the year. Standard commercial lines reserves may be as much as $30 billion deficient. Virtually all reserve problems are in the major casualty lines with workers’ compensation, commercial, auto and general liability (occurrence) significantly under-reserved. Annual Loss Reserve Survey reported continued deterioration. Industry has been creating an ugly past that will have to be paid for in the future - and the future is close at hand.

We believe that the industry may have under-reserved in the 1998 and 1999 accident years by as much as 10 points each. The past two years (and possibly three) have been under- reserved. Industry has essentially set reserves based on a decade of disinflation and favorable claims experience. Unfortunately, this benign claims environment appears to be changing owing to increased litigation, rising medical cost trends and rising inflationary pressures. Wall Street’s Current Views on Loss Reserves

AY CR are under pressure with diminished ability to harvest what once were redundant reserves without significant price increases. Wall Street’s Current Views on Loss Reserves

Companies will choose whether or not they wish to provide explicit forecasted earnings for upcoming quarter and year. Regulation FD and Earnings Expectations

If they decide to provide earnings guidance.... It must be to everyone at the same time No longer can analysts get more than anyone else Creates very narrow band of earnings estimates confirmed explicitly by management Pressures management to explain differences when earnings do not achieve expected levels Regulation FD and Earnings Expectations

If they decide not to provide earnings guidance.... More marketplace uncertainty will lead to wider range of analysts’ estimates. Much tougher for Company to respond to analysts who want to reconcile the Company’s actual result to the analyst’s expectation. Companies “missing the numbers” may see more or less stock price volatility. Regulation FD and Earnings Expectations

Earnings Management -- A Rating Agency Perspective November 14, 2000 Bill Wilt Moody’s Investors Service

Discussion Topics Operating earnings -- role of loss reserves Impact of change in reserve estimate -- material? Moody’s view of a ‘one-time’ charge Additional analytical obstacles Credibility -- the most important currency in capital markets

Operating Earnings Crux of work done by financial analysts Exclude all non-recurring items –Sale of subsidiary –Discontinued operations –Change in accounting practices –Haircut realized capital gains Less obvious -- change in reserve estimates

A Look Through the Industry’s Earnings

Changes in Reserve Estimates -- Material? XYZ Holding Company Investment in Affiliate $1,000Senior Debt: $350 Equity: $650 XYZ Operating Company Total Assets: $4,500 Loss Reserves: $3,000 Other Liab. $500 Surplus:$1,000

Changes in Reserve Estimates -- Material?

Moody’s View of a “One Time” Reserve Charge

Additional Analytical Obstacles “Leveraged” effect of reserves Merger and acquisition activity Increased utilization of finite reinsurance –Low risk transfer threshold create many financing arrangements –Cheap reinsurance -- sustainable? Restructuring / reorganization charges Other non recurring revenue and expenses

Credibility -- The Best Currency Managing earnings -- a dangerous game –Restatement alters perception of past -- and future earnings –Degree of skepticism very high Issues more than immediate shareholder value –Rx of stock price to reserve charge –Access to funds -- equity, debt, bank market Financial flexibility is critical rating factor

The Actuary & Earnings Management Q&A