25 October 2000 John Charles Reserving Standards Professional Issues

2 Overview Professional Issues affecting: Advice to a UK general insurance company on its reserves for financial reporting Professional Guidance Summary

3 Company Reserves Issues to be covered Who is responsible for setting reserves? What is the role of the actuary in this context? What is an acceptable range of reserves? What actions can an actuary take when their opinion is that the solvency of the company is imperilled?

4 Overall Framework Directors are responsible for setting reserves. Auditors provide independent verification and sign off of published financial statements. Company Actuary is an officer acting as an adviser. In the Lloyd’s Market, the actuary signs off the held reserves if they exceed his best estimate. Regulator wants to ensure that policyholders interests are not jeopardised. Other interested parties include Market analysts and rating agencies.

5 Directors Directors are expected to set reasonable reserves. Process of setting the reserves has to be rigorous and documented. Directors may use a professional to assist in the process of setting reserves. Directors view will be formally audited by accountants.

6 Directors Duties Case law lays down the following general obligations: to comply with the constitution and use their powers under it for proper purposes; to run the undertaking for the benefit of the company (ie, generally speaking for the benefit of its members as a whole) and not for any other purpose; to maintain their independence of judgement; to avoid profiting personally from their position and to avoid conflicts of interest without the consent of the members or the authority of the constitution; to act fairly between the members; and to apply reasonable care and skill in exercising all their functions.

7 Draft Statutory Statement of Directors Duties Summary of responsibilities: Compliance and Loyalty. Independence of Judgement. Conflict of Interest. Fairness. Care, Skill and Diligence. Source: Modern Company Law for a Competitive Economy - Developing the Framework: A Consultation Document form the Company Law Review Steering Group (March 2000).

8 Draft Statutory Statement of Directors Duties Care, Skill and Diligence A director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge skill and experience which he has. Case law: in older cases the standard was an ordinary prudent person. Section 214 of the Insolvency Act - now based on the reasonable skill and care of a reasonable person with the skill and knowledge of the director.

9 Draft Statutory Statement of Directors Duties Business Judgement Accepted that Directors are expected to take risks, often without the ability to fully examine the relevant factors. Accepted that the company’s success or failure depends on the directors not being unduly cautious as well as avoiding fool-hardiness. Appropriateness of risk depends on the ethos of the company and the character of its business and markets.

10 Draft Statutory Statement of Directors Duties Delegation and Reliance No express provision requiring directors to acquire and accept proper professional advice in areas where they lack competence. It is felt by the Steering Group that this is covered by the proper selection of advisers and subordinates and the scrutiny of their advice in accordance with the standard as it applies to each director.

11 Summary of Directors Obligations In setting the reserves the Directors are obliged not to: Deliberately under-reserve. Be deliberately over-optimistic in setting reserves or over-conservative. Knowingly conceal information that will have a material effect on the conclusions of a reserve review. But they are allowed to: Exercise business judgement and take risks taking account of the ethos of the company and the character of its business and markets.

12 Auditors Audit the process of setting the reserve. Since the 1995 year end they sign off accounts as true and fair. Are not allowed to recommend a specific reserve figure but can advise the directors on the range of reserves that they regard as reasonable. Will not sign off the reserves and accounts unless they feel that the reserves fall within a reasonable range. Ultimately the auditor’s opinion on the reasonableness of the reserves will determine whether or not the reserves are adequate for financial reporting.

13 Auditors What is reasonable in this context? Anything that cannot be described as unduly cautious or over-optimistic. Consider the ethos of the company. Consider general market practice. Consider prudence, consistency and materiality.

14 Role of Company Actuary To provide supporting evidence for the directors reserves usually in the form of a report. To assist the auditor in understanding the factors affecting the business and the basis underlying the reserves set by the Directors. Actuary is principally in role of providing advice to the directors in setting the reserves and communicating the basis of those reserves to the auditor.

15 Role of Company Actuary How to manage differences of opinion ? Reconsider factors likely to have affected the data with relevant staff from claims, underwriting, IT and customer service. Consider alternative methods. Identify your opinion of the best estimate and the range of results that you regard as reasonable. Identify the range of assumptions that you regard as reasonable. Carry out sufficient investigations to support your conclusions and key assumptions. If necessary identify further changes to produce an illustrative range which includes the proposed reserves.

16 Role of Company Actuary How to manage differences of opinion? If the report includes illustrations that the actuary does not believe are appropriate, this should be clearly stated in the report. Produce report showing position of the proposed reserves highlighting key assumptions. Comment on any particular areas of uncertainty. Consider the results in the context of market practice. Consider the materiality of the issue in the context of the audit and solvency. Note that the actuary may not be reviewing the totality of the business.

17 Role of Company Actuary Actuarial Report State the purpose and scope of the report clearly - state restrictions on use, specific limitations and unsuitability for outside parties as appropriate. It is essential to distinguish between your comfort zone for the reserves and the range of outcomes that may be considered reasonable. Objective is to provide a basis to enable the directors to understand the context of their reserving policy and enable the auditor to form an independent judgement about the reasonableness of the proposed reserves. Full documentation of the conclusions and the supporting analysis should be produced and filed.

18 Role of Company Actuary GN12 “ The report should outline and discuss the key assumptions made including those as to the legal and claims environment”. “If the report includes illustrations based on assumptions that the actuary does not regard as appropriate, this should be made clear in the report”.

19 Role of Company Actuary How to Manage Solvency Concerns? Project Company’s 3 year Trading performance and cash flows on a number of scenarios having regard to the business plan. Update the projections regularly for emerging experience. Communicate the results to senior management and discuss solutions to identified issues. Establish systems to identify the quality of new business and compare the results to market benchmarks. Monitor claim development to test the assumptions underlying the reserving basis. Recommend independent advice as appropriate.

20 Role of Company Actuary Points to bear in mind: The actuary is not a director in this situation, but an adviser. Distinguish between the financial management of the business and the company’s financial reporting philosophy. Advise management to commission an independent review if there is an irreconcilable difference or if you feel that solvency is threatened. Duty of client confidentiality.

21 Role of Company Actuary Client confidentiality PCS 4.1 An actuary has a duty to the profession and responsibility to any client must be consistent with that duty. An actuary’s responsibilities are personal and, in advising or otherwise acting for each client, the actuary must have proper regard to the trust and confidence which that implies. In particular, unless disclosure is required under statutory or judicial authority or Guidance Notes, the actuary must make no disclosure of the client’s affairs unless authorised by the client.

22 Role of Actuary Criticism of another actuary’s work Be clear in distinguishing differences of opinion. Acknowledge that others may quite properly hold different professional opinions. Acceptable if it is reasoned and felt to be justified. Identify structural differences in methodology if appropriate. High level explanation of difference in conclusions.

23 Role of Company Actuary Professional Conduct Standards, PCS “The actuarial profession has an obligation to serve the public interest. … Individually members must maintain and observe the highest standards of conduct.” “An actuary who has any doubt as to the attitude which should be adopted or the action which should be taken in a particular circumstance must seek guidance from the professional body. An actuary should normally seek guidance from a senior actuary.

24 Regulator May request discussion with the Company Actuary or presence may be required at Regulator’s meetings. Client confidentiality principle still applies but should discuss matters as authorised by your employer. If in doubt, you can ask for the points to raised to be sent in writing by the Regulator for a formal response.

25 FSA Code of Practice Principle 1 Individuals must act with integrity in carrying out their controlled function. Principle 2 Individuals must act with due skill, care and diligence in carrying out their controlled function. Principle 3 Individuals must observe proper standards of market conduct. Principle 4 Individuals must deal with the FSA and with other relevant regulators in an open and co-operative way.

26 FSA Code of Practice Principle 5 Senior managers must take reasonable steps to ensure that the regulated business of their firm for which they are responsible is organized so that it can be controlled effectively. Principle 6 Senior managers must exercise due skill, care and diligence in managing the regulated business of their firm for which they are responsible. Principle 7 Senior managers must take reasonable steps to ensure that the regulated business of their firm for which they are responsible complies with the regulatory requirements imposed on that business.

27 Summary Overall comments on operating environment Designed to give directors freedom to act subject to constraints of regulation and Company Law. Fit and proper person supervision for insurers. Regulator has authority to request additional information. Actuary’s role in this context is as an adviser.

28 Relationship diagram Company Law Accounting Standards Accounting Standards Institute of Actuaries Institute of Actuaries Actuary Regulator Policyholders Shareholders Auditors Company Officers including Directors Compan y

29 Relevant Professional Guidance Professional Conduct Standards GN12 General Insurance - Actuarial Reports GN18 Actuarial Reporting for UK General Insurance Companies writing US Regulated Business GN20 Actuaries Reporting Under the Lloyd’s Valuation of Liabilities Rules GN32 Actuaries and Friendly Societies: General Insurance Business GN33 Actuarial Reporting for Lloyd’s Syndicate writing US Business

30 Causes of Reserving Uncertainty Data Quality Reserving Uncertainty Reserving Uncertainty External Changes Claim Management Claim Management Processing Backlogs Processing Backlogs Underwriting Statistical Variation Statistical Variation Management and operating Changes Management and operating Changes

31 Summary of Reserving Indications Actuary’s best estimate Range of reasonable results Illustrative Range Company Market, GN18 GN20, GN33 Notes: 1. Opinion as to where the points lie will vary 2. Lloyd’s requirements are more strict than Company Market