The Actuarial Role on Risk-Focused Examinations Rebecca Freitag, FCAS, MAAA Merlinos & Associates IASA GEORGIA CHAPTER Fall Education Conference October 2015 Kirk Braunius, ASA, MAAA Merlinos & Associates

WHAT IS A “RISK-FOCUSED” EXAMINATION? 2 “The primary purpose of a risk-focused examination is to review and evaluate an insurer’s business processes and controls... to assist in assessing and monitoring its current financial condition and prospective solvency.... As part of this process, the examiner identifies and evaluates risks that could cause an insurer’s statements to be misstated both currently and prospectively.” 2015 NAIC Financial Condition Examiners Handbook, Preamble

RISK-FOCUSED METHODOLOGY 3  More clearly directs financial statement verification to only those key accounts and control objectives of those accounts with the greatest risk.  Directs the examination focus to the identification of significant strategic and operating risks, investigation of mitigation strategies for those risks, and recommendations for enhancements where appropriate to reduce residual risks to a more acceptable level NAIC Financial Condition Examiners Handbook

TYPES OF INSURANCE EXAMINATIONS 4  Financial Condition Examination  Market Conduct Examination Actuaries are requested to assist on both types

WHAT IS AN ACTUARY? 5 “A person whose job it is to tell insurance companies how much they should charge people for insurance based on risks; a person who calculates insurance and annuity premiums, reserves, and dividends.” noun ac·tu·ary \ ˈ ak-chə- ˌ wer-ē, -shə-, - ˌ we-rē-\

WHAT IS AN ACTUARY? 6 “Part super-hero. Part fortune-teller. Part trusted advisor. We help organizations plan for the future and protect themselves from loss.” BeAnActuary.org

WHAT ACTUARIES DO… 7  Ratemaking: TRADITIONAL insurance self-insurance captives audit support  Reserving: analysis compliance

WHAT ACTUARIES DO… 8  Due Diligence/Valuations  Reinsurance Program Development, Negotiations, Risk Transfer  Enterprise Risk Management/Own Risk Self-Assessment  Liquidations and Rehabilitations  Product Management  Exposure Monitoring  Predictive Analytics  Litigation Support  Public Policy Analysis  Strategic Planning  Systems Implementation/Conversion/Statistical Reporting  Business Plans/Feasibility Studies

PHASES OF A RISK-FOCUSED EXAMINATION 9 PHASE 1Understand the Company and Identify Key Functional Activities to be Reviewed PHASE 2Identify and Assess Inherent Risk in Activities PHASE 3Identify and Evaluate Risk Mitigation Strategies (Controls) PHASE 4Determine Residual Risk PHASE 5Establish/Conduct Detail Examination Procedures PHASE 6Update Prioritization and Supervisory Plan PHASE 7Draft Examination Report and Management Letter

HOW ACTUARIES ASSIST ON RISK-FOCUSED FINANCIAL CONDITION EXAMINATIONS 10  Reserve Adequacy  Underwriting and Pricing Strategy/Quality  Reserve Data  Appropriateness/Adequacy of Reinsurance Program  Reinsurance Reporting and Collectability Of 10 “Critical Risk Categories,” P&C/health actuaries are frequently involved in 5:

RESERVE ADEQUACY EXAMPLE 11 Prior to risk-focused exams… Actuary would perform an independent analysis on the reserves in the Annual Statement, Page 3, Lines 1 and 3, and Schedule P

RESERVE ADEQUACY EXAMPLE 12 In Phase 2 of the risk-focused exam process, an actuary may review…  Annual and Quarterly Statements  Management Discussion and Analysis  Statement of Actuarial Opinion  Actuarial Opinion Summary  High-level review of report supporting the Actuarial Opinion  Comments by External Auditor on Reasonability of Reserves  Prior Examination Report and/or Letter to Management, as well as any company responses  A.M. Best or other analytical summaries  Publicly-available information PHASE 2: DETERMINE INHERENT RISKS

RESERVE ADEQUACY EXAMPLE 13 In addition, the following may influence the actuary’s determination of inherent risk…  Conduct/attend interviews with Company personnel  Are reserves primarily for long or short-tailed lines? Are any particularly risky or volatile lines involved?  Is reserve development historically favorable, adverse, or neutral?  What is the relationship of reserves to surplus?  Does the actuarial report appear to be well-documented?  Does the Company book reserves close to the Appointed Actuary’s central estimate? If not, how material is the deviation? PHASE 2: DETERMINE INHERENT RISKS

RESERVE ADEQUACY EXAMPLE 14 Some controls/processes which Companies may have in place regarding reserves…  Is the carried reserve based on an actuarial analysis?  Does the actuary producing this analysis communicate with other departments to stay informed of any operational or industry changes that may impact the analysis? If so, is there any documentation of these meetings?  Is the analysis technically and/or peer-reviewed?  Who makes the decision on what reserve amount is carried?  Exchange of ideas between the outside and/or auditor actuary and management. PHASE 3: IDENTIFY AND EVALUATE RISK MITIGATION STRATEGIES

RESERVE ADEQUACY EXAMPLE 15  How does management use the actuarial analysis to determine the carried reserve? Are there procedures, committees, controls in place? If management deviates materially from the Appointed Actuary’s central estimate, is there a quantitative analysis supporting this deviation?  How involved/knowledgeable is the Audit Committee and/or the Board? Some controls/processes which Companies may have in place regarding reserves… (more) Actuaries may advise Departments of Insurance regarding control recommendations. PHASE 3: IDENTIFY AND EVALUATE RISK MITIGATION STRATEGIES

RESERVE ADEQUACY EXAMPLE 16  Review any Sarbanes-Oxley, Model Audit Review, or other similar documentation provided by the Company processes and controls  Review auditor testing of controls (internal audit or external auditors)  Make direct inquiries of Company personnel In determining and reviewing the controls in place, actuaries may… PHASE 3: IDENTIFY AND EVALUATE RISK MITIGATION STRATEGIES

RESERVE ADEQUACY EXAMPLE 17 PHASE 3: IDENTIFY AND EVALUATE RISK MITIGATION STRATEGIES Q: What can a Company do to enable Phase 3 to proceed more smoothly? A: Document processes and have documentation and evidence of controls readily available.

RESERVE ADEQUACY EXAMPLE 18  At the end of this process, the actuaries in coordination with the exam team determine the strength of the risk mitigation presented by the controls with two primary questions: PHASE 3: IDENTIFY AND EVALUATE RISK MITIGATION STRATEGIES Are the controls effectively designed to mitigate the risk? Actuaries (or other examiners) occasionally issue recommendations related to the design or operation of controls. Are the controls operating effectively?

RESERVE ADEQUACY EXAMPLE 19  Residual risk is classified as low, moderate, or high  It is determined somewhat formulaically based on inherent risk and control strength, with some room for judgment  Moderate or high risk results in some substantive (“detail”) procedures PHASE 4: DETERMINE RESIDUAL RISK

RESERVE ADEQUACY EXAMPLE 20  As examinations evolved, the focus moved from independent estimate to a review of the Appointed Actuary’s work, when possible  As the risk-focused examination process evolved even further, the focus moved from reviewing the Appointed Actuary’s work to reviewing the Company’s own actuarial support for the carried reserve PHASE 5: ESTABLISH/CONDUCT DETAIL EXAMINATION PROCEDURES

RESERVE ADEQUACY EXAMPLE 21 Q: How can Phase 5 proceed more efficiently for my Company? A: The Company actuaries’ work should be organized and well-documented Management deviations from the Company actuaries’ (or Appointed Actuary) central estimate should be documented and quantitatively supported when possible PHASE 5: ESTABLISH/CONDUCT DETAIL EXAMINATION PROCEDURES

RESERVE ADEQUACY EXAMPLE 22  Review the Appointed Actuary’s report  Review the external auditor or external consultant’s actuarial analysis (if performed)  Sensitivity test some inputs and selections in the actuarial or management support  Produce independent analysis on some portions of the reserve  Produce independent analysis on the majority or the entirety of the reserve PHASE 5: ESTABLISH/CONDUCT DETAIL EXAMINATION PROCEDURES If needed, examination actuaries may:

RESERVE ADEQUACY EXAMPLE 23 PHASE 5: ESTABLISH/CONDUCT DETAIL EXAMINATION PROCEDURES The examining actuary will inform the regulator of any recommendations or concerns

OTHER RISKS 24  Pricing  Reinsurance  Death, Disability, and Retirement Reserve  Unearned Premium Reserves on Long-Duration Contracts

MARKET CONDUCT EXAMINATIONS: ACTUARIAL INVOLVEMENT 25  Review of premium reporting by line  Price optimization  Industries or lines in which there appear to be discriminatory or unfair pricing  Confirmation that filed rate are being followed correctly

QUESTIONS? 26

Thank you! The Actuarial Role on Risk-Focused Examinations IASA GEORGIA CHAPTER Fall Education Conference October 2015 Rebecca Freitag, FCAS, MAAA Merlinos & Associates Kirk Braunius, ASA, MAAA Merlinos & Associates