Charles L. McClenahan 10 South Wacker Drive, Chicago, IL Dancin’ With the Devil Ranges and Adverse Deviation Casualty Loss Reserve Seminar, September 2006

2 Dancin’ With the Devil Range of Reasonable Estimates Risk of Material Adverse Deviation Some Suggestions for Consideration

3 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates History Purpose Misuse of Ranges New Actuarial Opinion Summary

4 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates History – Bob Anker discusses reserve ranges – CAS Statement of Principles - “a range of reserves can be actuarially sound” – COPLFR – “reasonable provision” if within the “range of reasonable estimates” – ASOP #36

5 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates ASOP #36 Definition (Section 3.6.4) A range of reasonable estimates is a range of estimates that could be produced by appropriate actuarial methods or alternative sets of assumptions that the actuary judges to be reasonable. Appropriate methods Reasonable Assumptions

6 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates

7 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates Purpose – The range reflects the fact that different actuaries using different reasonable methods and different appropriate assumptions will produce different reasonable estimates of reserves – The range is NOT permission to carry 95%

8 Casualty Loss Reserve Seminar, September 2006 Range of Reasonable Estimates Misuse of Ranges – The “Actuarial Limbo” or “How Low Can You Go?” – The “Actuarial Two-Step” – The “Actuarial Tango” or “It Takes Two” – The “Actuarial Waltz” or “It’s as Easy as 1-2-3”

9 Casualty Loss Reserve Seminar, September 2006 Exhaustive Research Reveals … 7.3% of actuaries are using inappropriate methods Of the remaining 92.7%, 8.4% are using unreasonable assumptions We have identified the 84.9% who are using appropriate methods and reasonable assumptions

10 Casualty Loss Reserve Seminar, September 2006 Exhaustive Research Reveals … Highest Best Estimate – Consultant named Max (last name withheld for privacy) – Max left his firm last month – Currently working in DC Lowest Best Estimate – Consultant named Minnie (last name withheld to avoid being sued) – Currently swamped with work

11 Casualty Loss Reserve Seminar, September 2006 Exhaustive Research Reveals …

12 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Limbo” or: “How Low Can You Go?” Minnie doesn’t know her best estimate is lowest

13 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Limbo” or: “How Low Can You Go?” So she establishes a range

14 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Limbo” or: “How Low Can You Go?” And signs off at the low end

15 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Limbo” or: “How Low Can You Go?” Another clean opinion for Minnie

16 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Two-Step” Step 1 – Appointed Actuary Determines Range

17 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Two-Step” Step 2 – Company Books to (or Near) Low

18 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Tango” or: “It Takes Two” Company Books at Low End of Its Own Range

19 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Tango” or: “It Takes Two” Appointed Actuary Sees Reserve Within Range

20 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Tango” or: “It Takes Two” Clean Opinion on what both agree is low reserve

21 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Waltz” or: “It’s as easy as 1-2-3” Appointed Actuary Prepares Analysis

22 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Waltz” or: “It’s as easy as 1-2-3” Appointed Actuary Shares Analysis with Company Company Selectively Critiques Analysis – Focus on areas where Appointed Actuary may be too high – Ignore areas where Appointed Actuary may be too low See? Claims are closing faster!

23 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Waltz” or: “It’s as easy as 1-2-3” Appointed Actuary Amends Analysis

24 Casualty Loss Reserve Seminar, September 2006 The “Actuarial Waltz” or: “It’s as easy as 1-2-3” Repeat as necessary

25 Casualty Loss Reserve Seminar, September 2006 New Actuarial Opinion Summary Signed and dated by the Appointed Actuary AOS should include the Appointed Actuary’s range of reasonable estimates and/or point estimates Where there has been one-year adverse development in excess of 5% of surplus, in at least three of the past five calendar years, include explicit description of the reserve elements or management decisions which were the major contributors.

26 Casualty Loss Reserve Seminar, September 2006 New Actuarial Opinion Summary Disclosure of best estimate and/or range will be helpful to regulators, not available to consumers – Confidentiality likely to be litigated – Bases for ranges will receive additional attention – May be client pressure for wider (lower) ranges – If reserve is near bottom of range, best estimate alone will be disclosed

27 Casualty Loss Reserve Seminar, September 2006 New Actuarial Opinion Summary 5% of Surplus Test

28 Casualty Loss Reserve Seminar, September 2006 New Actuarial Opinion Summary 5% of Surplus Test – Penalizes strengthening – Constant 5% benchmark – inflation will have major impact – Single test point: 5% in 3 of 5 years  No disclosure required for: 4th prior (1%) 3rd prior (2%) 2nd prior (4%) 1st prior (8%) Current(22%)

29 Casualty Loss Reserve Seminar, September 2006 Risk of Material Adverse Deviation ASOP # Significant Risks and Uncertainties (Explanatory Paragraph) - When the actuary reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation, the actuary should also include an explanatory paragraph in the statement of actuarial opinion. (See sections 3.4 and for guidance on evaluating materiality and considering risks and uncertainties.) The explanatory paragraph should contain the following: a. the amount of adverse deviation that the actuary judges to be material with respect to the statement of actuarial opinion; and b. a description of the major factors or particular conditions underlying risks and uncertainties that the actuary believes could result in material adverse deviation.

30 Casualty Loss Reserve Seminar, September 2006 Risk of Material Adverse Deviation 2005 Practice Note – The actuary should include within the Actuarial Report some detail on how the materiality threshold was chosen, including commentary on what items were considered in choosing the threshold. In addition, the Actuarial Report should include extended commentary on the risks considered in the actuary’s determination of whether a risk of material adverse deviation exists.

31 Casualty Loss Reserve Seminar, September 2006 Risk of Material Adverse Deviation Materiality Threshold – Possible factors to consider:  % of reserves  % of surplus  impact on income/earnings-per-share  impact on IRIS tests  impact on RBC  impact on Best’s or S&P ratings

32 Casualty Loss Reserve Seminar, September 2006 Risk of Material Adverse Deviation Difficult Questions – If the difference between the Appointed Actuary’s best estimate and the booked reserve exceeds the materiality threshold, is that a prima facie risk of material adverse deviation? – Are there so many potential risks that the important ones are likely to get lost in the boilerplate? – How do you quantify effects of:  Adverse judicial decisions?  Future inflation?  Currency fluctuation?

33 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Ownership of Reserve Estimate – Company must select carried reserve before independent Appointed Actuary estimates range (“untutored” reserve) – If untutored reserve is within range it is reasonable – If untutored reserve is below range, Appointed Actuary now “owns” the estimate (is establishing reserve) and a clean opinion requires reserve of at least AA’s best estimate

34 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Disclosure of position within range – If Appointed Actuary calculates range it should be disclosed – If Appointed Actuary calculates best estimate it should be disclosed – If Company has calculated range different from AA it should be disclosed

35 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Definition of “reasonable provision” – Current ASOP #36 – “if it is within the actuary’s range of reasonable reserve estimates” – Proposed – “if it is greater than or equal to the best estimate of a qualified actuary and it is within the opining actuary’s range of reasonable estimates.”

36 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Reserve Development Test – Scrap the 5% in 3 of 5 test – Development should be measured at equivalent point in range to avoid penalty for strengthening – Benchmark should reflect change in CPI

37 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Risk of Material Adverse Deviation – Universal risks should be enumerated and excluded from disclosure  Judicial interpretations  Retroactive legislation  Inflation  Currency fluctuation or revaluation  Theories of litigation  Emergence of previously unknown damage or disease

38 Casualty Loss Reserve Seminar, September 2006 Some Suggestions for Consideration Ranges of Reasonable Estimates – Avoid benchmarks based upon best estimate (i.e. ±x%)  Cannot assume every b.e. is at midpoint – Experience-based studies should correct for general under- estimation of ultimates  Widening the range tends to increase deficiency