1. Roles and Responsibilities of External Auditors and Actuaries Insurance Industry Workshop 1 – 2 November 2005 Bangkok, Thailand Kim Norris Managing Director International Advisory Group www.osfi-bsif.gc.ca

2. 2 Discussion Points External Auditors Roles and responsibilities of the Actuary Roles and responsibilities of an actuary Reporting Dynamic Capital Adequacy Testing (DCAT) Professional Standards and OSFI’s role

3. 3 External Auditors An independent audit opinion (required by legislation) provides credibility to financial statements External auditors are subject to standards with respect to qualifications, work and behaviour Professional standards Peer review Statutory requirements Public Oversight Board

4. 4 External Auditors Auditor’s opinion: unqualified or reserved reservation or qualification may be important from a supervisory perspective need to understand the reasons for the qualification does not necessarily provide assurance on the future viability of the institution or the effectiveness of management

5. 5 External Auditors OSFI reviews External Auditor’s work to: Help assess the institution enhance supervisors’ knowledge of the institution identify any prudential concerns raised and hence target areas for in-depth reviews

6. 6 Appointed/Consulting Actuaries Roles and responsibilities of an actuary Reporting Dynamic Capital Adequacy Testing (DCAT) Professional Standards and OSFI’s role Most jurisdictions now require that a qualified actuary attest to the adequacy and appropriateness of the insurer’s loss reserve

7. 7 Appointed/Consulting Actuaries Roles and responsibilities of an actuary OSFI’s expectation for the Appointed Actuary: To produce sound, consistent (so that two actuaries considering the same fact situation arrive at results that are not materially different), and appropriate work, monitored by the CIA The responsibilities of the actuary are spelled out in legislation

8. 8 Roles and responsibilities of an actuary The actuary will value: 1) the actuarial and other policy liabilities of the company as at the end of a financial year; and 2) any other matter specified by OSFI (e.g. as per the “AA Memo”) The actuary's valuation shall be in accordance with generally accepted actuarial principles unless otherwise specified by OSFI. Appointed/Consulting Actuaries

9. 9 Roles and responsibilities of an actuary DCAT provision The actuary will meet with the directors/audit committee at least once during each financial year in order to report, in accordance with GAAP and under any other specifications by OSFI, on the financial position of the company and its expected future financial condition. Whistle blowing provision If the actuary comes across any matters that have a material adverse effect on the financial condition of the company and require rectification, the actuary will report in writing the CEO, CFO and directors. If suitable action is not being taken to rectify the matters, the actuary will send a copy of the report to OSFI. Appointed/Consulting Actuaries

10. 10 Roles and responsibilities of an actuary Report on the policy liabilities in Annual Return Report to the shareholders and policyholders not less than 21 days before the company’s annual meeting State whether the annual statement fairly states the valuation results Meet with and report to the directors or the chief agent on the company’s future financial position (DCAT report) Appointed/Consulting Actuaries

11. 11 Appointed/Consulting Actuary’s Report Detailed actuarial report submitted to regulator Contains the opinion of the actuary concerning the fairness and adequacy of the figures for policy liabilities included in the insurer’s annual statements Contains detailed commentary and exhibits of data and calculations supporting the opinion Filed within 60 days of company’s year-end; 105 days for reinsurers Appointed/Consulting Actuaries

12. 12 Appointed/Consulting Actuary’s Report Purpose To give OSFI a comprehensive report documenting the work done by the AA to calculate the policy liabilities. OSFI does not release the Report. However, companies may release the Report for special purposes e.g. to rating agencies or to investment bankers Appointed/Consulting Actuaries

13. 13 Contents of the Appointed/Consulting Actuary’s Report Introduction and Scope Company, date, author Description of company operations Description of the type of data provided and the review and verification procedures Description of the procedures and/or methodology to transform data Description of the procedures to ensure the data is sufficient, reliable and accurate Disclosure of AA’s compensation and bonus structure Appointed/Consulting Actuaries

14. 14 Appointed/Consulting Actuary’s Report Expression of opinion includes the liability figures (both claim and premium liabilities) of the AA and that booked by the company includes a statement regarding the data reliability, sufficiency and consistency may be a qualified opinion Appointed/Consulting Actuaries

15. 15 Appointed/Consulting Actuary’s Report Comparison of actual experience with expected experience in the previous year-end valuation a comparison is provided for 5 years (general insurers) A comparison for insurance policy and contract liabilities for 3 years (life insurers) Appointed/Consulting Actuaries

16. 16 Appointed/Consulting Actuary’s Report – General Insurers Commentary description of case reserving process any significant changes in assumptions or techniques from the previous valuation report the principal characteristics of each line of business changes in the company’s marketing strategy, mix of business, level of retention, reinsurance, methods of recording data Appointed/Consulting Actuaries

17. 17 Appointed/Consulting Actuary’s Report – General Insurers Commentary (cont’d) expected ultimate claims and claim ratios for each accident year impact of industry pools impact of inter-company pooling agreements treatment of mass tort and environmental liabilities provision for adverse deviation (PfAD) Appointed/Consulting Actuaries

18. 18 Appointed/Consulting Actuary’s Report – General Insurers Database and exhibits exhibits should be provided for each line of business on a gross and net basis cumulative paid loss data by (accident year) case reserve by (accident year) reported claim counts by (accident year) open claim counts by (accident year) any other derived exhibits Appointed/Consulting Actuaries

19. 19 Appointed/Consulting Actuary’s Report – General Insurers Other the extent to which the Actuary uses the work of the Auditor must be discussed in the Report any reliance on or use of the work of another Actuary should be indicated reinsurance amounts recoverable must be stated any known problems in the collection of reinsurance should be specified Appointed/Consulting Actuaries

20. 20 Appointed/Consulting Actuary’s Report – General Insurers Review of claims liability data: Operational changes and external influences changes in underwriting practice changes in claims handling including case estimate practice changes in data processing changes in accounting changes in judicial, regulatory and legislative environment economic variables such as inflation Appointed/Consulting Actuaries

21. 21 Appointed/Consulting Actuary’s Report – General Insurers Review of claims liability data: Homogeneity and credibility of the data data is usually divided into lines of business to increase homogeneity the data set should be large enough to be credible; otherwise the actuary may use industry data to make selections Reinsurance limits Collateral sources e.g. salvage, subrogation, loss transfer Appointed/Consulting Actuaries

22. 22 Appointed/Consulting Actuary’s Report – General Insurers Review of claims liability data: Different valuation methods most often, the actuary will calculate at least two or more methods, compare them and then select valuation results from one or a combination of methods Appointed/Consulting Actuaries

23. 23 Appointed/Consulting Actuary’s Report – General Insurers Review of premium liability data: The claims estimates Premium development The rate level underlying the unearned premium Reinsurance Seasonality of losses Trend factors Appointed/Consulting Actuaries

24. 24 Appointed/Consulting Actuary’s Report – Life Insurers Asset Liability Management (ALM) report on each interest sensitive asset segment report on interest sensitivity of the liabilities cash flow Appointed/Consulting Actuaries

25. 25 Appointed/Consulting Actuary’s Report – Life Insurers Sources of earnings analysis of a company’s earnings by source in a prescribed format Appointed/Consulting Actuaries

26. 26 Appointed/Consulting Actuary’s Report – Life Insurers Participating policies review allocation of investment income and expenses transfers to shareholders from participating account divided policy Appointed/Consulting Actuaries

27. 27 Appointed/Consulting Actuary’s Report – Life Insurers Minimum Continuing Capital and Surplus Requirement (MCCSR) review cases where actuarial judgement is required e.g. – negative reserves & excess cash value – index–linked policies Appointed/Consulting Actuaries

28. 28 Dynamic Capital Adequacy Testing (DCAT) Definition: the process of analyzing and projecting the trends of a company’s capital position under a variety of future scenarios, to identify risk and threats and to suggest actions to take Purpose: to inform management and the Board of Directors about the potential threats to the solvency of the company Appointed/Consulting Actuaries

29. 29 Dynamic Capital Adequacy Testing (DCAT) Usefulness: alerting OSFI as to where there are risks of insolvency showing the variability of the business plan understand the risk profile of the company OSFI requires the production of the report but according to CIA standards The report must be sent OSFI within 30 days of presentation to the Board Also applies to companies in runoff The reports are an important component of a company’s risk management process Appointed/Consulting Actuaries

30. 30 Dynamic Capital Adequacy Testing (DCAT) Process of DCAT review of recent operations development of a base scenario examination of the risk categories stress testing of the risks selection of those scenarios requiring further analysis The base scenario will usually be the company’s financial plan Appointed/Consulting Actuaries

31. 31 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories: (1)Frequency and severity (2)Pricing (3)Misestimation of policy liabilities (4)Inflation (5)Interest rate (6)Premium volume Appointed/Consulting Actuaries

32. 32 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d): (7)Expense (8)Reinsurance (9)Deterioration of asset values (10)Government and political action (11)Off-balance sheet Appointed/Consulting Actuaries

33. 33 Dynamic Capital Adequacy Testing (DCAT) – Life Insurers 10 risk categories: (1)Mortality risks (2)Morbidity risks (3)Persistency risks (4)Cash flow mismatch risk (C-3 risk) (5)Deterioration of asset values (C-1 risk) Appointed/Consulting Actuaries

34. 34 Dynamic Capital Adequacy Testing (DCAT) – Life Insurers 10 risk categories (cont’d): (6)New business risks (7)Expense risks (8)Reinsurance risks (9)Government and political action (10)Off-balance-sheet risks Appointed/Consulting Actuaries

35. 35 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : ( 1) Frequency and severity catastrophic loss: earthquake, windstorm, flood, hail multiple catastrophic losses multiple large losses loss ratio being much higher than usual (about 10 points) Appointed/Consulting Actuaries

36. 36 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : (2) Pricing rate freeze increased competition (3) Misestimation of policy liabilities reserves being at too low a level especially for long-tailed lines there may be inflation or court decisions that were not factored in originally Appointed/Consulting Actuaries

37. 37 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : (4) Inflation at least 3 percentage points over that in the base scenario for five consecutive years yield curve shifts up by at least 150 based points at least half of all future payments will inflate at the higher trend factor Appointed/Consulting Actuaries

38. 38 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : (5) Interest rate a parallel shift of 300 bases points in the yield curve (6) Premium volume a reduction of up to 30% a significant increase in volume Appointed/Consulting Actuaries

39. 39 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : (7) Expense low premium volume but fixed expenses technology changes severe inflation court decisions related to market conduct (8) Reinsurance reinsurer insolvency increase in reinsurance rates disputes over policy conditions Appointed/Consulting Actuaries

40. 40 Dynamic Capital Adequacy Testing (DCAT) – General Insurers 11 risk categories (cont’d) : (9) Deterioration of asset values increase of 150 bases points decline in equities of 25% 50% decline in real estate 75% decline in the largest subsidiary (10) Government and political action increase in premium tax increase in assessments entry of new distribution channels (11) Off-balance sheet defaults on letters of credit Appointed/Consulting Actuaries

41. 41 Dynamic Capital Adequacy Testing (DCAT) Examination of the risk categories: scenarios that are tested should have a 1% to 5% probability of occurrence Stress testing of the risks: how far the risk factor has to change in order to drive the company’s surplus negative helps to determine sensitivity to certain risks and helps fix the scenarios Appointed/Consulting Actuaries

42. 42 Dynamic Capital Adequacy Testing (DCAT) Selection of scenarios requiring further analysis at least 3 scenarios must be examined in detail ripple effect and management action must be included in scenario testing Appointed/Consulting Actuaries

43. 43 Dynamic Capital Adequacy Testing (DCAT) Actuary’s opinion: Financial condition is satisfactory if throughout the forecast period, the company meets all its future obligations under the base scenario and all plausible adverse scenarios and under the base scenario, it meets the minimum regulatory capital requirement Appointed/Consulting Actuaries

44. 44 Dynamic Capital Adequacy Testing (DCAT) Actuary’s report: Must report any plausible adverse scenarios that cause the insurer to fall below the minimum regulatory capital requirement If the capital is less than the company’s target level but greater than 100% the actuary must comment on the possibility that the regulator would exercise its authority to impose restrictions which would affect the company’s ability to successfully execute its business plan Appointed/Consulting Actuaries

45. 45 Principles to keep in mind: OSFI relies on the AA’s opinion Canadian Institute of actuaries (CIA) develops appropriate standards CIA standard of professional conduct applies OSFI’s role: verify that the actuary’s work is reliable and in compliance identify concerns with a company’s liabilities identify risk and threats take action when necessary Appointed/Consulting Actuaries

46. 46 OSFI’s review of DCAT: compliance with CIA Standards format of the report appropriateness of adverse scenarios recommendations follow-up on issues previously raised other: financial condition, type of business, structure of company, effectiveness of management Appointed/Consulting Actuaries

47. 47 Thank You