1. Materiality and Statements of Actuarial Opinion Presentation to Appointed Actuary Seminar September 20-21, 2004 PD-11 Materiality Joseph A. Herbers, ACAS, MAAA Principal & Consulting Actuary Pinnacle Actuarial Resources, Inc.

2. Materiality and Statements of Actuarial Opinion Comments relate only to statutory SAO, not to other SAO’s Materiality in context of required disclosures Assume working knowledge of NAIC Instructions for SAO and ASOP 36

3. Materiality and ASOP 36 “Material” or “materiality” is mentioned at least 13 times in ASOP 36 Section 3.4 devoted to “Materiality”

4. ASOP Section 3.4 In evaluating materiality within the context of a reserve opinion, the actuary should consider the purposes and intended uses for which the actuary prepared the statement of actuarial opinion Evaluate materiality based on professional judgment, materiality guidelines or standards applicable to SAO and actuary’s intended purpose for the SAO

5. Materiality Standard Need for separate ASOP on Materiality? Subcommittee on Reserving agreed that it would be better to already have a materiality standard, but lack of such standard is not critical to use of ASOP 36 Principal uses of materiality in ASOP are for the actuary to decide if explanatory paragraph is needed

6. Where Do We Look for Guidance? SEC FASB Supreme Court NAIC Financial Examiners Handbook VFIC NAIC Accounting Practices and Procedures Manual

7. SEC Staff Accounting Bulletin No. 99 Exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements … is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold Days of relying simply on +/-5% are over However, SEC has no objection to such rules of thumb as an initial step in assessing materiality

8. FASB No. 2 The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of item Management must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality

9. U. S. Supreme Court TSC Industries v. Northway, Inc., 426 U.S. 438,449 (1976) A fact is material if there is a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available Determinations of materiality require “delicate assessments of inferences a reasonable shareholder would draw from a given set of facts and the significance of those inferences to him”

10. NAIC Financial Examiners Handbook Dollar amount above which the examiner’s perspective of the company’s financial position will be influenced Overall Materiality Individual Balance Sheet items Planning Materiality (PM) – starting point is 1% to 5% of surplus

11. VFIC Appendix 7 to P/C Practice Note developed by COPLFR Discussion of materiality and ASOP 36 Specific citations of the words material, materially, materiality Discussion of guidance from NAIC and SEC

12. NAIC Accounting Practices and Procedures Manual Materiality judgments are primarily quantitative in nature Is this item large enough for users of the information to be influenced by it? Magnitude of the items is such that it is probable that the judgment of a reasonable person relying upon the statutory financial statement would have been changed or influenced by the inclusion or correction of the item

13. Which financial values are important to the intended user? Regulator Statutory Surplus Risk Based Capital Loss, LAE, Unearned Premium Reserves IRIS Tests Appraisal New Worth (GAAP) Net Income Earning per Share

14. Who are Intended Users? Regulators Management Investors Auditors Reinsurers Rating Agencies Policyholders Claimants ABCD

15. Crux of the Problem With all these intended users, how do I determine what a reasonable person will view as material?

16. Regulatory View Survey of Regulators’ view of materiality threshold (Fall 2000) “It all depends” (7) 1% to 5% of Surplus (6) “It’s up to you” (2) 10% of surplus (1)

17. View of Practicing Actuaries Informal Survey subsequent to year-end 2000 opinion season (mostly consultants) 10% of reserves/20% of surplus (3) 15% of surplus (2) 15% of reserves/25% of surplus (1) 1% - 5% of surplus (1)

18. Suggested Multiple Trigger Approach Difference between held reserves and high end of range of indicated reserves Impact of indicated reserves on IRIS Tests 10-12 Impact of indicated reserves on RBC

19. Materiality Considerations Single vs. multiple line company Net Retention Single Company vs. Member of Group Access to Capital Management Prior loss reserve runoff Financial Strength

20. Management as User of SAO Viewed as regulatory requirement Disclose as little as possible Boilerplate Language Materiality viewed relative to surplus or total reserves

21. Case Studies Mutual Auto Insurance Company Multi-Line Casualty Company Lawyers Prof. Liab. Mutual Ins Co Reinsurance Company

22. Mutual Auto Insurance Co. 19951996199719981999 Surplus25,12030,05437,60841,76645,792 NWP24,28325,06025,22324,73323,994 NWP to Surplus0.970.830.670.590.52 Reserves14,52514,555 Reserves to Surplus 0.350.32 Net Income9722,3432,4501,013842 Admitted Assets54,75660,89269,44274,57980,114 Pre-Tax ROR22.0%23.1%27.4%14.0%12.1% Loss Reserve Development -12.6%-9.5%-5.2%-3.9% Best’s RatingA++ 5 % ReserveDeviation as % of Surplus1.7%1.6% Net Income71.7%86.4%

23. Multi-line Casualty Insurance Co. 19951996199719981999 Surplus121,337115,728128,811123,28984,851 NWP122,945158,18293,34199,39075,892 NWP to Surplus1.011.370.720.810.89 Reserves113,867111,829 Reserves to Surplus 0.921.32 Net Income 10,733 Admitted Assets294,805319,920282,994282,415244,291 Pre-Tax ROR- 2.5%- 5.9%11.3%- 8.2%-25.4% Loss Reserve Development +22.0%+21.9%+20.2%+17.0% Best’s RatingA- B++ 5 % ReserveDeviation as % of Surplus4.6%6.6% Net Income-109%-145%

24. Lawyers Prof. Liability Mutual Insurance Co. 19951996199719981999 Surplus6,3057,3297,3348,1549,641 NWP3,3474,5934,8645,6785,979 NWP to Surplus0.530.630.660.700.62 Reserves6,4018,1788,53610,14111,291 Reserves to Surplus 1.021.121.161.241.17 Net Income7427032787211,079 Admitted Assets19,60522,25623,26126,53129,599 Pre-Tax ROR15.4%18.3%1.4%11.7%17.0% Loss Reserve Development + 4.2%- 0.5%-18.4%-13.4% Best’s RatingB++ 5 % ReserveDeviation as % of Surplus5.1%5.6%5.8%6.2%5.9% Net Income43.1%58.2%153.5%70.3%52.3%

25. Reinsurance Company 19951996199719981999 Surplus272,374396,677423,616402,652401,392 NWP205,065429,870645,832698,440653,984 NWP to Surplus0.751.081.521.731.63 Reserves1,038,4601,179,181 Reserves to Surplus 2.582.94 Net Income22,980 35,7941,2648,375 Admitted Assets733,2251,491,7761,608,0261,745,1561,877,779 Pre-Tax ROR12.0%0.3%14.9%5.2%4.7% Loss Reserve Development + 1.8%+ 7.9%+ 7.5%+ 6.7% Best’s RatingAAA+ 5 % ReserveDeviation as % of Surplus12.9%14.7% Net Income4108%704%

26. Quantitative Approaches to Materiality Stochastic Modeling “Murphy” method – regression techniques “Mack” method – distribution free statistical approach “Renshaw & Vernall” – generalized linear models

27. Conclusions Must consider viewpoint of Intended Users Many “unintended” users because SAO is a public document Use reasonable person test Our view of materiality is typically much broader/wider than that of our audiences Suggest a multiple trigger approach for assessing materiality Consider totality of information, and give it “thoughtful consideration”