1. kpmg1 THE ACTUARY AND EARNINGS MANAGEMENT Martha Marcon Aaron Halpert Assurance Partner Principal KPMG LLP Casualty Actuarial Society Spring Meeting May 8, 2000

2. kpmg2 THE ACTUARY AND EARNINGS MANAGEMENT zDefinitions zCurrent SEC Focus zHow would it affect P&C insurers zWhat are the actuarial considerations zConclusions zQuestions/Answers

3. kpmg3 Earnings Management zWhat is earnings management? zWhere did the concept come from? zWhat does it mean to insurance companies? Casualty Actuarial Society

4. kpmg4 Earnings Management Definition zActions without events or conditions occurring at the time to justify such actions zAdjusting company’s reported earnings to meet market expectations

5. kpmg5 Earnings Management zArthur Levitt (SEC Chairman) Speech 9/28/98: “The Numbers Game” zFortune Article 8/2/99: “Lies, Damned Lies, and Managed Earnings” zW. R. Grace SEC Enforcement Action

6. kpmg6 Levitt (SEC Chairman) Speech zThe pressure to “make your numbers” zIdentified 5 abuses y“Big Bath” restructuring charges yCreative acquisition accounting yMiscellaneous cookie jar reserves yAbuse of materiality yRevenue recognition

7. kpmg7 Levitt (SEC Chairman) Speech zLevitt’s call for action included: yMore disclosure yMore guidance on revenue recognition yStrengthen audit committee process yAsked SEC staff to look at materiality: hence SAB #99

8. kpmg8 Staff Accounting Bulletin 99 - Materiality zQuantitative and Qualitative zIf a reasonable person would consider a matter important - it’s material zVolatility of market reaction

9. kpmg9 Staff Accounting Bulletin 99 - Materiality Factors Defining Materiality zCapable of precise measurement zMasks a change in earnings or other trends zHides a failure to meet analysts’ expectations zChanges a loss into income or vice versa zCompliance with regulatory requirements zCompliance with loan covenants

10. kpmg10 Earnings Management Management of earnings considerations for insurance companies: How does one test management’s best estimate of the reserves? Does an overly wide range enable management to manage earnings? What drive’s materiality? Are we too focused on reserve adequacy, and not enough on the earnings impact? What about materiality at a business segment level?

11. kpmg11 Earnings Management Actuarial Considerations

12. kpmg12 SEC Focus Affects our Actuarial Focus zIncreased statutory reporting zDocumentation for response to SEC questions, and M,D,&A. zNew actuarial methodologies As an example, consider the impact on Environmental and Asbestos Reserves reporting

13. kpmg13 Actuarial Considerations SEC CONCERNS y“Big Bath” restructuring charges yCreative acquisition accounting yAbuse of materiality yMiscellaneous cookie jar reserves yRevenue recognition

14. kpmg14 Actuarial Considerations SEC CONCERNS y“Big Bath” restructuring charges yCreative acquisition accounting yAbuse of materiality yMiscellaneous cookie jar reserves yRevenue recognition

15. kpmg15 Actuarial Considerations Creative acquisition accounting zReserves should not be adjusted in purchase accounting zLarge adjustments should be reflected as an error in prior years financial statements, not adjustments to goodwill.

16. kpmg16 Actuarial Considerations SEC CONCERNS y“Big Bath” restructuring charges yCreative acquisition accounting yAbuse of materiality yMiscellaneous cookie jar reserves yRevenue recognition

17. kpmg17 ASOP No. 36 SAO Regarding P&C Reserves Materiality z“Consider the purposes and intended uses…” z“Evaluate materiality based on … intended purpose…” z“…for an actuarial appraisal…it might be appropriate to evaluate materiality in terms of…annual net income…”

18. kpmg18 Reserves to earnings leverage

19. kpmg19 Actuarial Considerations SEC CONCERNS y“Big Bath” restructuring charges yCreative acquisition accounting yAbuse of materiality yMiscellaneous cookie jar reserves yRevenue recognition

20. kpmg20 Miscellaneous cookie jar reserves (As described in Arthur Levitt’s Speech) “A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs.” “In doing so, they stash accruals in cookie jars during good times and reach into them when needed in the bad times.”

21. kpmg21 How will the focus on earnings affect our reserve estimates? zReserve Ranges - SOP #36:”The actuary should consider the implications of uncertainty in loss and LAE reserve estimates in determining a range of reasonable reserve estimates…” zHow quickly can you identify turning points in development trends? Consider the recent experience in personal auto and workers compensation.

22. kpmg22 Change in reserves - Impact on Earnings Consolidated Industry Totals 1 Year Auto & WC Total Loss Reserve Release Net Income Calendar Year ($ Billions) ($ Billions) % 1998 $5.56 $30.77 18 1997 7.23 36.82 20 1996 7.49 24.40 31 Source: Best’s Aggregates and Averages

23. kpmg23 How will the focus on earnings affect our reserve estimates and opinions? zAre reserves recorded at a consistent point within the range? zFair value accounting - loss reserves will reflect a risk loading - the consistency of the loading from year to year will be important

24. kpmg24 Actuarial Considerations SEC CONCERNS y“Big Bath” restructuring charges yCreative acquisition accounting yAbuse of materiality yMiscellaneous cookie jar reserves yRevenue recognition

25. kpmg25 Revenue Recognition zLong Duration/Multi Year Contracts uAlready a focus area in Statements of Actuarial Opinion uNeed to assure that premiums are earned consistent with the the underlying exposure zSpecial considerations such as FASB 113 - recognition of gains in reinsurance transactions

26. kpmg26 Earnings Management: Conclusions zMay focus actuary’s attention to impact on earnings along with reserve adequacy; zAdds additional emphasis to determining that the insurer’s approach to reserving is consistently applied; zFair value accounting will introduce new issues related to revenue/earnings recognition; zThe SEC’s focus significantly raises the bar