1. Casualty Actuarial Society Insurance Accounting for Actuaries May 17, 2005  Presented by: Kevin Wick, FCAS, MAAA

2. PricewaterhouseCoopers Page 2 Financial Reporting Context “The most appropriate reserve within a range of actuarially sound estimates depends on … the financial reporting context in which the reserve will be presented.” Current Loss Reserving Principles

3. PricewaterhouseCoopers Page 3 Financial Reporting Context “The most appropriate reserve within a range of actuarially sound estimates depends on … the financial reporting context in which the reserve will be presented.” Current Loss Reserving Principles “Loss reserves are utilized for a variety of purposes, including financial reporting, valuation, commutation and ratemaking.” “The context in which loss reserves are presented may indicate elements to be reflected in the loss reserves.” Proposed Loss Reserving Principles

4. PricewaterhouseCoopers Page 4 Financial Statements Purpose is to communicate financial information to the users Standards established on how to account for various items Objective is to account for various items in accordance with standards -reaction of users not relevant A good financial statement is one that accounts for all the items appropriately -results may be good or bad

5. PricewaterhouseCoopers Page 5 Current Accounting Standards for Loss Reserves “Best estimate” of the unpaid claim costs Basic consistency between GAAP and Statutory Conceptual framework for current guidance -SFAS 5: Accounting for Contingencies (March 1975)

6. PricewaterhouseCoopers Page 6 Key issues confronted when accounting guidance (SFAS 5) established Overall issue -“Accounting Accruals” versus “Financial Decisions” Specific contentions 1.Financial “protection” provided by accruals 2.Income fluctuation 3.Comparability of financial statements

7. PricewaterhouseCoopers Page 7 “Accounting Accruals” versus “Financial Decisions” “Accounting Accruals” Simply a method of allocating costs among accounting periods No effect on an enterprise’s cash flow “Financial Decisions” Choosing how to financially deal with a contingency Example includes “to buy first dollar insurance coverage or be self-insured” FASB “…the presence or absence of an accrued credit on the balance sheet will have no effect on the consequences of that decision”

8. PricewaterhouseCoopers Page 8 Contention 1: Financial “protection” provided by accruals Contention Accruals provide financial “protection” similar to reinsurance Without reserve margins, enterprises will be forced to purchase insurance or reinsurance because they will not have the protection provided by the reserve margin

9. PricewaterhouseCoopers Page 9 Contention 1: Financial “protection” provided by accruals Contention Accruals provide financial “protection” similar to reinsurance Without reserve margins, enterprises will be forced to purchase insurance or reinsurance because they will not have the protection provided by the reserve margin FASB Response “accruals … in no way protect the assets available... to pay claims” “Accrual, in and of itself, provides no financial protection that is not available in the absence of accrual”

10. PricewaterhouseCoopers Page 10 Contention 2: Income fluctuation Contention It is important to set aside reserves to avoid reporting net income that fluctuates widely from period to period

11. PricewaterhouseCoopers Page 11 Contention 2: Income fluctuation Contention It is important to set aside reserves to avoid reporting net income that fluctuates widely from period to period FASB Response “Financial statement users have indicated that information about earnings variability is important to them” -Consider both “expected” return and “variability” “If the nature of the business is such that there are variations in periodic net income, that fact should not be obscured”

12. PricewaterhouseCoopers Page 12 Contention 3: Comparability of financial statements Contention Regular periodic accrual of losses, whether or not they have occurred, is justified on the grounds of comparability of financial statements -Self-insurance costs versus insurance costs -Various amounts of reinsurance purchased

13. PricewaterhouseCoopers Page 13 Contention 3: Comparability of financial statements Contention Regular periodic accrual of losses, whether or not they have occurred, is justified on the grounds of comparability of financial statements -Self-insurance costs versus insurance costs -Various amounts of reinsurance purchased FASB Response “to report activity when there has been none would obscure a fundamental difference in circumstances between enterprises that transfer risks and others that do not”

14. PricewaterhouseCoopers Page 14 Principles/Quotes underlying SFAS 5 “The sole result of accrual, for financial accounting and reporting purposes, is allocation of costs among accounting periods” “The use of an accounting reserve does not reduce or eliminate risk” “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur” “The Board cannot sanction the use of an accounting procedure to create the illusion of protection from risk when, in fact, protection does not exist”

15. PricewaterhouseCoopers Page 15 What is the Financial Reporting Perspective? “The consulting actuary continues to feel that conservative reserve margins are necessary because of the uncertainty in original reserve estimates due to the limited experience base, large potential swings in ultimate liabilities, and the Company’s relatively small total capital position”

16. PricewaterhouseCoopers Page 16 What is the Financial Reporting Perspective? Financial Reporting Perspective Translation “The consulting actuary seems to be having trouble distinguishing between funding for uncertain reserves versus financial reporting of uncertain reserves.” “The consulting actuary continues to feel that conservative reserve margins are necessary because of the uncertainty in original reserve estimates due to the limited experience base, large potential swings in ultimate liabilities, and the Company’s relatively small total capital position”

17. PricewaterhouseCoopers Page 17 What is the Financial Reporting Perspective? “I know my reserve point estimate is well above all the indications from my methods. The 2004 loss year looks extremely favorable but the 2005 year is much worse. Lowering the reserves will just create large swings in their claim costs”

18. PricewaterhouseCoopers Page 18 What is the Financial Reporting Perspective? Financial Reporting Perspective Translation “It is imperative that the users of the financial statements be kept unaware of the risks this company is involved with” “I know my reserve point estimate is well above all the indications from my methods. The 2004 loss year looks extremely favorable but the 2005 year is much worse. Lowering the reserves will just create large swings in their claim costs”

19. PricewaterhouseCoopers Page 19 What is the Financial Reporting Perspective? “I have some concerns regarding the various changes at the Company … I believe it is appropriate to be conservative at this time”

20. PricewaterhouseCoopers Page 20 What is the Financial Reporting Perspective? Financial Reporting Perspective Is what this actuary “believes” relevant? Translation “I am ignorant of the financial reporting standards my work is being used for” “I have some concerns regarding the various changes at the Company … I believe it is appropriate to be conservative at this time”

21. PricewaterhouseCoopers Page 21 What is the Financial Reporting Perspective? “The reserves are presented both reasonably and conservatively…it is much more likely than not they will develop favorably…my actuarial judgment calls (used for deriving my BEST estimate) tended to be conservative…I can see your concern regarding the bias…my preference is to bring the estimates down over the next few years.”

22. PricewaterhouseCoopers Page 22 What is the Financial Reporting Perspective? Financial Reporting Perspective Translation “I am going to help this company misrepresent their financial statements, but mind you only for a few years. An added bonus on this approach is the company will be able to take advantage of tax deductions they are not entitled to” “The reserves are presented both reasonably and conservatively…it is much more likely than not they will develop favorably…my actuarial judgment calls (used for deriving my BEST estimate) tended to be conservative…I can see your concern regarding the bias…my preference is to bring the estimates down over the next few years.”

23. PricewaterhouseCoopers Page 23 What is the Financial Reporting Perspective? “As long as a company maintains the same level of conservatism in their reserves, the income is not distorted”

24. PricewaterhouseCoopers Page 24 What is the Financial Reporting Perspective? Financial Reporting Perspective Translation “it is okay to misrepresent financial statements as long as you do it consistently” Why would you do this? “As long as a company maintains the same level of conservatism in their reserves, the income is not distorted”

25. PricewaterhouseCoopers Page 25 What is the Financial Reporting Perspective? “Accounting tells the story, it does not write the story”

26. PricewaterhouseCoopers Page 26 What is the Financial Reporting Perspective? Financial Reporting Perspective Translation “I can distinguish between my role in financial reporting versus my role in making financial decisions” “Accounting tells the story, it does not write the story”