MATERIALITY AND THE RISK OF MATERIAL ADVERSE DEVIATION: A REGULATORY PERSPECTIVE

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MATERIALITY AND THE RISK OF MATERIAL ADVERSE
DEVIATION A REGULATORY PERSPECTIVE

• CASUALTY LOSS RESERVE SEMINAR
• September 11-12, 2006
• Moderator Kris DeFrain, FCAS, MAAA
• NAIC, Chief Managing Actuary - Property/Casualty
• Panelists Wendy Germani, FCAS, MAAA
• (retired) Texas Department of Insurance
• Melissa Greiner
• PC Actuary, Pennsylvania Insurance Department

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Topics

• Within the context of Statutory Statements of
  Actuarial Opinion
• What is materiality?
• What are acceptable standards of materiality?
• Is there a Risk of Material Adverse Deviation?
• Risks and Uncertainties
• Other observations

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Why is Materiality Important for Opinion Writers ?

• NAIC Annual Statement Instructions require the
  opining actuary to
• Provide specific paragraphs to address the risk
  of material adverse deviation (RMAD).
• Identify the materiality standard and the basis
  for establishing this standard.
• Must explicitly state whether or not there is
  RMAD.
• If there is RMAD, describe the major factors,
  etc. that could result in MAD.

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Who Cares about Materiality and WHY?

• Regulators
• Rating Agencies
• SEC?
• Others

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WHAT IS MATERIALITY?

• AAA Task Force on Materiality developed a
  generalized description of the concept of
  Materiality.
• ASOP 36 and other Standards of Practice dont
  define it per se.
• Materiality ASOP 36 Considerations for the
  Practicing Actuary - CAS
• NAIC APPM has a definition.
• SECs definition is similar to the NAICs.

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Materiality Concepts on Professionalism

• Paper by AAAs Task Force on Materiality
• An omission, understatement or overstatement in
  a work product is material if it is likely to
  affect either the intended principal users
  decision-making or the intended principal users
  reasonable expectations.
• Reflecting on Materiality The User is Key

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According to NAIC Accounting Practices
Procedures Manual

• A omission or misstatement of an item in a
  statutory financial statement may be material if
  it is of such a magnitude that it is probable
  that the judgment of a reasonable person relying
  upon the statutory financial statement would be
  changed or influenced by the inclusion or
  correction of the item.

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ASOP 36

• Section 3.4.The actuary should consider the
  purposes and intended uses for which the actuary
  prepared the Statement of Actuarial Opinion. The
  actuary should evaluate materiality based on
  professional judgment, materiality guidelines or
  standards applicable to the Statement of
  Actuarial Opinion and the actuarys intended
  purpose for the Statement of Actuarial Opinion.

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Know Your User !!!

• Principal User
• Intended User
• Unintended User
• Different Users have different expectations
  regarding materiality.

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• Identify the Materiality Standard
• and the Basis for
• Establishing This Standard

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Considerations in Materiality Standard for
ReservesFrom Materiality ASOP 36

• Would the misstatement put the insurer in danger
  of a breach of covenant or regulatory
  requirement?
• RBC Trigger?
• Minimum Capital Requirement
• IRIS ratio failure
• Turn profit into loss?
• Relative size is usually more important than
  absolute size.
• Lines of business written by company

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Possible Standards of Materiality

• of Surplus
• of Reserves
• Reinsurance (Zero Net Reserve Companies)
• Minimum of of Surplus, of Reserves and
  Amount to trigger an RBC action level.
• Other

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Standards Used for Texas Domestics - 2005
Type Count Percentage
Surplus 126 61
Loss LAE Reserves 20 10
Combination 21 10
Reinsurance 13 6
Other 25 12
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Standards Used for Texas Domestics 2004 over 2005
Type 2004 2005
Surplus 64 61
Loss LAE Reserves 9 10
Combination 5 10
Reinsurance 1 6
Other 20 12
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Standards Used for Pennsylvania Domestics 2005
Type Count Percentage
Surplus 97 68
Loss LAE Reserves 12 8
Combination 28 20
Other 5 4
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Standards Used for Pennsylvania Domestics 2005
over 2004
Type 2004 2005
Surplus 63.8 68.3
Loss LAE Reserves 14.5 8.5
Combination 17.4 19.7
Other 4.3 3.5
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Standards Used for Pennsylvania Domestics 2005
over 2004
Type 2004 2005
Surplus 63.8 68.3
Loss LAE Reserves 14.5 8.5
Combination 17.4 19.7
Other 4.3 3.5
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Combination of StandardsPA Domestic Data
2004 2005
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General ObservationsMateriality Standards

• Regulatory actuaries generally observed a more
  thorough discussion of the consideration of
  materiality standards in Opinions from 2004 to
  2005
• Appears to be a general trend to consider
  multiple measures of materiality
• More combinations of materiality bases in
  Opinions.
• Less Opinions with a single basis of materiality.
• Here are a few examples

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Combination Example 1

• In determining the materiality standard, I note
  the Opinion is a tool of solvency regulation.
  Thus, the selected standard is oriented towards
  the potential impact a misstatement of reserves
  would have on surplus levelsand is a minimum of
  three values (1) 20 of surplus, (2) 10 of loss
  and LAE reserves after pooling and (3) difference
  between surplus less Company Action Level RBC.

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Combination Example 2

• Based on my understanding of the use of this
  (Opinion), I evaluated materiality in the context
  of 15 of loss and LAE reserves, 25 of surplus,
  and action/control level from RBC, of the minimum
  was selectedThe minimum was adjusted to reflect
  where within the range of reasonable estimates
  the Companys reserves fell.

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Combination Example 3

• Based on my review I consider a deviation
  greater than xxx,000 to represent a material
  adverse deviation. This standard is based on my
  professional judgment with consideration as to
  Companys surplus, liquid assets, reserve balance
  and authorized control level of the Company.

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Combination Example 4

• In developing the threshold for the risk of
  material adverse deviation, I considered the
  companys loss and LAE reserves, statutory
  surplus and RBC position as of (year-end). Based
  on review of these considerations, I selected a
  materiality standard of xxx,000, which is about
  10 of carried loss and LAE reserves.

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Consideration of RBC Position

• I have considered a MAD to be one in which the
  actual net outstanding loss and LAE exceed
  carried reserves by an amount greater than 10 of
  surplus... I also verified that a 10 deviation
  in the Companys net reserves would not reduce
  the Companys Total Adjusted Capital to below the
  Company Action Level Capital.
• May be MORE appropriate to include this for
  companies with RBC scores at lower end of
  spectrum vs. healthy RBC scores.
• Regulators do not necessarily have to see this in
  all Opinions.

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What is the Bright Line Indicator?

• Outside bound of what is material.
• If 10 of the Net Reserves are greater than the
  difference between the Total Adjusted Capital and
  Company Action Level Capital,
• Then regulators expect to see explicit Relevant
  Comment paragraphs discussing the factors giving
  rise to the presence or absence of RMAD.

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Consideration of RBC Position
Should appointed actuaries be expected to comment
on the Bright Line Indicator in Opinions?

• YES if the Bright Line Indicator is crossed
• Although reference to the BLI test is removed
  from the 2006 Regulatory Guidance Draft document,
  the test is still part of the NAICs Financial
  Analysis Handbook.
• We will discuss Guidance briefly at the end of
  our presentation.

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• Is there a Risk of
• Material Adverse Deviation?

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• I do not believe that there are significant risks
  and uncertainties that could result in material
  adverse deviation in the loss and loss adjustment
  expense reserves.

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Relevant Comments should allow a regulator to
answer these questions

• Is there a Risk of Material Adverse Deviation?
• What amount of adverse deviation does the actuary
  consider material?
• Why does the actuary consider that amount to be
  material for this company?
• Do I understand why the actuary believes that
  material adverse deviation is or is not a risk
  for this company?
• Given this guidance, what are your thoughts on
  the following language

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Example 1 Unclear

• The Materiality Standard is established as 10
  of reported statutory surplus, or xxx,000 as
  shown in Exhibit B Disclosures. I estimate the
  likelihood of material adverse deviation arising
  from normal variations in expected results to be
  about 16. I estimate the likelihood of material
  favorable development to exceed 50.
• Thoughts from audience??

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Example 1 - Improved

• The Materiality Standard is established as 10
  of reported statutory surplus, or xxx,000 as
  shown in Exhibit B Disclosures. I estimate the
  likelihood of material adverse deviation arising
  from normal variations in expected results to be
  about 16, not a significant likelihood. I
  estimate the likelihood of material favorable
  development to exceed 50.

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Example 2 Unclear

• I have established a materiality standard of 5
  from my point estimateIn my opinion, the
  Companys reserves is 1.xxx million in excess of
  my point estimate.
• Actuary provides lengthy paragraph on changes to
  actuarial assumptions and approach.
• In addition to knowing the reinsurance
  arrangements, actuary determined adequacy of
  Gross reserves, from which Net results were
  determined.
• Thoughts from audience??

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Example 3 Unclear

• Actuary did not believe there was RMAD. 15 of
  Statutory Surplus was used as a materiality
  standard.
• The Companys RBC ratio was 200.6 dropping from
  about 300 from previous year.
• Is this a suitable standard?
• Should the actuary check the Companys RBC ratio,
  when deciding on a materiality standard?
• Thoughts from audience??

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So, is there RMAD?

• Pennsylvania domestics
• More appointed actuaries concluded No RMAD in
  2005 from 2004.
• Statements on RMAD were more clear (or less
  vague) in interpretation.
• Regulators want appointed actuaries to be clear
  in their position on RMAD

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So, is there RMAD?

• Texas Domestics
• No RMAD for 81 of total companies.
• No RMAD for 70 of companies with net reserves
  greater than zero.
• Texas has a high concentration of companies that
  carry 0 in net reservesthen what?
• To be continued

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General ObservationsRMAD Discussion

• Regulatory actuaries generally observed a more
  thorough consideration and discussion of RMAD
  from 2004 to 2005
• Improvements likely due to combination of
• Increased regulatory actuary review and feedback
  on Opinions
• AAA Opinion Writers Symposium
• Better understanding from appointed actuary
  community on regulators expectations
• Keep up the good work!

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Net-Zero Companies

• Now, lets switch gears
• What if the Company has 0 carried net reserves,
  due to a pooling arrangement or cession to the
  parent?
• What are the options to the opining actuary?

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Risk of MAD on Zero Net Reserves TX Domestics

• About 90 net-zero companies
• 97 of Opinion writers concluded no RMAD
• Comments remote or no risk since company cedes
  100
• 13 included additional comments on Reinsurance
• there exists a contingent net liability with
  respect to ceded reinsurance in the event that
  reinsurers become unable to meet obligations
  under existing reinsurance agreements.
• 2 concluded yes to RMAD, citing Reinsurance
  Rapid Growth as risk factors.
• 1 conclusion about RMAD indeterminable.

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Risk of MAD on Zero Net Reserves PA Domestics

• 8 net-zero companies
• 7 of 8 Opinion writers concluded no RMAD
• Comments remote or no risk since company cedes
  100
• 4 of 8 included additional comment that there
  exists a contingent net liability with respect to
  ceded reinsurance in the event that reinsurers
  become unable to meet obligations under existing
  reinsurance agreements.
• 1 of 8 concluded yes to RMAD, as the Company
  was in Action Level RBC at year-end, citing
  Reserve Variability in medical malpractice and
  Reinsurance Collectibility as risk factors.

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• Risks and Uncertainties

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• Risks and Uncertainties
• Appointed actuaries are expected to describe the
  major factors that could result in Material
  Adverse Deviation

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Risks and Uncertainties

• Opinion writers need to discuss in this section,
  why or why not there is RMAD and the factors that
  would lead to RMAD.
• Explanation should not include general, broad
  statements about risks and uncertainties due to
  economic changes, judicial decisions, regulatory
  actions, political or social forces, etc.
• List does not need to be exhaustive.
• Should be specific to the Companys book of
  business and operations.
• We offer the following as good and bad examples

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Risk Factor DiscussionGood Example 1

• The major factors underlying the risks and
  uncertainties which could result in MAD include
• The significant concentration in premium volume
  in 2003 through 2005 from business that is
  relatively new to the Company.
• Lack of data available for reserve analysis on
  Companys financial guaranty exposure.
• Significant reliance on the use of judgment by
  the Company in selecting factors for setting loss
  reserves.

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Risk Factor DiscussionGood Example 2

• I have identified the major risks and
  uncertainties as
• Significant changes in claims operations over the
  last xx years, which creates volatility in the
  development patterns and therefore necessitates
  considerable reliance on benchmark development
  patterns.
• Rapid growth with net premium increasing six fold
  over the last xx years.
• Companys cession of an amount of loss and LAE
  reserves that exceeds its surplus to an unrated
  (offshore) affiliate.

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Risk Factor DiscussionGood Example 3

• There are a variety of risk factors that expose
  the Companys reserves to significant
  variability. I have identified the major risk
  factors
• Significant increase in policyholders in 2002
• New coverages offered beginning in 2002
• Increases in the policy limit
• The long-tail nature of medical professional
  liability coverage.
• The opining actuary includes a detailed paragraph
  on EACH of these points within the body of the
  Opinion.

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Risk Factor DiscussionBad Example 1

• Although the carried reserves as of 12/31/05 are
  within my reasonable range, I do believe that
  there is a substantial risk of material adverse
  deviation in the Companys reserves as measured
  against a materiality standard of 10 of surplus.
  Carried reserves are about 110 of surplus, so a
  10 deficiency in reserves would results in a
  loss of more than 10 of surplus. A deviation of
  this magnitude, while not anticipated, is not a
  statistically insignificant possibility.
• What are this risk factor(s) that could impact
  the reserve to surplus ratio?

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Risk Factor Discussion

• Opinions that contained ONLY the general
  uncertainty comments for RMAD without
  consideration for company specific comments.
• PA decrease from a few to none
• TX decrease from 18 to 16
• Again, another positive trend for improved
  Opinion disclosure!
• mostly from a single firm

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Risks and Uncertainties DiscussedEven if no RMAD?

• But the NAIC Instructions dont require me, as
  an appointed actuary to provide a discussion of
  risk factors when Risk of MAD is not present.
• Statistics shown of Opinions that discuss
  company specific risk factors, after actuary
  concluded no Risk of MAD.

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Risks and Uncertainties Discussed Even if no
RMAD?

• Company specific risk factors cited for No
  RMAD
• Growth in long-tailed lines
• Medical cost inflation trends
• AE, claims initiatives, construction defect
  liabilities
• XS over large deductible and self-insured
  exposures
• Regulators view this type of disclosure very
  positively.
• These same factors could possibly lead to
  RMAD for the Company in the future.
• Again, keep up the good work!

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Other Observations
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Materiality and Link to Actuarial Opinion Summary

• What if actuary said no to RMAD, yet company
  carried reserves in lower end of actuarial range?
• Consideration given to surplus and RBC levels. If
  low, appointed actuaries should expect a call
  from the domestic regulator.
• Why is there no RMAD?
• Is the Materiality threshold possibly set too
  high?

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Regulatory Guidance - 2006

• Separate Guidance for Actuarial Opinion and
  Actuarial Opinion Summary.
• No longer need to attach (public) Opinion to the
  (confidential) Summary
• New Scope items actuary should be cognizant of
• Coverage for Service Contracts
• Prepaid loss adjustment expenses
• Draft document exposed at NAIC Fall meeting a few
  days ago copies available.

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• QUESTIONS ?????