The Actuary

1
The Actuary Earnings Management

• Casualty Actuarial Society-Annual Meeting
• November 14, 2000
• Moderated by
• Marc F. Oberholtzer, FCAS
• Principal Consultant, PricewaterhouseCoopers LLP

2
The Actuary Earnings Management-Why Now?

• Increased scrutiny by SEC, press. Past history
  is not indicative of current or future
  environment
• Message Awareness needs Heightened for
  Actuaries
• Understand how actuarial work is incorporated
  into quarterly financial reporting
• Be congizant of SECs, press and others
  perception of actions

3
The Actuary Earnings Management-Opening Ideas

• ABC Ins Co typically reserves 3-5 above
  internal actuary estimate. In a quarter, ABC
  reserved 1 above estimate.
• Do you construe this as (a) normal volatility or
  (b) earnings management?
• Same situation, but ABC now exceeds expectations
  reserving at 3 redundant, ABC would have fallen
  short.

4
The Actuary Earnings Management-Opening Ideas

• ABC Ins Co purchases a finite aggregate
  reinsurance cover. Contract barely transfers
  enough risk transfer to qualify. ABC is now very
  likely to meet its publicized goal of a combined
  ratio below 105.
• Do you construe this as (a) earnings management
  or (b) a shrewd business decision?

5
The Actuary Earnings Management-Defined

• Actions taken without a specific event to justify
  the accounting to alter results where the
  perceived motivation is to comply with certain
  expectations
• Or the lack of action with a specific event
• PC insurers are susceptible to scrutiny timing
  of earnings are heavily dependent on estimates

6
The Actuary Earnings Management-Panelists

• Matthew Adams, CPAPartner, PricewaterhouseCoopers
  LLP
• Albert D. Ciavardelli, CPAVice
  President-Finance, PMA Capital Corp
• William M. Wilt, FCASVice President, Moodys
  Investor Services

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The Actuary Earnings Management

• An Auditors Perspective
• Matthew Adams, PricewaterhouseCoopers LLP

8
The Actuary Earnings Management

• Wall Streets Expectations - How Does Your
  Company Measure Up?
• Al Ciavardelli
• PMA Capital Corporation

9
Earnings Management Has there
always been a strong focus on Hitting the
Numbers?

• As stock values rise, the negative repercussions
  of not Hitting the Numbers are magnified.
• Greater number of significant one day declines in
  stock values due to one quarters earnings
  disappointment.

10
Wall Streets Views on
Earnings

• Measured Quarterly
• Earnings Quality
• Earnings Visibility/Stability
• Growth
• Hit the Numbers
• Uniqueness of Insurance Companies

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Quarterly Earnings Short-term Performance
Measure

• Benchmark for Portfolio Managers
• Predictive value is over-rated
• Consistent results comfort investors
• Stock price performance key management focus

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Managements
Views on Earnings

• Value Creation
• Short-term earnings focus is the basis for a poor
  business plan
• Earnings Quality
• Earnings Visibility/Stability
• Balance Sheet Strength
• Sound business plan, good execution on pricing
  and underwriting discipline will drive the
  earnings

13
Stock Price ValuationIts more than Meeting
Expectations

• Internal Factors
• Performance metrics - return on equity, PTOI
• Improving revenue, loss and earnings trends
• Consistent performer - no surprises
• Management credibility
• Dividend yield

14
Stock Price ValuationIts more than Meeting
Expectations

• External Factors
• Interest rate environment
• General stock market trends
• Competitors earnings surprises
• Sector weighting
• New vs. old economy
• Regulatory environment (AE, tobacco)

15
Variety of Ways to
Measure Earnings
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Wall Streets Current Views on Loss Reserves

• Companies will have to continue to strengthen
  reserves during the year.
• Standard commercial lines reserves may be as much
  as 30 billion deficient. Virtually all reserve
  problems are in the major casualty lines with
  workers compensation, commercial, auto and
  general liability (occurrence) significantly
  under-reserved.
• Annual Loss Reserve Survey reported continued
  deterioration. Industry has been creating an
  ugly past that will have to be paid for in the
  future - and the future is close at hand.

17
Wall Streets Current Views on Loss Reserves

• We believe that the industry may have
  under-reserved in the 1998 and 1999 accident
  years by as much as 10 points each.
• The past two years (and possibly three) have been
  under-reserved.
• Industry has essentially set reserves based on a
  decade of disinflation and favorable claims
  experience. Unfortunately, this benign claims
  environment appears to be changing owing to
  increased litigation, rising medical cost trends
  and rising inflationary pressures.

18
Wall Streets Current Views on Loss Reserves

• AY CR are under pressure with diminished ability
  to harvest what once were redundant reserves
  without significant price increases.

19
Regulation FD and Earnings Expectations

• Companies will choose whether or not they wish to
  provide explicit forecasted earnings for upcoming
  quarter and year.

20
Regulation FD and Earnings Expectations

• If they decide to provide earnings guidance....
• It must be to everyone at the same time
• No longer can analysts get more than anyone else
• Creates very narrow band of earnings estimates
  confirmed explicitly by management
• Pressures management to explain differences when
  earnings do not achieve expected levels

21
Regulation FD and Earnings Expectations

• If they decide not to provide earnings
  guidance....
• More marketplace uncertainty will lead to wider
  range of analysts estimates.
• Much tougher for Company to respond to analysts
  who want to reconcile the Companys actual result
  to the analysts expectation.
• Companies missing the numbers may see more or
  less stock price volatility.

22
Earnings Management -- A Rating Agency
PerspectiveNovember 14, 2000Bill WiltMoodys
Investors Service
23
Discussion Topics

• Operating earnings -- role of loss reserves
• Impact of change in reserve estimate -- material?
• Moodys view of a one-time charge
• Additional analytical obstacles
• Credibility -- the most important currency in
  capital markets

24
Operating Earnings

• Crux of work done by financial analysts
• Exclude all non-recurring items
• Sale of subsidiary
• Discontinued operations
• Change in accounting practices
• Haircut realized capital gains
• Less obvious -- change in reserve estimates

25
A Look Through the Industrys Earnings
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Changes in Reserve Estimates -- Material?
XYZ Holding Company
Investment in Affiliate 1,000
Senior Debt 350 Equity 650
XYZ Operating Company
Total Assets 4,500
Loss Reserves 3,000 Other Liab. 500
Surplus 1,000
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Changes in Reserve Estimates -- Material?
28
Moodys View of a One Time Reserve Charge
29
Moodys View of a One Time Reserve Charge
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Additional Analytical Obstacles

• Leveraged effect of reserves
• Merger and acquisition activity
• Increased utilization of finite reinsurance
• Low risk transfer threshold create many financing
  arrangements
• Cheap reinsurance -- sustainable?
• Restructuring / reorganization charges
• Other non recurring revenue and expenses

31
Credibility -- The Best Currency

• Managing earnings -- a dangerous game
• Restatement alters perception of past -- and
  future earnings
• Degree of skepticism very high
• Issues more than immediate shareholder value
• Rx of stock price to reserve charge
• Access to funds -- equity, debt, bank market
• Financial flexibility is critical rating factor

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The Actuary Earnings Management

• QA