Casualty Actuarial Society

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

2. “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 Financial Reporting Context

3. “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 Financial Reporting Context • “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. 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 Financial Statements

5. “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) Current Accounting Standards for Loss Reserves

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

7. “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” “Accounting Accruals” versus “Financial Decisions”

8. 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 Contention 1: Financial “protection” provided by accruals

9. 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” Contention 1: Financial “protection” provided by accruals

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

11. 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” Contention 2: Income fluctuation

12. 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 Contention 3: Comparability of financial statements

13. 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” Contention 3: Comparability of financial statements

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. “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” What is the Financial Reporting Perspective?

16. 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” What is the Financial Reporting Perspective?

17. “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” What is the Financial Reporting Perspective?

18. 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” What is the Financial Reporting Perspective?

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

20. 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” What is the Financial Reporting Perspective?

21. “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.” What is the Financial Reporting Perspective?

22. 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.” What is the Financial Reporting Perspective?

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

24. 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” What is the Financial Reporting Perspective?

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

26. 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” What is the Financial Reporting Perspective?