Materiality and the Actuary

1. Materiality and the Actuary Presentation to Casualty Loss Reserve Seminar September 12-13, 2005 Moderator: Joseph A. Herbers, ACAS, MAAA Principal & Consulting Actuary, Pinnacle Actuarial Resources, Inc. Member, Committee on Property and Liability Financial Reporting Panelists: Mary D. Miller, FCAS, MAAA Actuary, Ohio Dept. of Insurance AAA Vice President, Casualty Issues Charles C. Emma, FCAS, MAAA Principal & Consulting Actuary, Pinnacle Actuarial Resources, Inc. Member, AAA Casualty Practice Council

2. Materiality and the Actuary • Comments relate only to statutory SAO • Materiality in context of required disclosures • Assume working knowledge of NAIC Instructions for SAO and ASOP 36

3. Materiality and ASOP 36 • “Material” or “materiality” is mentioned at least 13 times in ASOP 36 • Section 3.4 devoted to “Materiality”

4. ASOP Section 3.4 • In evaluating materiality within the context of a reserve opinion, the actuary should consider the purposes and intended uses for which the actuary prepared the statement of actuarial opinion • Evaluate materiality based on professional judgment, materiality guidelines or standards applicable to SAO and actuary’s intended purpose for the SAO

5. Materiality Standard • Need for separate ASOP on Materiality? • Subcommittee on Reserving agreed that it would be better to already have a materiality standard, but lack of such standard is not critical to use of ASOP 36 • Principal uses of materiality in ASOP are for the actuary to decide if explanatory paragraph is needed

6. Where Do We Look for Guidance? • SEC • FASB • Supreme Court • NAIC Financial Examiners Handbook • VFIC • NAIC Accounting Practices and Procedures Manual

7. SEC Staff Accounting Bulletin No. 99 • Exclusive reliance on certain quantitative benchmarks to assess materiality in preparing financial statements … is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold • Days of relying simply on +/-5% are over • However, SEC has no objection to such rules of thumb as an initial step in assessing materiality

8. FASB No. 2 • The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of item • Management must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality

9. U. S. Supreme Court • TSC Industries v. Northway, Inc., 426 U.S. 438,449 (1976) • A fact is material if there is a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available • Determinations of materiality require “delicate assessments of inferences a reasonable shareholder would draw from a given set of facts and the significance of those inferences to him”

10. NAIC Financial Examiners Handbook • Dollar amount above which the examiner’s perspective of the company’s financial position will be influenced • Overall Materiality • Individual Balance Sheet items • Planning Materiality (PM) – starting point is 1% to 5% of surplus

11. VFIC • Appendix 7 to P/C Practice Note developed by COPLFR • Discussion of materiality and ASOP 36 • Specific citations of the words material, materially, materiality • Discussion of guidance from NAIC and SEC

12. NAIC Accounting Practices and Procedures Manual • Materiality judgments are primarily quantitative in nature • Is this item large enough for users of the information to be influenced by it? • Magnitude of the items is such that it is probable that the judgment of a reasonable person relying upon the statutory financial statement would have been changed or influenced by the inclusion or correction of the item

13. Regulator Statutory Surplus Risk Based Capital Loss, LAE, Unearned Premium Reserves IRIS Tests Appraisal New Worth (GAAP) Net Income Earning per Share Which financial values are important to the intended user?

14. Regulator Statutory Surplus - Y Risk Based Capital - Y Loss, LAE, Unearned Premium Reserves - Y IRIS Tests – Maybe AOS Threshold Underwriting Income Net Income Which financial values are important to Mary?

15. Who decides what number is booked What are the variable components of the compensation package For the CEO/CFO For the Actuary if an employee What else is important to Mary?

16. Regulators Management Investors Auditors Reinsurers Rating Agencies Policyholders Claimants ABCD Who are Intended Users?

17. Crux of the Problem • With all these intended users, how do I determine what a reasonable person will view as material?

18. Regulatory View • Survey of Regulators’ view of materiality threshold (Fall 2000) “It all depends” (7) 1% to 5% of Surplus (6) “It’s up to you” (2) 10% of surplus (1)

19. Regulatory View • Most regulators think a rule of thumb is OK as a starting point. • Regulators want the choice to reflect the individual company situation • Regulators Do Not want to see thesame standard used by every actuary in the consulting firm or in every Opinion written by an individual actuary

20. Mary’s View – Then and Now • My initial rule of thumb in 2001 – 5% of surplus –Explain if over 10% • Today – Reflect the individual company’s circumstances • Over 20% OK if there IS RMAD • Less than 5% OK if there is NOT RMAD Expect a call if I think it’s too high or too low

21. View of Practicing Actuaries • Informal Survey subsequent to year-end 2000 opinion season (mostly consultants) 10% of reserves/20% of surplus (3) 15% of surplus (2) 15% of reserves/25% of surplus (1) 1% - 5% of surplus (1)

22. Mary’s View of Practicing Actuaries • You are getting better – Most of you are anyway • Your feedback is important to regulators • You don’t call us as often as you should

23. Example from 2003, 2004 SAO’s

24. Suggested Multiple Trigger Approach • Difference between held reserves and high end of range of indicated reserves • Impact of indicated reserves on IRIS Tests 10-12 • Impact of indicated reserves on RBC

25. Materiality Considerations • Single vs. multiple line company • Net Retention • Single Company vs. Member of Group • Access to Capital • Management • Prior loss reserve runoff • Financial Strength

26. Management as User of SAO • Viewed as regulatory requirement • Disclose as little as possible • Boilerplate Language • Materiality viewed relative to surplus or total reserves

27. Is there, or isn’t there? Only your actuary knows for sure. • The data supporting this opinion may produce a wide range of potential outcomes. This variability which is inherent in any reserve estimate could result in material adverse deviation from the carried net reserve amounts….I am considering a material adverse deviation to be …an amount which is 8.1% of surplus. … Other than the stated question of inherent variability, I do not believe that there are significant risks and uncertainties that could result in material adverse deviation.

28. Conclusions • Must consider viewpoint of Intended Users • Many “unintended” users because SAO is a public document • Use reasonable person test • Our view of materiality is typically much broader/wider than that of our audiences • Suggest a multiple trigger approach for assessing materiality • Consider totality of information, and give it “thoughtful consideration”

29. The SAO Who Cares and What Do They Want? • Who It’s Intended For • Regulator • Who It’s Not Intended For • Analyst

30. Choice of a Standard • Two Schools • Lower Is Better • “An SAO with an RMAD is better than one without one” • Higher Is Better • “I only want RMAD’s when it really matters”

31. Observed Standards Percent of Surplus • 5%, 10%, 20% • Most common Percent of Reserves • 10% Percent of Company Action Level RBC