THE ACTUARY AND EARNINGS MANAGEMENT

Martha Marcon Aaron Halpert Assurance Partner Principal KPMG LLP KPMG LLP Casualty Actuarial Society Spring Meeting May 8, 2000 THE ACTUARY AND EARNINGS MANAGEMENT kpmg

THE ACTUARY AND EARNINGS MANAGEMENT • Definitions • Current SEC Focus • How would it affect P&C insurers • What are the actuarial considerations • Conclusions • Questions/Answers kpmg

Earnings Management • What is earnings management? • Where did the concept come from? • What does it mean to insurance companies? kpmg Casualty Actuarial Society

Earnings Management Definition • Actions without events or conditions occurring at the time to justify such actions • Adjusting company’s reported earnings to meet market expectations kpmg

Earnings Management • Arthur Levitt (SEC Chairman) Speech 9/28/98: “The Numbers Game” • Fortune Article 8/2/99: “Lies, Damned Lies, and Managed Earnings” • W. R. Grace SEC Enforcement Action kpmg

Levitt (SEC Chairman) Speech • The pressure to “make your numbers” • Identified 5 abuses • “Big Bath” restructuring charges • Creative acquisition accounting • Miscellaneous cookie jar reserves • Abuse of materiality • Revenue recognition kpmg

Levitt (SEC Chairman) Speech • Levitt’s call for action included: • More disclosure • More guidance on revenue recognition • Strengthen audit committee process • Asked SEC staff to look at materiality: hence SAB #99 kpmg

Staff Accounting Bulletin 99 - Materiality • Quantitative and Qualitative • If a reasonable person would consider a matter important - it’s material • Volatility of market reaction kpmg

Staff Accounting Bulletin 99 - Materiality Factors Defining Materiality • Capable of precise measurement • Masks a change in earnings or other trends • Hides a failure to meet analysts’ expectations • Changes a loss into income or vice versa • Compliance with regulatory requirements • Compliance with loan covenants kpmg

Earnings Management • Management of earnings considerations for insurance companies: • How does one test management’s best estimate of the reserves? Does an overly wide range enable management to manage earnings? • What drive’s materiality? Are we too focused on reserve adequacy, and not enough on the earnings impact? What about materiality at a business segment level? kpmg

Actuarial Considerations Earnings Management kpmg

SEC Focus Affects our Actuarial Focus • Increased statutory reporting • Documentation for response to SEC questions, and M,D,&A. • New actuarial methodologies As an example, consider the impact on Environmental and Asbestos Reserves reporting kpmg

Actuarial Considerations SEC CONCERNS • “Big Bath” restructuring charges • Creative acquisition accounting • Abuse of materiality • Miscellaneous cookie jar reserves • Revenue recognition kpmg

Actuarial Considerations Creative acquisition accounting • Reserves should not be adjusted in purchase accounting • Large adjustments should be reflected as an error in prior years financial statements, not adjustments to goodwill. kpmg

ASOP No. 36SAO Regarding P&C Reserves Materiality • “Consider the purposes and intended uses…” • “Evaluate materiality based on … intended purpose…” • “…for an actuarial appraisal…it might be appropriate to evaluate materiality in terms of…annual net income…” kpmg

Reserves to earnings leverage kpmg

Miscellaneous cookie jar reserves(As described in Arthur Levitt’s Speech) “A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs.” “In doing so, they stash accruals in cookie jars during good times and reach into them when needed in the bad times.” kpmg

How will the focus on earnings affect our reserve estimates? • Reserve Ranges - SOP #36:”The actuary should consider the implications of uncertainty in loss and LAE reserve estimates in determining a range of reasonable reserve estimates…” • How quickly can you identify turning points in development trends? Consider the recent experience in personal auto and workers compensation. kpmg

Change in reserves -Impact on Earnings Consolidated Industry Totals 1 Year Auto & WC Total Loss Reserve Release Net Income Calendar Year ($ Billions) ($ Billions) % 1998 $5.56 $30.77 18 1997 7.23 36.82 20 1996 7.49 24.40 31 Source: Best’s Aggregates and Averages kpmg

How will the focus on earnings affect our reserve estimates and opinions? • Are reserves recorded at a consistent point within the range? • Fair value accounting - loss reserves will reflect a risk loading - the consistency of the loading from year to year will be important kpmg

Revenue Recognition • Long Duration/Multi Year Contracts • Already a focus area in Statements of Actuarial Opinion • Need to assure that premiums are earned consistent with the the underlying exposure • Special considerations such as FASB 113 - recognition of gains in reinsurance transactions kpmg

Earnings Management:Conclusions • May focus actuary’s attention to impact on earnings along with reserve adequacy; • Adds additional emphasis to determining that the insurer’s approach to reserving is consistently applied; • Fair value accounting will introduce new issues related to revenue/earnings recognition; • The SEC’s focus significantly raises the bar kpmg

THE ACTUARY AND EARNINGS MANAGEMENT