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THE ACTUARY AND EARNINGS MANAGEMENT

Martha Marcon Aaron HalpertAssurance Partner Principal KPMG LLP KPMG LLP

Casualty Actuarial SocietySpring Meeting

May 8, 2000

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THE ACTUARY AND EARNINGS MANAGEMENT

DefinitionsCurrent SEC FocusHow would it affect P&C insurersWhat are the actuarial considerationsConclusionsQuestions/Answers

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Earnings Management

What is earnings management?Where did the concept come from?What does it mean to insurance

companies?

Casualty Actuarial Society

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Earnings Management

DefinitionActions without events or conditions

occurring at the time to justify such actions

Adjusting company’s reported earnings to meet market expectations

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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

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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

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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

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Staff Accounting Bulletin 99 - Materiality

Quantitative and QualitativeIf a reasonable person would

consider a matter important - it’s material

Volatility of market reaction

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Staff Accounting Bulletin 99 - Materiality

Factors Defining MaterialityCapable of precise measurementMasks a change in earnings or other trendsHides a failure to meet analysts’

expectationsChanges a loss into income or vice versaCompliance with regulatory requirementsCompliance with loan covenants

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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?

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Earnings Management

Actuarial Considerations

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SEC Focus Affects our Actuarial Focus

Increased statutory reportingDocumentation for response to SEC

questions, and M,D,&A.New actuarial methodologies

As an example, consider the impact onEnvironmental and Asbestos Reservesreporting

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Actuarial Considerations

SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition

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Actuarial Considerations

SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting

Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition

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Actuarial Considerations

Creative acquisition accountingReserves should not be adjusted

in purchase accountingLarge adjustments should be

reflected as an error in prior years financial statements, not adjustments to goodwill.

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Actuarial Considerations

SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition

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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…”

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Reserves to earnings leverage

Consolidated Industry Results All Amounts in $Billions

Calendar Year1998 1997 1996 1995 1994

Loss Reserves 301 300 302 299 290LAE Reserves 64 64 64 62 59

-------------- -------------- -------------- -------------- --------------Loss and LAEReserves

365 364 366 361 349

Net Income AfterTaxes

31 37 24 21 11

Leverage=Income/Reserves 8% 10% 7% 6% 3%

Source: Best’s Aggregates and Averages

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Actuarial Considerations

SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar Miscellaneous cookie jar reservesreserves

Revenue recognitionRevenue recognition

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Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves(As described in Arthur Levitt’s (As described in Arthur Levitt’s

Speech)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.”

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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.

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Change in reserves -Impact on Earnings

Consolidated Industry Totals

1 Year Auto & WC Total Loss Reserve Release Net IncomeCalendar 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

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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

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Actuarial Considerations

SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition

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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

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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