Reconciliation and The Actuarial Opinion ydneW ,inamreG ,SACF AAA, dna semloH ,nnywG ,SACA AAAM Reconciliation And The Actuarial Opinion Wendy ,inamreG FCAS, MAAA Texas Department of Insurance Holmes Gwynn, ACAS, MAAA Texas Department of Insurance 2004 Reserves Call Paper Program Abstract The opining actuary is required by ASOP 36 and the NAIC Property/Casualty Annual Statement Instructions to reconcile the data used in his or her analysis of the loss and loss adjustment reserves with Schedule P Part 1 in the Annual Statement. This paper reviews the importance of a reconciliation, what data to include in a reconciliation, a description of the reconciliation process (including illustrative examples), and discussions of applicable Actuarial Standards of Practice. While the emphasis here is on Schedule P, it is no less true for GAAP or for ratemaking exercises. 2 The authors gratefully acknowledge the help of Nicole Elliott, who has participated in the editing of this document. In addition we want to thank those regulatory actuaries who recognize the problems associated with reconciliations and encouraged us to produce this 'document. We hope it will bring some illumination to an area that we believe is critical to the credibility of the stated actuarial opinion. CAVEAT: This paper is intended only as an aid and does not supercede the actuary's professional judgment, any Actuarial Standards of Practice or NAIC instructions. The Importance of a Detailed Reconciliation The actuarial opinion has become an increasingly important supplement to the Annual Statement since becoming a requirement in 1990. Even though the insurer is not committed to booking the reserves developed by the actuary, management has been under a growing pressure to book actuadally sound reserves. That pressure will likely continue to grow in years to come. As it does, actuarial integrity will be questioned and challenges will surface, be it from management, regulators, or actuarial peers. Opinions will vary, but what should not vary is the underlying data used to determine the ultimate losses and the relationship that data has to the financial results of the company. A portion of the opining actuary's work product, which does not appear to be fully understood, is the reconciliation requirement. The opiner states in the formal opinion that: "In forming my opinion on the loss and loss adjustment expense reserves, I relied upon data prepared by the responsible officers or employees of the company or group to which it belongs. 1" NAIC Annual Statement Instructions for Property/Casualty, 2003, 83p With these words, the actuary places a major caveat on the opinion being rendered. In this statement of reliance, the actuary is saying the opinion is only as good as the information given by company management. However, when things go wrong at a company, in one way or another, management has been responsible. So this statement, while perhaps making the opining actuary feel better, may detract from the credibility of the opinion itself. Adding credibility back into the opinion, the opining actuary continues: 1" evaluated that data for reasonableness and consistency. I als0 reconciled that data to Schedule P, Part 1 of the company's current Annual Statement. 2'' This language is very important to the integrity of the opinion. This paper is written to suggest ways to help the opining actuary take the necessary steps to demonstrate that the data used to form the opinion, relates to the data presented in Schedule P of the Annual Statement. This in turn relates to the financial pages of the Statement which reflect the statutory financial well-being of the company. In general, the actuarial workpapers are very good at presenting the analysis performed by the actuary, but are less effective when attempting to substantiate that the data is reliable. When a reconciliation is included, it is frequently done on a total case reserves basis. This is often not enough to give the reviewer a 2 IBID comfort level that all losses have been considered and/or that the data is in the appropriate cells. In one major case, an actuary used these words, but failed to reconcile the data. As a result, incorrect data was used to find the company's reserves so inadequate as to make it insolvent, placing the company in receivership. At a subsequent trial, it was found that the actuary used incorrect data. The company was not insolvent, and a jury made an $11 million malpractice damage award against the actuaries. 3 This example demonstrates why the actuary needs to do more than just rely on the data given. More frequently the example works the other way. If one were to review the insolvencies in recent history, more often than not, inadequate reserves would be involved. The reserve inadequacy is usually not due to actuarial incompetence, but to data quality issues. Therefore, the actuary when reviewing the data for reasonableness and consistency should consider every possible aspect of the data. The cases in this paper not only relate the reconciliation to the bottom line, but also to the detail. 3 Dailey, Joseph and Selznick, Loren, "Navigating The Litigation Minefield: A Guide To Actuarial Malpractice Claims", Mealey's Litigation Report; Insurance Insolvency, Vol. 41 #5 When considering the detail necessary, the actuary should be guided by ASOP #9: "Documentation should be sufficient for another actuary practicing in the same field to evaluate the work. The documentation should describe clearly the sources of data, the material assumptions, and methods."" The greater the detail in the reconciliation, the more credibility can be placed on the words "reasonable" and "consistent" used by the opining actuary. Relationship to Accounting As opining actuaries complete their analysis, they generally turn their results over to accountants to complete the financial reporting. The accountants may then allocate the IBNR reserves to the various lines of business and/or companies based on a predefined allocation process. The greatest difficulty usually occurs when the two disciplines within the company have an undefined dual responsibility which is not mutually understood. Communication between the two disciplines is vital to the reconciliation process. 4 Actuarial Standards Board of the American Academy of Actuaries, "'Actuarial Standard of Practice No. 9, Documentation and Disclosure ni Property and Casualty Insurance Ratemaking, Loss Reserving, and Valuations, Paragraph 5.2 Two links should be established with regard to Schedule P. The first link is between Schedule P and the reserves on Page 3 (Liabilities.) This tie is rarely violated and is well understood by the accountant and the opining actuary. The second link is the tie between the actuarial reserves and the Schedule P reserves. The reconciliation provides that link. In addition to increasing the credibility of the opinion, a good reconciliation provides the reviewing actuary with a better understanding how the actuarial workpapers relate to Schedule P. As the actuary states reliance on other officers of the company for data quality, the actuary should assume or share responsibility for how the actuarial work product is reflected or relates to the financial statements of the company. The financial statements, of course, contain the numbers on which the actuary states the opinion. The opining actuary, while not responsible for the audit of Schedule P, needs to be sure the work product is represented correctly in Schedule P, and/or that Schedule P correctly reflects the opinion. The actuary does not have to personally do the reconciliation, but is responsible for the work product and the level of detail in the reconciliation. As an additional check, in 2004 the NAIC has added an instruction to the auditor to subject the data used by the appointed actuary to testing procedures. "The auditor is required to determine what historical data and methods have been used by management in developing the loss reserve estimate and whether the auditor will rely on the same data or different statistical data in evaluating the reasonableness of the loss reserve estimate... Through inquiry of the Appointed Actuary, the auditor should obtain an understanding of the data identified by the Appointed Actuary as significant." s These instructions point to a need for the auditor to better understand the actuarial database on which the reserve estimate is based. While the construction of a good reconciliation may be an arduous task, the benefits are worthwhile. If the actuary and the accountant have an understanding up front that the reconciliation is an important part of his work product, then they can make the construction of the reconciliation a joint project. In this instance the auditors will also derive an extra benefit in their review of the company. The reconciliation should be thorough enough to demonstrate the actuary has considered all loss information from the actuarial database, as well as loss information not included in the actuarial analysis, but is reflected in Schedule P. s 2004 NIAC Annual Statement Instructions Property & Casualty, 11/2003 Nonsubstantive Revisions, Page 48: Annual Audited Financial Reports- Item 9. Data To Reconcile The P&C Practice Note 6 gives a good synopsis of what is required. Data elements from Schedule P, Part 1 (by line) to be reconciled to the actuarial database are: "A. each of the following types of data, if relied upon significantly in forming the actuarial opinion... • paid losses; • incurred (case basis)losses; • paid defense and cost containment expenses; • incurred (case basis) defense and cost containment expense; • paid adjusting and other expenses, and • earned premiums. B. the reconciliation consisted of comparing the changes from the prior year-end values (e.g., current calendar year paid losses and changes in case basis loss reserves), in detail by line of business and year in which losses were incurred to the extent that such detail was relied upon significantly and is provided in Schedule P...." This language suggests that incremental reconciliations may be acceptable. 6 Property and Casualty Practice Note, December 2003, Statements of Actuarial Opinion on P & C Loss Reserves as of December 3 I, 2003, Appendix 1 l0