THE ACTUARY AND
EARNINGS MANAGEMENT
Martha Marcon
Assurance Partner
KPMG LLP
Aaron Halpert
Principal
KPMG LLP
Casualty Actuarial Society
Spring Meeting
May 8, 2000
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THE ACTUARY AND
EARNINGS MANAGEMENT
Definitions
Current SEC Focus
How would it affect P&C insurers
What are the actuarial considerations
Conclusions
Questions/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
Definition
Actions 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 Qualitative
If 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 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
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Earnings Management
Management of earnings considerations for
insurance companies:
•ow does one test management’s best
H
estimate of the reserves? Does an overly
wide range enable management to manage
earnings?
•hat drive’s materiality? Are we too focused
W
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 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
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Actuarial Considerations
SEC CONCERNS
“Big Bath” restructuring charges
Creative acquisition accounting
Abuse of materiality
Miscellaneous cookie jar reserves
Revenue recognition
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Actuarial Considerations
SEC CONCERNS
“Big Bath” restructuring charges
Creative acquisition
accounting
Abuse of materiality
Miscellaneous cookie jar reserves
Revenue recognition
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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.
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Actuarial Considerations
SEC CONCERNS
“Big Bath” restructuring charges
Creative acquisition accounting
Abuse of materiality
Miscellaneous cookie jar reserves
Revenue recognition
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ASOP No. 36
SAO 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 $Billions
1998
Loss Reserves
LAE Reserves
Loss and LAE
Reserves
Calendar Year
1997
1996
1995
1994
301
300
302
299
290
64
64
64
62
59
-------------- -------------- -------------- -------------- -------------365
364
366
361
349
Net Income After
Taxes
Leverage=Income/Reserves
31
37
24
21
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8%
10%
7%
6%
3%
Source: Best’s Aggregates and Averages
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Actuarial Considerations
SEC CONCERNS
“Big Bath” restructuring charges
Creative acquisition accounting
Abuse of materiality
Miscellaneous cookie jar
reserves
Revenue recognition
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Miscellaneous cookie jar reserves
(As described in Arthur Levitt’s
Speech)
“A third illusion played by some companies
is using unrealistic assumptions to
estimate liabilities for such items as sales
returns, loan losses or warranty costs.”
“In doing so, they stash accruals in cookie
jars during good times and reach into
them when needed in the bad times.”
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How will the focus on
earnings affect our reserve
estimates?
Reserve Ranges - SOP #36:”The actuary
should consider the implications of
uncertainty in loss and LAE reserve
estimates in determining a range of
reasonable reserve estimates…”
How quickly can you identify turning
points in development trends? Consider
the recent experience in personal auto
and workers compensation.
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Change in reserves Impact on Earnings
Consolidated Industry Totals
Calendar Year
1998
1997
1996
1 Year Auto & WC
Loss Reserve Release
($ Billions)
$5.56
7.23
7.49
Total
Net Income
($ Billions)
$30.77
36.82
24.40
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20
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 reserves
Revenue 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
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