MATERIALITY AND THE RISK OF
MATERIAL ADVERSE DEVIATION: A
REGULATORY PERSPECTIVE
CASUALTY LOSS RESERVE SEMINAR
September 11-12, 2006
Moderator:
Panelists:
Kris DeFrain, FCAS, MAAA
NAIC, Chief Managing Actuary - Property/Casualty
Wendy Germani, FCAS, MAAA
(retired) Texas Department of Insurance
Melissa Greiner
P&C Actuary, Pennsylvania Insurance Department
Topics
Within the context of Statutory Statements of
Actuarial Opinion:
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What is materiality?
What are acceptable standards of materiality?
Is there a Risk of Material Adverse Deviation?
Risks and Uncertainties
Other observations
Why is Materiality Important for
Opinion Writers ?

NAIC Annual Statement Instructions require
the opining actuary to:
Provide specific paragraphs to address the risk of
material adverse deviation (RMAD).
 Identify the materiality standard and the basis for
establishing this standard.
 Must explicitly state whether or not there is RMAD.
 If there is RMAD, describe the major factors, etc.
that could result in MAD.
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Who Cares about Materiality and
WHY?
 Regulators
 Rating
 SEC?
 Others
Agencies
WHAT IS MATERIALITY?
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AAA Task Force on Materiality – developed a
generalized description of the concept of
Materiality.
ASOP 36 and other Standards of Practice don’t
define it per se.
“Materiality & ASOP 36; Considerations for the
Practicing Actuary” - CAS
NAIC APPM has a definition.
SEC’s definition is similar to the NAIC’s.
Materiality
Concepts on Professionalism
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Paper by AAA’s Task Force on Materiality
“An omission, understatement or overstatement
in a work product is material if it is likely to
affect either the intended principal user’s
decision-making or the intended principal user’s
reasonable expectations.”
“Reflecting on Materiality: The User is Key”
According to NAIC Accounting
Practices & Procedures Manual

A omission or misstatement of an item in a
statutory financial statement may be material if
it is of such a magnitude that it is probable that
the judgment of a reasonable person relying
upon the statutory financial statement would be
changed or influenced by the inclusion or
correction of the item.
ASOP 36
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Section 3.4:….”The actuary should consider the
purposes and intended uses for which the
actuary prepared the Statement of Actuarial
Opinion. The actuary should evaluate materiality
based on professional judgment, materiality
guidelines or standards applicable to the
Statement of Actuarial Opinion and the
actuary’s intended purpose for the Statement of
Actuarial Opinion.”
Know Your User !!!
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Principal User
Intended User
Unintended User
Different Users have different expectations
regarding materiality.
Identify the Materiality Standard
and the Basis for
Establishing This Standard
Considerations in Materiality
Standard for Reserves
From Materiality & ASOP 36
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Would the misstatement put the insurer in danger of a
breach of covenant or regulatory requirement?
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RBC Trigger?
Minimum Capital Requirement
IRIS ratio failure
Turn profit into loss?
Relative size is usually more important than absolute
size.
Lines of business written by company
Possible Standards of Materiality
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% of Surplus
% of Reserves
Reinsurance (Zero Net Reserve Companies)
Minimum of % of Surplus, % of Reserves and
Amount to trigger an RBC action level.
Other
Standards Used for Texas Domestics
- 2005
Type
Count
Percentage
Surplus
126
61%
Loss & LAE Reserves
20
10%
Combination
21
10%
Reinsurance
13
6%
Other
25
12%
Standards Used for Texas Domestics
2004 over 2005
Type
% 2004
% 2005
Surplus
64%
61%
Loss & LAE Reserves
9%
10%
Combination
5%
10%
Reinsurance
1%
6%
Other
20%
12%
Standards Used for Pennsylvania
Domestics – 2005
Type
Count
Percentage
Surplus
97
68%
Loss & LAE
Reserves
Combination
12
8%
28
20%
Other
5
4%
Standards Used for Pennsylvania
Domestics – 2005 over 2004
Type
% 2004
% 2005
Surplus
63.8%
68.3%
Loss & LAE
Reserves
Combination
14.5%
8.5%
17.4%
19.7%
Other
4.3%
3.5%
Standards Used for Pennsylvania
Domestics – 2005 over 2004
Type
% 2004
% 2005
Surplus
63.8%
68.3%
Loss & LAE
Reserves
Combination
14.5%
8.5%
17.4%
19.7%
Other
4.3%
3.5%
Combination of Standards
PA Domestic Data
2004
2005
17%
36%
64%
Reserves &
Surplus
Reserves &
Surplus
Reserves,
Surplus, RBC,
et al
Reserves,
Surplus, RBC,
et al
83%
General Observations
Materiality Standards
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Regulatory actuaries generally observed a more
thorough discussion of the consideration of
materiality standards in Opinions from 2004 to
2005
Appears to be a general trend to consider
multiple measures of materiality:
More “combinations” of materiality bases in
Opinions.
 Less Opinions with a single basis of materiality.
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Here are a few examples:
Combination – Example #1
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“In determining the materiality standard, I note
the Opinion is a tool of solvency regulation.
Thus, the selected standard is oriented towards
the potential impact a misstatement of reserves
would have on surplus levels…and is a
minimum of three values: (1) 20% of surplus,
(2) 10% of loss and LAE reserves after pooling
and (3) difference between surplus less
Company Action Level RBC.”
Combination – Example #2
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“Based on my understanding of the use of this
(Opinion), I evaluated materiality in the context
of 15% of loss and LAE reserves, 25% of
surplus, and action/control level from RBC, of
the minimum was selected…The minimum was
adjusted to reflect where within the range of
reasonable estimates the Company’s reserves
fell.”
Combination – Example #3
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“Based on my review I consider a deviation
greater than $xxx,000 to represent a material
adverse deviation. This standard is based on my
professional judgment with consideration as to
Company’s surplus, liquid assets, reserve balance
and authorized control level of the Company.”
Combination – Example #4
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“In developing the threshold for the risk of
material adverse deviation, I considered the
company’s loss and LAE reserves, statutory
surplus and RBC position as of (year-end).
Based on review of these considerations, I
selected a materiality standard of $xxx,000,
which is about 10% of carried loss and LAE
reserves.”
Consideration of RBC Position
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“I have considered a MAD to be one in which the
actual net outstanding loss and LAE exceed carried
reserves by an amount greater than 10% of surplus... I
also verified that a 10% deviation in the Company’s net
reserves would not reduce the Company’s Total
Adjusted Capital to below the Company Action Level
Capital.”
May be MORE appropriate to include this for
companies with RBC scores at lower end of spectrum
vs. healthy RBC scores.
Regulators do not necessarily have to see this in all
Opinions.
What is the Bright Line Indicator?
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Outside bound of what is material.
If 10% of the Net Reserves are greater than the
difference between the Total Adjusted Capital
and Company Action Level Capital,
Then regulators expect to see explicit Relevant
Comment paragraphs discussing the factors
giving rise to the presence or absence of
RMAD.
Consideration of RBC Position
Should appointed actuaries be expected to comment on
the Bright Line Indicator in Opinions?
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“YES” if the Bright Line Indicator is crossed
Although reference to the BLI test is removed from
the 2006 Regulatory Guidance Draft document, the
test is still part of the NAIC’s Financial Analysis
Handbook.
 We will discuss Guidance briefly at the end of our
presentation.
Is there a Risk of
Material Adverse Deviation?
I do not believe that there are significant
risks and uncertainties that could result
in material adverse deviation in the
loss and loss adjustment expense
reserves.
Relevant Comments should allow a
regulator to answer these questions:
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Is there a Risk of Material Adverse Deviation?
What amount of adverse deviation does the actuary
consider material?
Why does the actuary consider that amount to be
material for this company?
Do I understand why the actuary believes that material
adverse deviation is or is not a risk for this company?
Given this guidance, what are your thoughts on the
following language:
Example #1 – Unclear
“The Materiality Standard is established as 10% of
reported statutory surplus, or $xxx,000 as shown
in Exhibit B: Disclosures. I estimate the
likelihood of material adverse deviation arising
from normal variations in expected results to be
about 16%. I estimate the likelihood of material
favorable development to exceed 50%.”
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Thoughts from audience??
Example #1 - Improved
“The Materiality Standard is established as 10% of
reported statutory surplus, or $xxx,000 as shown
in Exhibit B: Disclosures. I estimate the
likelihood of material adverse deviation arising
from normal variations in expected results to be
about 16%, not a significant likelihood. I
estimate the likelihood of material favorable
development to exceed 50%.”
Example #2 – Unclear
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I have established a materiality standard of ±5%
from my point estimate…In my opinion, the
Company’s reserves is $1.xxx million in excess
of my point estimate.
Actuary provides lengthy paragraph on changes to
actuarial assumptions and approach.
 In addition to knowing the reinsurance
arrangements, actuary determined adequacy of
Gross reserves, from which Net results were
determined.
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Thoughts from audience??
Example # 3 – Unclear
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Actuary did not believe there was RMAD. 15%
of Statutory Surplus was used as a materiality
standard.
The Company’s RBC ratio was 200.6%;
dropping from about 300% from previous year.
Is this a suitable standard?
Should the actuary check the Company’s RBC
ratio, when deciding on a materiality standard?
Thoughts from audience??
So, is there RMAD?
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Pennsylvania domestics
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More appointed actuaries
concluded “No RMAD”
in 2005 from 2004.
Statements on RMAD
were more clear (or less
vague) in interpretation.
Regulators want
appointed actuaries to be
clear in their position on
RMAD
80
70
60
50
Yes
No
Unclear
40
30
20
10
0
2004
2005
So, is there RMAD?
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Texas Domestics
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“No RMAD” for 81% of total
companies.
“No RMAD” for 70% of
companies with net reserves
greater than zero.
Texas has a high
concentration of companies
that carry $0 in net
reserves…then what?
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To be continued
180
160
140
120
Yes
No
Unclear
100
80
60
40
20
0
2004
2005
General Observations
RMAD Discussion
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Regulatory actuaries generally observed a more
thorough consideration and discussion of RMAD from
2004 to 2005
Improvements likely due to combination of:
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Increased regulatory actuary review and feedback on
Opinions
AAA Opinion Writers Symposium
Better understanding from appointed actuary community on
regulator’s expectations
Keep up the good work!
Net-Zero Companies
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Now, let’s switch gears
What if the Company
has $0 carried net
reserves, due to a pooling
arrangement or cession
to the parent?
What are the options to
the opining actuary?
Risk of MAD on Zero Net Reserves
– TX Domestics
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About 90 “net-zero” companies
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97% of Opinion writers concluded no RMAD
Comments: remote or no risk since company cedes 100%
 13 included additional comments on Reinsurance
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there exists a contingent net liability with respect to ceded
reinsurance in the event that reinsurers become unable to meet
obligations under existing reinsurance agreements.
2 concluded “yes” to RMAD, citing Reinsurance &
Rapid Growth as risk factors.
 1 conclusion about RMAD indeterminable.
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Risk of MAD on Zero Net Reserves
– PA Domestics
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8 “net-zero” companies
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7 of 8 Opinion writers concluded no RMAD
Comments: remote or no risk since company cedes 100%
 4 of 8 included additional comment that there exists a
contingent net liability with respect to ceded reinsurance
in the event that reinsurers become unable to meet
obligations under existing reinsurance agreements.
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1 of 8 concluded “yes” to RMAD, as the Company
was in Action Level RBC at year-end, citing Reserve
Variability in medical malpractice and Reinsurance
Collectibility as risk factors.
Risks and Uncertainties
Risks and Uncertainties
Appointed actuaries are expected to
describe the major factors that
could result in Material Adverse
Deviation
Risks and Uncertainties
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Opinion writers need to discuss in this section, why or
why not there is RMAD and the factors that would
lead to RMAD.
Explanation should not include general, broad
statements about risks and uncertainties due to
economic changes, judicial decisions, regulatory actions,
political or social forces, etc.
List does not need to be exhaustive.
Should be specific to the Company’s book of
business and operations.
We offer the following as good and bad examples:
Risk Factor Discussion
Good Example #1
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The major factors underlying the risks and uncertainties
which could result in MAD include:
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The significant concentration in premium volume in 2003
through 2005 from business that is relatively new to the
Company.
Lack of data available for reserve analysis on Company’s
financial guaranty exposure.
Significant reliance on the use of judgment by the Company
in selecting factors for setting loss reserves.
Risk Factor Discussion
Good Example #2
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I have identified the major risks and uncertainties as:
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Significant changes in claims operations over the last xx years,
which creates volatility in the development patterns and
therefore necessitates considerable reliance on benchmark
development patterns.
Rapid growth with net premium increasing six fold over the
last xx years.
Company’s cession of an amount of loss and LAE reserves
that exceeds its surplus to an unrated (offshore) affiliate.
Risk Factor Discussion
Good Example #3
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“There are a variety of risk factors that expose the
Company’s reserves to significant variability. I have
identified the major risk factors:
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Significant increase in policyholders in 2002;
New coverages offered beginning in 2002;
Increases in the policy limit;
The long-tail nature of medical professional liability
coverage.”
The opining actuary includes a detailed paragraph on
EACH of these points within the body of the Opinion.
Risk Factor Discussion
Bad Example #1
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“Although the carried reserves as of 12/31/05 are
within my reasonable range, I do believe that there is
a substantial risk of material adverse deviation in
the Company’s reserves as measured against a
materiality standard of 10% of surplus. …Carried
reserves are about 110% of surplus, so a 10%
deficiency in reserves would results in a loss of more
than 10% of surplus. A deviation of this magnitude,
while not anticipated, is not a statistically insignificant
possibility.”
What are this risk factor(s) that could impact the
reserve to surplus ratio?
Risk Factor Discussion
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Opinions that contained ONLY the general
uncertainty comments for RMAD without
consideration for company specific comments.
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PA: decrease from a few to none
TX: decrease from 18 to 16**
Again, another positive trend for improved
Opinion disclosure!
**mostly from a single firm
Risks and Uncertainties Discussed
Even if no RMAD?
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“But the NAIC Instructions
don’t require me, as an
appointed actuary to provide
a discussion of risk factors
when Risk of MAD is not
present.”
Statistics shown: % of
Opinions that discuss
company specific risk factors,
after actuary concluded no
Risk of MAD.
35.0%
30.0%
25.0%
20.0%
2004
2005
15.0%
10.0%
5.0%
0.0%
PA
TX
Risks and Uncertainties Discussed
Even if no RMAD?
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Company specific risk factors cited for “No
RMAD”:
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Growth in long-tailed lines
Medical cost inflation trends
A&E, claims initiatives, construction defect liabilities
XS over large deductible and self-insured exposures
Regulators view this type of disclosure very
positively.
These same factors could possibly lead to
RMAD for the Company in the future.
Again, keep up the good work!
Other Observations
Materiality and Link to Actuarial
Opinion Summary
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What if actuary said “no” to RMAD, yet
company carried reserves in lower end of
actuarial range?
Consideration given to surplus and RBC levels.
If low, appointed actuaries should expect a call
from the domestic regulator.
Why is there no RMAD?
 Is the Materiality threshold possibly set too high?
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Regulatory Guidance - 2006
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Separate Guidance for Actuarial Opinion and Actuarial
Opinion Summary.
No longer need to attach (public) Opinion to the
(confidential) Summary
New Scope items actuary should be cognizant of:
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Coverage for Service Contracts
Prepaid loss adjustment expenses
Draft document exposed at NAIC Fall meeting a few
days ago – copies available.
QUESTIONS ?????