THE ACTUARY AND EARNINGS MANAGEMENT Martha Marcon Assurance Partner KPMG LLP Aaron Halpert Principal KPMG LLP Casualty Actuarial Society Spring Meeting May 8, 2000 1 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 2 kpmg Earnings Management What is earnings management? Where did the concept come from? What does it mean to insurance companies? Casualty Actuarial Society 3 kpmg 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 4 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 5 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 6 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 7 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 8 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 9 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? 10 kpmg Earnings Management Actuarial Considerations 11 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 12 kpmg Actuarial Considerations SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reserves Revenue recognition 13 kpmg Actuarial Considerations SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reserves Revenue recognition 14 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. 15 kpmg Actuarial Considerations SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reserves Revenue recognition 16 kpmg 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…” 17 kpmg Reserves to earnings leverage Consolidated Industry Results All Amounts in $Billions 1998 Loss Reserves LAE Reserves Loss and LAE Reserves Calendar Year 1997 1996 1995 1994 301 300 302 299 290 64 64 64 62 59 -------------- -------------- -------------- -------------- -------------365 364 366 361 349 Net Income After Taxes Leverage=Income/Reserves 31 37 24 21 11 8% 10% 7% 6% 3% Source: Best’s Aggregates and Averages 18 kpmg Actuarial Considerations SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reserves Revenue recognition 19 kpmg Miscellaneous cookie jar reserves (As described in Arthur Levitt’s Speech) “A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs.” “In doing so, they stash accruals in cookie jars during good times and reach into them when needed in the bad times.” 20 kpmg How will the focus on earnings affect our reserve estimates? Reserve Ranges - SOP #36:”The actuary should consider the implications of uncertainty in loss and LAE reserve estimates in determining a range of reasonable reserve estimates…” How quickly can you identify turning points in development trends? Consider the recent experience in personal auto and workers compensation. kpmg 21 Change in reserves Impact on Earnings Consolidated Industry Totals Calendar Year 1998 1997 1996 1 Year Auto & WC Loss Reserve Release ($ Billions) $5.56 7.23 7.49 Total Net Income ($ Billions) $30.77 36.82 24.40 18 20 31 Source: Best’s Aggregates and Averages 22 % 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 23 kpmg Actuarial Considerations SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reserves Revenue recognition 24 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 25 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 26 kpmg