The Actuary’s Role in Due Diligence
The Consultant’s Perspective
Presented at the CAS Annual Meeting
Washington, DC
November 2000
by
Gail M. Ross, FCAS, MAAA
Am-Re Consultants, Inc.
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Presentation Overview
Actuary’s Involvement In:
 Pre-Due Diligence
 Sell Side
 Buy Side
 Due Diligence
 Buy Side
 Sell Side
 Common Theme
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Pre-Due Diligence - Sell Side
Case Study:
Seller - small privately held single state, mono-line carrier
Buyer - regional multi-line carrier
Buyer approached Seller stating their interest in acquiring
them. Initial offer of 1.5 times book value.
Seller was very interested but felt they needed help prior to
proceeding.
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Pre-Due Diligence - Sell Side
Actuary’s Involvement In Providing
Assistance to Seller:
 Operational Review
 Valuation
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Pre-Due Diligence - Sell Side
 Operational Review
Actuaries worked in conjunction with
specialists from other functional disciplines.
Goal was to determine Seller’s operational
areas of strength and weakness.
Based on findings, Seller implemented certain
operational changes which ultimately enhanced
its value.
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Pre-Due Diligence - Sell Side
 Operational Review
Claims consultants recommended changes in
two major areas:
• Seller had poor medical cost containment controls
and changes were recommended in the areas of bill
review and nurse case management.
• Staffing was too low resulting in case loads being
too high. By adding to staff, adjusters would be able
to be more proactive in settling claims and use of
outside adjusters could be reduced (lowering ALAE)
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Pre-Due Diligence - Sell Side
 Operational Review
Underwriters also recommended changes in
two areas:
• Commission levels were unnecessarily higher than
the market.
• Underwriting controls were in place but not being
followed resulting in acceptance of high exposure
risks.
Actuaries quantified the impact of changes in
these areas on future loss, LAE and expense
ratios.
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Pre-Due Diligence - Sell Side
 Valuation
Seller knew the book value of their company
but did not know what range of values the
market (and in particular, Buyer) might place
on them.
Seller felt they would be in a better bargaining
position with Buyer by getting an independent
valuation.
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Pre-Due Diligence - Sell Side
 Valuation
Actuaries performed a number of different
projections of market value.
• Discounted cash flow analyses under alternative
scenarios with varying assumptions of growth,
pricing, loss ratios, expense ratios, investment
returns, etc.
• Price based upon multiples of book value and
multiples of earnings using information from recent
acquisitions of publicly held companies.
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Pre-Due Diligence - Sell Side
Case Study Outcome:
Buyer acquired Seller for a price equal to 1.9 times book
value.
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Pre-Due Diligence - Buy Side
Case Study:
Buyer - financial group with multiple insurance company investments
Seller - privately held national excess and surplus lines carrier
Seller approached Buyer seeking an investment partner to
finance a management buy-out of the company with ultimate
goal of taking the company public.
Buyer was somewhat interested but preferred conducting
limited pre-due diligence before proceeding.
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Pre-Due Diligence - Buy Side
Actuary’s Involvement In Providing
Assistance to Buyer:
 Review of Seller’s most recent reserve study
 Three day on-site meeting with Seller
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Pre-Due Diligence - Buy Side
 Reserve Review
Conducted a high level review of most recent
independent actuarial report (supporting the
reserve opinion).
Tested six month actual claim emergence and
payments versus expected.
Goal was to assess level of adequacy of carried
reserves and where potential problems areas
might be.
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Pre-Due Diligence - Buy Side
 Reserve Review
Based on high level review, actuaries were able
to inform claims and underwriting consultants
that construction defect (CD) might be a
problem area to focus on during on-site
meeting.
Reserves appeared to be posted at the low end
of the range.
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Pre-Due Diligence - Buy Side
 On-Site Meeting
Buyer’s consultants (actuaries, claims,
underwriting, financial) met with Seller’s
management to get a company overview.
Underwriters learned that the Seller had written
a sizeable book of general contractors,
subcontractors, and developers in California
through mid 90s and corrective underwriting
actions began in 1996.
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Pre-Due Diligence - Buy Side
 On-Site Meeting
Claims consultants learned that no formal
tracking system for CD had yet been developed
and all CD claims were being directed to
outside counsel.
With no claim formal tracking system in place,
actuaries could not segregate CD from liability
triangles and were forced to make judgments
regarding ultimate CD losses based upon ad
hoc, manual claims department listings.
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Pre-Due Diligence - Buy Side
Case Study Outcome:
Buyer elected to walk away from the transaction citing CD
issue as the “deal breaker”.
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Due Diligence - Buy Side
Case Study:
Buyer - large publicly held national multi-line writer
Target - medium-sized publicly held regional multi-line writer
Target wrote primarily middle-market personal and
commercial lines business produced by independent agents.
Seller had difficulty differentiating itself, had been losing
market share and results had been deteriorating.
Buyer saw a growth opportunity in acquiring Target.
Transaction was directed by an investment banker working
on behalf of Buyer.
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Due Diligence - Buy Side
Actuary’s Involvement In Providing
Assistance to Buyer:
 Participated in full scope due diligence
Perform independent reserve review
Interface with other members of due diligence team
 Assisted bankers with valuation assumptions
 Provided Buyer with post-acquisition insights
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Due Diligence - Buy Side
 Independent Reserve Review
Met with Target’s Chief Actuary and Senior
Reserve Actuary to discuss data availability,
data segmentation, and reserving issues.
Due to time constraints we focused on the lines
of business that reflected the major portion of
the reserves and had the most potential for
variability.
Segregated into on-going and discontinued (e.g.
asbestos and environmental) operations.
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Due Diligence - Buy Side
 Independent Reserve Review
Performed analysis on both a gross and net
basis separately for loss , ALAE, ULAE.
A point estimate and a range of results was
calculated.
Relied on interface with the other members of
the due diligence team for the qualitative
aspects of the analysis.
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Due Diligence - Buy Side
 Interface with Due Diligence Team
Underwriters’ review indicated that although
regular (inflationary) rate changes had been
taken, rate levels had actually been
deteriorating due to increased use of
discretionary pricing. The actuaries factored
this into our loss ratio picks.
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Due Diligence - Buy Side
 Interface with Due Diligence Team
Systems consultants documented the timing of
the implementation of a new claims system.
Claims consultants confirmed a slowdown then
speed-up of claims closures during this time
period. Actuaries used the Berquist-Sherman
method to adjust development factors for these
changes.
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Due Diligence - Buy Side
 Interface with Due Diligence Team
Financial consultants assessed the credit
worthiness of reinsurers. Actuaries used this
information to test the adequacy of the reserve
for uncollectible reinsurance recoverable.
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Due Diligence - Buy Side
 Valuation Assumptions
The investment bankers were modeling the
transaction. They relied heavily on the
actuaries for the assumptions they used in the
valuation.
• Calendar year payout of reserves (separately for
A&E).
• Loss and LAE ratios for new AYs by line.
• Claim payment and emergence patterns by line for
new AYs.
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Due Diligence - Buy Side
 Post-Acquisition Insights
Since the Buyer was planning to integrate the
Target with their ongoing operations they were
interested in our insights in the following areas.
• Opportunities for expense savings (e.g., staffing
levels, offices).
• Compatibility of systems.
• Competency of senior management.
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Pre-Due Diligence - Buy Side
Case Study Outcome:
Reserves were deficient by approximately 20%, primarily
from the core (on-going) book of business.
The actuaries acted as overall coordinators in compiling the
team’s findings for presentation to the Buyer.
The reserve deficiency was factored into the pricing of the
transaction and the acquisition was made.
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Due Diligence - Sell Side
Case Study:
Same case study as Due Diligence - Buy Side
The Seller’s actuarial team played an important role
during due diligence.
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Due Diligence - Sell Side
Impact of Seller’s Actuarial Team
In order to maintain confidentiality, only senior
managers of Seller interacted with Buyer.
Chief Actuary and Senior Reserve Actuary
were fully informed on details of the functions
they managed.
Chief Actuary was a very good communicator
to non-actuaries which was important in
discussing some of the differences in the
reserve projections.
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Common Themes
The actuary’s role in due diligence is not
just quantitative.
The technical skills taught in the Syllabus form
the foundation of our knowledge base.
We need to be able to interpret how operational
aspects of the insurance entity impacts the
quantitative results.
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Common Themes
We generally act as project managers and
need to be able to coordinate the
presentation of results (the “story telling”).
Because of this, as actuaries we need to
continually enhance our communication
skills (both written and verbal).
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