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THE ACTUARY AND EARNINGS MANAGEMENT
Martha Marcon Aaron HalpertAssurance Partner Principal KPMG LLP KPMG LLP
Casualty Actuarial SocietySpring Meeting
May 8, 2000
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THE ACTUARY AND EARNINGS MANAGEMENT
DefinitionsCurrent SEC FocusHow would it affect P&C insurersWhat are the actuarial considerationsConclusionsQuestions/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
DefinitionActions 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 QualitativeIf 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 MaterialityCapable of precise measurementMasks a change in earnings or other trendsHides a failure to meet analysts’
expectationsChanges a loss into income or vice versaCompliance with regulatory requirementsCompliance with loan covenants
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Earnings Management
Management of earnings considerations for insurance companies:
�How does one test management’s best estimate of the reserves? Does an overly wide range enable management to manage earnings?
�What drive’s materiality? Are we too focused 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 reportingDocumentation for response to SEC
questions, and M,D,&A.New actuarial methodologies
As an example, consider the impact onEnvironmental and Asbestos Reservesreporting
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Actuarial Considerations
SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition
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Actuarial Considerations
SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting
Abuse of materiality Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition
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Actuarial Considerations
Creative acquisition accountingReserves should not be adjusted
in purchase accountingLarge 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 reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue recognition
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ASOP No. 36SAO 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 $Billions
Calendar Year1998 1997 1996 1995 1994
Loss Reserves 301 300 302 299 290LAE Reserves 64 64 64 62 59
-------------- -------------- -------------- -------------- --------------Loss and LAEReserves
365 364 366 361 349
Net Income AfterTaxes
31 37 24 21 11
Leverage=Income/Reserves 8% 10% 7% 6% 3%
Source: Best’s Aggregates and Averages
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Actuarial Considerations
SEC CONCERNS “Big Bath” restructuring charges Creative acquisition accounting Abuse of materiality Miscellaneous cookie jar Miscellaneous cookie jar reservesreserves
Revenue recognitionRevenue recognition
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Miscellaneous cookie jar reservesMiscellaneous cookie jar reserves(As described in Arthur Levitt’s (As described in Arthur Levitt’s
Speech)Speech)
“A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs.”
“In doing so, they stash accruals in cookie jars during good times and reach into them when needed in the bad times.”
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How will the focus on earnings affect our reserve
estimates?Reserve Ranges - SOP #36:”The actuary
should consider the implications of uncertainty in loss and LAE reserve estimates in determining a range of reasonable reserve estimates…”
How quickly can you identify turning points in development trends? Consider the recent experience in personal auto and workers compensation.
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Change in reserves -Impact on Earnings
Consolidated Industry Totals
1 Year Auto & WC Total Loss Reserve Release Net IncomeCalendar Year ($ Billions) ($ Billions)
%
1998 $5.56 $30.77 18 1997 7.23 36.82 20 1996 7.49 24.40 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 reservesMiscellaneous cookie jar reserves Revenue recognitionRevenue 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