Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes May 2006

Sarbanes-Oxley Section 404 Internal Controls and Actuarial

Processes

May 2006

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Disclaimer

•Views and opinions expressed in this presentation and the underlying paper are those of the authors.

•Needless to say then, they do not represent the opinions of the CAS, nor any employer of the presenters, nor any sponsors of the meeting.

•Anyone who says otherwise is not only wrong, but is clearly itching for a fight.

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Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes

• Background

• COSO Framework

• Scope for Actuarial Processes

• Issues

Information Integrity & Availability

Analysis

End User Applications

Management’s Best Estimate

• Documentation

•Considerations by Size of Company

• Status

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Comments by Harvey Pitt (SEC Chairman when SOX was Passed)

Question: How is SOX like the weather

Answer: Everyone talks about it, but no-one does anything about it

Quote from Mr. Pitt

“The statute was hastily – and, therefore, badly – drafted; but it was and remains, necessary

Source: Wall Street Journal, April 13, 2006

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Background

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Background

SOX Section 404 Company Requirements:

– State management’s role in establishing and maintaining an adequate central structure and procedures for financial reporting;

– Report on the effectiveness of their internal controls over financial reporting procedures

• Including supporting documentation of controls, and testing of their effectiveness.

SOX Section 404 Auditor Requirements:

– Attest to and report on management’s assessment of internal controls;

– Attest to the effectiveness of internal controls.

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Background

Deficiency = situation arises where internal controls are identified as not effective

Responses

– Identify and implement remediation steps

– Evaluate seriousness of the deficiency

Type of Deficiency Criteria Reporting Requirement

Deficiency Doesn’t rise to a more serious level.

Auditor to management.

Significant Deficiency Results in a more than remote likelihood of a misstatement that is more than inconsequential.

Auditor to Audit Committee

Material Weakness Results in a more than remote likelihood of a material misstatement.

Auditor to Audit Committee and in Audit Opinion (a public document).

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The COSO Framework

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The COSO Framework

•Committee of Sponsoring Organizations issued in 1992 AKA The Treadway Commission; Provides a basic framework for all internal controls; Implementers not required to use this framework– But most do.

•What is the framework Control Environment; Risk Assessment; Control Activities; Information and Communication; Monitoring.

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Diagram of COSO Based Internal Control Structure

*Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors

Elements of COSO Based Internal Control Structure

*Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors

Scope for Actuarial Processes

Property/Casualty Insurance Operations Chain:

Producer solicits/binds coverage, or policy renews

Underwriting Process

Policy expires and may be renewed or audited

Claims are received or estimated

Underwriter verifies risk acceptability and price

Policy is submitted to Underwriter

Underwriting/Claims Transaction

Underwriting Guides

Product Rate Plan and Coverage

Premiums Written and Earned

Resulting Financial FlowsLosses received, recorded, estimated

Business DesignMarkets Targeted

Underwriting Expenses result

Transactional Data Systems

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Underwriting Guides




Business Design

Markets Targeted


Transactional Data SystemsTraditional Financial Statement

Audit Focus

Property/Casualty Insurance Operations Chain:

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Property/Casualty Insurance Internal Controls affecting Estimated Balance Sheet and Income Statement Items

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Underwriting Guides




Business DesignMarkets Targeted


Transactional Data Systems

Additional Focus Areas for Internal Controls

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Estimated Balances Must Properly Reflect the Following Company Operations

Source A

Source B

Source C

Company Risk Assumption/

Underwriting Practices

Company Claims

Handling andSettlementPractices

Company IT/Data Design and

Collection Process

PerformEstimates

and Analysis

Review and Communication

Process

Committee Process

Input intoAccounting

System & ReviewSource Z

Information and Communication


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Estimated Balances Must Properly Reflect the Following Company Operations

Source A

Source B

Source C

Company Risk Assumption/

Underwriting Practices

Company Claims

Handling andSettlementPractices

Company IT/Data Design and

Collection Process

PerformEstimates

and Analysis

Review and Communication

Process

Committee Process

Input intoAccounting

System & ReviewSource Z



Underwriting and Claims Data Analysis

Management Review Process

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Comments on Operational Internal Controls and Sarbanes-Oxley, Section 404

AICPA gives guidance as to how Sarbanes-Oxley applies to Internal controls in operational areas

– Only controls which affect financial statement reporting are subject to Sarbanes-Oxley;

– Includes items with significant input to financial reporting;

– Should be taken to include disclosures.

Examples and the AICPA guidance are in the following table.

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Operational Controls; Management Responsibility Contrasted with Section 404 Goals

Area of ControlSection 404 Internal Controls Include:

Examples of Additional Management Responsibilities, not section 404

In General (from AICPA 319, item 40)

Address “Inherent and control risks to evaluate the likelihood that material misstatement could occur in the financial statements”

Address “identify, analyze, and manage risks that affect entity objectives”

Underwriting Company intent around which exposures to insure, at what prices, terms and conditions is clear, is followed, and consistent with assumptions underlying balance sheet and income statement estimates

Management executes an underwriting strategy that provides appropriate returns with reasonable risk to capital providers. Staffing resource is appropriate to the volume of business.

Claims Case reserving philosophy, and claims processes are understood, impacts of changes are understood, and consistent with assumptions underlying profit, loss, and balance sheet estimates

Claim settlements are fair to both claimants and capital providers. Appropriate legal strategies are pursued to defend policyholders. Claims staffing resource is appropriate to the volume of claims.

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Industry Track Record

Industry Experience-Runoff of Held Loss and LAE ReservesIndustry All Lines Experience in millions of US$

Reserve DateHeld Reserves for

Loss and LAE

(Equity)/ Deficiency as Recorded

12/31/2004Ratio (Eq)/Def to Held Reserves

12/31/1995 360,940 (723) -0.2%12/31/1996 365,319 189 0.1%12/31/1997 363,351 6,119 1.7%12/31/1998 378,278 24,638 6.5%12/31/1999 375,734 45,101 12.0%12/31/2000 372,075 64,129 17.2%12/31/2001 389,764 60,076 15.4%12/31/2002 414,813 34,650 8.4%12/31/2003 448,652 9,882 2.2%12/31/2004 486,438 NA NA

Accident Year Evaluated at 12/31/2004Negative means favorable runoff

Source for Accident Year: AM BEST Aggregates and Averages, "Industry Schedule P".

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Industry Track Record

Industry Experience-Loss and Loss Expense RatioComparison of Accident Year to Calendar Year

CY

Earned Premium 000,000's

Accident Year Loss and LAE

Ratio

Calendar Year Loss and LAE

Ratio Difference1995 247,338 76.1% 78.9% -2.8%1996 257,558 78.3% 78.4% -0.1%1997 265,356 76.0% 72.8% 3.2%1998 270,253 82.6% 76.5% 6.1%1999 277,760 84.8% 78.9% 5.9%2000 291,472 86.7% 81.3% 5.4%2001 312,286 86.7% 88.4% -1.7%2002 351,388 74.0% 81.5% -7.5%2003 394,951 68.2% 75.0% -6.8%2004 425,230 70.2% 72.8% -2.7%Total 3,093,591 77.6% 78.3% -0.6%

Accident Year Evaluated at 12/31/2004Negative means the Accident Year Ratio is Less Than the Calendar Year RatioSource for Calendar Year: AM BEST Aggregates and Averages, "Cumulative by Line Net Underwriting Experience, Industry".

Source for Accident Year: AM BEST Aggregates and Averages, "Industry Schedule P".

Information Integrity and Availability

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Data

•Controls to ensure data is accurate and complete

•Data is available to enable comprehensive analysis

•Data is available to monitor compliance with Claims and Underwriting controls

•Data is available to support management review needs, including tracking of trends

Information Integrity and Availability

Data Analysis

Underwriting and Claims

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Quantitative Data:

– Verify information is entered timely and accurately and available to management and analysts to make estimates;

– Review reconciliation procedures used to discover processing or data errors; investigation process in place when discrepancies arise?

– Review the edit process used to ensure correctness of operational data for use by management in breakdowns required for analysis, such as class of business, coverages granted;

– Verify that data elements are coded and reported in the detail required to support critical analysis needs (losses, expenses, claim counts, premium, etc.);

– Identify and review new impact events, such as new products and regulations, and determine if appropriate data is being gathered;

– Validate the compilation and availability of cost trend information underlying the financial estimates.

Completeness Accuracy Judgmental Areas

Data

Control Activities, Information and Communication, Monitoring

Data Analysis

Underwriting & Claims

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Qualitative Data:

– Capture interaction with claims department;

– Capture interaction with underwriting department;

– Verify that information gained from such interactions are manifested within actuarial analysis in an appropriate manner;

– For companies with multiple business units, ensure that information is interpreted and used consistently across business units.


Data


Data Analysis


Analysis

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Actuarial Analysis

Analysis

•Access to data is sufficiently convenient to analysts

•Available information is incorporated in analysis

•Communication process with underwriting, claims, management is sufficient

•Appropriate methods are used

•Communication of results to management is clear

Data Analysis


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Validate that the estimation process encompasses sufficiently broad technical analytics for the business written;

Verify that information from the internal operating environment (underwriting, claims) is used to support and validate estimates, including consideration of large losses;

Review the segmentation of the business into lines of review, and the controls in place to ensure the business in each segment is correctly understood and reflected in estimates;

Verify that external trends and changes are identified, and incorporated into the analysis;

Review the process used to keep estimates current between review dates (currency of data relative to financial statement date);

Review the process followed to validate estimates with functional management;

Validate that the considerations in the CAS and AAA guidance are followed and documented.


Analysis


Data Analysis



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•Spreadsheets, databases, word documents,….

•One of the most problematic pieces of control documentation

•Relevant literature; PwC publication “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley Act”

•There is a group dedicated to spreadsheet risks, lots of stories available

See Website http://www.eusprig.org/stories.htm

•University of Hawaii research that error rates on spreadsheets near 90%

And this goes near 100% if more than 200 lines

http://www.eusprig.org/stories.htm

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Priority of Spreadsheet Controls

Source: “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley ActAvailable at www.Pwcglobal.com

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What Controls to Consider

•Backups

•Archiving

•Security

Controls over Access

•Change Control and Version Control

Such as Formula Locking

•Baselining – In depth review of calculations and functions

•Internal Data Reconciliations

•Peer Review – Sometimes outside the chain of reporting

•Documentation

Management’s Best Estimate vs. Actuarial Best Estimate

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Management’s Best Estimate vs. Actuarial Best Estimate

•Management Review Process

•Process to determine booked reserves is reasonable

•Reserve Committee and management review is effective

•Underlying assumptions, such as trends, are validated

Data Analysis


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Review the process to determine carried reserves from the analysis and indications;

Review the reserve committee process and minutes to ensure proper management control, involvement, and review in the estimating process;

Review controls to ensure the estimate selection process is consistent with the outcome of the underlying estimates, or reasons for departure are documented – including quantification of reasons;

Verify controls are in place to validate the underlying assumptions in the estimating process are consistent with the observations of functional management;

Review the process to reconcile the estimates with the underlying trends.


Management ReviewProcess


Data Analysis


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Reserve Committee Process (best practices)

– Charter spelling out charge and operation of Committee;

– Participation by Senior Management, Finance, Claims, Underwriting, Actuarial;

– Access to a well documented actuarial estimate and range prepared prior to the Committee meeting;

– Active questioning by Committee;

– Well documented outcome of Committee meetings, including approved reserve amount;

– Documentation of differences between management’s best estimate and actuarial best estimate.


Management ReviewProcess


Data Analysis


Documentation Issues

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Documentation

•While SOX has changed the documentation commonly used in Actuarial work, Accounting documentation requirements are similar to common standards prior to SOX.

•Most Common Pitfalls

Controls should be specific

– What is the control?, who performs?, who reviews?, what is the documentation?, how often?, where maintained?

Informal processes do not fully replace controls;

Conservatism doesn’t take the place of controls;

Lack of misstatement in the past doesn’t obviate the need for controls.

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Documentation (continued)

•Most Common Pitfalls

Controls over reserves usually just at year end, but release of results to markets quarterly;

Controls over processes with significant input to financial statement balances missing;

“Common knowledge” instead of rigorous analysis;

Considering the auditor as part of the control process;

Forgetting controls over significant actuarial balances other than reserves.

Considerations by Size of Company

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Considerations by Size of Company

•All companies need to weight costs and benefits associated with implementation of SOX 404. Management may consider some deficiencies acceptable relative to costs associated with remediation.

•Larger companies generally have the actuarial resources to implement internal controls effectively.

•Smaller companies likely have resource constraints, most apparently relative to peer review.

Third party actuarial analysis;

Thorough review (and documentation) of reserves by all professionals in the organization that would be best versed in reasonability of reserves --- senior claims, underwriting, and finance management.

Status of Implementation

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Status – Recent Events

•For most large domestic entities; Implemented 2004

•Large foreign filers; Implementation in 2006

•NAIC considering statutory rules

Current form would affect large entities, newly impacting about 190 Companies;

Proposed effective for 2009;

No external audit requirement.

•Canadian Securities Administrator has proposed SOX type requirements

No external audit requirement.

Documents

Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes May 2006