Actuaries and Analysts Trade Barbs Over Reserve Deficiencies

At about the same time, Fitch Ratings Ltd. in New York released a special report and conducted a teleconference about its conclusion that the industry is up to $77 billion under-reserved. Fitchs report, "Property/Casualty Insurance Reserves at Year-end 2002: Filling the HoleSlowly," did not focus on actuaries as the cause of reserve shortfalls. But during the teleconference, actuaries were chided for failing to make accurate reserve calculations.

"Its not that actuaries are dumb," Fitch managing editor Keith M. Buckley assured his audience during the teleconference. "Its more that the future just doesnt like to be predicted."

These unexpected salvos sent actuariesmore used to being the targets of respectful humor about their legendary precision than a target for blamescrambling to defend their ability and honor.

The S&P report "is not about actuaries or reservingit is an obvious attempt to explain away the errors some analysts have made in estimating property-casualty insurers earnings," said Rade Musulin, a spokesperson for the Washington, D.C.-based American Academy of Actuaries. Mr. Musulin, an actuary, is also vice president of Gainesville, Fla.-based Florida Farm Bureau Insurance Companies.

The other major U.S. property-casualty actuarial trade associationthe Arlington, Va.-based Casualty Actuarial Societyposted a copy of the American Academys response to the S&P report on its Web site and agrees with that response, noted CAS spokesperson Mike Boa. "The American Academy is the voice of the profession, and the CAS is the education and research arm," Mr. Boa explained.

"The S&P report over-reacted and used inflammatory terms in trying to make a point," said John Purple, chief actuary for the Connecticut Insurance Department in Hartford. "I think that the S&P analysts were frustrated because recent reserve actions have affected the accuracy of their analyses of insurance companies," he added.

Bob Anker, a retired actuary and former CEO of Indianapolis, Ind.-based American States Insurance Companies (now part of Safeco), called the S&P report "tabloid journalism."

"I am extraordinarily disappointed that S&P would release something that shallow," Mr. Anker said. "It affixes blame, with no evidence."

In the Fitch special report and teleconference, Fitch analysts suggested that actuaries over-reliance on past results, and inability to use those results to accurately predict the future, are partly to blame for the reserve shortfalls. Fitch senior director James B. Auden noted that the under-reserving is attributable to three factors.

"First, there is up to a $38 billion deficiency for accident years 1997 through 2002," Mr. Auden said. "In addition, asbestos reserves for policies written prior to the early 1970s are short by as much as $29 billion. There is also an up to $10 billion deficiency related to latent exposures, such as environmental damage, silica, tobacco and future mass tort litigation."

According to Fitchs Mr. Buckley, who moderated the teleconference, "cheating" and "being wrong" are the two main reasons for the deficiency problem.

"Cheating is when insurers smooth earnings by booking reserves at the low end of the range," Mr. Buckley explained. He noted that reserves are by their nature an estimate, giving creative managements room to manipulate. Mr. Buckley pointed out that such manipulation is more apt to occur when managers want to minimize reserves for losses [and resulting loss ratios] under policies with low premiums that were written during the soft market.

On a hopeful note, Mr. Buckley predicted that heightened scrutiny by state regulators, combined with Sarbanes-Oxley requirements, would diminish such cheating.

"Being wrong," Mr. Buckley continued, is when reserves are in good faith miscalculated. "Actuarial science is sophisticated guesswork," he said. "Even best practices can lead to the wrong assumptions."

S&P analysts were not as kind to the actuarial profession as Fitchs Mr. Buckley.

The "ongoing parade of reserve additions" by U.S. property-casualty insurers calls into question the credibility of insurance actuaries, the S&P report stated. The report complains of "huge surprises" in reserving additions, as insurers reassess their requirements for future payouts.

Reserve additions in 2003, S&P noted, will likely exceed the "massive" $22 billion total for all lines of business in 2002, which itself outstripped the $11.6 billion total in 2001.

According to the S&P report, the actuarial profession "may be excused" for underestimating asbestos liabilities, which comprised $10.9 billion of 2002s reserve additions. "Even apart from that, the average commercial lines writer is not properly assessing its risk in normal bread-and-butter business," said S&P credit analyst Sid Ghosh. Mr. Dreyer identified those lines as automobile, workers compensation and malpractice, among others.

Mr. Musulin of the American Academy of Actuaries responded that actuaries have estimated reserves within reasonable ranges, but that events such as 9/11 and "unprecedented volatility" in the insurance market have caused losses "to exceed reasonable expectations."

These events make it unfair to accuse actuaries of "naivet? or knavery," Mr. Musulin said, referencing words used in the S&P report. "Fraud should not be inferred from misfortune, but that is exactly what the authors [of the S&P report] are trying to suggest," added Mr. Musulin. "Its wrong, misleading and unfair to their readers."

Mr. Anker added that much of what the S&P and Fitch reports complain about is more a function of the economy than actuarial science. "We are in one of those economies in which economic indicators are not reliable," Mr. Anker noted. "The same forces that are making budgets and other financial items hard to predict are also affecting loss reserve calculations."

"Pressure on management and actuaries is also coming from the marketplace, which stresses short-term results," Mr. Anker pointed out. "Most actuaries do the right thing and resist those pressures."

After being informed of actuaries reaction to the report, S&Ps Mr. Dreyer appeared ready to extend an olive branch. "We were not trying to rile up the [actuarial] profession," Mr. Dreyer insisted, "and we were not implying fraud" by actuaries.

Rather, it is the reliability of the financial data being submitted by insurerswhether by their actuaries, accountants, managers or board of directorsthat S&P finds troubling, according to Mr. Dreyer.

"Insurers should have better disclosure and own up to their [reserve] shortfalls earlier," Mr. Dreyer said. "But we dont see them doing that. Our intent was to signal that we are changing our interpretation of information provided to us by insurance companies, as well as our reliance on and decisions based on that data."

The implication, according to Mr. Dreyer, is that S&P will in the future be giving such insurer-provided information less weight in the financial rating process.

However, some actuaries agreed with the substance of the S&P reports premise of greater actuarial accountability, while at the same time taking issue with the reports tone.

Chet Szczepanski, chief actuary for the Pennsylvania Insurance Department in Harrisburg, said: "I take no issue with the point that actuaries should be held accountable for their work as respects loss reserving." But much of what S&P wrote didnt pertain to reserve opinions, he added. There was a lot of broadly-focused criticism that wasnt backed up, according to Mr. Szczepanski. "It was a shotgun approach," he said.

"Actuaries have a professional code of conductthey shouldnt be signing reserve opinions that they dont agree with," Mr. Szczepanski stressed. "Actuaries that do that should be called to task by their professional body and disciplined."

While acknowledging that actuaries sometimes feel pressure from firm partners, insurer managements and other sources, Mr. Szczepanski noted that the code of ethics should never be compromised.

However, setting reserves at the low end of a range was not seen by Mr. Szczepanski as an ethical problem. "If there is a range, then the actuary is entitled to make a choice at the low end of the range if he or she deems that to be adequate," he explained.

Mr. Purple of the Connecticut Insurance Department noted that new loss reserve rules of the Kansas City, Mo.-based National Association of Insurance Commissioners may assist actuaries in sidestepping range-based disputes. "The NAIC rule would require actuaries to disclose a range of estimates," Mr. Purple said. "Then the regulator would look at where management has booked reserves relative to the actuaries estimates."

Mr. Anker recalled a time when he as an actuary had to deal with a top manager who took way too many liberties with loss reserves.

"I was dealing with an executive who had recently taken over an insurance company whose reserves were in disrepair," Mr. Anker related. "It was a closely-held company getting ready to be sold. In the good times, the company would overstate reserves in order to understate earnings and reduce taxes. In bad times, they would understate reserves so earnings would look better."

"Then I came in and explained that if the executive didnt stop overstating reserves, he could go to jail for tax evasion," Mr. Anker continued. That was not a welcome suggestion, but Mr. Anker refused to back down. "The executive eventually got the message and stopped," said Mr. Anker.

"Actuaries who must deliver bad news to management or who are faced with an ethical dilemma must dig in their heels and not be intimidated," Mr. Purple stressed. Having actuaries as part of the management team can prevent ethical dilemmas from arising, he added.

S&Ps Mr. Dreyer went on to note that he has a gripe with certain outside actuaries who, as part of their written contract with their insurance company clients, insist that their identities not be revealed. When asked if those outside actuaries want to remain anonymous out of fear of being held accountable for their mistakes, Mr. Dreyer responded that people can "draw their own conclusions about that."

Insurance company managements tendency to camouflage and delay bad news from seeping down to bottom-line results was also blasted by the S&P report.

Among the ways insurers "suppress bad news," according to the report, are: spreading reserve additions over several quarters; drawing reserves from one business line to mask deficiencies in another; relying too heavily on reinsurers to carry their liability burdens; and using complex reinsurance arrangements to take credit today for expected future investment earnings on reserves.

"The accounting profession has come in for a lot of criticism in recent years for signing misleading financial statements," Mr. Dreyer noted. "Meanwhile, the insurance industry has done something almost as egregious by, in effect, overstating prior-year earnings by billions of dollars. Somehow, actuaries have avoided the spotlight for abetting this."

Mr. Purple of the Connecticut department disputes S&Ps comparisons between accountants and actuaries. "Accountants are focused on the balance sheet and reporting what happened in the past," he noted. "Actuaries, on the other hand, must project into the future."

And sometimes, as Fitchs Mr. Buckley pointed out, "the future just doesnt like to be predicted."

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 5, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.