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Casualty Loss Reserve Seminar, September 2006
Dancin’ With the Devil
Ranges and Adverse Deviation
Charles L. McClenahan
10 South Wacker Drive, Chicago, IL 60606
ACTUARIAL CONSULTING
Dancin’ With the Devil

Range of Reasonable Estimates

Risk of Material Adverse Deviation

Some Suggestions for Consideration
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Range of Reasonable Estimates

History

Purpose

Misuse of Ranges

New Actuarial Opinion Summary
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Range of Reasonable Estimates

History
– 1973 - Bob Anker discusses reserve ranges
– 1988 - CAS Statement of Principles - “a range of reserves can
be actuarially sound”
– 1994 - COPLFR – “reasonable provision” if within the “range of
reasonable estimates”
– 2000 - ASOP #36
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Range of Reasonable Estimates

ASOP #36 Definition (Section 3.6.4)
A range of reasonable estimates is a range of estimates that
could be produced by appropriate actuarial methods or
alternative sets of assumptions that the actuary judges to be
reasonable.
Appropriate methods
Reasonable Assumptions
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Range of Reasonable Estimates
Best Estimate
Range of
Reasonable
Estimates
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Range of Reasonable Estimates

Purpose
– The range reflects the fact that different actuaries using
different reasonable methods and different appropriate
assumptions will produce different reasonable estimates of
reserves
– The range is NOT permission to carry 95%
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Range of Reasonable Estimates

Misuse of Ranges
– The “Actuarial Limbo” or “How Low Can You Go?”
– The “Actuarial Two-Step”
– The “Actuarial Tango” or “It Takes Two”
– The “Actuarial Waltz” or “It’s as Easy as 1-2-3”
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Exhaustive Research Reveals …

7.3% of actuaries are using inappropriate methods

Of the remaining 92.7%, 8.4% are using unreasonable assumptions

We have identified the 84.9% who are using appropriate methods and
reasonable assumptions
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Exhaustive Research Reveals …

Highest Best Estimate
– Consultant named Max (last name withheld for privacy)
– Max left his firm last month
– Currently working in DC

Lowest Best Estimate
– Consultant named Minnie (last name withheld to avoid being sued)
– Currently swamped with work
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Exhaustive Research Reveals …
Minnie's
Best
Estimate
Range of
Reasonable
Estimates
Casualty Loss Reserve Seminar, September 2006
Max's
Best
Estimate
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The “Actuarial Limbo”
or: “How Low Can You Go?”

Minnie doesn’t know her best estimate is lowest
Range of
Reasonable
Estimates
Casualty Loss Reserve Seminar, September 2006
Minnie's
Best
Estimate
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The “Actuarial Limbo”
or: “How Low Can You Go?”

So she establishes a range
Minnie's Range
Range of
Reasonable
Estimates
Casualty Loss Reserve Seminar, September 2006
Minnie's
Best
Estimate
13
The “Actuarial Limbo”
or: “How Low Can You Go?”

And signs off at the low end
Minnie's Range
Booked
Reserve
Casualty Loss Reserve Seminar, September 2006
Range of
Reasonable
Estimates
Minnie's
Best
Estimate
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The “Actuarial Limbo”
or: “How Low Can You Go?”

Another clean opinion for Minnie
Booked
Reserve
Casualty Loss Reserve Seminar, September 2006
Range of
Reasonable
Estimates
15
The “Actuarial Two-Step”

Step 1 – Appointed Actuary Determines Range
Range of
Reasonable
Estimates
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The “Actuarial Two-Step”

Step 2 – Company Books to (or Near) Low
Booked
Reserve
Range of
Reasonable
Estimates
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The “Actuarial Tango”
or: “It Takes Two”

Company Books at Low End of Its Own Range
Booked
Reserve
Company
Range
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The “Actuarial Tango”
or: “It Takes Two”

Appointed Actuary Sees Reserve Within Range
Booked
Reserve
Range of
Reasonable
Estimates
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The “Actuarial Tango”
or: “It Takes Two”

Clean Opinion on what both agree is low reserve
Booked
Reserve
Company
Range
Booked
Reserve
Range of
Reasonable
Estimates
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The “Actuarial Waltz”
or: “It’s as easy as 1-2-3”

Appointed Actuary Prepares Analysis
Best Estimate
Range of
Reasonable
Estimates
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The “Actuarial Waltz”
or: “It’s as easy as 1-2-3”

Appointed Actuary Shares
Analysis with Company

Company Selectively Critiques
Analysis
– Focus on areas where
Appointed Actuary may be too
high
See? Claims are closing faster!
– Ignore areas where Appointed
Actuary may be too low
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The “Actuarial Waltz”
or: “It’s as easy as 1-2-3”

Appointed Actuary Amends Analysis
New Best
Estimate
New Range
of Reasonable
Estimates
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The “Actuarial Waltz”
or: “It’s as easy as 1-2-3”
2
1
Best Estimate
Range of
Reasonable
Estimates
3
Repeat as
necessary
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New Best
Estimate
New Range
of Reasonable
Estimates
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New Actuarial Opinion Summary



Signed and dated by the Appointed Actuary
AOS should include the Appointed Actuary’s range of
reasonable estimates and/or point estimates
Where there has been one-year adverse development in
excess of 5% of surplus, in at least three of the past five
calendar years, include explicit description of the reserve
elements or management decisions which were the major
contributors.
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New Actuarial Opinion Summary

Disclosure of best estimate and/or range will be helpful to
regulators, not available to consumers
– Confidentiality likely to be litigated
– Bases for ranges will receive additional attention
– May be client pressure for wider (lower) ranges
– If reserve is near bottom of range, best estimate alone will be
disclosed
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New Actuarial Opinion Summary

5% of Surplus Test
Reserve Equivalent of 5% of Surplus
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Commercial Lines
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Personal Lines
Total Industry
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New Actuarial Opinion Summary

5% of Surplus Test
– Penalizes strengthening
– Constant 5% benchmark – inflation will have major impact
– Single test point: 5% in 3 of 5 years

No disclosure required for:
4th prior
(1%)
3rd prior
(2%)
2nd prior
(4%)
1st prior
(8%)
Current
(22%)
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Risk of Material Adverse Deviation

ASOP #36
3.3.3 Significant Risks and Uncertainties (Explanatory Paragraph) - When the actuary
reasonably believes that there are significant risks and uncertainties that could result in
material adverse deviation, the actuary should also include an explanatory paragraph in
the statement of actuarial opinion. (See sections 3.4 and 3.6.5 for guidance on
evaluating materiality and considering risks and uncertainties.) The explanatory
paragraph should contain the following:
a. the amount of adverse deviation that the actuary judges to be material with respect
to the statement of actuarial opinion; and
b. a description of the major factors or particular conditions underlying risks and
uncertainties that the actuary believes could result in material adverse deviation.
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Risk of Material Adverse Deviation

2005 Practice Note
– The actuary should include within the Actuarial Report some detail
on how the materiality threshold was chosen, including commentary
on what items were considered in choosing the threshold. In
addition, the Actuarial Report should include extended commentary
on the risks considered in the actuary’s determination of whether a
risk of material adverse deviation exists.
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Risk of Material Adverse Deviation

Materiality Threshold
– Possible factors to consider:






% of reserves
% of surplus
impact on income/earnings-per-share
impact on IRIS tests
impact on RBC
impact on Best’s or S&P ratings
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Risk of Material Adverse Deviation

Difficult Questions
– If the difference between the Appointed Actuary’s best estimate and
the booked reserve exceeds the materiality threshold, is that a prima
facie risk of material adverse deviation?
– Are there so many potential risks that the important ones are likely
to get lost in the boilerplate?
– How do you quantify effects of:



Adverse judicial decisions?
Future inflation?
Currency fluctuation?
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Some Suggestions for Consideration

Ownership of Reserve Estimate
– Company must select carried reserve before independent
Appointed Actuary estimates range (“untutored” reserve)
– If untutored reserve is within range it is reasonable
– If untutored reserve is below range, Appointed Actuary now “owns”
the estimate (is establishing reserve) and a clean opinion requires
reserve of at least AA’s best estimate
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Some Suggestions for Consideration

Disclosure of position within range
– If Appointed Actuary calculates range it should be disclosed
– If Appointed Actuary calculates best estimate it should be disclosed
– If Company has calculated range different from AA it should be
disclosed
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Some Suggestions for Consideration

Definition of “reasonable provision”
– Current ASOP #36 – “if it is within the actuary’s range of reasonable
reserve estimates”
– Proposed – “if it is greater than or equal to the best estimate of a
qualified actuary and it is within the opining actuary’s range of
reasonable estimates.”
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Some Suggestions for Consideration

Reserve Development Test
– Scrap the 5% in 3 of 5 test
– Development should be measured at equivalent point in range to
avoid penalty for strengthening
– Benchmark should reflect change in CPI
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Some Suggestions for Consideration

Risk of Material Adverse Deviation
– Universal risks should be enumerated and excluded from disclosure






Judicial interpretations
Retroactive legislation
Inflation
Currency fluctuation or revaluation
Theories of litigation
Emergence of previously unknown damage or disease
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Some Suggestions for Consideration

Ranges of Reasonable Estimates
– Avoid benchmarks based upon best estimate (i.e. ±x%)

Cannot assume every b.e. is at midpoint
– Experience-based studies should correct for general under-
estimation of ultimates

Widening the range tends to increase deficiency
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