How (and Why) to Read a Statement of Actuarial Opinion
What is this document, and should you read it?
Author: Grover M. Edie, MBA, FCAS, MAAA, CPCU, ARP, CERA, ARM
Consulting Actuary, Huggins Actuarial Services, Inc.
What is it?
The National Association of Insurance Commissioners (“NAIC”) requires that a qualified actuary issue a statement of opinion on certain reserves included in the annual financial statement of an insurance company. It is a prescribed document, required by statute, that provides important information to state regulators. That document is also required to be available to members of the Board of Directors.
Why should you read it?
Loss and Loss Expense Reserves are usually the largest liabilities listed on an insurance company’s balance sheet. These reserves are the amounts set aside to pay for claims and their expenses that have already happened and for which the company is obligated to pay, whether they have been reported to the company or not.
These reserves consist of two components. The first are the case reserves, which are estimates of the ultimate unpaid costs for each reported claim, as posted by claims adjusters or through another means, such as a formula reserve.
The second component of the loss and loss expense reserves are labeled “Bulk and IBNR” reserves in the annual statement. They do not apply to specific claims, and are calculated using statistics, models, and other means.
A high percentage of property/casualty insurance company insolvencies have been due to the inadequacy of their loss and loss adjustment expense reserves. Each state now requires that a qualified actuary attest to the reasonableness of these reserves in what is called the “Statement of Actuarial Opinion” (“SAO”). It is frequently referred to as the “Opinion.”
If you are on the board of an insurance company, you should read the SAO.
Navigating the SAO
The main components of the SAO are prescribed by the NAIC:
- Identification,
- Scope,
- Opinion,
- Relevant Comments and
- Exhibits A and B.
Identification
This paragraph should identify the actuary issuing the opinion and their relationship with the Company, their qualifications for acting as appointed actuary, their date of appointment and specify that the appointment was made by the Board of Directors.
Scope
This section should identify both the reserve items upon which the appointed actuary is providing an opinion and also a description of the nature of those reserves, such as (1) whether the reserves are nominal or discounted, (2) whether the reserves includes an explicit risk margin, and (3) whether the reserves are gross or net of specified recoverables. This section also discusses who prepared the data used in the actuary’s analysis and whether that data was reconciled to Schedule P, Part 1 of the Company’s current Annual Statement.
Opinion
This short section is the central feature of the SAO. Of critical importance is whether or not the opinion is “clean”.”
A clean opinion states that the loss reserves:
- Meet the requirements of the domiciliary state;
- Are consistent with reserves computed with accepted loss reserving standards and principles; and
- Make a reasonable provision in the aggregate for all unpaid loss and loss adjustment expense obligations of the Company under the terms of its contracts and agreements.
The first two items are rarely an issue; it is the third point that usually prompts the question. In a sense, a “clean” opinion is saying that in the actuary’s opinion, the booked loss and loss expense reserves are reasonable.
The alternatives to a “clean” opinion are generally not good, and are outlined below:
A Qualified opinion happens when the reserves for a certain item or items are in question; either they cannot be reasonably estimated, or the actuary is unable to render an opinion on those specific items.
A Deficient or Inadequate Opinion occurs when the carried reserve amount is less than the minimum amount believed to be reasonable. The appointed actuary will state that the carried reserves do not make a reasonable provision for the unpaid loss and loss adjustment expense obligations of the Company.
A Redundant or Excessive Opinion is rare and occurs when the carried reserves are greater than the maximum amount believed by the appointed actuary to be reasonable. In this situation, the actuary issues a redundant opinion.
A No Opinion is another rare rendering. The actuary’s ability to give an opinion is dependent upon data, analyses, assumptions, and related information deemed sufficient to support a conclusion. If the actuary cannot reach a conclusion due to deficiencies or limitations with this information, he/she may issue a statement of “No Opinion” which should include a statement as to why no opinion could be given.
Relevant Comments
The appointed actuary must provide RELEVANT COMMENT paragraphs to address the certain topics of regulatory importance. This section starts with a listing of the Company-Specific Risk Factors, which lists the risks that expose the Company’s reserves to variability. The lack of items in this section does not mean the company is not subject to risk.
This is where you would find the actuary’s comments about the impact of COVID-19, the potential impact of legislative decisions, the potential for claim payments in excess of policy limits, comments concerning the long tail nature of the coverage provided, observations concerning concentrations of business in a single line or limited number of states, or other items of concern to the actuary.
The next section, “Risk of Material Adverse Deviation,” answers three important questions:
- Is there a risk of a material adverse deviation (i.e., divergence) from the loss and loss expense reserves booked?
- When is this deviation considered “material?”
- What are the sources of these deviations?
In other words, “How big does an issue have to be financially before there is a concern?” and “How did the actuary come up with that number?”
An indication that there are one or more items that pose a risk of material adverse deviation may or may not be a cause for concern. Conversely, the absence of a significant risk of material adverse deviation does not imply that additional factors will not be identified in the future as having a significant influence on the company’s reserves; it is a statement concerning a point in time.
While the interest in Asbestos Exposures and Environmental Exposures has waned in recent years, these can still represent a significant exposure to the company. These are addressed in the section bearing that title.
Most companies do not write policies with durations over thirteen months, but the section titled Disclosure of Unearned Premium Reserves for Long Duration Contracts will provide information to that effect.
The Reinsurance Collectability section provides information pertaining to the likelihood of the company’s ability to collect on its reinsurance. While the actuary’s comments do not imply an opinion as to the financial stability of any of the reinsurers, it should include information from management regarding any collectability problems the company has encountered with its reinsurers. Publicly available information and the reinsurers’ ratings provided by a rating agency are used by the actuary to reach his/her conclusion.
The NAIC has a series of mathematical formulas, or “NAIC IRIS Tests,” that are applied to various Annual Statement entries. Of the thirteen formulas, the last three, Tests 11, 12 and 13, concern the booked loss and loss expense reserves. The actuary is required to look at these tests and comment on any that fall outside the range of acceptance: i.e., they “fail” the test.
If the company fails any of these tests, the appointed actuary will provide a narrative as to why and comment on the level of importance of this failure.
The narrative portion of the SAO ends with the actuary’s signature and contact information.
Exhibits A and B provide information “at a glance” for the regulator.
In summary, the SAO should answer the following:
- Is the opinion qualified or unqualified (i.e., “Clean”)?
- How financially large does a deviation need to be to pose a material risk to the finances of the company, and are there any such risks?
- Did the company fail any IRIS Tests? And if so, why?
Authored by:
Grover M. Edie, MBA, FCAS, MAAA, CPCU, ARP, CERA, ARM
Consulting Actuary
Huggins Actuarial Services, Inc.
