Actuaries Supporting the Financial Audit:

Independence Issues and the Impact of the Sarbanes-Oxley Act

Mike Grillaert, PartnerCasualty Loss Reserve Seminar

September 24, 2002

Overview of Presentation

Provisions of the Sarbanes-Oxley Act:

– New oversight board

– Changes to certain professional standards

– Audit partner rotation

– Conflicts of interest

– Duties of audit committees

– Management’s assessment of internal controls

– Non-audit services

Standards

Board not responsible for accounting standards

Expected that the SEC and the Board will initially adopt current standards – including the SEC independence rules

Significant guidance on the new provisions of the Act will need to be released in the form of regulations and interpretations

Department of Justice will provide guidance concerning matters that fall under criminal law

To which clients does Sarbanes-Oxley apply?

The Act applies to “Issuers”, and it defines Issuer as follows:– The term “issuer” means an issuer, the securities of which

are registered under section 12 of that Act, or that is required to file reports under section 15(d), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933, and that it has not withdrawn.

This does include foreign registrants We believe that the current definitions in the SEC

rules for affiliates will continue to apply to the independence provisions of the Act.

Effective Dates

7/30/02 10/28/02 1/26/03 4/26/03 10/23/03

Board members in place within 90 days of law Board must be functional on or before 270 days* of law Audit firms registered on or before 180 days* after SEC

determines that Board is functional Non-audit services provisions effective 180 days* after SEC

determines that Board is functional

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Conflicts of Interest

The Act prohibits registered public accounting firms from auditing issuers whose CEO, CFO, or chief accounting officer (or equivalent positions):– was employed by the accounting firm, and– participated in the audit of the issuer in any

capacity

during the one year period prior to the initiation of the audit

Duties of Audit Committees

Audit Committee is “directly responsible for the appointment, compensation and oversight” of the auditor– Auditor reports directly to the audit committee

Act establishes independence definition for audit committee members– No fees to members other than for board service– May not be an “affiliated person” of the issuer or any

subsidiary

SEC to require disclosure that the audit committee has at least one financial expert, or if not, why not

Audit Committee Financial Expert

Financial expert to be defined by the SEC considering the following elements– Public Accountant or Auditor– CFO, Controller, CAO or similar– Understanding of GAAP and financial statements– Experience in

• Preparation or auditing of financial statements of similar issuers

• Accounting for estimates, accruals and reserves

• Internal controls

– An understanding of Audit Committee functions

Management’s Assessment of Internal Control

The Act requires that an issuer’s annual report contain a report from management on internal control

External auditor required to attest to management’s assertion concerning its assessment of internal control as part of audit

What are Non-Audit Services under the Act?

Sarbanes-Oxley includes a definition of “non-audit services”, as follows:

– The term “non-audit services” means any professional services provided to an issuer by a registered public accounting firm, other than those provided to an issuer in connection with an audit or a review of the financial statements of an issuer.” (emphasis added)

Act has the force of “law” – makes it “unlawful” to do certain things – including providing certain “non-audit services” to an issuer

Non-Audit Services – Prohibited Activities

The Act identifies eight categories of “Prohibited Activities”– Bookkeeping and related services– Financial information systems– Appraisals & valuations– Actuarial services– Internal audit outsourcing– Management functions or human resources– Broker, dealer or investment advisor services– Legal services & expert services

In addition, the Board may adopt regulations prohibiting other services

Actuarial Services

“Actuarial Services” are not defined in the Act. SEC is charged with developing implementation rules

for the Act within 180 days of July 31. 60 day comment period.

Current SEC rules already define “actuarial services”. No changes are anticipated.

In the event of a change, it would not be effective until 2003 or later.

Preapproval of Services

Act requires pre-approval of audit and “other non-audit services” by the audit committee

We believe that where XYZ CPA Firm is providing auditing services, the services of all XYZ member firms are included

Audit committees may delegate preapproval to one or more independent members, however the full committee needs to approve at the next scheduled meeting

Non-audit Services Disclosure Requirement

The Act requires Audit Committees to disclose all approved non-audit services to be performed by the auditor to investors in periodic reports required by section 13(a) (i.e. 10-K & 10-Qs)

May be annual or more frequent – depending on Board’s interpretation

Appraisals & Valuations

Current Rules Sarbanes-Oxley

Not permitted if amounts are material to f/s or if results will be audited

??

Contribution-in-kind reports may be permitted (case-by-case basis)

Specifically included in the law; ??

Fairness opinions not permitted

No change

Actuarial Services

Current Rules Sarbanes-Oxley

Generally prohibited for insurance company reserves and related accounts

No change

May assist management in other cases/situations

No change

Employee benefit information generally permitted

??

Questions?

The Current Role of Actuary on the Audit

Terrence M. O’BrienPrincipal

PricewaterhouseCoopers LLP

Actuaries Supporting the Financial Audit

CLRS – September 23, 2002

Policies and Practices

Actuarial involvement on insurance entities has evolved from– In-house resource on select companies and issues– Recommended involvement with responsibility for

reserves– Required involvement with responsibility for contingent

liabilities and assets

Actuary is charged with responsibility to sign off on reserves

If actuary determines that reserves are outside an acceptable range, the issue is submitted to consultation

Policies and Practices

Recommended reliance on an actuary to identify and evaluated self-insured liabilities for non-insurance enterprises is limited to clients with certain features or larger clients

– Self insured losses– Deductible losses– Retrospective premiums – Exhaustion of coverage issues– Asbestos or pollution liabilities

Entities Covered by Policy for Insurers

Property & Casualty insurers Enterprises with captive insurance entities Non-insurance entities that have subsidiaries

that write third-party insurance coverage Blue Cross/Blue Shield organizations Life insurance entities that write accident and

health policies Other entities underwriting short-duration

contracts

Covered Items

Assets and liabilities that:– Relate to insured risks– Involve future contingent events– Are not subject to precise determination

Liabilities for Unpaid Loss and Loss Expenses

Typically the most significant item

The approach to testing reserves may vary by client– Review of client’s methodology– Sensitivity testing based on client

methodology– Independent development of a

corroborative range

Reinsurance Reserves

Approach to reserves is the same for direct or net reserves– Review of client’s methodology– Sensitivity testing based on client

methodology– Independent development of a

corroborative range

Reinsurance Policy Structure Issues

Assessment of transfer of risk

Interpretation of contract language and review of the associated accounting

Return Premiums under Retrospectively Rated Policies

Many companies develop return or additional premiums on an account level

Reserves reflect development of losses and specific provisions of the account’s program

Certain policyholder dividend reserves are developed in the same fashion

Computation of Premium Deficiencies

Under codification premium deficiencies are now required for statutory accounting

Deferred acquisition costs require a test of recoverability based on the profitability of the relevant segment of business

Often the most critical issue is the proper grouping of business into segments based on how business is sold and serviced

Reserves for Contingent Commissions

Contingent Commission arrangements may vary over time and by class of agent

While sensitive to loss, amounts may not vary directly with losses

Premium Reserves

Unearned premium reserves not based on pro rata calculations

Primarily warranty related policies with terms greater than 12 months– Requires the projection of future losses under

inforce policies– GAAP and Statutory may differ

Earned but unreported premiums– Variance in premium projections usually drives an

associated variance in loss and LAE reserves

Future Policy Benefits

May be relevant for discontinued lines of business

Expansion of the Actuary’s Role on the Audit Team

Actuaries Supporting the Financial Audit

CLRS – September 23, 2002

Jan Lommele, FCAS, MAAAPrincipal

Expansion of the Actuary’s RoleOn the Audit Team

Review of Actuary’s Current Role– Participate on audits with material

insurance balance sheet or other financial statement items

– Provide specialist “opinion” relating to loss reserve estimates

Deep quantitative skill set

Expansion of the Actuary’s RoleOn the Audit Team

Actuaries are a valuable addition to an audit team – the benefits of their knowledge and experience translate

into value added audit services for our clients

Client

• Data “gurus”• Additional analytics• Modeling capability

• Industry benchmarking• Current events• Best practices• Early indication of problem areas

• Insurance programs • Current litigation

Specialized knowledge of insurance and insurance products

Risk assessment capability

Audit Team

Expansion of the Actuary’s RoleOn the Audit Team

In addition to loss reserves, there are a number of balance sheet areas where actuarial involvement may be beneficial

Insurance Company Audits

Assets Liabilities

Goodwill asset

ALM/asset duration

Capital Adequacy – RBC

Unearned premium reserves

Anticipated S&S

Premium deficiency reserves

Insurance Company Audits – Other Items FAS 113 – risk transfer Review of reinsurance/retention levels Financial modeling (output and appropriateness of) Reinsurance collectibility Subsequent events EBUB Premium revenue recognition

Expansion of the Actuary’s RoleOn the Audit Team

Balance sheet items– Loss reserves– Discounting – Retrospective premium reserves– Risk margins

Other items

Expansion of the Actuary’s RoleOn the Audit Team

Actuarial participation not limited to insurance company audits……

Non Insurance Company Audits

Insurance costs Review of alternative risk structures/financing Data issues Policy language Identification of unique exposures and

risk assessment Confidence intervals/reserve position in range

Expansion of the Actuary’s RoleOn the Audit Team

Non Insurance Company Audits – other items

Expansion of the Actuary’s RoleOn the Audit Team

Examples of “non traditional” services provided to audit teams

Modeling

Credit Reform – CF Models

Review of insurance premiums charged by government contractors

Income Tax Issues

Expansion of the Actuary’s RoleOn the Audit Team

Your (and the audit teams’) awareness of accounting literature/ASB21/current events

Get clarity around scope (timing, fees, etc.) For non-insurance companies – determine audit expertise

around insurance Awareness of any potential independence issues Future scope of audit

? Other Things to Think About?