Actuaries Supporting the Financial Audit: Independence Issues and the Impact of the Sarbanes-Oxley Act

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Actuaries Supporting the Financial
AuditIndependence Issues and the Impact of the
Sarbanes-Oxley Act
Mike Grillaert, Partner Casualty Loss Reserve
Seminar September 24, 2002
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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
• Managements assessment of internal controls
• Non-audit services

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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

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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  that it has not withdrawn.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.

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Effective Dates

• 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

Firm registrations Non-audit svcs effective
Board functional
SEC regs. on Independence
Board named
Law signed
7/30/02 10/28/02 1/26/03
4/26/03 10/23/03
Outside limits
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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

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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

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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

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Managements Assessment of Internal Control

• The Act requires that an issuers annual report
  contain a report from management on internal
  control
• External auditor required to attest to
  managements assertion concerning its assessment
  of internal control as part of audit

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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

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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

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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.

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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

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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
  Boards interpretation

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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
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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 ??
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Questions?
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The Current Role of Actuary on the Audit
Actuaries Supporting the Financial Audit CLRS
September 23, 2002

• Terrence M. OBrien
• Principal
• PricewaterhouseCoopers LLP

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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

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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

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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

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Covered Items

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

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Liabilities for Unpaid Loss and Loss Expenses

• Typically the most significant item
• The approach to testing reserves may vary by
  client
• Review of clients methodology
• Sensitivity testing based on client methodology
• Independent development of a corroborative
  range

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Reinsurance Reserves

• Approach to reserves is the same for direct or
  net reserves
• Review of clients methodology
• Sensitivity testing based on client
  methodology
• Independent development of a corroborative
  range

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Reinsurance Policy Structure Issues

• Assessment of transfer of risk
• Interpretation of contract language and review of
  the associated accounting

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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 accounts program
• Certain policyholder dividend reserves are
  developed in the same fashion

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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

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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

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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

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Future Policy Benefits

• May be relevant for discontinued lines of
  business

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Expansion of the Actuarys Role on the Audit Team

• Actuaries Supporting the Financial Audit
• CLRS September 23, 2002

Jan Lommele, FCAS, MAAA Principal
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Expansion of the Actuarys RoleOn the Audit Team

• Review of Actuarys Current Role
• Participate on audits with material insurance
  balance sheet or other financial statement items
• Provide specialist opinion relating to loss
  reserve estimates

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Expansion of the Actuarys 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
Audit Team
Deep quantitative skill set

• Data gurus
• Additional analytics
• Modeling capability

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

Specialized knowledge of insurance and insurance
products

• Insurance programs
• Current litigation

Risk assessment capability
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Expansion of the Actuarys RoleOn the Audit Team
Insurance Company Audits
In addition to loss reserves, there are a number
of balance sheet areas where actuarial
involvement may be beneficial
Assets
Liabilities
Goodwill asset ALM/asset duration Capital
Adequacy RBC
Unearned premium reserves Anticipated
SS Premium deficiency reserves
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Expansion of the Actuarys RoleOn the Audit Team

• 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

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Expansion of the Actuarys RoleOn the Audit Team
Non Insurance Company Audits
Actuarial participation not limited to insurance
company audits

• Balance sheet items
• Loss reserves
• Discounting
• Retrospective premium reserves
• Risk margins
• Other items

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Expansion of the Actuarys RoleOn the Audit Team
Non Insurance Company Audits other items

• 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

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Expansion of the Actuarys 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
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Expansion of the Actuarys RoleOn the Audit Team
? Other Things to Think About?

• 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