February 2001 Actuarial Review - Discounting Reserves with Insufficient Assets

Ethical Issues Forum
Discounting Reserves with Insufficient Assets
by David J. Otto

Editor's Note: This article is part of a series written by members of the CAS Committee on Professionalism Education (COPE) and the Actuarial Board of Counseling and Discipline (ABCD). The opinions expressed by readers and authors are for discussion purposes only and should not be used to prejudge the disposition of any actual case or modify published professional standards as they may apply in real-life situations.
The Lack of Surplus Fund (Fund) was established five years ago to provide a medical malpractice self-insurance program for participating members of the Hospital Association. John D. Actuary, a consulting actuary, has been hired by the Fund to provide an actuarial estimate of the Fund's liabilities. The Fund intends to book John's loss reserve estimate in its financial statement.
Over the past few years, the Fund has operated in a deficit position (i.e., assets are insufficient to cover liabilities). As of the end of this year, John estimates the Fund's undiscounted loss reserves at $100 million. The Fund's corresponding assets are only $35 million.
Fund management has asked John to provide his loss reserve estimate on a discounted basis. John is concerned about discounting the loss reserves to present value because the Fund clearly does not have enough assets to generate the investment income needed to cover any projected investment return.
Can John produce a report to management presenting the needed loss reserves on a discounted basis?
Yes

Actuaries providing loss reserve estimates are not required to incorporate an analysis of assets. According to comments contained in the transmittal memorandum of Actuarial Standard of Practice (ASOP) No. 20, Discounting of Property and Casualty Loss Adjustment Expense Reserves, page vii, the subcommittee "agreed that valuation calculations may be unrealistically burdensome in a reserving context." Since the scope of John's assignment did not include an analysis of assets, he is not in the position to opine on the Fund's financial condition.
John intends to include a disclaimer in his report stating: "I have not examined the assets underlying the liabilities and have formed no opinion as to the validity or value of those assets."
John believes disclaimers such as this allow him to accommodate the client's request and provide adequate warning to the reader of the report regarding discounting issues.
Reserve estimates also should be able to stand on their own, regardless of the Fund's retained assets. Reserve estimates are often presented in terms of a "market value" by using a risk-adjusted discount rate independent of the unique characteristics of the Fund's assets. According to ASOP No. 20: "The selected interest rates may reflect the time value of money without particular reference to assets (see 5.4.1) or may be based on the investment return from a particular portfolio (see 5.4.3)."
No

It would be inappropriate for John to discount the loss reserves. Principle 1 of the Statements of Principles Regarding Property and Casualty Loss and Loss Adjustment Expense Reserves states: "An actuarially sound loss reserve…is a provision based on estimates derived from reasonable assumptions and appropriate actuarial methods…." It is unreasonable to assume the Fund's liabilities are backed by valid assets and there is no cash flow problem—especially since John is aware this is not the case.
This position is further supported in the ASOP No. 20, Section 5.1, which states: "The actuary should be aware of the context in which the discounted reserves are to be used. The actuary should use assumptions and methodology in the discounting process that are appropriate for that context."
Also, John should not discount reserves for use in the financial statement because the Fund's financial condition would be presented in a manner that is misleading. Precept 8 of the Code of Professional Conduct states: "An Actuary who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties."
Finally, the disclaimer suggested above, in favor of discounting, is unacceptable because it will warn only the most informed reader. Besides, a disclaimer's intended use is not to allow the actuary to perform services known to be inappropriate. Actions such as this do not help the actuarial profession fulfill its responsibility to the public.