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Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes. May 2006. Disclaimer. Views and opinions expressed in this presentation and the underlying paper are those of the authors.

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Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes

May 2006


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Disclaimer

  • Views and opinions expressed in this presentation and the underlying paper are those of the authors.

  • Needless to say then, they do not represent the opinions of the CAS, nor any employer of the presenters, nor any sponsors of the meeting.

  • Anyone who says otherwise is not only wrong, but is clearly itching for a fight.


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Sarbanes-Oxley Section 404 Internal Controls and Actuarial Processes

  • Background

  • COSO Framework

  • Scope for Actuarial Processes

  • Issues

    • Information Integrity & Availability

    • Analysis

    • End User Applications

    • Management’s Best Estimate

  • Documentation

  • Considerations by Size of Company

  • Status


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Comments by Harvey Pitt (SEC Chairman when SOX was Passed)

  • Question: How is SOX like the weather

  • Answer: Everyone talks about it, but no-one does anything about it

  • Quote from Mr. Pitt

  • “The statute was hastily – and, therefore, badly – drafted; but it was and remains, necessary

Source: Wall Street Journal, April 13, 2006


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Background


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Background

  • SOX Section 404 Company Requirements:

    • State management’s role in establishing and maintaining an adequate central structure and procedures for financial reporting;

    • Report on the effectiveness of their internal controls over financial reporting procedures

      • Including supporting documentation of controls, and testing of their effectiveness.

  • SOX Section 404 Auditor Requirements:

    • Attest to and report on management’s assessment of internal controls;

    • Attest to the effectiveness of internal controls.


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Background

  • Deficiency = situation arises where internal controls are identified as not effective

  • Responses

    • Identify and implement remediation steps

    • Evaluate seriousness of the deficiency


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The COSO Framework


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The COSO Framework

  • Committee of Sponsoring Organizations issued in 1992

    • AKA The Treadway Commission;

    • Provides a basic framework for all internal controls;

    • Implementers not required to use this framework– But most do.

  • What is the framework

    • Control Environment;

    • Risk Assessment;

    • Control Activities;

    • Information and Communication;

    • Monitoring.


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*Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors

Diagram of COSO Based Internal Control Structure


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Elements of COSO Based Internal Control Structure

*Presented with thanks to “Tone at the Top” published by the Institute of Internal Auditors


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Scope for Actuarial Processes


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Business Design

Underwriting Process

Product Rate Plan and Coverage

Underwriting Guides

Markets Targeted

Underwriting/Claims Transaction

Producer solicits/binds coverage, or policy renews

Policy expires and may be renewed or audited

Underwriter verifies risk acceptability and price

Claims are received or estimated

Property/Casualty Insurance Operations Chain:

Policy is submitted to Underwriter

Transactional Data Systems

Resulting Financial Flows

Underwriting Expenses result

Premiums Written and Earned

Losses received, recorded, estimated

13


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Business Design

Underwriting Process

Product Rate Plan and Coverage

Underwriting Guides

Markets Targeted

Underwriting/Claims Transaction

Producer solicits/binds coverage, or policy renews

Policy expires and may be renewed or audited

Underwriter verifies risk acceptability and price

Claims are received or estimated

Policy is submitted to Underwriter

Traditional Financial Statement Audit Focus

Transactional Data Systems

Resulting Financial Flows

Underwriting Expenses result

Premiums Written and Earned

Losses received, recorded, estimated

Property/Casualty Insurance Operations Chain:

14


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Business Design

Underwriting Process

Markets Targeted

Product Rate Plan and Coverage

Underwriting Guides

Underwriting/Claims Transaction

Producer solicits/binds coverage, or policy renews

Policy expires and may be renewed or audited

Property/Casualty Insurance Internal Controls affecting Estimated Balance Sheet and Income Statement Items

Underwriter verifies risk acceptability and price

Claims are received or estimated

Policy is submitted to Underwriter

Transactional Data Systems

Additional Focus Areas for Internal Controls

Resulting Financial Flows

Underwriting Expenses result

Premiums Written and Earned

Losses received, recorded, estimated

15


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Estimated Balances Must Properly Reflect the Following Company Operations

Source A

Company

Risk Assumption/

Underwriting

Practices

Information and Communication

Source B

Source C

Perform

Estimates

and Analysis

Company IT/

Data Design and

Collection Process

Review and

Communication

Process

Committee

Process

Input into

Accounting

System

& Review

Source Z

Company

Claims

Handling and

Settlement

Practices

Information and Communication


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Estimated Balances Must Properly Reflect the Following Company Operations

Source A

Company

Risk Assumption/

Underwriting

Practices

Information and Communication

Source B

Source C

Perform

Estimates

and Analysis

Company IT/

Data Design and

Collection Process

Review and

Communication

Process

Committee

Process

Input into

Accounting

System

& Review

Source Z

Company

Claims

Handling and

Settlement

Practices

Information and Communication

Underwriting and Claims

Management Review Process

Analysis

Data


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Comments on Operational Internal Controls and Sarbanes-Oxley, Section 404

  • AICPA gives guidance as to how Sarbanes-Oxley applies to Internal controls in operational areas

    • Only controls which affect financial statement reporting are subject to Sarbanes-Oxley;

    • Includes items with significant input to financial reporting;

    • Should be taken to include disclosures.

  • Examples and the AICPA guidance are in the following table.


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Operational Controls; Management Responsibility Contrasted with Section 404 Goals


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Industry Track Record


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Industry Track Record


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Information Integrity and Availability


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Management Review Process

Analysis

Data

Underwriting and Claims

Information Integrity and Availability

  • Data

  • Controls to ensure data is accurate and complete

  • Data is available to enable comprehensive analysis

  • Data is available to monitor compliance with Claims and Underwriting controls

  • Data is available to support management review needs, including tracking of trends


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Management Review Process

Analysis

Data

Underwriting & Claims

Control Activities, Information and Communication, Monitoring

Data

  • Quantitative Data:

    • Verify information is entered timely and accurately and available to management and analysts to make estimates;

    • Review reconciliation procedures used to discover processing or data errors; investigation process in place when discrepancies arise?

    • Review the edit process used to ensure correctness of operational data for use by management in breakdowns required for analysis, such as class of business, coverages granted;

    • Verify that data elements are coded and reported in the detail required to support critical analysis needs (losses, expenses, claim counts, premium, etc.);

    • Identify and review new impact events, such as new products and regulations, and determine if appropriate data is being gathered;

    • Validate the compilation and availability of cost trend information underlying the financial estimates.

Completeness

Accuracy

Judgmental Areas


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Management Review Process

Analysis

Data

Underwriting & Claims

Control Activities, Information and Communication, Monitoring

Data

  • Qualitative Data:

    • Capture interaction with claims department;

    • Capture interaction with underwriting department;

    • Verify that information gained from such interactions are manifested within actuarial analysis in an appropriate manner;

    • For companies with multiple business units, ensure that information is interpreted and used consistently across business units.

Completeness

Accuracy

Judgmental Areas


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Analysis


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Management Review Process

Analysis

Data

Underwriting and Claims

Actuarial Analysis

  • Analysis

  • Access to data is sufficiently convenient to analysts

  • Available information is incorporated in analysis

  • Communication process with underwriting, claims, management is sufficient

  • Appropriate methods are used

  • Communication of results to management is clear


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Management Review Process

Analysis

Data

Underwriting & Claims

Control Activities, Information and Communication, Monitoring

Analysis

  • Validate that the estimation process encompasses sufficiently broad technical analytics for the business written;

  • Verify that information from the internal operating environment (underwriting, claims) is used to support and validate estimates, including consideration of large losses;

  • Review the segmentation of the business into lines of review, and the controls in place to ensure the business in each segment is correctly understood and reflected in estimates;

  • Verify that external trends and changes are identified, and incorporated into the analysis;

  • Review the process used to keep estimates current between review dates (currency of data relative to financial statement date);

  • Review the process followed to validate estimates with functional management;

  • Validate that the considerations in the CAS and AAA guidance are followed and documented.

Completeness

Accuracy

Judgmental Areas

Peer Review !


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End User Applications


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End User Applications

  • Spreadsheets, databases, word documents,….

  • One of the most problematic pieces of control documentation

  • Relevant literature; PwC publication “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley Act”

  • There is a group dedicated to spreadsheet risks, lots of stories available

    • See Website http://www.eusprig.org/stories.htm

  • University of Hawaii research that error rates on spreadsheets near 90%

    • And this goes near 100% if more than 200 lines


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Priority of Spreadsheet Controls

Source: “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley Act

Available at www.Pwcglobal.com


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What Controls to Consider

  • Backups

  • Archiving

  • Security

    • Controls over Access

  • Change Control and Version Control

    • Such as Formula Locking

  • Baselining – In depth review of calculations and functions

  • Internal Data Reconciliations

  • Peer Review – Sometimes outside the chain of reporting

  • Documentation


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Management’s Best Estimate vs. Actuarial Best Estimate


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Management Review Process

Analysis

Data

Underwriting and Claims

Management’s Best Estimate vs. Actuarial Best Estimate

  • Management Review Process

  • Process to determine booked reserves is reasonable

  • Reserve Committee and management review is effective

  • Underlying assumptions, such as trends, are validated


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Management Review Process

Analysis

Data

Underwriting & Claims

Control Activities, Information and Communication, Monitoring

Management ReviewProcess

  • Review the process to determine carried reserves from the analysis and indications;

  • Review the reserve committee process and minutes to ensure proper management control, involvement, and review in the estimating process;

  • Review controls to ensure the estimate selection process is consistent with the outcome of the underlying estimates, or reasons for departure are documented – including quantification of reasons;

  • Verify controls are in place to validate the underlying assumptions in the estimating process are consistent with the observations of functional management;

  • Review the process to reconcile the estimates with the underlying trends.

Completeness

Accuracy

Judgmental Areas


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Management Review Process

Analysis

Data

Underwriting & Claims

Control Activities, Information and Communication, Monitoring

Management ReviewProcess

  • Reserve Committee Process (best practices)

    • Charter spelling out charge and operation of Committee;

    • Participation by Senior Management, Finance, Claims, Underwriting, Actuarial;

    • Access to a well documented actuarial estimate and range prepared prior to the Committee meeting;

    • Active questioning by Committee;

    • Well documented outcome of Committee meetings, including approved reserve amount;

    • Documentation of differences between management’s best estimate and actuarial best estimate.

Completeness

Accuracy

Judgmental Areas


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Documentation Issues


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Documentation

  • While SOX has changed the documentation commonly used in Actuarial work, Accounting documentation requirements are similar to common standards prior to SOX.

  • Most Common Pitfalls

    • Controls should be specific

      • What is the control?, who performs?, who reviews?, what is the documentation?, how often?, where maintained?

    • Informal processes do not fully replace controls;

    • Conservatism doesn’t take the place of controls;

    • Lack of misstatement in the past doesn’t obviate the need for controls.


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Documentation (continued)

  • Most Common Pitfalls

    • Controls over reserves usually just at year end, but release of results to markets quarterly;

    • Controls over processes with significant input to financial statement balances missing;

    • “Common knowledge” instead of rigorous analysis;

    • Considering the auditor as part of the control process;

    • Forgetting controls over significant actuarial balances other than reserves.


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Considerations by Size of Company


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Considerations by Size of Company

  • All companies need to weight costs and benefits associated with implementation of SOX 404. Management may consider some deficiencies acceptable relative to costs associated with remediation.

  • Larger companies generally have the actuarial resources to implement internal controls effectively.

  • Smaller companies likely have resource constraints, most apparently relative to peer review.

    • Third party actuarial analysis;

    • Thorough review (and documentation) of reserves by all professionals in the organization that would be best versed in reasonability of reserves --- senior claims, underwriting, and finance management.


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Status of Implementation


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Status – Recent Events

  • For most large domestic entities; Implemented 2004

  • Large foreign filers; Implementation in 2006

  • NAIC considering statutory rules

    • Current form would affect large entities, newly impacting about 190 Companies;

    • Proposed effective for 2009;

    • No external audit requirement.

  • Canadian Securities Administrator has proposed SOX type requirements

    • No external audit requirement.


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