When a company begins the due diligence process for acquiring another entity, several actuarial factors must be considered. For risk related specifically to property and casualty, the main question needing to be answered pertains to the actual liabilities being acquired and how accurately they are being estimated. When the target company has maintained insurance programs involving large deductibles, self-insured retentions, captive insurance programs, or retro programs, the financial statements for the their associated liabilities should contain an amount for required reserves as determined by an actuary. The acquisition due diligence process should therefore ensure these liabilities are appropriately priced in the deal. However, reality doesn’t always allow for this process. Time may be short, the data may not be clean, or historical insurance programs may be unclear and complex. With this in mind, we have developed a checklist that should provide some guidance in evaluating these liabilities.i
- Determine if a prior actuarial report has been completed for the entity being acquired. If so, the review can be faster and easier, especially if the date of the report does not differ significantly from the acquisition date. The report may also contain summaries of retentions and policy coverage for historical periods. In some cases, an independent review of the actuarial report may be sufficient in lieu of a full independent analysis. It is important to verify that the actuarial report was completed by a credentialed actuary in a firm independent from the target company.
- Create a matrix by year and by risk of the retained loss exposure. This summary should indicate the type of retained losses (self-insured retention, large deductible, retro plan, etc.) and the amount of retained losses on a per occurrence and aggregate basis.
- Determine if there is a tail liability exposure on any claims-made policies. Tail liability refers to claims that may be reported after an evaluation date but occurring prior to the evaluation date. Failure to identify claims-made tail exposure can lead to a significant understatement of liability. Claims-made coverage only covers claims made (reported) during the actual policy period, so there may be unfunded liability for claims that have already occurred but not yet been reported. Since there is no insurance in place for claims that may be reported after the current policy terminates, they are effectively being retained on an unlimited basis. This liability should therefore be examined and subsequently reflected on the financial statements.
- Determine how retained allocated loss adjustment expenses (ALAE) are treated and affect the retained liability by year and by risk, as certain risks can have significant ALAE exposure. If ALAE is in addition to the retention or on a pro-rata basis, the actual retained losses on any claim could be significantly greater than the stated per occurrence retention.
- Analyze any liabilities handled in a captive insurance company. Review the financials and statement of actuarial opinion for the captive. Then, verify the amount of surplus or shareholder equity and review any actuarial opinion comments related to potential material adverse deviation.
- Review the liabilities associated with the risk on a gross (or unlimited) basis. The gross liabilities minus potential insurance receivables should therefore equal the net retained liabilities. As part of this process, the insurance receivables should be reviewed to determine if there are any collectability issues.
- Review the program structure to determine if there are any other topics or issues that require further review. This possibly includes retro plans and the status of those plans, collateral issues, and warranty risks.
- Review internal procedural or systemic changes that may affect the retained liabilities. These may include changes in: claims administrators, reserving philosophy, safety programs, hiring programs, geographical exposure to risk, employee job demographics, etc.
- Consult with an independent actuary. This may involve either a review of the company’s current actuarial report or a full independent analysis. If a full analysis is needed, the collected information will flow into the analysis with current loss and exposure information. Ask the actuary to compare the results to the company’s prior actuarial report and highlight key differences.
It is not uncommon for liabilities to be significantly greater than initially thought due to unfunded risks, unknown risks, or understated valuations. In addition, liabilities could change significantly, even in a short period of time – therefore, a final review should take place as near to the close date as possible.
We welcome your feedback by posting a comment, or contacting Michelle Bradley at mb@SIGMAactuary.com.
© SIGMA Actuarial Consulting Group, Inc.
The term often used to describe these acquired liabilities is “required reserves”. The required reserves are comprised of the case reserves (set by claims adjusters on the loss run) and IBNR (incurred but not reported losses). IBNR losses normally include the potential for late reported claims as well as development on case reserves over time. The required reserves can be discussed on both a gross (before any insurance) or net/retained (after insurance) basis.