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					The Actuary’s Role in Due Diligence
      The Consultant’s Perspective

        Presented at the CAS Annual Meeting
                  Washington, DC
                   November 2000

           Gail M. Ross, FCAS, MAAA
             Am-Re Consultants, Inc.
Presentation Overview
Actuary’s Involvement In:
 Pre-Due Diligence
   Sell Side
   Buy Side
 Due Diligence
   Buy Side
   Sell Side
 Common Theme
Pre-Due Diligence - Sell Side

Case Study:
Seller - small privately held single state, mono-line carrier
Buyer - regional multi-line carrier

Buyer approached Seller stating their interest in acquiring
them. Initial offer of 1.5 times book value.

Seller was very interested but felt they needed help prior to

Pre-Due Diligence - Sell Side
Actuary’s Involvement In Providing
Assistance to Seller:

 Operational Review

 Valuation

Pre-Due Diligence - Sell Side
 Operational Review
  Actuaries worked in conjunction with
   specialists from other functional disciplines.
  Goal was to determine Seller’s operational
   areas of strength and weakness.
  Based on findings, Seller implemented certain
   operational changes which ultimately enhanced
   its value.

Pre-Due Diligence - Sell Side
 Operational Review
  Claims consultants recommended changes in
   two major areas:
    • Seller had poor medical cost containment controls
      and changes were recommended in the areas of bill
      review and nurse case management.
    • Staffing was too low resulting in case loads being
      too high. By adding to staff, adjusters would be able
      to be more proactive in settling claims and use of
      outside adjusters could be reduced (lowering ALAE)
Pre-Due Diligence - Sell Side
 Operational Review
  Underwriters also recommended changes in
   two areas:
     • Commission levels were unnecessarily higher than
       the market.
     • Underwriting controls were in place but not being
       followed resulting in acceptance of high exposure
  Actuaries quantified the impact of changes in
   these areas on future loss, LAE and expense
   ratios.                                                 7
Pre-Due Diligence - Sell Side
 Valuation
  Seller knew the book value of their company
   but did not know what range of values the
   market (and in particular, Buyer) might place
   on them.
  Seller felt they would be in a better bargaining
   position with Buyer by getting an independent

Pre-Due Diligence - Sell Side
 Valuation
  Actuaries performed a number of different
   projections of market value.
     • Discounted cash flow analyses under alternative
       scenarios with varying assumptions of growth,
       pricing, loss ratios, expense ratios, investment
       returns, etc.
     • Price based upon multiples of book value and
       multiples of earnings using information from recent
       acquisitions of publicly held companies.
Pre-Due Diligence - Sell Side

Case Study Outcome:

Buyer acquired Seller for a price equal to 1.9 times book

Pre-Due Diligence - Buy Side

Case Study:
Buyer - financial group with multiple insurance company investments
Seller - privately held national excess and surplus lines carrier

Seller approached Buyer seeking an investment partner to
finance a management buy-out of the company with ultimate
goal of taking the company public.

Buyer was somewhat interested but preferred conducting
limited pre-due diligence before proceeding.
Pre-Due Diligence - Buy Side
Actuary’s Involvement In Providing
Assistance to Buyer:

 Review of Seller’s most recent reserve study

 Three day on-site meeting with Seller

Pre-Due Diligence - Buy Side
 Reserve Review
  Conducted a high level review of most recent
   independent actuarial report (supporting the
   reserve opinion).
  Tested six month actual claim emergence and
   payments versus expected.
  Goal was to assess level of adequacy of carried
   reserves and where potential problems areas
   might be.
Pre-Due Diligence - Buy Side
 Reserve Review
  Based on high level review, actuaries were able
   to inform claims and underwriting consultants
   that construction defect (CD) might be a
   problem area to focus on during on-site
  Reserves appeared to be posted at the low end
   of the range.

Pre-Due Diligence - Buy Side
 On-Site Meeting
  Buyer’s consultants (actuaries, claims,
   underwriting, financial) met with Seller’s
   management to get a company overview.
  Underwriters learned that the Seller had written
   a sizeable book of general contractors,
   subcontractors, and developers in California
   through mid 90s and corrective underwriting
   actions began in 1996.

Pre-Due Diligence - Buy Side
 On-Site Meeting
  Claims consultants learned that no formal
   tracking system for CD had yet been developed
   and all CD claims were being directed to
   outside counsel.
  With no claim formal tracking system in place,
   actuaries could not segregate CD from liability
   triangles and were forced to make judgments
   regarding ultimate CD losses based upon ad
   hoc, manual claims department listings.
Pre-Due Diligence - Buy Side

Case Study Outcome:

Buyer elected to walk away from the transaction citing CD
issue as the “deal breaker”.

Due Diligence - Buy Side
Case Study:
Buyer - large publicly held national multi-line writer
Target - medium-sized publicly held regional multi-line writer
Target wrote primarily middle-market personal and
commercial lines business produced by independent agents.
Seller had difficulty differentiating itself, had been losing
market share and results had been deteriorating.

Buyer saw a growth opportunity in acquiring Target.
Transaction was directed by an investment banker working
on behalf of Buyer.                                              18
Due Diligence - Buy Side
Actuary’s Involvement In Providing
Assistance to Buyer:
 Participated in full scope due diligence
  Perform independent reserve review
  Interface with other members of due diligence team

 Assisted bankers with valuation assumptions
 Provided Buyer with post-acquisition insights
Due Diligence - Buy Side
 Independent Reserve Review
  Met with Target’s Chief Actuary and Senior
   Reserve Actuary to discuss data availability,
   data segmentation, and reserving issues.
  Due to time constraints we focused on the lines
   of business that reflected the major portion of
   the reserves and had the most potential for
  Segregated into on-going and discontinued (e.g.
   asbestos and environmental) operations.         20
Due Diligence - Buy Side
 Independent Reserve Review
  Performed analysis on both a gross and net
   basis separately for loss , ALAE, ULAE.
  A point estimate and a range of results was
  Relied on interface with the other members of
   the due diligence team for the qualitative
   aspects of the analysis.

Due Diligence - Buy Side
 Interface with Due Diligence Team
  Underwriters’ review indicated that although
   regular (inflationary) rate changes had been
   taken, rate levels had actually been
   deteriorating due to increased use of
   discretionary pricing. The actuaries factored
   this into our loss ratio picks.

Due Diligence - Buy Side
 Interface with Due Diligence Team
  Systems consultants documented the timing of
   the implementation of a new claims system.
   Claims consultants confirmed a slowdown then
   speed-up of claims closures during this time
   period. Actuaries used the Berquist-Sherman
   method to adjust development factors for these

Due Diligence - Buy Side
 Interface with Due Diligence Team
  Financial consultants assessed the credit
   worthiness of reinsurers. Actuaries used this
   information to test the adequacy of the reserve
   for uncollectible reinsurance recoverable.

Due Diligence - Buy Side
 Valuation Assumptions
  The investment bankers were modeling the
   transaction. They relied heavily on the
   actuaries for the assumptions they used in the
     • Calendar year payout of reserves (separately for
     • Loss and LAE ratios for new AYs by line.
     • Claim payment and emergence patterns by line for
       new AYs.
Due Diligence - Buy Side
 Post-Acquisition Insights
  Since the Buyer was planning to integrate the
   Target with their ongoing operations they were
   interested in our insights in the following areas.
     • Opportunities for expense savings (e.g., staffing
       levels, offices).
     • Compatibility of systems.
     • Competency of senior management.

Pre-Due Diligence - Buy Side

Case Study Outcome:
Reserves were deficient by approximately 20%, primarily
from the core (on-going) book of business.

The actuaries acted as overall coordinators in compiling the
team’s findings for presentation to the Buyer.

The reserve deficiency was factored into the pricing of the
transaction and the acquisition was made.

Due Diligence - Sell Side
Case Study:

Same case study as Due Diligence - Buy Side

The Seller’s actuarial team played an important role
during due diligence.

Due Diligence - Sell Side
Impact of Seller’s Actuarial Team
  In order to maintain confidentiality, only senior
   managers of Seller interacted with Buyer.
  Chief Actuary and Senior Reserve Actuary
   were fully informed on details of the functions
   they managed.
  Chief Actuary was a very good communicator
   to non-actuaries which was important in
   discussing some of the differences in the
   reserve projections.                            29
Common Themes

The actuary’s role in due diligence is not
 just quantitative.
  The technical skills taught in the Syllabus form
   the foundation of our knowledge base.
  We need to be able to interpret how operational
   aspects of the insurance entity impacts the
   quantitative results.

Common Themes

We generally act as project managers and
 need to be able to coordinate the
 presentation of results (the “story telling”).
Because of this, as actuaries we need to
 continually enhance our communication
 skills (both written and verbal).