Lessons Learned From Actuarial Due Diligence

Take yourself back to those school days when you sat at the dining room table or in your bedroom doing math homework. Geometry was likely not the most exciting thing to learn, but when you apply it to real-world situations like playing pool or light refraction it becomes a whole lot more interesting. For me, even though I still think actuarial math is interesting in most of its forms, it’s the most interesting when it’s the most impactful. One of the best examples of this is in the context of mergers and acquisitions, where a few percentage points can result in millions of dollars, and more than that can cause a deal to be quickly secured or killed.

When I’m performing due diligence on a target company, especially in the PEO space, there are common areas that sellers miss. Below are the top five most missed opportunities for sellers, counting down to the most commonly missed opportunity.

5: POOR RENEWALS

I know we’re starting off wild and crazy, but less than favorable insurance renewals cause pain points across the board. In many cases, poor renewals result from a lack of time and attention, not experience. Make sure that you allocate enough time to properly prepare for these discussions, whether it be understanding actuarial indications, your own internal analyses, or broker comparisons and market trends. Let data support your argument and have confidence that nothing is amiss within your team.

4: INACCURATE OR OUTDATED PRICING METHODS

Another area that sticks out like a sore thumb is when companies use pricing models or approaches that are more judgmental, and market driven rather than influenced by actual data and analytics. With so many tools available on the market, there’s little to no reason for a firm not to involve some level of their own data, external data, or both to inform optimal pricing.

3: CLAIMS HANDLING ISSUES

One of the easiest things for both buyers and sellers to evaluate are basic claims metrics such as report lags, frequency and severity, and more. Often, when claim experience deteriorates, there is usually something simplistic in claims underlying it. It is my job in performing due diligence to figure out what that is, but often my opinion is that the seller could have caught the same thing and either resolved it or had a plan to share to the buyer. Either way would likely put the transaction on firmer footing.

2: CASH ACCOUNTING

While it doesn’t happen often, I do sometimes see firms with long-tailed insurance liabilities like workers’ compensation using cash accounting. Not only does this significantly skew earnings, but it also raises questions as to the experience of a CFO and his or her partner firms. Said another way, I’ve seen deals die once a buyer learns that a PEO is using cash accounting.

1: INADEQUATE OR REDUNDANT RESERVES

When PEOs set reserves for insurance liabilities, they rely on the work of independent actuarial firms to understand what their actuary thinks is a reasonable estimate for outstanding reserve liabilities, and then decide what amount to accrue. For whatever reason, there is a disconnect and the accrual is materially too high (or too low), implying that resultant earnings are actually much better (or worse). Because it’s not cost effective to have two actuarial firms providing separate estimates, one of the best things PEOs can do is to have a better understanding of actuarial analyses.

Here’s a hypothetical example. A PEO has seen its claims experience worsen over 2020 and 2021 but has seen improvements from its end since 2022. However, their actuary estimates reserves to be at the same ultimate loss ratio basis as 2020 and 2021 based on an understanding that this is a worsening trend. If the PEO’s risk manager or CFO sees a disconnect, they should initiate a conversation with their actuary to understand the basis for the actuary’s assumptions and/or conclusions. If the PEO understands the actuarial methodology enough, they may even be able to ask targeted questions as to certain selections and adjustments. In this hypothetical example, the question could lead to a series of conversations where the actuary did not have all the information that the PEO had, and thus was far too high in their reserves.

While stories from M&A engagements make for interesting reading, they make for even better lessons from which management can learn and improvements can be made. Whether you’re preparing for a sale or just looking to improve best practices, make sure to check through this list and to avoid being caught unawares.

Originally posted to PEO insider: https://peoinsider.org/articles/lessons-learned-from-actuarial-due-diligence/

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