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The Actuary The magazine of the Institute & Faculty of Actuaries
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Financial condition reporting

Question: Did you hear the joke about how to spot an actuary driving a car?
Answer: They drive without taking their eyes off the rear-view mirror.

Australian approved actuaries are currently preparing for an extension to their statutory reporting role. At present, an approved actuary is required to report annually (and, to a lesser extent, quarterly) on aspects of the technical liabilities of an authorised general insurer. The reporting is to the effect that provisions for both claim and premium related liabilities are adequate, based on a prescribed Prudential Standard for assessing such liabilities. This requirement was established during the regulatory reform process for general insurers, the first stage of which took effect from 1 July 2002. However, following recent activity, the Australian Prudential Regulation Authority (APRA) is soon expected to confirm that the role of the approved actuary will be expanded to include the production of an annual financial condition report (FCR) with almost immediate effect.

The HIH effect
This recent activity included the report of the royal commission (headed by the Hon Justice Owen) on the demise of HIH. HIH was a large Australian general insurer that became insolvent in 2001. Because of HIH’s dominant position in several insurance markets, this insolvency had devastating effects on many risk-related areas of the Australian economy. In the royal commission report, Justice Owen acknowledged the support of a special working party of the Institute of Actuaries of Australia (IAAust), headed by recent president Tony Coleman, in reaching his conclusions. One of the key recommendations of the Owen Report was an actuarial FCR, to be delivered to each insurer’s board of directors (and copied to APRA), to help prevent the neglect of financial control mechanisms highlighted in the HIH collapse. Also, under stage two of the regulatory reform process, APRA postulated a financial condition reporting tool, which sparked an open and helpful debate in the industry on the value of such a document and its authorship.

In anticipation of such an outcome from the continuing regulatory reform process, the IAAust had already established a working group to develop a range of guidance, and ultimately a professional standard, for FCRs. The working group, chaired by Chris Latham, included a number of senior actuaries from the Australian general insurance market as well as APRA representation. This group published an initial draft guidance paper late in 2003, to assist a healthy discussion, already active within the profession, on the pros and cons of an actuary’s role in financial condition reporting.

The definition of ‘financial condition’
A major problem in the development of financial condition reporting is the absence of a commonly recognised definition of the term ‘financial condition’. The definition can range from a comprehensive view of the current balance sheet to an assessment of a number of tangible and intangible items, including allowance for strategic planning and likely operational development.
It can be argued that APRA’s current definition lies at the more tangible, ‘current balance sheet’ end of this range. As recognised in the existing stage two reform documentation and the IAAust’s guidance, the following elements of an FCR appear clear:

a disciplined, financially based view of the company’s business, and particularly the recent experience;
a perspective on the liabilities of the insurer, focusing on the opportunities to improve the methodology used for interpreting these liabilities;
examination of the company’s assets, extending to a review of capital adequacy in conjunction with a comparison with statutory minimum capital needs;
a financial analysis of the company’s risk concentration, incorporating investigation of the effectiveness of its reinsurance programme;
a full review of the pricing and premium rating process, concentrating on technical justification for the adequacy of the premium rates being set by the company on each of its insurance lines.
There is also strong support for the inclusion of an analysis of the risk-management processes of the company, taking account of operational as well as financial risk.

Defining the actuarial role
From the perspective of a company’s board of directors, though, it may be argued that such an FCR falls short of a full review of financial condition, since it excludes a comprehensive analysis of the current operations of company, or its strategy for development of its future business. It is in these areas that the current debate is especially interesting. One school of thought essentially argues that the current APRA definition represents the full scope of a general insurer’s business to which an actuary’s experience and investigations can add value. Even in this case, current actuarial activity is unlikely to be comprehensive, and hence the actuary’s report needs to rely on the investigations and views of other professionals and experts within the company. Another viewpoint is that an actuary’s training prepares her or him with the means to provide an opinion on all areas of a company’s business, although such an opinion may be limited, and very reliant on information provided from other sources from within the company. Perhaps the best interpretation of this debate is that both sets of views will eventually converge over time through iterative improvements in the actuary’s FCR.

This interpretation is consistent with IAAust’s approach and APRA’s current thinking. The IAAust working group is planning to develop its current guidance in two directions. First, it is preparing a draft actuarial standard for FCRs that will be based on the ‘current tangible balance sheet value’. Second, it is developing an Institute guidance note to assist the iterative process as broadly described above. At the same time, APRA is mindful of the current limitations on the actuary’s role in the management of general insurers in Australia and has made it clear (informally at this stage) that it will not be requiring a full report on all aspects of an insurer’s financial condition. APRA will, however, be expecting areas in which the approved actuary has little or no experience to be recognised and for the appropriate experts’ knowledge and views to be noted. Such an approach will ensure that potential areas of actuarial investigation are highlighted within the report.

Whatever definition of financial condition is finally derived, it is clear that the FCR must go beyond mere recognition and documentation to the identification of areas for improvement (together with the means for improvement).

The way ahead
Although financial condition reporting is a new experience for most general insurance actuaries in Australia, we are not breaking new ground in global actuarial terms. For many years FCRs were part of the statutory reporting structure for life insurers in Australia. They are still an important part of the financial control process for the board of directors of a life insurer, which is required, by legislation, to undertake an actuarial ‘financial investigation’, even if there is no longer any regulatory need for premium rates to be actuarially certified. Although many aspects of the management of a general insurer are completely different from life insurance business management, there are numerous parallels, and it is important to benefit from this experience.

FCRs have been a part of the non-life insurance regulatory structure in Canada for the past three years. Interestingly, a recent survey available on the Canadian Institute of Actuaries website appears to demonstrate that most insurers perceive financial condition reporting as a pure compliance requirement, rather than a real value-adding tool. Given the far-sightedness of the Canadian actuarial profession, we can be confident that steps were taken to avoid this outcome. Reasons for the apparent failure, at least initially, for insurers to recognise the full value of FCRs need to be fully understood, and steps taken to avoid the same outcome in Australia.

From personal experience in preparing FCRs, it is important to devote sufficient time to the planning and discussion of (a) the data sources and (b) the more subjective input from members of financial and operational management teams within the company. The exercise also highlights the potential pitfalls in examining financial condition from an inappropriate perspective. For instance, most sizeable insurance groups (in Australia and globally) tend to consist of a number of insurance entities. If APRA’s current polarised, entity-based approach continues, it may lead to some inappropriate conclusions, since, as far as financial condition is concerned, the insurance group itself should usually be the focus of attention.

The actuarial profession has been handed an opportunity to add real value to the ongoing financial and strategic management of general insurers in Australia. We must be careful to develop this opportunity at a realistic pace and not over-strain the profession’s current abilities, We also want to avoid creating a ‘tick-a-box’ compliance culture, which would compromise the opportunity to add value, and may lead to a negative reaction. This in turn would reduce the potential for sharing the progress that the FCR represents with other global actuarial organisations. However, if we are mindful of these potential pitfalls as I believe we are in the Australian profession there is a real chance that actuaries will be spending more of their time looking through the car windscreen.

Dave Finnis is a senior actuary at Insurance Australia Group, Australasia’s largest general insurer

Acknowledgements: I’d like to thank my Australian actuarial colleagues, Tony Coleman and Blair Nicholls, for their helpful comments on this article. However, responsibility for the content remains mine

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