Solvency II: The real actuarial function
Colin Czapiewski considers the general insurance actuarial function within the framework of Solvency II
01 MAR 2012 | COLIN CZAPIEWSKI
Solvency II has presented our profession with an interesting challenge and opportunity. The Framework Directive specifies a role for the ‘actuarial function’ that we must ensure that we are fully prepared for. Part of this necessitates that we understand just what we are being asked to do.
Attention has been focussed on the vertical level of non-proportional reinsurance, but far more problems have emerged as a result of inappropriate horizontal reinsurance protection.
It is useful to examine what is actually included within the ‘effective actuarial function’, and what else should also have been included by those who drafted the Directive.
Of the nine points of Article 48 of the Directive defining the role of the actuarial function, the first six relate to data, and to the calculating and monitoring of technical provisions. Most UK actuaries who have the necessary experience can perform these six functions to an acceptably high standard.
The remaining three points relate to opining on, or contributing to the effective implementation of, underwriting policy, reserve reasonableness and risk management. The two obviously omitted topics will be familiar to most actuaries: business planning and asset liability management.
Underwriting is a specialised role often performed by professional underwriters. However, an actuary can help to produce a framework for the overall underwriting policy. In broad underwriting categories of business, as opposed to reserving categories, the expected premiums, claims, expenses and reinsurance can be brought together in the form of a likelihood distribution showing the probability of ruin. Some of the factors to be considered are quantifiable, such as claims inflation and investment income.
An opinion on underwriting policy should also include less quantifiable factors such new types of claim, changes in the propensity to claim and other more hypothetical matters. In the modern insurance world, the business underwritten will be assessed as to aggregate exposures, concentration, other types of risk, whether it falls within the appetite of the insurer, and the general underwriting processes and guidelines.
Some individual policies will need to be assessed – perhaps a random sample or a selection of the larger ones. An overall opinion should be provided regarding the strengths and weaknesses of the approach to underwriting. This analysis should be within the scope of an experienced UK actuary with a critical appreciation of the issues involved.
Why is the insurer buying reinsurance in the first place? Is the insurer buying the appropriate type and level of reinsurance? Often inappropriate reinsurance is purchased because the reasons for its purchase are not properly considered. Low level reinsurance may be little more than a money swap, and it is likely that the long-term effects of its purchase are detrimental to the reinsured.
Conversely, if the reinsurance helps to protect the capital base and is efficient in doing so, then it may be an effective purchase if the price paid for the amount of protection is correct. Unfortunately, the reinsurance is often purchased simply because it was bought the year before.
Historically, attention has been focussed on the vertical level of non-proportional reinsurance, but far more problems have emerged as a result of inappropriate horizontal reinsurance protection. With so many changes in the underlying claims environment, such as from people living in new geographical areas, climate change, the solvency requirement at a 99.5% confidence level, the extremes of several very large infrequent claims occurring in one policy period and other factors, the reinsurance for the forthcoming policy period must be carefully considered.
Risk management systems and risk modelling of capital requirement calculations
The implementation of an efficient risk management system and especially risk modelling with the capital requirement calculations requires effective teamwork between the actuarial function and the risk management function. It is all too easy for important aspects of risk to fall between them or for both to address aspects of them. Insurers generally have a risk modelling team, and especially if they write aggregations of business, such as catastrophe exposed business, when monitoring and controlling the business is vital to the margins of the risk. Actuaries have always been at the forefront of risk modelling and should fit in well.
However, areas where risk is easy to identify but hard to quantify have not been a domain of actuaries and could necessitate actuaries learning more about the issues involved. Many aspects of operational risk would come under this area. Some techniques used by some actuaries in practice that apply methods in the middle of probability distributions are inappropriate at the extremes. Care and research are needed to ensure that UK actuaries are aware of the limitations of such techniques.
So much for what is included; but what is not there?
Actuaries should be involved in the financial planning of a business. The initial planning for a new accounting period may begin over six months before the start of the year. Capital requirements, reinsurance requirements, likely estimated ultimate premium income and claims must be assessed to arrive at a first estimate of the financial result. These will be educated guesses at the very early stages, but should consider past experience and current market conditions.
As time passes, the initial forecasts are revised, become initial estimates, revised estimates and eventually final estimates. The actuary has an important role to play, in conjunction with the financial and accounting functions to ensure the robustness of the indicative amounts and percentages.
Asset and liability management
Insurers have an investment function that may be conservative or aggressive. In my opinion, this is not really related to the role of an actuary. The actuary can assist by forecasting the liability cash flows. The investment function can then judge how far to deviate from the matched position and consider the risk involved in doing so.
Initially, the funds invested flow from the premium income less any reinsurance purchased and premium expenses. As events occur giving rise to potential claims, then the position of currencies and timing of claims payments become more firm. The IBNR and then the outstanding claims may now prove to become a better measurement than premiums. Clearly, this is an appropriate area for substantial actuarial involvement.
Of course, the above is to some degree speculative as no one really knows what the final Solvency II picture will look like. However, there is no doubt that an actuarial profession that has done its homework properly, educated its members and is fully prepared for the commencement of Solvency II will provide invaluable support to the UK insurance industry.
Colin Czapiewski is a consultant advising UK and overseas insurance companies and Lloyd’s managing agencies