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The Actuary The magazine of the Institute & Faculty of Actuaries

Exercising actuarial judgement

Back in the late 1980s, while committees of actuaries scratched their heads and wondered
where the profession might be headed next,
they little realised that the life insurance industry was busy creating a whole new mini-career for several hundred of us. The pensions review has generated highly paid, flexible work that for many actuaries has meant very high rewards, the opportunity to work from home, and the impetus to set up firms of their own.

What is the pensions review?
Financial products should be sold with best advice in mind. This means that the product sold should be the most appropriate for the individual, not necessarily the product that pays the highest level of commission. The pensions review arose from individuals being sold personal pensions when it may have been better to sell them nothing at all since they had a better alternative, ie their occupational pension scheme.
There are two broad categories of cases within the pensions review, namely transfers and opt-outs. Transfers are where individuals had already left their occupational schemes and were persuaded to transfer their accrued rights into insurance company contracts rather than to leave them in their occupational schemes. Opt-outs are where they were persuaded to leave their occupational scheme in favour of a personal pension, or were advised not to join their occupational scheme.
Both transfers and opt-outs are further subdivided into actual loss cases and prospective loss cases. Actual loss cases are where the policyholder has retired, died, or both. Prospective loss cases are where any potential loss has yet to be crystallised through death or retirement.

Scope and size of the review
The deadline for all the potentially mis-sold cases to be reviewed is 30 June 2002. By this time, the industry should have reviewed a staggering 2m cases and paid out somewhere in the region of £11bn in compensation.

Basic calculation concepts
The basic principle in performing a review is to compare the value of the benefits accrued under the personal pension with those that would have accrued had the sale not taken place. The simplest type of calculation is a prospective loss transfer case where the value of the personal pension fund is compared with the value of the deferred benefits had the transfer not taken place. However, even this calculation is complicated by the need to allow for the impact on state earnings-related pension scheme benefits, to adjust for any additional voluntary contributions paid, and to assess a number of difficult occupational scheme benefits, such as the possibility of discretionary enhancements.
Opt-out calculations also need to take into account how contributions into the personal pension compare with the contributions that would have been paid into the occupational scheme. For this reason, and others, much more data is generally required to complete an opt-out calculation.
The basis for performing the calculations is set by the Financial Services Authority each quarter the start of quarter dates for this purpose being 1 February, 1 May, 1 August, and 1 November. The effective calculation date for prospective loss cases is always one of these four dates, eg all prospective loss calculations performed from 1 August to 30 October will use the August basis and the effective date of calculation will be 1 August. Actual loss cases must also be carried out using the appropriate basis, although the effective date of calculation is more flexible.
Unlike many areas of actuarial work, this field uses a basis which is wholly prescriptive and leaves no room for individual actuarial judgement.
The ideal form of redress is by reinstatement back into the occupational scheme. Unfortunately, this is often not possible and therefore it is necessary to augment the benefits from the personal pension. For prospective loss cases, this is achieved through augmenting the existing fund or, if the fund has ‘disappeared’ because of the charges levied, by setting up a new policy. The calculations will give a percentage figure (as at the start of the quarter) by which the fund should be augmented. This percentage will apply regardless of the performance of the fund since the start of the quarter. For actual loss cases the redress can be a combination of a lump-sum payment and an augmentation to any pension being paid.

Reasons for loss
Perhaps surprisingly, the proportion of cases that result in compensation being due is very similar for transfers and opt-outs between 80% and 90% overall.
There are five main reasons why transfer cases may produce a loss:
– The basis at review date is normally much stronger than that used to produce the original transfer value.
– The charges on the personal pension fund may have had a considerable detrimental impact on the fund performance.
– The underlying investments on the personal pension fund have been poor.
– Subsequent benefit improvements that were not allowed for in the transfer value would have considerably improved the otherwise deferred benefits.
– The transfer value itself may have been quite low. (Although actuaries are given guidance on how to calculate transfer values, there is considerable scope for individual judgement.)
In addition to the five points listed above, opt-outs may result in a loss owing to:
– the premature break in the link with final salary;
– the loss of the value of employer contributions.
The effect on the individual’s SERPS pension is a factor common to both types of calculations, although the impact of this could go either way.

Jobs for the boys (and girls)
A whole new actuarial industry has sprung up as a result of the pensions review. Many insurance companies have been unable or unwilling to cope with all the calculations in-house and have turned to outsourcers for help. Specialist companies have been set up to provide outsourcing services and have lured many actuaries into their midst by offering flexible working conditions and high rates of pay. For those who believe the review to be a minor issue for actuaries it is a sobering fact that the largest specialist outsourcer, HCAS, subcontracts pension review work to over 200 actuaries and senior students. It is estimated that well over 400 actuaries are currently involved in the review on pretty much a full-time basis.
Given the prescriptive nature of the basis you may wonder why actuaries are heavily involved in the review.
In an ideal world the data provided will be perfect. The software will be able to cope with any odd aspects of scheme design and the operators will make no errors. In reality, data is often lacking, out of date, contradictory, or all of these. The software used is excellent for most schemes, but cannot cope with some of the more complex scheme designs.
Actuaries add value by exercising judgement. Most clerical staff can use the software where the scheme is straightforward and the data is perfect. However, actuarial skills come into their own in deciding whether missing data is significant enough to be pursued or whether the final answer is sensible.

Is the work boring?
Most actuaries may have heard that working on the review is boring. Strangely, this view normally comes from those who haven’t worked on the review. We can only speculate as to why they should want to perpetuate such a myth.
Actuaries working in the review often cite it as being the purest actuarial job they have ever done. While there is an element of repetition, many cases require actuarial judgement to be exercised. How many non-review actuaries can claim to be using their actuarial skills on an almost daily basis?

Is it well paid?
In a word, yes. The economics of supply and demand have served the profession well in this respect. Many outsourcers pay fees according to the number of cases an actuary processes. Earnings in excess of £10,000 per month are very common for actuaries working full-time on the review. Many have employed assistants to help with some of the more basic work and have been able to increase their earnings further.
The nature of the work also lends itself to home working. Zero commuting time often allows a reasonably full working week to be fitted in to suit the rest of your life. So whether this involves attending to family needs or practising your swing while the golf course is quiet, a combination of flexible hours and high pay has proved a powerful attraction to many.

The flip side
Finally, although the review has provided a bonanza to many actuaries it has caused severe headaches for many insurers and independent financial advisers. Notwithstanding the many millions paid in compensation, insurers in particular have had their pay structures disrupted as they try to retain their actuaries and prevent them from being lured elsewhere.