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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk management: Risky business

The Financial Reporting Council (FRC) has now published its Actuarial Quality Framework. If the FRC treads a similar path to that in place for auditors — where the Audit Inspection Unit regularly undertakes spot checks and publicly reports on the quality of audits at the top firms – detailed external oversight by the regulator on the quality of work undertaken by actuarial firms is perhaps only a couple of years away.

The main risk here is reputational. One of the Big Four accountancy firms was recently criticised for its ethical conflicts procedures, and this led to a lengthy article in the Financial Times. To limit the likelihood of the regulator’s torch shining unfavourably on your work, firms should re-visit their risk management procedures to check that they adequately support the Framework. By way of example, can you show that your Statement of Recommended Practice (SORP) has “robust criteria for selecting assumptions which incorporate findings from theoretical and empirical research based on past experience and current market structures”?

One of the risks of increased (public) criticism of actuarial work is that stakeholders may be more likely to complain when things do not go according to plan. We have seen from the July 2007 FRC report on stakeholder needs, that non-executive directors already feel equipped to challenge actuarial work. Given the pressure on actuaries to better explain their work, it may only be a matter of time before trustees feel similarly empowered. Set out below are some of the legal issues relevant to the drivers of actuarial quality, both in the context of a review by the regulator and in the event of a claim.

This covers the reliability and usefulness of actuarial methods. Fundamental to reliability is data quality. At a general level, the Framework’s statement that actuarial methods should “incorporate checks on the reliability and usefulness of data” makes sense. However, care should be taken to make it clear in your engagement letter what checks you are going to undertake and whether anyone else should take responsibility for data accuracy. By way of example, if you are estimating an insurance company’s reserves, do you intend to be held responsible for the accuracy of all representations made by management about the business?

Care also needs to be taken to ensure you fully understand the data that has been provided. An actuarial firm in Canada was on the receiving end of a claim a few years ago due, in part, to a data interpretation failure. The client had given salary information which, in hard copy, was said to show annual pensionable earnings at the start of the year and, in soft copy, showed total earnings over that year. The actuarial firm did not notice the discrepancy and used the soft copy data as if it showed annual earnings. While the reasonableness checks did pick up some anomalies, no one considered why they existed.

The key legal risks are dependant on your audience. For communications to clients, a valuable layer of protection in the event of a complaint can come from having an enforceable limitation-of-liability clause in your terms of engagement. We stress ‘enforceable’ because, if the court finds your clause to be unreasonable, then your liability will be unlimited (for example, the court does not substitute the unreasonable limit with a reasonable one). There are no hard rules as to what limit of liability will be upheld by the court. However, the factors considered include:
>> The relative bargaining position of the parties when the terms of reference were agreed
>> Whether the limitation was negotiated or the subject of discussion
>> Whether the fees were altered to reflect the level of limitation n Whether the client could have entered into a similar contract with another firm without having to accept a similar limitation.

Usually, if your work product is circulated to a third party without your knowledge, you will not owe a duty to the ultimate recipient. They have not paid for your time, you are unaware who they are, and their use of your work product will be different from the purpose for which you prepared it. However, as a precaution, it is sensible to make it clear in any written report and in your terms of reference that you do not consent to the circulation of your work to anyone other than the person you have addressed it to. If a third party is intended to have your report, then consider requiring, in advance, a release letter from them confirming that no duty is owed.

A word of warning when it comes to multi-party meetings or discussions. It is possible to assume a duty to someone by answering a question. In one case, the audit partner from a large accountancy firm was found to have assumed a duty to the purchaser of his client’s business after attending one meeting and saying that he ‘stood by’ the audited accounts. It was later discovered that the accounts contained a negligent error in them. The court ordered the accountancy firm to pay £65m damages.

A couple of years ago, a purchaser tried, unsuccessfully, to bring a claim against a firm of actuaries in a broadly similar situation. In that case, a pension scheme valuation report was provided — at the client’s request — to the lawyers of the prospective purchaser. Although the report substantially underestimated the pension scheme deficit, the actuarial firm was not found to have assumed any duty to the purchaser and so no damages were payable. This was because:

>> The report had been provided in an administrative context
>> There was no suggestion that the purchaser might rely on it in either deciding whether to enter into the transaction, or in setting the purchase price
>> The actuary was not asked whether she stood by the accuracy of the report.

The framework covers both technical skills, ethics and professionalism. With regards to technical skills, the law requires actuaries to provide the level of service of an ordinary competent actuary in their particular field. When making a complaint about a professional’s work, stakeholders will often use documents such as the Framework as evidence of the standard of work expected. Given that the drivers of quality are broadly drafted, risk management processes which flesh out those drivers (provided they have been followed) may make it easier to reject a complaint seeking too wide an interpretation of the Framework.

As regards ethics, one of the drivers is having procedures in place for managing conflicts of interest. Thought should be given as to what type of client will be able to give ‘informed consent’ under the Actuaries Code (when published). The explanatory notes to the Solicitors Code point out that it will generally only be sophisticated clients with in-house legal advisers who will be able to weigh up the risks of giving consent to act on the basis of the limited information they will have been given. This may be a useful model to follow.

This encourages steps such as hot and cold peer reviews. When documenting such reviews, care should be taken to ensure that any corrective action that has been taken (both for that client and across the firm as a whole) is also documented. Both the regulator and claimant lawyers will perk up if they find internal criticism of your work.

In litigation, claimants still need to prove the existence of duty, breach, causation and loss to successfully claim damages. However, the wide language of the Actuarial Quality Framework means that risk management processes should be reviewed to ensure that they cover the new landscape, so as to limit reputational risks.

Caroline Hunter-Yeats is a partner in the professional liability group at Simmons and Simmons
Ed MacKenna is an associate in the professional liability group at Simmons and Simmons