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The Actuary The magazine of the Institute & Faculty of Actuaries

Treating PRE fairly

‘If I write that my soul thinks, then it will be visible, and the words will be its body.’ That such importance should be attributed to words by the blind and deaf Helen Keller – who wrote this striking line at the age of ten – tells us much about how important, albeit taken for granted, words are to those of us gifted with sight and hearing.Partly as a result of Lord Penrose’s report, the meaning of words in general – and of the three words ‘policyholders’ reasonable expectations’ (PRE) in particular – is set to become an ever more contentious subject in the insurance sector. The ‘correct’ interpretation of PRE is becoming an increasingly important aspect of financial management, and not only for with-profits business (see the article about reviewable premiums on p32).While reading Lord Penrose’s comments on PRE and the inability of actuaries to understand the phrase, I couldn’t help wondering what Lord Denning’s thinking would have been. Given the lack of any legal definition of the term, Lord Denning would no doubt have made matters more interesting by going backwards and introducing a different PRE, ‘Parliament’s reasonable expectations’: what were the lawmakers reasonably expecting to achieve in their legislation?I mention this to highlight how considerably subject to subjective considerations the field of PRE is: from what PRE was originally meant to mean at one extreme, to questions such as ‘which policyholders’, and of course the fundamental, quasi-Pilatian question, ‘what is reasonable?’.In An Inquiry into the Nature And Causes of the Wealth of Nations, Adam Smith wrote: ‘The overweening conceit which the greater part of men have of their own abilities is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune has been less taken notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued…’The public’s general lack of ability to think rationally about matters such as probability, or the time value of money, does not seem to have improved since Adam Smith’s time: it is this lack which has given rise to the field of behavioural finance. Most readers, I am sure, will have encountered studies of how different people have markedly different interpretations of terms such as ‘likely’, ‘possible’ and ‘probable’. When will we learn to replace such terms with numerical probability ranges – and should an assessment of PRE attempt to allow for ‘average irrationality’?We must add to such (im)perceptive mists the question of what material policyholders may have read that might have influenced their expectations. Lord Penrose attached great importance to the Equitable’s bonus notices, a somewhat contentious view – how many appointed actuaries would have considered the PRE implications ten years ago? By extension, what material are we ignoring now which might be taken down in evidence and used against insurers in years to come? Will policyholders be able to construct plausible cases to support their claims using, for instance, bosh from insurance company ‘illiterature’ about ‘our uncompromising passion to serve you’ and similar (although such nonsense should make policyholders realise the sort of company they are dealing with – see Rupert Morris’s excellent article on p36)? And to this we must add the unpredictability of linguistic shift: words which now mean one thing could, in a few years, acquire quite a different connotation (a very gay idea…). However are we to turn all these qualitative factors into justifiable quantifications?One theoretically interesting approach to ‘reasonably’ quantifying PRE is suggested by the oxymoronic logic of the market. The concept of fair value originally arose as a way of valuing a buyer’s reasonable expectations of an object’s worth. Could we try to quantify PRE as being those expectations which will lead to the policy in question having a modelled value equal to its market value? And, moving swiftly away from arguments involving circularity, secondhand policies, and implausible replicating portfolios, we might entertain another notion taken from the world of fair value: creditworthiness.Dodgy insurers operating in Fairvaluania (a far-away – some would say mythical – land) should reduce their liabilities in recognition of their credit-un-worthiness. Likewise, to accord with the reasonable expectations of policyholders exposed to incessant stories about the demise of the UK insurance sector, perhaps insurers could introduce an RMSTFVCA (reasonable market survivor terminal fair value creditworthiness adjustment) and slash 10% or 20% off maturity payments as they arise. This money could be diverted to employing the many staff who will be needed to determine what the reasonable expectations of their policyholders really are, via the careful reading of every word policyholders have or may have been exposed to, regular interviews with specimen policyholders and ‘control’ non-policyholders, and regular ‘industry PRE’ surveys of relevant groups of policyholders. (By the way, do policyholders expect that an insurer will charge to their policies the costs of determining their expectations?)And we haven’t even started thinking about how the FSA’s new catchphrase, ‘treating customers fairly’, might be interpreted in a few years’ time.