Second edition Understanding Actuarial Management

Understanding Actuarial Management:

the actuarial control cycle

Second Edition

Edited by Clare Bellis, Richard Lyon, Stuart Klugman and John Shepherd

vii

Foreword

Understanding Actuarial Management: the actuarial control cycle was first published in 2003 by the Institute of Actuaries of Australia, in response to demands from Australian universities for a resource to support Part II of its education syllabus. Since that time, the Actuarial Control Cycle concept has been adopted as part of the education syllabus of many actuarial associations around the world, including the Society of Actuaries.

In planning this second edition, the Institute of Actuaries of Australia and the Society of Actuaries have partnered to produce a completely revised text, ensuring that the requirements of both professional bodies and those of the International Actuarial Association and the UK Actuarial Profession have been met. This collaboration has resulted in what we believe to be a global textbook, for a global profession.

The teams of editors, authors and reviewers who participated in this project were sourced from around the world, reinforcing the project's aims of global application. In particular, the commitment and dedication of the three editors of this edition, Clare Bellis, Richard Lyon and Stuart Klugman, have produced an extremely valuable resource for actuarial students in Australia, the US, Canada and around the world.

On behalf of the Institute of Actuaries of Australia, the Society of Actuaries and the rest of the profession, we offer our congratulations and sincere gratitude to the editors and authors of this second edition of Understanding Actuarial Management: the actuarial control cycle, for the exceptional contribution they have made to our future.

Bozenna Hinton President Institute of Actuaries of Australia

March 2010

S. Michael McLaughlin President Society of Actuaries

Contents

Foreword Preface

Chapter 1:

Introduction

by the Editors

1.1 What this book is about 1.2 What is an actuary? 1.3 The control cycle framework 1.4 The structure of the book 1.5 An illustration of the Actuarial Control Cycle 1.6 Fred's coffee shop 1.7 Applying the control cycle framework 1.8 Communicating the results of actuarial work 1.9 Conclusion CD Items References (other than CD Items)

Fred's Coffee Shop ? Risk Management Frameworks

Chapter 2: Risk Management Frameworks

by Ian Laughlin

2.1 Introduction

2.2 Risk management framework (RMF)

2.3 Large financial services providers

2.4 What is risk?

2.4.1 2.4.2

Systemic and diversifiable risks Risk and reward

2.5 Types of risk

2.5.1 2.5.2

Financial risks Non-financial risks

2.5.3 2.5.4

Hazard risks and underwriting risks Formal definitions of risk types

2.6 What is risk management?

2.7 What is ERM?

2.7.1 2.7.2

Defining ERM Forces supporting ERM

2.7.3

Integration of ERM into planning

2.8 Risk management process

2.8.1

Establish the context

2.8.2 2.8.3

Identify risks Analyze risks

2.8.4

Evaluate risks

2.8.5 2.8.6

Treat risks Monitor and review

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Understanding Actuarial Management: the actuarial control cycle

2.9 Communicate and consult

32

2.9.1

Documentation and reporting

32

2.9.2

Risk management policy and/or strategy

34

2.10 Execution

34

2.11

Risk management interests, responsibilities and governance 35

2.11.1

Shareholders

35

2.11.2

Board of directors

35

2.11.3

Board risk management committee and audit

committee

36

2.11.4

Senior management

37

2.11.5

Chief Actuary

37

2.11.6

Middle management and staff

38

2.11.7

Customers (policyholders, bank depositors and

borrowers, pension fund members etc)

38

2.11.8

Regulators

39

2.11.9

Service providers and intermediaries

39

2.11.10

Employers as pension/superannuation fund sponsors 39

2.12 Capital and risk management

40

2.13 Critical success factors and causes of ERM failure

40

2.14 Measurement of success

41

2.15 Practical implications for actuaries

41

2.16 Key learning points

42

CD Items

42

References (other than CD Items)

43

Recommended further reading

44

Fred's Coffee Shop ? Being Professional

45

Chapter 3: Being Professional

47

by Clare Bellis

3.1 Introduction

47

3.2 What is a profession?

48

3.2.1

The characteristics of a profession

48

3.2.2

The theory about why professions exist

49

3.2.3

How the concept of a profession is changing over

time

50

3.2.4

How the concept of a profession varies from country

to country

50

3.3 The role of the professional body

52

3.3.1

General comments

52

3.3.2

The actuarial profession: the international level

53

3.3.3

The national level

54

3.3.4

Professional guidance

54

3.3.5

Monitoring standards within the actuarial profession 56

3.3.6

How do the codes apply to you?

57

3.4 The regulatory role of the actuary

57

3.4.1

General comments

57

3.4.2

Prudential supervision

57

3.4.3

Other customer protection

58

3.4.4

Disclosure to third parties

59

3.4.5

Examples of legislated roles for actuaries

59

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3.5 Professional issues to consider while you work on any task 60

3.5.1

Ethical behavior

60

3.5.2

Conflicts of interest

61

3.5.3

Consideration of other stakeholders

61

3.5.4

Materiality

62

3.5.5

Reliance on other experts

62

3.6 How to do a professional job

62

3.6.1

Before you start

63

3.6.2

Define the task

63

3.6.3

Collect the information you need

63

3.6.4

Check for reasonableness

63

3.6.5

Communicating the results

64

3.7 Practical implications for actuaries

64

3.8 Key learning points

64

CD Items

65

References (other than CD Items)

65

Fred's Coffee Shop ? The Need for Financial Products

67

Chapter 4: The Need for Financial Products

69

by Anthony Asher

4.1 Meeting needs

69

4.2 The financial life cycle

69

4.2.1

Introduction to the financial life cycle

69

4.2.2

Income

69

4.2.3

Expenses

70

4.2.4

Savings

70

4.2.5

Different socio-economic classes

72

4.3 Risks and volatility in the life cycle

73

4.3.1

Studies of household income, expenses and savings 73

4.3.2

Income risks

73

4.3.3

Expense risks

74

4.3.4

Risks in savings

77

4.4 Business needs

78

4.4.1

Equity or capital

78

4.4.2

Managing risks

79

4.4.3

Tax and regulatory arbitrage

80

4.5 Products designed to meet financial needs

80

4.5.1

Monetary products

81

4.5.2

Insurance

83

4.5.3

Long-term savings products

90

4.5.4

Retirement income products

95

4.6 Other sources of financial security

97

4.6.1

Families

97

4.6.2

Governments

98

4.6.3

Employers

100

4.7 Practical implications for actuaries

101

4.8 Key learning points

101

CD Items

102

References (other than CD Items)

102

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Understanding Actuarial Management: the actuarial control cycle

Fred's Coffee Shop ? The Context of Actuarial Work

Chapter 5: The Context of Actuarial Work

by John Shepherd

5.1 Why consider the context?

5.1.1 5.1.2 5.1.3

Introduction Context: external forces Context is not static

5.2 Components of the context

5.3 Two special components

5.4 Government and judicial context

5.4.1 5.4.2 5.4.3

Government Taxation Social assistance and social insurance

5.4.4

Judicial decisions

5.5 Physical environment

5.5.1

Climate and natural perils

5.5.2 5.5.3

Pandemics Man-made disasters

5.5.4

Technological developments

5.6 Economic and social environment

5.6.1

Economic conditions and trends

5.6.2

Demographic structure and trends

5.6.3 5.6.4

Work and employment patterns Social factors and trends

5.6.5

Industrial issues

5.7 Industry and business environment

5.7.1

Range of products and services offered

5.7.2 5.7.3 5.7.4

Convergence of financial institutions Product distribution and intermediaries Accounting standards and practices

5.7.5 5.7.6 5.7.7

Competition Industry associations Stakeholders

5.7.8 5.7.9

Corporate culture Globalization

5.8 Practical implications for actuaries

5.9 Key learning points

CD Items

References (other than CD Items)

Fred's Coffee Shop ? Applying Risk Management

Chapter 6: Applying Risk Management

by Stuart Wason

6.1 Introduction

6.2 Identifying risk

6.2.1

Identifying insurer risks

6.2.2

Identifying superannuation risks

6.2.3 6.2.4

Identifying funds management risks Identifying banking risks

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107

107 107 108 109 109 111 111 111 112 112 113 113 113 114 115 115 116 116 117 118 119 120 120 120 121 121 124 124 125 126 127 128 129 129 130 131

133

135

135 138 140 147 149 151

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6.3 Risk assessment

152

6.3.1

Quantitative versus qualitative assessment

153

6.3.2

Experience data

153

6.4 Risk treatment

157

6.4.1

Avoid

159

6.4.2

Retain

160

6.4.3

Reduce

162

6.4.4

Transfer

162

6.4.5

Exploit

165

6.4.6

Reinsurance

165

6.5 Recent lessons learned

167

6.5.1

Systemic connections more extensive than expected 168

6.5.2

Misaligned incentives worsened the turmoil

168

6.5.3

Insufficient consideration of extreme events

169

6.5.4

Insufficient investor due diligence

169

6.6 Practical implications for actuaries

170

6.6.1

Risk management is more than just risk models

171

6.6.2

Each period of turmoil is different

172

6.7 Key learning points

172

CD Items

173

References (other than CD Items)

173

Fred's Coffee Shop ? Regulation

Chapter 7: Regulation

by Craig Thorburn

7.1 Introduction

7.1.1 7.1.2 7.1.3

The sources of law Levels of regulation Types of law

7.2 The scope of laws that influence the financial sector and the work of actuaries

7.3 Types of regulation and the objectives of governments

7.3.1

Taxation legislation

7.3.2 7.3.3 7.3.4 7.3.5 7.3.6

The regulation of markets and companies Other objectives for regulation The regulation of specific types of business Prudential regulation Arguments for keeping regulation to a minimum

7.3.7

Arguments in favor of regulation

7.4 International organizations that influence regulation

7.4.1

International regulatory standards

7.5 Summary of core principles

7.6 Official roles for actuaries

7.7 The structure of regulation and supervisory institutions

7.8 Practical implications for actuaries

7.9 Key learning points

CD Items

References (other than CD Items)

175

177

177 177 178 179

180 181 181 181 184 185 186 188 189 190 190 192 192 193 194 194 196 196

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Understanding Actuarial Management: the actuarial control cycle

Fred's Coffee Shop ? Product Design

Chapter 8: Product Design

by Jeffrey Beckley

8.1 Introduction

8.2 Stage 1 of the product design control cycle

8.2.1

Identify the need for a new product

8.2.2

Develop a product strategy

8.3 Stage 2 of the product design control cycle

8.3.1

Project management

8.3.2

Design features to control risks

8.3.3

Competition, the marketplace, and the pricing

process

8.3.4

Stakeholder expectations

8.3.5

Deciding whether to launch the product

8.4 Stage 3 of the product design control cycle

8.4.1

Distributing the product to our clients

8.4.2

Risk selection

8.4.3

Administration of the product

8.4.4

Asset-liability management

8.5 Stage 4 of the product design control cycle

8.6 Practical implications for actuaries

8.7 Key learning points

CD Items

References (other than CD Items)

197

199

199 199 199 202 207 207 209

210 212 214 214 215 218 220 221 221 221 222 223 223

Fred's Coffee Shop ? Modeling

Chapter 9: Modeling

by Andrew D. Smith

9.1 Introduction

9.2 Examples of models

9.2.1 9.2.2

Automobile insurance Savings product with an investment guarantee

9.2.3 9.2.4

Fairness of insurance prices Valuing pension benefits

9.2.5

Investment risks and returns

9.2.6

Setting dividend policy

9.2.7

Mortality improvement

9.2.8

Social behavior

9.3 What is a model?

9.3.1 9.3.2

Case study ? building a model of inflation and interest rates Using a fitted model

9.3.3

Challenging a fitted model

9.4 Normative approaches to modeling

9.4.1

Modeling in the physical and social sciences

9.4.2

Exploratory data analysis

9.4.3

Model calibration

9.4.4 9.4.5

Fit to evidence Hypothesis testing

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