The Importance of Actuaries

Importance of Actuaries

This brief article attempts to outline why actuaries could have made the difference and why actuaries can make the difference in today’s complex financial world. It is an effort to explain why the use of actuarial knowledge, techniques and expertise could have helped avoid or at least mitigate the effects of the recent financial crisis.

Our profession can offer so much, yet it is understood by so few people and appreciated by even fewer. I strongly believe that actuaries could be instrumental in helping many financial institutions avoid serious mishaps, but more than anything else they could really add value to an organization.

Most of what follows has been borrowed from an excellent article, “Actuaries would have made a difference”, that was written by James MacGinnitie, an actuary. It really covers all the things that went through my mind as far as the recent financial crisis is concerned. Personally, I strongly believe that if Banks had strong actuarial teams that were as vital and integral to their structure as they are in insurance companies, things could have been a lot different?

We, Actuaries, would have made a difference because:

We are used to taking a long-term view. Although this used to be a prerogative for the life and pension actuaries, at least in our market, it is increasingly changing and becoming an integral part of the job description of non – life actuaries as well. We learn to think how things can possibly be over the long – term with life benefits becoming payable possibly over several or tens of years in to the future, pension obligations extending for decades, and also long-tailed casualty covers.

We understand that choosing the right model is very important, but it’s even more important to test it and calibrate it appropriately. We have been taught not to exclude extreme events because “such a loss will never happen or cannot reappear.” In fact, in certain lines of business the most important aspect of the risk assessment is the fat tail that we model to cater for those extreme events.

We understand that the distribution function for most risks is not the nice symmetric bell curve or normal distribution that most analysts were using, but rather one of several distribution functions that have longer, fatter tails. The emphasis of risk analysis in capital markets on the value-at-risk (V@R or VAR) concept, which is based on the normal distribution, was one of the problems in the recent financial crisis. This is because the Normal Distribution usually understates the chances of bad outcomes, both in frequency and in amount. We, on the other hand, understand that large but infrequent events need to be included in any model. In fact, our understanding of the latter has been a frequent cause of debate between our profession and marketing people or executives eager to introduce a new product or show better results by discounting the possibility of an infrequent larger risk materializing.

We understand and we know that when underwriting standards are lowered the result will be worse experience, and these should be reflected in the price, and in any reserves set aside to pay losses. In the recent financial crisis the problematic mortgages did not perform as modelled because underwriting standards deteriorated (in certain cases they were not even there). We have learned to question changes in underwriting and other aspects of operations that might have an impact on developing experience. Our insistence on our basic actuarial principles and our investigative approach is not always appreciated, but in many cases it was what made a difference between saving an operation or breaking it.

Generally we do not like derivatives unless these are used for hedging purposes. We consider derivatives on derivatives that are part of the current problems as a proxy for gambling and not as genuine investments. In fact, we are not comfortable with any complex financially engineered structures that seek to manipulate certain inefficiencies in the regulatory or business environment and which depend on the presumption that we are smarter than the others. We have been taught that whatever we do could come back and haunt us, unless appropriate actuarial principles are followed.

We have been trained to value liabilities even in the absence of deep liquid market for them, such as pension obligations, outstanding casualty losses and life insurance benefits. We have been taught how to produce reasonably accurate estimates for claims that have not yet been reported to the insurer. Similar techniques would be useful for many of the assets that are currently being marked to nonexistent market values.

We are required and expected to model expectations, then measure actual results and use those measurements to recalibrate our modelling. If only this was used in the capital markets in a similar way?

We are accustomed to transparency. Our professional standards require an actuarial report to back our opinion which must contain sufficient detail so that another actuary can appraise the conclusions.

We have professional standards and we only do work for which we are qualified. We follow professional guidance from our accrediting organizations. Our professional associations invest a lot of time and effort to keep up to date and we must continue our professional education throughout our careers.

We take it upon us that we have a responsibility to protect the public. The pension plans and insurance companies promise to deliver several years into the future, benefits to survivors and retirees and we understand that they have an obligation to do their best to make sure that those benefits will be paid when they are needed. We aren’t perfect. There are examples of insurers and pension plans that failed, but the frequency is relatively small, and in many cases it was in spite of the actuary’s advice.

As regulators, legislators and central banks seek to design a better future; it would be helpful to include more actuarial training and thinking.

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