IAA Committee on Insurance Regulation The Role of the Actuary in the Prudential Supervision of Insurance Companies

The Role of the Actuary in Prudential Supervision

Introduction The purpose of this note is to set out the IAA’s position on the role that actuaries should fulfil in the prudential supervision of insurance companies. This paper is intended to lay out a vision of best practices and recognizes that no country has these best practices in place yet. It also sets out the factors that actuaries should consider in evaluating the financial condition of insurers. This document should be read in conjunction with the more detailed note “Insurance Liabilities - Valuation and Capital Requirements” prepared by the IAA’s Insurance Accounting Committee as an adjunct to their consideration of the IASC’s 1999 Insurance Issue Paper.

It is expected that this paper will form the basis of an ongoing dialogue with the International Association of Insurance Supervisors (“IAIS”) on the involvement of actuaries in the prudential supervision of insurers. In particular, this paper extends the scope of the Committee’s response to the IAIS’s own paper “On Solvency, Solvency Assessment and Actuarial Issues” published in April 2000.

The evolution of prudential supervision of insurance companies is at different stages in different countries. The role of actuaries in that supervision is also evolving. The roles and standards set out in this note should be seen as broad goals towards which it is hoped that IAA member associations, together with the regulators with whom they work, can progress. This document will itself evolve as best practice in prudential supervision develops.

The Importance of Prudential Supervision The IAA is committed to the effective supervision of insurance and fully supports the work of the IAIS in raising standards in all aspects of the prudential supervision and management of solvency of insurers. In particular, the IAA continues to promote the highest standards of actuarial practice in regard to insurance finances. The IAA is doing this by promoting common standards, based on best practice internationally, for examining technical competence, for professional conduct and for disciplinary procedures. (It is acknowledged in this statement that these “best practices”, when implemented in a particular jurisdiction, will need to conform to local laws and regulations. The IAA recommends that the IAIS encourage the convergence of the principles of regulations where practical.)

The actuarial profession is especially well placed to support the regulators in their role of safeguarding the interests of policyholders. This is partly because the profession’s training and practice provides insight and experience in managing the risks which face insurance companies. It is also because, enshrined in the principles of the profession, is the requirement to serve the public (IAA Statutes, Article 3).

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Framework for Solvency and Capital Adequacy The IAA believes that in order to operate prudently the total financial requirement for an insurer is best expressed as:

(i) a realistic provision based on the expected value of future experience (described below as the funding criterion) which meets the existing obligations of the company; plus

(ii) an additional capital sum based on the risks in the insurer’s business (generically known as “risk-based capital”) and the business’s immediate capital investment plans, and intended to provide a minimum specified level of capital adequacy.

The IAA favours this approach because it believes that the best evidence of an insurer’s ongoing financial soundness is a combination of profitable business operations and sufficient capital. Profitable sales and service indicates that the insurer is building its capital base and that it is likely to remain in business for the foreseeable future. It also gives some indication of the quality of management. Sufficient capital indicates that the insurer can meet with a particular level of confidence the inevitable fluctuations in risk exposures, claim amounts and financial circumstances that may be expected to occur over the runoff of its existing policy obligations , while funding the essential capital requirements of new policies, technological developments and general business initiatives.

The analysis and management of insurance risk have been core skills of the actuarial profession since its earliest days and continue to be central to its scientific development. The IAA sees this process as a key responsibility of the actuarial profession and encourages investigation into the identification, understanding and quantification of the risks inherent in insurance enterprises. It seeks to bring together relevant research and practical experience, both by actuaries and by other related disciplines such as financial economists, accountants and risk managers (as well as work by seismologists, engineers, meteorologists, epidemiologists and the like) in order to provide a coherent risk framework to the insurance industry and its regulators. On the basis of this developing risk framework, the IAA will seek to investigate appropriate structures for risk-based capital measures.

The IAA recognises that the prudent management of an insurer depends on the broadest application of risk management techniques. This includes the use of dynamic financial models and scenario testing in order to understand the steps management can take to avoid or mitigate adverse outcomes. As a result of the actuary’s knowledge of risk analysis techniques coupled with practical experience, the actuary has a central role to play in ensuring the integrity of such testing.

Regulators of financial institutions are coming to see that such broad-based investigations represent the basis for the most comprehensive form of solvency management and to seek to incorporate the findings from such investigations into their assessment of a company’s financial soundness. The actuarial profession endorses this development. If regulators wish to rely, in the future, on these detailed investigations, the actuarial profession is well placed to provide professional opinions in connection with the work performed.

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The IAA also notes that the ongoing financial soundness of insurers depends not only on quantitative data but on qualitative analysis as well. This would include coherent and comprehensive risk management systems, a ‘fit and proper’ regime for directors and executives and strong corporate governance procedures. The actuarial profession has considerable experience to contribute to the design of such qualitative prudential systems. Moreover, many individual actuaries will have the personal qualities and experience to strengthen this process through their direct involvement in management.

The Involvement of Actuaries In the simplest of insurance regimes it may be possible for the supervisory authorities to rely solely on the regular preparation and submission of prescribed financial data based on a formulaic approach. The training and expertise of actuaries would be helpful in this process, but not essential.

However, the increasing sophistication and complexity of insurance products and markets make reliance on a formulaic approach increasingly unreliable. Innovation must either be prohibited or it must be accepted that it will generally remain ahead of a rigid supervisory structure. In addition, for some products such as general insurance, the dynamics of the claims process render inherently unreliable the use of rigid formulae across all companies. We believe that an effective response for supervisory authorities is to utilise professional practitioners of whom actuaries, by virtue of their training and experience, are the most appropriate.

Actuaries, as members of a professional body, must meet a high level of standards of training and conduct. They are monitored by their professional colleagues and are subject to disciplinary procedures. It is difficult to envisage an alternative professional structure that could provide a similar level of confidence on the part of insurance supervisors.

Actuarial professional bodies develop codes of conduct that reflect their particular relationship with the supervisory authorities. These codes require that actuaries look beyond any formulaic requirements imposed by regulations to the underlying principles that are to be observed. Codes of conduct also set the priorities by which actuaries must abide, regardless of commercial pressures (although it is recommended that these codes of conduct be underpinned by a supportive legislative basis).

The IAA has initiated a process to develop international standards, particularly with respect to the implementation of international accounting requirements, and will actively promote the coherent delivery of international actuarial requirements. Consequently, professional standards, both of conduct and of expertise, will be maintained at the national level and coordinated across national borders.

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The IAA believes that the supervision of insurers is best served by the active involvement of actuaries in the broadest range of financial activities, including where feasible management at a senior level within a company or organisation. In particular, the IAA supports the appointment of one actuary as the "responsible" or "appointed" actuary to take professional responsibility for the actuarial supervision of the insurer's operations, including the evaluation of the financial risks that could affect the capital needs of the insurance operations.

The Range of Actuarial Supervision The "responsible" actuary should have direct access both to the Board of Directors of the insurer and to the highest level of executive management . The relevant professional body should be able and willing to assist or provide a process to ensure that "responsible" actuaries are appropriately experienced and qualified for these responsibilities. The key areas for which actuarial supervision is considered essential are:

(i) pricing and product design; (ii) establishing aggregate policy and claim liabilities; (iii) determining compliance with legal or regulatory capital requirements when applicable or recommending capital levels in the absence of legal or regulatory requirements; and (iii) monitoring market conduct and policyholders' expectations where policies allow the management of insurance companies to exercise discretion over contractual terms and conditions.

In addition, the responsible actuary has certain direct responsibilities to the regulators.

Each of these areas is considered below.

I Pricing and product design The premium level set by an insurer will ultimately be the responsibility of the board of directors of the insurance company unless they are required to be used by the regulators in the territory concerned. In practice, the Board delegates this responsibility to management. Nevertheless, good supervision requires that the directors be advised as to the financial implications of adopting any proposed premium pricing policy. The responsible actuary should be able to provide advice as to the soundness of the product’s structure and whether the premiums are capable of covering the best estimate cost of:

(i) the policy obligations; (ii) the capital required to support the operation of the policy; (iii) any policy options against the insurer including the cost of hedging any risks as necessary. Where risks are unmatchable or uncontrollable, the responsible actuary should bring this to the attention of the directors in the clearest terms and explain the consequent increase in capital requirements; and (iv) front and back office operations.

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If the premiums are not capable of covering these costs then it is necessary to have a demonstration that the organisation can absorb such subsidised pricing without impairing its financial soundness.

The involvement of actuaries in the area of product design and pricing can provide balance between the interests of policyholders and shareholders. The involvement of actuaries following a strong code of conduct can allow a regulator to have confidence that insurers are selling policies which are sound in the context of the insurer's overall financial strength. This can allow regulators to dispense with the inefficient and potentially uncompetitive process of prior approval of premium rates.

II Establishing aggregate policy and claim liabilities and determining capital requirements The actuary should ensure that the total assets of the insurer can meet the following criteria:

(a) Funding Adequacy: the total assets plus future premiums and asset revenues shall be sufficient to cover:

(i) the current expected value of the obligations under the existing business in force and existing claim obligations, together with appropriate margins for risk; (ii) capital requirements; (iii) risk absorption and hedging; (iv) administrative costs; and (v) the funding of sales activity in the short term.

(b) Earnings Capacity: an assessment of the expected future free cash flows (from existing and new business) should not, under reasonably probable future scenarios, be negative at any point in the future in order to ensure that there is:

(i) appropriate incidence of distributable profits; (ii) transferability of policy liabilities; and (iii) advance warning of adverse developments.

(c) Strategic Capital Adequacy: Total free surplus plus free asset revenues should be sufficient, according to the organisation’s approved medium term business plan, to finance future expected new business costs and associated additional solvency requirements. This is a particularly important role in the many mutual insurance organisations. The involvement of actuaries in general business planning ensures that a proper balance of shareholder and policyholder interests will be considered from the outset. This will support a prosperous and financially strong insurance industry, which is in the long-term best interest of the insuring public, without compromising the position of current policyholders.

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(d) Dynamic Capital Adequacy Testing: Capital should be sufficient under demanding but not unrealistic scenarios either to:

(i) supplement available funds to cover the cost of policy obligations and operations; or (ii) transfer the liabilities to another carrier.

With their skills and experience in statistics, finance, insurance products and insurance operations, actuaries are needed to advise on appropriate aggregate policy and claims liabilities and the range and likelihood of possible outcomes. Actuaries are also crucial to assessing, advising and reporting on the current and future capital needs of insurance operations under a range of circumstances and the major factors driving these needs. A number of insurance regulators rely on responsible actuaries to have the prime responsibility for these functions in insurance operations as this provides a level of detailed oversight which the regulators themselves are usually not able to provide. When the responsible actuary also supplies a report on the calculation methods used, the results and the conclusions to the regulator as well as the Board, this provides a good mechanism for regulatory oversight and query back to the company at the highest level.

III Monitoring Market Conduct and Policyholders’ Expectations Many insurance policies provide that the insurer can use discretion in applying their terms and conditions. Also, the outcomes for the policyholders can be uncertain, for example because of future investment conditions. In these circumstances, the responsible actuary should monitor the expectations that policyholders have as to how they should be treated as the insurer exercises the contractual discretion in the policy. These expectations might arise either through information given or implied at the time of sale, or through the continuing practice of the insurer. If the responsible actuary believes that the reasonable expectations of policyholders are not being met, this should be brought to the attention of the directors. This should ensure that:

(i) promises made are being honoured; (ii) an equitable distribution of policyholder dividends/bonuses occurs; (iii) unit pricing for unit linked policies is accurate and fair; (iv) discretionary alterations of policies do not result in excessive cost to the policyholder; and (v) illustrations to prospective policyholders are not misleading or overly optimistic.

IV Direct responsibility to the regulators In many insurers the responsible actuary will be in a senior executive position. However, he or she may well not have direct control over all the actions required to be taken to protect policyholders’ and claims beneficiaries’ interests, either in terms of company solvency or of their reasonable expectations as to the company’s exercise of contractual discretion . In order that the responsible actuary can ensure that appropriate action is taken to protect policyholders and beneficiaries, he or she must have the right to present any of his or her concerns to the directors of the insurer. If the directors refuse to act on the responsible actuary’s advice, the responsible

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actuary should have the right, indeed the responsibility, to contact the relevant authorities to express these concerns. This course of direct action should be regarded as a last resort when all other avenues for persuading the insurer’s management have been exhausted. Any responsible actuary forced to take this course should have legal protection from action by the insurer’s management.

Summary The ability of regulatory authorities to protect policyholders, by maintaining solvency and by ensuring that their reasonable expectations are met, is greatly enhanced by the extensive involvement of actuaries in insurers’ operations. The IAA believes that the appointment of an actuary (the ‘responsible actuary’) to take professional responsibility for the monitoring of key financial aspects of an insurer’s operations provides comfort to both regulators and policyholders that regulations are being correctly applied and policyholders and claimants are protected.

October 2001

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