Radar and tea leaves (Or, what does an actuary really do?)

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By Gail Kappeler, Gary R. Josephson | 01 January 2007

Originally printed in the January/February issue of Public Risk magazine. Reprinted with permission from the Public Risk Management Association. © 2007

When a self-insured public entity seeks actuarial consultation for the first time, there’s often a measure of mystery that accompanies the process. Risk managers and finance directors, who will usually be the ones working with the actuary, may wonder what really goes on inside an actuarial analysis. "What does an actuary do?" is a common question, because the specifics of the profession stand somewhat outside general knowledge—by comparison, we all know that pilots fly airplanes and dentists fill teeth.

Perhaps some of the mystery is related to the often complex, data-intensive calculations that are the foundation of actuarial work. A good actuary uses statistical, business, and mathematical acumen to consider the numerous potential scenarios of loss, most of which never occur, some of which do. The actuary uses statistical modeling to predict a range in which the actual losses may fall. You might think of an annual actuarial analysis as far-ranging radar that scans what the future may hold, then helps organizations respond in terms of price-setting, reserve decisions, forecasting, reinsurance, and the like. However, even with all the data analysis, consider that there is always an element of "reading the tea leaves" where a good actuary needs to rely on informed judgment.

In some respects, the actuary’s role might parallel that of a weather forecaster. Both are tasked with estimating something that will happen in the future, both rely on often complex models that consider many variables, both examine long-term patterns and trends, and both know that the future will not always behave as predicted.

Scope of actuarial estimates

The services typically provided by an actuary include loss reserve analysis, pricing, reinsurance evaluations, surplus analysis, and benchmarking. Actuaries are not accountants but are frequently mistaken for auditors. Actuaries do not perform audit-type functions such as data verification or financial statement sign-off, although they often work with auditors by providing them the liability estimates they need to complete the financial statement review.

In performing a loss reserve analysis, the actuary typically uses mathematical models to create future scenarios using data from past years, while also keeping an eye on changes in present and future conditions that might affect the results. In loss reserve analysis, these models produce a measurement of the expected cost of the unknown liabilities and overall adequacies or inadequacies of your self-insured loss reserves. Actuaries will usually evaluate different methods in determining their "best estimate" of loss reserves. Often they will evaluate different types of data—e.g., paid losses, incurred losses, and reported claims—in applying these methods. The result may be a single best estimate or a range of estimates. Ranges are valuable because they give a sense of the variability that exists in any estimate.

Loss reserve analysis is typically done annually—perhaps more often with larger entities—so that changes in the many possible variables can be tracked. Loss reserve analysis can serve several functions: to determine liabilities for unpaid or as-yet-unreported claims; to provide information for required annual financial statements; and to serve as a basis for future funding decisions.

While a loss-reserving analysis is used to measure an entity’s cost for past claims, a pricing (or funding) analysis estimates the amount needed to budget for future claims. A pricing study typically begins with the results of a reserve analysis. The estimates of ultimate losses for past years are adjusted for changes in cost levels (often called trend) as well as anticipated changes in exposure for the time period that is being priced.

The estimate of future claims is only a starting point for a pricing analysis. The actuary works with management to determine the extent to which the following will be considered in the premium rates:

  • Investment income: Next year's losses will be paid well into the future. Management needs to consider whether the investment income that can be generated from the premiums can be used to reduce the funding requirement.
  • Risk margins: Management needs to consider what happens if next year's losses exceed the projections. Will funds be available to support any variation? Or should the funding amounts include a risk margin to allow for this possibility?
  • Cost allocation: Are funding rates uniform for all departments, or are there other risk or loss experience characteristics that should be reflected in the rates?

Another important consideration in both reserving and funding is the potential for large, surprising, unpredictable claims. Excess insurance is an important tool for managing this risk. As the financial and natural world's uncertainties seem to erupt with greater frequency and intensity (Hurricane Katrina is an obvious example), self-insureds need to consider the value of excess insurance to help them manage unpredictable claims. Actuaries can use various models and data from other sources to help compare and predict the various outcomes your entity could have with differing levels of excess insurance, so you can choose wisely and appropriately regarding this issue.

The benefits of actuarial analysis

Whether the above tasks are performed by an actuary or not, most of them must be completed in some fashion—be it by in-house personnel, accountants, brokers, or others—in order to prepare required financial reports, and to satisfy any regulatory or reporting requirements. But the difference a trained actuary can make lies in the ability to identify and quantify patterns and to recognize variables that may alter these patterns. Such details may truly affect annual pricing adjustments and other important financial decisions.

Should a client be choosy about its actuary? Absolutely. A good actuary should be explicit and communicative. That doesn't necessarily mean he or she will spend hours explaining every detail of the analysis, but the overall points and their implications should be utterly clear. An actuarial firm should work objectively, have solid credentials and references, and have some means of internal quality control. For property and casualty analyses, actuaries should have credentials from the Casualty Actuarial Society. Designations of FCAS (Fellow) or ACAS (Associate) indicate that the actuary has met the educational and professional requirements that will qualify him or her to provide sound actuarial analysis. Good actuaries are within reach—ask for referrals from others inside your network, or reach out to professional associations or colleagues in other states in order to find a consultant best suited to your group's needs.

Taken together, all the facets of an actuarial analysis will enable you to make wiser, more precise decisions for the next year, and for years to come, in terms of cost allocations, funding requirements, premiums, reserves, and other key issues. Along with an annual loss reserve analysis, actuarial consultations for your entity's pricing, IBNR claims, and excess insurance costs are typically annual, too, though large entities may need more frequent analyses to keep on top of large numbers of variables and levels of unpaid claim liabilities. However frequent, you should find that actuarial consultation is well worth the price. It is for a good reason that actuaries have been called "financial architects" who improve clients' financial decision making. It's because we make the tea leaves easier to read.

GARY JOSEPHSON, FCAS, MAAA, is a principal and consulting actuary with Milliman's Milwaukee office. He specializes in property and casualty insurance and has extensive experience in commercial insurance. He has evaluated loss reserve requirements for insurance and reinsurance companies, pools and self-insurance trusts, and self-insured entities in both the public and private sectors. He is a frequent speaker at national and regional PRIMA conferences.

GAIL KAPPELER, ACAS, MAAA, is an associate actuary in Milliman's Milwaukee office. Her area of expertise is property and casualty insurance, specifically ratemaking, loss reserve analysis, and financial planning. Gail has extensive experience in both commercial and personal lines, and has also assisted clients in analyzing association-sponsored and self-insurance programs and in quantifying and reporting environmental liabilities.