How accurate should we expect an actuarial review to be? asks Nigel Allen.

Insurers and reinsurers alike still struggle to find their footing on the increasingly slippery rungs of the ratings ladder. A regular contributing factor in the market's ratings freefall is the inadequacy of loss reserves, with hardly a week going by without a re/insurer flagging up reserving deficiencies, closely followed by the rating agency announcements of its subsequent downgrade. The most recent case (at time of writing) is that of XL Capital, which, on 13 January, following its claims audit and year-end reserve reviews, announced a pre-tax reserve charge of $694m. While the reviews cite an increase in claims in the third quarter resulting from business underwritten between 1997 and 2001 as responsible for the charge, some question why the reserves were inadequate in the first place.

"Actuaries are signing off on reserves that turn out to be wildly inaccurate. It's an abysmal track record," said Steve Dreyer of Standard & Poor's, in the rating agency's report 'Insurance Actuaries: A Crisis of Credibility', issued in November 2003. His comments are supported by Sid Gosh, also an S&P analyst, who added, "... reserve shortfalls don't just happen overnight.

What happened to all the reserving opinions signed by actuaries in prior periods?" The gloves are off.

The role of the actuary

According to the International Association of Insurance Supervisors (IAIS), an actuary is defined as "a professional trained in evaluating the financial implications of contingent events. Actuaries require an understanding of the stochastic nature of insurance, the risks inherent in assets and the use of statistical models." More simply, the actuary's role is to estimate a company's liability for outstanding claims and establish the solvency position of the insurer. It is therefore clear that the successful operation of the insurance industry as a whole is dependent upon the sound performance of the actuarial profession.

Fundamental to the actuarial profession fulfilling the demands of this role is its ability to fully understand the probabilities underpinning insurance risk. The IAIS states that the professional actuary working in the insurance sector must also possess a thorough grasp of stochastic modeling, the use of discounted cash flows, coupled with an awareness of the role of derivatives and "an understanding of volatility and adverse deviation". It is therefore imperative that the appointed actuary possesses the relevant qualifications and experience to provide the insurer with appropriate advice.

The UK regulator, the Financial Services Authority, in its guidance on the appointment of an actuary, states that the firm must "take reasonable steps" to ensure that the person is capable of performing the functions required and is also a Fellow of the Institute of Actuaries or of the Faculty of Actuaries. Not only must the individual have the relevant qualifications, but he or she must also possess the relevant levels of experience appropriate to the scale and complexity of the functions required by the particular firm.

However, just as a meal is only as good as the quality of the ingredients, irrespective of the culinary skills of the chef, so the actuary can only be expected to fully assess the standing of the insurer being reviewed based on the quality of the information provided. Under most legislation governing the actuarial profession, the appointed actuary has a right of access to all information (books, statements, accounts) as can be reasonably considered necessary to allow them to successfully complete the functions required. The requirement is also placed on the firm that it makes all of the information fully available and must provide the actuary with sufficient resources, including access to relevant individuals, as well as data, to facilitate the actually in their duties.

Upon completion of the review, the insurer is required to allow the actuary direct access to the company's board of directors to allow them to relay the findings of their report and to give advice based on these findings. What could possibly go wrong?

Under the hammer

The actuarial profession has come under increasing scrutiny, with a dramatic rise in the number of legal actions involving actuaries over the last ten years. Cases against actuaries are usually for malpractice, citing poor reserve estimates, errors in valuation programming, or conflicts of interest. One such case is that of HIH. On 17 April 2003, the HIH Royal Commission, set up in the aftermath of the collapse of the second largest general insurer in Australia, publicly issued a series of 61 recommendations to prevent such an event reoccurring. The recommendations have since swept across the insurance regulatory landscape like a bushfire, with few bodies escaping some form of fire damage. While never set up to point the finger of blame, the Commission referred a series of individuals and entities to the Australian Securities & Investments Commission (ASIC) or the Director of Public Prosecutions (DPP), including a number of actuaries, for possible breaches of the law. However, it was David Slee, HIH's consulting actuary, who took the brunt of the heat.

Slee was accused of underestimating HIH's outstanding claims liabilities by approximately A$5.3bn, according to Richard Wilkinson, an actuarial consultant from KPMG employed by liquidator Tony McGrath to crunch the figures of the defunct insurer. However, the Commission was informed that for a number of years, Slee's actuarial reports had cited accounting deficiencies which were affecting risk valuations, but these warnings had never been acted upon. It was also said that Slee was denied access to information deemed vital to an accurate review of the insurer's financial standing.

A number of questions arose from this case, and the Institute of Actuaries of Australia (IAAust) sought to tackle them head on, resulting in its report of 5 May 2003 into the findings of the HIH Royal Commission. In its submission to the Commission, the IAAust had highlighted the importance of independent peer review by another actuary of an actuary's annual report on an insurer's liabilities. However, the Commissioner, while appreciating that such a procedure would be worthwhile, did not feel inclined to make it a mandatory process, stating that it may prove overly costly and delay the process.

Even so, in Recommendations 15 and 16, the Commissioner called upon the Australian Prudential Regulation Authority (APRA) and the IAAust to implement "compulsory certification of the completeness and accuracy of data, and a requirement for more detailed disclosure of the exercise, incidence and impact of subjective judgment and departure from historical experience", according to the report. Although it is not yet compulsory for governing bodies to certify their members' work, the onus on the professional to provide an adequate description of the methods used and the reasons for choosing these methods is on the increase.

It is also interesting to note that the Commissioner stated that, "prior to the collapse of HIH, the actuary had no formal or statutory role in the regulatory framework of the general insurance industry". In October 2003, the IAIS issued a guidance paper entitled The use of actuaries as part of a supervisory model, which highlighted the importance of the actuary in ensuring the financial standing not only of the individual company, but of the insurance industry as a whole. The use of the actuary in a supervisory role is fairly widespread, but in some jurisdictions the role takes on more of a regulatory focus, such as in Canada, where the 'responsible' actuary is under a legislative duty to 'whistleblow' to the insurance supervisor should the management of the insurer in question fail to act upon the actuary's advice.

Conclusion

In response to the S&P report of last November, Rade Musulin, chairperson of the American Academy of Actuaries' Communications Review Committee, said: "There are huge challenges in writing reserve opinions that consider all of the real and potential factors, much less unimaginable events such as September 11 ... Actuaries have estimated reserves within reasonable ranges but recent adverse events have caused losses that exceed reasonable expectations." This response sounds remarkably similar to those given by rating agencies when asked why they failed to spot the imminent decline of yet another re/insurer.