The role of the actuary in non-life insurance has expanded out of all recognition as companies seek to understand their risk profile. However, you do not have to be an actuary to apply actuarial methods, says Peter Lee.

Despite the much talked about change in the global insurance and reinsurance industries, the press has passed relatively little comment about the role of the actuary. Yet this role has changed out of all recognition over the last two decades. The process may not be the stuff of catchy headlines, but its influence extends to virtually every area of operation.

The actuary is no longer a shadowy figure who crunches numbers in the background - or at least this need not be the case. Actuarial analysis is used increasingly to give insurers and reinsurers competitive advantage in areas that were previously out of bounds, such as pricing, capital allocation, product development, and even marketing. And much of the most creative, innovative work is to be found in the non-life sector.

Actuaries in the US and Europe have led these changes. Lloyd's of London started the practice of using actuaries in non-life insurance in the early 1980s, driven by the statutory requirement for minimum solvency levels and the need to be more professional in their measurement. The authorities demanded scientific methods of assessing risk and the reserving levels required to support insurance activity. The reinsurance company market in London quickly followed.

By the end of the decade, the spotlight was very much on domestic UK personal lines insurers. The British insurance market was, and still remains, one of the most competitive in the world, and arguably the most deregulated. To survive and make a profit in such a cut-throat environment, companies must use their own data to gain the best possible understanding of the risks they are accepting, as well as their overall exposure as a company.

It was natural, therefore, that the UK should lead the way in the development of actuarial and statistical methodology. Particularly important was the fact that insurers did not have access to industry-wide pooled data and they had to make the best use of their own data, however small. This soon extended beyond reserving into pricing, and many actuaries have become involved in product development that combines actuarial risk assessment, market competitiveness and underwriting judgment. To support this, actuarial techniques are being developed that focus on the demand side of the profit equation, analysing both customer and competitor behaviour, and their reactions to price change.

Mike Brockman, one of the pioneers of this pricing activity, acknowledges that the early methods and pricing principles were basic by today's standards. With the help of more advanced statistical techniques, supported by powerful, state-of-the-art actuarial software that takes into account competitors' activities, it is now possible to be far more detailed, specific and accurate about what constitutes a profitable price for a particular policy or customer.

Explicit rating tables can be developed to calculate the technical rate for any risk to which expenses are added, either proportionately or additively, depending on the operational infrastructure. Price modifier tables can then be layered on top of this to allow underwriters and marketeers to pitch the price on commercial or qualitative grounds. Each `component' of the premium can be stored on a database for management information feedback and control purposes.

The UK motor markets were the first to embrace this new approach, closely followed by the domestic household markets. In the latter case, the technical rates can make use of the wealth of external information available related to the impact of natural perils. Typically, the technical rates for each postcode zone - a convenient differentiator of physical location - take into account the propensity for flood, windstorm, subsidence and theft, for which external data providers have built predictive models. These can be combined with the insurer's own information, and the technical rating structures can be designed to be reflective of each peril risk. More recently, the industrial and commercial insurance markets have begun to follow suit. Actuaries are now being challenged to develop these ideas for both the small and large risks, and even global commercial exposures.

In the past six or seven years actuaries have also been involved, in the development of pricing skills and software solutions for the reinsurance market where relevant data can be scarce, and where pricing strategy is difficult to determine. This requires careful analysis of existing in-house data, supported by available data from the wider market. What constitutes an acceptable price for a risk, and the trade-off implied in risk-based capital between the uncertainty of the lines written and the likely size of return, constitutes a key strategic decision.

It is important to stress that decisions about pricing are determined by wider considerations than just actuarial analysis, and probably always will be. It is for underwriters and their most senior managers to determine overall strategy, for example, whether profit or market share should be the main corporate imperative.

Nonetheless, if insurers and reinsurers are to be competitive, these deliberations demand the best possible information. Nearly all insurance and reinsurance companies are sitting on a wealth of data, and only a small minority of them put it to full use. Actuarial methods are now accepted as integral to the business process, an aid to reducing nasty surprises to the minimum. In fact, they are so valuable that they should not be restricted to actuaries.

One of the greatest contributions the actuarial profession can make to the underwriting community is to pass on more of its skills, so that decisions are more technically based. Basic actuarial knowledge underpinned by modern systems of data gathering and analysis will help the industry remain profitable even when there is a downturn in rates. The actuary's job too often involves advising insurers and reinsurers where they went wrong in retrospect, rather than helping them to get it right in the first place. When underwriters and their managers know the right questions to ask, where to find the necessary data and how to interpret it, and who can understand and manipulate risk models, they are more likely to make a profit for their shareholders.

Having extolled the virtues of my profession, it is also important to stress that there are certain limits. We will never replace underwriters, although a few actuaries have become underwriters, and some have even become chief executives. Our main focus, however, is to provide informed analysis from which the big decisions can be made. With that reservation, the full potential for the use of actuarial knowledge has yet to be fulfilled. It will continue to develop as insurers and reinsurers seek new ways to understand the markets they are in and the risks they are accepting. One area of current expansion is the use of financial modeling to test the strength of insurance and reinsurance companies (see box above).

The number of actuaries will certainly increase, as will the scope and range of their activity. A sophisticated understanding of numbers, and how they interrelate, will always be the core skill, but a lot more is now required of an actuary. Knowing how to make full use of information technology is essential, as is a sound understanding of the business and underwriting processes. Getting the right balance and relationships between actuaries and underwriters is a business-critical challenge for the modern insurer and reinsurer.

Understanding risk experience
When is an insurance or reinsurance company financially secure? How should solvency be measured? Under what extreme circumstances would an insurer be unable to meet its obligations? Some of the most advanced actuarial work tries to answer these questions, which are almost as old as the industry itself. Although September 11 has speeded up the process, regulators throughout much of the world, especially Europe and North America, were already demanding a risk-based approach to solvency. This requires insurers and reinsurers to demonstrate that their businesses could withstand extreme events, or combinations of loss events.

Insurers increasingly have to show that they have fully identified their risks and potential aggregate exposures, that they have allowed for external influences such as possible bad reinsurance debts and adverse movements in investment markets, and that they have reviewed the full range of outcomes, including the possibility of several negative developments happening at the same time.

To achieve this, a growing number of large insurers and reinsurers are creating dynamically-based financial models. Although mathematically complex, they can give simple answers to key questions about a company's ability to handle its exposures. Apart from helping to satisfy regulators, these financial models can help insurers make full use of their capital. Benefits include:

  • capital adequacy and allocation;
  • scenario testing;
  • reinsurance purchasing;
  • product and pricing strategy;
  • security ratings;
  • business expansion; and
  • mergers and acquisitions.
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  • Peter Lee is a senior consultant at specialist non-life actuary EMB (formerly English Matthews Brockman).

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