Views on Actuarial Risk

Jennifer Li, ASA, FCA, MAAA, is a lead actuary for the state of Alabama and represents the state on various National Association of Insurance Commissioners (NAIC) committees. “My life is full of surprises,” she says. “I never know who I am going to meet and how they will alter my plans and change my life.”

Li skipped high school and completed two bachelor’s degrees in engineering and statistics in 2003. After that, she obtained a master’s degree in actuarial science and in 2005 took on a corporate valuation role that focused on actuarial technical work. She then worked as a corporate actuary for more than 10 years for several U.S.- and European-based insurers, conducting actuarial modeling, model validation, assumption setting, pricing, profit testing, projection, product design, International Financial Reporting Standards (IFRS), U.S. generally accepted accounting principles (GAAP) and statutory valuation.

In 2016, she became an insurance regulator in the state of California and relocated to Alabama for a new adventure in 2020. This is now her sixth year as a regulator focusing on reviews in life and annuity principle-based reserving (PBR), asset adequacy analysis, enterprise risk management (ERM), governance, rates of long-term care and health insurance.

In this interview, Li talks about her regulatory experience and provides her perspective on actuarial risk.

Please describe your regulatory experience as it relates to actuarial risk.

As a regulator, I have had many discussions with industry actuaries spanning various actuarial topics and different practice areas. Applying a largely principle-based approach requires more actuarial judgment. This brought to light the varying views of actuarial risk among actuaries serving different stakeholders in the market. One definition of actuarial risk is an actuary assesses risks inappropriately that could cause insurance insolvency or result in a mispriced product. It is a top concern with insurance regulators—that actuaries take the actuarial risk seriously and pay more attention to this topic.

What is your perspective on actuarial risk in today’s insurance market?

Today, insurance products enhance creativity to catch consumers’ eyes. Big data, machine learning (ML) and artificial intelligence (AI) have changed the role of insurance and, therefore, the role of actuaries has evolved for insurance innovation. Actuaries develop assumptions for innovative product specifications using more models, dynamic assumptions, predictive analytics, ML, AI or other advanced analytics that may create other risks such as human errors. Dealing effectively with actuarial risk in today’s volatile economic environment and insurance market is difficult. Although ML and AI could increase actuarial model accuracy to manage actuarial risk, they also could create additional risks such as unintended discriminatory pricing. Moreover, machines cannot improve with experience and will need to be rebuilt and retrained.

Insurance companies invest assets to support their reserves, and regulators oversee the insurance companies to ensure the assets are adequate to satisfy the companies’ obligations. Both insurance specifications and investment products embrace innovation to attract investors, especially those high-yield assets. The evolution of complex assets will increase actuarial risk further.

What regulations, actuarial guidelines and standards govern these risks?

Many Actuarial Standards of Practice (ASOPs) may be applicable to modeling with big data, ML, and AI, including ASOPs 1, 2, 7, 12, 15, 23, 25, 41, 54 and 56. As discussed earlier, AI could create additional risks such as unintended discriminatory pricing. I’ve heard from another insurance department that they took legislative action and introduced a bill to prohibit an insurer from unfair discrimination in insurance practices.

There are two new actuarial guidelines that will become effective soon. One guideline is for asset adequacy testing for investment product innovation focusing on complex assets or high-yield assets. This guideline will be incorporated into chapter 30 of the NAIC Valuation Manual (VM-30). Some ASOPs that may be applicable to this guideline are ASOPs 7, 11, 22, 23, 41 and 56.

Another guideline is for insurance product innovation for the new hybrid variable annuity product called index-linked variable annuity (ILVA). These ILVA products don’t have values determined directly by the market prices of the underlying assets. Therefore, this guideline sets forth principles and requirements for determining values. Some ASOPs that may be applicable to this guideline are ASOPs 7, 23, 41, 54 and 56.

During the NAIC spring national meeting, it was mentioned that the Actuarial Standards Board (ASB) is working on revisions to some ASOPs, such as ASOPs 7, 12 and 41, and is developing new ASOPs on reinsurance pricing and actuarial opinions without asset adequacy analysis.

As a regulator, how do you ensure a company properly measures actuarial risk?

It depends. Stress and sensitivity testing, scenario analysis, standard deviation, conditional tail expectation (CTE) and dynamic adjustment for the risk factors are my primary focus. For example, I may check the standard deviation of the actual-to-expected (A/E) ratio for experience studies, review standard deviations for equity scenario volatilities, examine CTE to see if a company could get benefits in the tail and assess tail behavior or tail risk.

Market risk is the material risk that interest rate and equity sensitivity may be captured by the stochastic rate paths from the scenario generator. I would review the market risk sensitivity results. Although some papers discuss how the results of stress testing could be misleading by model and parameter errors, it is still a powerful tool for tail shock and supports the company in building risk appetite and plans hedging. In reviewing the own risk and solvency assessment (ORSA) report, I compare the stress tests used, review mitigation strategies for risks and look for correlation among risk factors.

Moreover, I check if the company performs scenario testing for risk combinations and assesses the potential ripple effects. Companies are required to perform sensitivity tests for material risk factors and apply a safety margin for uncertainty. However, in reality, risks often occur in combinations. Thus, the single-factor sensitivity tests may be insufficient.

In today’s increasingly complex, uncertain and volatile world, companies face numerous risks and uncertainties. Thus, a sophisticated approach to assess the risk that incorporates multivariate actuarial risk modeling and stochastic simulation of many potential outcomes would help the regulator understand the effect of various scenarios on the company’s financial condition and solvency.

Regarding asset-liability management (ALM), I would consider the gross and net portfolio yield, average asset rating and the duration of the portfolio to ensure the asset strategies aim to support the liabilities. In addition, if the strategies related to actuarial risk have changed from the previous year, the reasons for such changes and the impacts on different risk factors (dollar amount and percentage) are essential items to review.

How can actuarial risk turn into opportunities for organizations?

I agree with the positive impact of a risk being an opportunity. For example, the fundamental concept of investment decisions is an asset that has a higher expected return also has a higher risk or volatility of that value. We have seen a much higher level of investment in new ventures and companies looking to grow their books. Companies know that they can optimize their portfolio allocation for diversification to reduce risks without overly depressing returns.

Actuarial risk evolves from the rapidly changing insurance market, which means risk assessment and management practices also may need to change. Companies must operate and adapt their risk, compliance, internal controls and information technology (IT) practice, as well as redefine their governance. It will make companies’ risk functions more efficient and enhance their overall reputation, which will further grow their businesses.

However, the evolving risk requires more skills to develop risk measures. I’ve heard companies voice their concerns that current modeling capabilities may not be very effective to manage greater risk as it continues to evolve.

What is the most notable issue that you observed in 2021?

Other state regulators observed that adding the prescribed mortality margins for some life/long-term care (LTC) combination products causes modeled reserves to decrease rather than increase. Chapters 20 and 31 of the NAIC Valuation Manual (VM-20 and VM-31) have been updated to address this issue to make sure that mortality margins always increase—rather than decrease—the modeled reserve.

There are many similar products in the Asian market, and their statutory reserve methodologies may be different than the U.S. market. I am not sure if they have the same issue.

What are your thoughts on the recent technology enhancements related to actuarial risk?

Predictive analytics has been around for a long time and has gained more attention due to the emergence of ML and AI. I’ve seen many companies use predictive modeling for underwriting, lapse or surrender rates, mortality rates and universal life (UL) premium assumptions. Some companies are using ML or AI in the testing process for actuarial assumptions in different practice areas.

An example of advanced analytics affecting actuarial risk that I was involved in related to a company that performed predictive modeling to determine lapse rates for a variable annuity product that resulted in a significant positive impact on their surplus. Many factors, including updated lapse data, impacted this result. But shifting to a predictive modeling technique had the most significant impact on the results.

Can you tell us more about “varying views of actuarial risk among actuaries” as you indicated in your response to the first question?

From my pricing reviews, some companies’ actuarial projections for their insurance products could create premiums that are unfair to consumers. In my actuarial valuation reviews, there are various findings that experience study is always the primary concern. Based on my reviewing experience, many actuarial communications and documentation from industry actuaries to regulators didn’t provide sufficient information. While some provided sufficient communication, there is always room for improvement. This is often the result of different considerations and perspectives among actuaries, or the actuaries seeing the actuarial risk from different angles.

Most insurance companies operate for profits. Thus, the corporate actuary handles actuarial risk with considerations of the company’s risk appetite, product competitiveness, financial targets and so forth. The regulator, on the other hand, emphasizes consumer protection, insurance market stability, governance and disclosure. The consulting actuary provides professional support and advice for the corporate actuary or regulator to meet their client’s requirements. Each reviews actuarial risk differently. The considerations of actuarial risk may be up for philosophical debate, where actuaries realize that there is a discrepancy between their points of view.

What are your suggestions to reconcile the varying views of actuarial risk among actuaries?

Increasing communication and transparency will work best to reconcile different perspectives among actuaries and bridge the gap between industry actuaries and regulators. The evolving principle-based approach leaves more room for interpretation. Transparency will go a long way toward building trust and a common ground between industry actuaries and regulators. To ensure companies are complying with regulations, companies should provide sufficient disclosures in the actuarial communications and documentation. Standards for communication and disclosure are outlined in ASOPs 21 and 41. The reviews I’ve worked on in which there was ideal transparency resulted in a much smoother review process.

Actuarial risk is more than just assumption setting. The company’s compliance team—in conjunction with actuarial and other related divisions—and senior management must incorporate the actuarial risk considerations throughout and document the effort to show regulators that the risks are addressed properly and ensure that the risk considerations are consistent across the business.

There is also a need to include governance in actuarial communications and documentation. Good governance is all about identifying, assessing and managing risk. There are ASOPs that address actuarial governance on data, assumptions and models, including ASOPs 10, 22, 23, 41, 54 and 56. Regulators would request evidence of a robust governance.

In your view, what is the primary challenge in reconciling varying views of actuarial risk between industry actuaries and regulators?

Disclosures! The difficult challenge ahead for companies is their concern about releasing sufficient material information to regulators as the actuarial risk may be considered based on their company’s business plans and financial purposes. The company also may worry that providing additional information possibly could trigger a regulatory investigation. Regulators would like to see a glass box instead of a black box. How to solidify disclosure requirements would be the regulator’s responsibility.

Do you have anything else to share about actuarial risk?

Actuarial risk is a broad subject. I have so much to say and will discuss actuarial risk in more detail, as well as the interactions between risks (actuarial and nonactuarial factors), in my next article. One risk could impact other risks immediately, or it could affect other risks after a certain period. Stay tuned for more.

The opinions expressed in this article are the authors’ own and do not necessarily represent the views of the Society of Actuaries, the U.S. government, any state departments or the National Association of Insurance Commissioners (NAIC).

Copyright © 2022 by the Society of Actuaries, Chicago, Illinois.