Relevance of Risk Margin to The Actuarial Control Cycle

The principle underlying the actuarial control cycle are:

• Identifying a business problem
• Addressing the problem or analysing the problem to be able to implement solutions
• These actions are monitored, and the process repeated if another problem suffices or the solutions are not working as intended. Therefore, it is a cycle.

All these are done within the context of actuarial work.

Identifying the Problem

In terms of reserves set for life insurance companies, businesses have identified that there are a lot of uncertainties around the figures due to factors such as data error, underwriting risk, risk around methodologies, assumptions assumed, regulatory environment, physical environment, and outbreak of diseases and so on. Due to these uncertainties, companies sometimes end up paying more than reserved for which impacts profit and could even result to insolvency depending on the size of the variation. For instance, a case where not all data involved in analyzing a portfolio was used for reserving can result to under reserving. Also, if we are overly prudent with mortality assumptions and do not fit the mortality table to represent the target population, we might be understating our death cost. There could also be cases of expense allocation not done properly per policy and inflation not assumed right. All these cases and more can result to reserves being insufficient to meet future liabilities.

Analyze the problem and Implement the Solution

One-way businesses have addressed this to look at the impact on reserves if these assumptions were to be higher than that was assumed. Sensitivity and stress tests can be done. That way, the business can also look at past experiences together to assess the level of variation. By doing this, one way to address this problem is to add a risk margin on the reserve arrived at. This acts as a buffer if the actual experience is more than the projected reserves calculated. It helps to ensure that the company has made provisions for unforeseen events.

The regulators also help in this regard by ensuring that all company’s reserves are no less than 75% confidence level. This is being referred to as a 75% probability of sufficiency in general insurance.

Monitoring Experience

It is one thing to set a risk margin, it is also another thing to ensure that the level set is realistic for the business and still enough, especially for a business that constantly expands its portfolio. Some reasons for monitoring experience are:

• review assumptions;
• to be able to understand the trend behind the emerging experience and factors facilitating it;
• to develop a history and trend of experience over time;
• to assist in the analysis of profit;
• to provide information to different Stakeholders such as regulators, shareholders, management, and so on.

Shareholders would be interested in this result as they would want to know the drivers behind the profit and management should be able to justify the high-risk margin set for the business. Ideally, we expect risk margins to be set high when a company’s portfolio is dominant in a high-risk area. Experience analysis, therefore, helps the business to review its assumptions. Also, when drivers behind emerging experiences are identified and analyzed, it helps the company’s risk management team to be able to focus on those areas also and speak to the necessary team to ensure efficiency. That way, risks are being managed. For example, if it is noticed that lapse rates are increasing higher than expected, a business will be able to look more into why this is happening and why they cannot retain business. A business can also decide to review guarantee rates on investment contracts if the economy is performing poorly and it is anticipated to continue that way for some years.

With this process, a business can then decide if to reset assumptions and the level of risk margin. It is very important to ensure data quality with this process.

Context of Actuarial Work

When setting the appropriate level of risk margin, factors affecting our work also must be considered. Such as the regulatory view on risk margin, and what we anticipate the inflation rate or interest rate to be in the future based on economic indices. Most life insurance contracts are long-term in nature, so the discount factor used to determine r the present value of reserves is important, especially for long-duration contracts. Our physical environment in case of an outbreak of diseases also needs to be considered when deciding the assumptions to use.

Conclusion

Risk margin is therefore important to act as a buffer for the uncertainties and can serve as a useful tool in managing risk. When a company makes an allowance of such risks, it in one way, helps to prevent insolvency. It is therefore important that risks associated with the business are identified and analyzed before deciding the appropriate level of risk margin to use.

Risk margin is not just applied in reserving but also used in other areas such as pricing, economic capital, and embedded value computations. It is also important when a company wants to determine the value of the new business.

The size of the risk margin determines the profit that will be declared. Under Margin of Surplus, the best estimate liability will increase in the year of change and reduce profit margin. Full recognition of liabilities needs to be made as early as possible, ideally in the same year of earned premium. Thus, provision is made in advance of future claims payments that will ultimately emerge. The risk margin will not only impact the initial profit or loss at the start but also emerging profit in later years. If an appropriate risk margin representing the portfolio is not considered, then profit can be overstated which may result to insolvency if the experience deviates from the projected.