PD 6 – Update on International Standards

PD 6 – Update on International Standards Presentation to the CIA Appointed Actuary Seminar In Montreal on September 20, 2004 by W. Paul McCrossan

Three hot and burning issues that might affect Canadian FCIAs • Morris Commission into the Actuarial Profession in the UK is being watched closely by OSFI who are prepared to talk to Morris • 2006 ICA and concerns of the CICA • Use of equity returns in liability calculations

Morris Royal Commission in the Actuarial Profession in the UK • Background failure of Equitable Life, stresses in other prominent UK life insurers • Wind up and curtailment of many UK pension schemes • Failure of one general insurer • Sustained press and judicial criticism of actuaries (the “archaic actuary” in a series of articles in the Financial Times)

Lord Penrose’s Overall Conclusions • Professional standards – insufficiently developed • Discipline – weak • Appointed Actuary – too much reliance • Professional culture – slow to criticize • Intellectual Base – too narrow to bear its responsibilities • Professional governance – not open to scrutiny • GAD – complacent

Weak professional standards concerning PRE • The standard was composed “in terms of Delphic obscurity” • “The guidance offered no standards of performance … such as might have been expected of a professional body” • “In attempting to put a professional gloss on the language of the Act, the profession appears, no doubt unintentionally, to have seriously misled itself”

Weak professional standards concerning PRE(Continued) • “Some elements of the profession took an overly narrow view of PRE (i.e. that there could be adequate reserving without provision for terminal bonus)”. • “The actuarial profession as a whole failed to develop any coherent principles or rules of practice … (because) the profession resisted prescription”.

Absence of guidance on liabilities on embedded options (GAOs) “As late as 1997, when it set up a working party to consider the issue, the actuarial profession had not established any specific guidance on reserving for annuity guarantees … despite a clear requirement to value all guarantees in the regulations.” “(Even) when the working party reported later in 1997, it failed to recommend an approachto be taken.”

Absence of guidance on liabilities on embedded options (GAOs) continued • “Professional bodies that confer privileges on their members have corresponding obligations to ensure that there are sufficient and effective professional standards by which to measure members’ performance of their duties to their clients and the public.” • “Recognizing the idiosyncratic practices of individual members is not an acceptable substitute.” • “It is proof of a failure to consider and resolve the issue over decades in which policyholders’ contributions were taken under deferred annuity contracts.”

Professional Discipline is weak due to poor standards and poor disciplinary processes • “If any external reliance is to be placed on the professional opinion of any actuary, the actuarial profession must be encouraged to impose appropriate discipline … if the profession does not wish to be judged by the lowest common denominator: • it must have a well-developed set of prescribed standards; and • it must have a properly developed procedural system to confront deviant conduct.”

Professional Discipline is weak due to poor standards and poor disciplinary processes (Continued) • “It would improve the public image of the profession if it were seen to accept the responsibility for direct intervention. … I would invite ministers to offer encouragement and support for initiatives that the profession might take in this direction.”

Role of the Appointed Actuary • “Regulation was based on an over-reliance on the appointed actuary …” • “There must be concern at the reliance that has been placed in the past on an office that could encompass such extremes in terms of experience and authority within life offices.” • GN1’s note to actuaries who are directors (“A special responsibility is owed to the (AA) by any other actuary who is a director … he should be careful not to act in any way as to diminish the status of the (AA)”) led to a reluctance to criticize.

Role of the Appointed Actuary(Continued) • (Even with respect to Lord Penrose’s own actuarial advisor), “actuaries have proved singularly reticent in criticism of fellow professionals”. • “Without firm rules or well developed principles there was … an inadequate basis for criticism that would have beenrobust in the face of hostile reaction.”

The actuarial profession is too narrow to bear the responsibilities it has assumed • “No specific accounting standards have been issued by the appropriate … bodies … (and) insurance regulations … in addition to actuarial guidance issued by the profession to its members (have governed)”. • “The published accounts … became progressively less relevant as reflections of the actual conduct of business of the Society … consistent with practice that had failed to keep up with industrial developments.”

The actuarial profession is too narrow to bear the responsibilities it has assumed (Continued) • “Actuaries … were not competent to adjudicate on the (legal) issues that emerged.”

The actuaries’ work is not open to scrutiny • “There is no effective monitoring, and poor understanding, of the dividing lines between the technical actuarial area and the exercise of discretionary powers based on technical material.” • “It appears to be a particular conceit of the actuaries that the exercise of discretion was as much their exclusive preserve as the arithmetic that instructed it.”

The actuaries’ work is not open to scrutiny (Continued) • “It is the defining characteristic of an expert that he or she can communicate the results of his or her expertise with sufficient clarity to enable any reasonably intelligent person vested with decision making power effectively to exercise that power. Actuaries need not be in an exceptional position in this respect.” • “(The) precise arrangements are less important than the solution to the problem of independent and effective actuarial ‘audit’ “

On the GAD • “There was a general failure on the part of the regulators and GAD to follow up issues that arose in the course of their regulation.” • “Given the confused state of the information, it was perhaps understandable that GAD failed immediately to detect the true meaning of disclosures. However, it is less understandable that the obscurity did not provoke detailed and relevant questioning.”

On the GAD(Continued) • “The failure to respond to the information tendered about … (inadequate provisioning for) … annuity guarantees … was a serious error.” • “(C)asual acceptance of the Society’s position on guarantees … reflects complacency for which there could be no justification.”

The CICA’s concerns with the ICA (and JPS) Both the JPS and ICA (in Section 346) allow the auditor to use the valuation by the (AA) of the actuarial and other policy liabilities as at the end of a financial year and the increase in the actuarial liabilities of the company for a financial year. Auditors allege actuaries and insurers are resisting additional analysis by the auditor beyond simply using the work of the AA. The problem may be either about professional fees or about a failure to use section 347 (right to information) aggressively. One possible solution to this resistance is to remove section 346 from the 2006 ICA.

Use of equity returns in liability calculations A major problem in UK insurance and pension liability calculations is the use of expected equity returns in liability calculations. Actuarial liabilities should not just reflect provisions for best estimate returns but should have some prudential margin in them.

Use of equity returns in liability calculations (Continued) In the case of insurer segregated fund guarantees in Canada, the approach to prudential requirements is that a GAAP liability in respect of “fat tailed” equity experience should be in the range 60 CTE to 80 CTE. In Australia 80% confidence levels are used. But in the UK, practice was to use expected long term returns even as the insurance and pension contracts had high levels of guarantees.

Use of equity returns in Canadian liability calculations In Canada, similar (but different) techniques are used by pension actuaries and insurance actuaries in respect of returns from equities backing fixed dollar liabilities. These may lead to lower liabilities than would be determined if assets were assumed to be investment quality bonds. BUT, the 60 and 80 CTE returns expected from equities derived from stochastic modeling are far less than expected returns from equities and the 60 CTE is (as expected) close to the 80% confidence level using post 1924 TSE 300 total return data.

Use of equity returns in Canadian liability calculations(Continued) Can the use of expected yields on equities be justified for use in liability calculations – even given the equity RBC factor when the expected levels of returns after defaults from bonds have much greater certainty?

Canadian actuaries should be pro-active in addressing perceived problems • Complacency may lead to challenges to the role of the actuary. • “If it does break”, will actuaries be allowed to fix it?

PD 6 – Update on International Standards