By Michelle Bradley, ACAS, MAAA, ARM, CERA and Enoch Starnes
Through a series of blogs, SIGMA has begun to address some common questions, requirements, and issues based on our previous experience with clients and auditors. The first blog in the series focused on actuarial qualifications and an actuarial qualification statement. The second focused on auditor inquiries related to actuarial independence. In our third entry, we focused on the interaction between auditors and actuaries in regards to the data used in an actuarial analysis. The fourth topic covered the various dates used in the process of an actuarial analysis. This article will focus on the actuarial methodology and common audit inquires related to methodology.
A previous SIGMA blog article addressed actuarial methods. Specifically, it discussed common methods used along with their strengths and weaknesses. The Actuarial Standard of Practice 43 (ASOP 43) is referenced in this blog, particularly Section 3.6.1. It may be helpful to review the article’s contents before continuing:
Though we are unlikely to cover every aspect of actuarial methodology, there are a number of areas commonly targeted for inquiry that we will focus on. The first of these is in regards to loss development factors. Often, auditors want to understand the source and methodology used in their calculation. If the selected factors are unique to the company’s loss history, how credible is the loss history itself? In this particular instance, credibility is based on a couple different items: the volume and indicativeness of the historical data provided. Volume-wise, actuaries typically only rely on a company’s loss history if there are at least three sets of data evaluated at sequential (normally annual) points in time. More importantly, the data provided must be indicative of the company’s future loss patterns. Large amounts of historical data could easily be invalidated if, for instance, the company has a division that is part of an acquisition or shifts their focus to a different industry.
When calculating ultimate loss estimations, large claims and the methods used to deal with them are another area often placed under high scrutiny. For example, does the actuary consider the frequency with which large claims occur in relation to the overall claim frequency? Are the probabilities of these claims occurring reflected in both the estimated ultimate losses and pure loss rate? Vital to these considerations are the company’s retention levels. While auditors usually check that retentions are understood by the actuary on a basic level, they are also very interested in situations that include high retention levels in relation to the average loss severity. In these cases, provisions must be made by the actuary for the chance, small though it may be, that a claim far exceeds the averages indicated by the loss history.
The outcome of the aforementioned methods, the estimated required reserve amount, is usually given a range around a central point. This range and the methods used to create it can cause a few questions during the auditing process. The most basic of these is what the range is based on. Does it comply with what the actuarial industry would consider reasonable? If it is skewed optimistically or pessimistically, what are the reasons for that adjustment? A number of factors can alter the size of a range, including the number of open claims, the retention level, and the variability indicated by the company’s loss history, among others. Companies who are given a range for their reserve estimation must also be careful when selecting what point within that range they wish to reserve at (given that they do not choose the central point). If, for whatever reason, they switch between the optimistic and pessimistic ends of a range from one evaluation to the next, an auditor may call into question what caused them to do so. In simpler terms, they may wish to know what caused the company to suddenly change their stance on their expected losses. Finally, companies who attempt to reserve at the optimistic end of a given range and then further reduce the estimate by discounting should consider that auditors normally do not allow this.
Inquiries can be made into the economic side of an analysis as well. One of the most common questions is in regard to the methodology or source for the selection of the discount rate. Does it come directly from the company, and if not, does it consider the company’s industry and economic climate? Furthermore, in situations that include divested or new operations, auditors typically examine the ways in which actuaries adjust their methodology to reflect the impact of those situations. Trend factors can also become a topic for discussion if projection methods are considered for immature historical periods.
As you’ve probably gathered by now, actuarial science contains many facets beyond the most obvious mechanical ones. The act of creating an actuarial analysis involves a great deal of judgment, making the use of proper methodology incredibly important to ensuring as much accuracy as possible. Of course, auditors are well aware of this fact and devote a significant portion of their time and resources to investigating the various methods an actuary uses along with their reasons for doing so. By identifying methodological areas that are often subject to more scrutiny and working with your actuary to remedy any questionable items lying therein, you should be able to not only ensure that the auditing process goes smoothly, but also feel confident in your knowledge of the actuarial process and how it helps your organization.
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© 2015 SIGMA Actuarial Consulting Group, Inc.