INTERNATIONAL ACTUARIAL ASSOCIATION (IAA)

THE FUNCTION OF THE ACTUARY IN PRUDENTIAL

SUPERVISION

Introduction
The International Actuarial Association, (“IAA”) is the organization of actuarial associations
representing over 95% of the world’s professional actuaries all of whose full members are
subject to qualification standards and codes of professional conduct. The qualification standards
require a combination of education and experience that assure a unique understanding of the
insurance industry, the operations of insurance companies, and the internal and external factors
that impact insurance companies.
This paper documents a range of functions in which actuaries can be engaged in the prudential
supervision of insurance companies. It incorporates a number of activities that insurance
supervisors may call upon actuaries to perform, all of which can be of substantial assistance and
value in the regulatory process.
We recognize that the roles that actuaries are expected to perform will vary over time by country,
line of business, relationship to the company, and corporate structure and culture. These
differences must be taken into account in applying the various comments and recommendations
contained in this paper and the reader should not expect that every recommendation can or
should be applied in every circumstance. It is hoped, however, that this paper will provide some
insights into ways that actuaries may be able to help make the supervision of the business of
insurance more effective and more efficient.
We also recognize that various terms related to the business of insurance and corporate
governance are used in different ways in different lines of business, countries and cultures and
many of those differences cannot be addressed in this relatively short paper. For example, this
paper is written from the more common perspective of a Board of Directors having ultimate
responsibility over the management of an insurer but we recognize that other models may also be
applicable even though they are not addressed herein. Another example is the treatment of
policyholders is phrased in terms of “policyholders’ reasonable expectations” but in some
jurisdictions the treatment of policyholders is determined in different ways using different
descriptive language.
While each of the activities documented in this paper is within the scope of actuarial capability in
most jurisdictions, the actuaries in a specific jurisdiction may not yet be in a position to carry out
a particular assignment for a variety of reasons such as limited numbers or experience of
members, relative maturity of the profession and its members, or inadequate legal framework.
Therefore, insurance supervisors should recognize that additional preparation may be required by
the local actuarial organization or amendments may be required in applicable legislation, before

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actuaries in the jurisdiction can fulfill such responsibilities. The IAA is prepared to assist both
the local regulator and the local actuarial association wherever desired.
The evolution of prudential supervision of insurance companies is at different stages in different
countries and we recognize that conditions in a particular jurisdiction such as the size and
number of companies, the products they sell, and resources available to regulators also
determine, in large part, the appropriate regulatory regime. The role of actuaries in that
supervision also varies and is evolving everywhere, extremely rapidly in some places. The
various functions described in this note represent a range of approaches that we hope that IAA
member associations and the regulators with whom they work can utilize to progress toward
more effective and efficient prudential supervision. This document will itself evolve as actuarial
capability and accepted practice in prudential supervision each develop
The paper also sets out both issues in prudential supervision that the IAA believes should be of
particular concern to regulators and significant factors that actuaries consider in evaluating
insurers’ financial condition. This document should be read in conjunction with the more
detailed note, “Insurance Liabilities – Valuation and Capital Requirements,” prepared by the
IAA’s Insurance Accounting Committee as an adjunct to their consideration of the IASC’s 1999
Insurance Issue Paper.
This paper is meant to be a basis for broad ongoing dialogues with both the IAA member
organizations and with the International Association of Insurance Supervisors (“IAIS”) on the
involvement of actuaries in the prudential supervision of insurers. In particular, this paper
extends the scope of the Committee’s response to the IAIS’s own paper, “On Solvency, Solvency
Assessment and Actuarial Issues,” published in April 2000. We are also aware that IAIS has
published a draft paper, “The Use of Actuaries as Part of a Supervisory Model.” We hope that
this paper along with ongoing dialogue may be of assistance in that process.

The Importance of Prudential Supervision

The IAA is committed to the effective supervision of insurers and fully supports the work of the
IAIS in raising standards in all aspects of the prudential supervision and management of
solvency of insurers. In particular, the IAA continues to promote high standards of actuarial
practice in regard to insurance finances. The IAA is doing this by promoting common standards
for examining technical competence, for professional conduct and for disciplinary procedures.
Clearly, these practices, when implemented in a particular jurisdiction, will need to conform to
local laws and regulations. The IAA recommends that the IAIS encourage the convergence of the
principles of regulations where practical.

The actuarial profession is especially well placed to support regulators in safeguarding the
interests of policyholders. This is partly because the profession’s training and practice provides
insight and experience in managing the risks which insurance companies face. It is also because,
the requirement to serve the public is highlighted in the principles of the profession (IAA
Statutes, Article 3).

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Framework for Solvency and Capital Adequacy

The IAA believes that, in order to operate prudently, the total financial requirement for an
insurer can best be expressed as the sum of:

(i) a realistic provision based on the expected value of future experience (described
below as the funding criterion) which meets the existing obligations of the company;
plus

(ii) an additional capital sum based on the risks in the insurer’s business (generically
known as “risk-based capital”) and the insurer’s immediate business and capital
investment plans, and which is intended to provide a minimum defined level of
capital adequacy.

The IAA favors this approach because it believes that an insurer’s ongoing financial soundness is
maintained through a combination of profitable business operations and sufficient capital.
Profitable operations indicate that the insurer is building its capital base and is likely to remain in
business for the foreseeable future. It also gives some indication of the quality of management.
Sufficient capital indicates that the insurer can meet, with a particular level of confidence, the
inevitable fluctuations in risk exposures, claim amounts and financial circumstances that may be
expected to occur over the runoff of its existing policy obligations, while funding the essential
capital requirements of new policies, technological developments and general business
initiatives.

The analysis and management of insurance risk have been core skills of the actuarial profession
since its earliest days and continue to be central to its scientific development. The IAA sees this
process as a key responsibility of the actuarial profession and encourages investigation into the
identification, understanding and quantification of the risks inherent in insurance enterprises. It
seeks to bring together relevant research and practical experience, both by actuaries and by other
related disciplines such as financial economists, accountants and risk managers, as well as work
by seismologists, engineers, meteorologists, epidemiologists and the like, in order to provide a
coherent risk framework to the insurance industry and its regulators. On the basis of this
developing risk framework, the IAA seeks to investigate appropriate structures for risk-based
capital measures.

The IAA recognizes that the prudent management of an insurer depends on broad application of
risk management techniques; techniques such as the use of dynamic financial models, scenario
testing, statistical estimation and credibility analysis to identify the steps management can take to
understand, avoid or mitigate adverse outcomes. Actuaries’ knowledge of risk analysis
techniques, coupled with practical experience in applying them, permits actuaries to play a
central role in maintaining the integrity of this process.

Regulators of financial institutions are coming to appreciate the value of comprehensive

solvency management to assess a company’s financial soundness. The actuarial profession
endorses this development. If regulators wish to rely, in the future, on such comprehensive

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solvency management, the actuarial profession is well placed to provide professional opinions
concerning, and to participate in, the work performed.

Further, the ongoing financial soundness of insurers depends not only on quantitative data but on
qualitative analysis as well as an effective business framework. This includes coherent and
comprehensive risk management systems, a “fit and proper” regime for directors and executives
and strong corporate governance procedures. In many jurisdictions, the actuarial profession has
been able to contribute its experience and perspective to help strengthen the design of such
qualitative prudential systems.

The Involvement of Actuaries

In the simplest of insurance regimes, supervisory authorities may choose to rely solely on the
regular preparation and submission of prescribed financial data based on a formulaic approach.
The training and expertise of actuaries can be helpful in such a process, particularly in
developing and validating the appropriate formulas, but may not be absolutely essential in the
application of the formulae.

However, the growing sophistication and complexity of insurance products and markets make
reliance on a formulaic approach as the primary solution increasingly unreliable. Unless
innovation is to be curtailed, the evolving insurance industry will generally require a supervisory
framework beyond a rigid supervisory structure. In addition, for some products such as general
insurance, the dynamics of the claims process render inherently unreliable the use of rigid
formulae across all companies. We believe that supervisory authorities can rely upon actuaries’
experience, training and professional integrity to support more dynamic regulatory oversight.

Actuaries, as members of a professional body, must meet high standards of conduct, qualification
and practice. They are monitored by their professional colleagues and are subject to disciplinary
procedures, a professional process specifically developed to strengthen the level of confidence
on the part of insurance supervisors.

Actuarial professional bodies develop codes of conduct that require actuaries to meet high
standards of integrity and competence. Codes of conduct also set the priorities by which
actuaries must abide, regardless of commercial pressures (although it is strongly recommended
that these codes of conduct be underpinned by a supportive regulatory and legislative system).

The IAA has begun developing international standards of practice, particularly with respect to
the implementation of international accounting requirements. The IAA also encourages local
actuarial associations to develop nation specific standards of practice for actuaries working in
their countries. Consequently, professional standards, of both conduct and practice are being
established and maintained at all appropriate levels.

The IAA believes that the supervision of insurers is well served by the active involvement of
actuaries in a broad range of financial activities including, whenever feasible, management at a
senior level within a company or organization. In some instances, when supported by the

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appropriate legal framework and safeguards, the IAA has seen great value from the appointment
of one actuary as the "responsible" or "appointed" actuary to take professional responsibility for
the management of actuarial aspects of the insurer's operations, including the evaluation of the
financial risks that could affect the insurer’s capital needs. In other cases, we have seen the
effective use of more than one actuary to provide the actuarial opinions required by law. The
IAA recognizes that accountants, lawyers, experts in particular risks such as seismologists, and
other professionals also provide important expertise to the overall management of insurance
companies. However, actuaries’ unique blend of training, professional standards and practical
application enable them to quantify, project and manage the full range of risks making their
participation on an insurer’s team of management professionals invaluable. This should be the
benchmark by which alternative risk control mechanisms are tested and we believe that, for most
practical purposes, this makes the presence of a “responsible” actuary an essential component.

The Range of Actuarial Involvement in Prudential Supervision

The "responsible" actuary, where that approach to actuarial involvement in management is
adopted, should have direct and regular access both to the Board of Directors of the insurer and
to the highest level of executive management. The IAA believes that supervision is best served
by involving the actuary in all of the five areas described below. In general, effectiveness is
usually diminished by excluding one or more of them. The key areas for which active actuarial
participation may be considered valuable are:

(i) Pricing and product design;

(ii) Monitoring the expectations of policyholders and potential policyholders where policies
allow the management of insurance companies to exercise discretion over contractual
terms and conditions.

(iii) Establishing aggregate policy and claim liabilities;

(iv) Determining compliance with legal or regulatory capital requirements when applicable
and recommending appropriate capital levels; and

(v) Reporting responsibility directly to the Board and, if statutorily required, to Regulators.

The relevant professional body should assist or provide a process, firstly, to prepare
"responsible" actuaries to make sure that they will be appropriately educated and experienced for
each of these responsibilities and, secondly, to monitor the discharge of their professional duties.

I. Pricing and product design

The premium level set by an insurer is the responsibility of the Board of Directors of the
insurance company, except to the extent that regulators restrict the premium setting process in
the territory concerned. In some corporate structures, the Board often delegates this
responsibility to management. Nevertheless, good supervision requires that the Board be advised
as to the financial implications of adopting any proposed premium pricing policy. The

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responsible actuary should be able to provide advice as to the soundness of the product’s
structure and whether the premiums are capable of covering the estimated cost of:

(i) the policy obligations;

(ii) the capital required to support the operation of the policy;

(iii) any policy options against the insurer, including the cost of hedging any risks (as
desirable). Where risks are unmatchable or uncontrollable, the responsible actuary
should be able to bring this to the attention management and the Board and to explain
the consequent increase in capital requirements; and

(iv) front and back office operations.

If the premiums are not capable of covering these costs, it is necessary to demonstrate that the
organization can absorb such subsidized pricing without impairing its overall financial
soundness.

Actuaries’ participation in product design and pricing can help balance the interests of
policyholders and shareholders, giving the regulator confidence that insurers are selling policies
which are sound in the context of their overall financial strength. This may allow regulators, in
some cases, to dispense with the process of requiring prior approval of premium rates or
dividend scales.

II Safeguarding Policyholder Interests

Many insurance policies, particularly life policies, permit the insurer to use discretion in
applying the terms and conditions relating to benefits that are not guaranteed. Also, outcomes
for policyholders can be uncertain, for example, because of future investment conditions. In
these circumstances, while others may have direct responsibility for the fair treatment of
policyholders, the responsible actuary can, as part of the regulatory requirements, monitor the
reasonable expectations of policyholders and how they are treated as the insurer exercises the
contractual discretion in the policy. While others might be given this monitoring responsibility,
we believe that, in most instances, the responsible actuary is in a strong position to do this work
and can be assisted by professional standards of practice.

Policyholders’ expectations might arise either through information provided at the time of sale,
or through the continuing practice of the insurer. If the responsible actuary believes that the
reasonable expectations of policyholders are not being met, this should be brought to the
attention of management and the Board, so that:

(i) promises made are honored;

(ii) an equitable distribution of policyholder dividends/bonuses occurs consistent with the

“reasonable” expectations of policyholders;

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(iii) unit pricing for unit linked policies is accurate and is reflective of expected
administration;

(iv) discretionary interpretations of policies do not unnecessarily disadvantage the

policyholder; and

(v) illustrations to prospective policyholders are not overly optimistic or otherwise

misleading.

III. Establishing Aggregate Policy And Claim Liabilities

The estimation of insurance liabilities, including policy provisions and aggregate claim
liabilities, is a major area of focus for actuarial science. For many insurance products, the
actuarial training and education programs are the only professional programs designed for this
work. Therefore, it is imperative in many situations for an actuary to be involved in the setting
of reported insurance liabilities.

Depending on the regulatory expectations, the actuary can be used to do some or all of the
following for and on behalf of the Board to determine whether the total assets of the insurer can
meet the following criteria:

(a) Funding Adequacy: the total assets backing insurance liabilities and required capital
plus future premiums and asset revenues are expected to be sufficient to cover:

(i) the current expected value of the contractual and constructive obligations
(including benefits and claim administrative costs) under the existing business in
force and existing claim obligations, together with appropriate margins for risk;

(ii) capital requirements;

(iii) risk absorption and hedging;

(iv) administrative costs; and

(v) the funding of sales activity in the near term.

(b) Earnings Capacity: an assessment of the expected future free cash flows (from all
existing and planned new business) should, under reasonably rigorous future scenarios,
be adequate at any point in the future to provide for:

(i) appropriate incidence of distributable profits;

(ii) transferability of policy liabilities; and

(iii) advance warning of adverse developments.

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IV. Determining Appropriate Capital

With their skills and experience in statistics, finance, insurance products and insurance
operations, actuaries can advise on appropriate aggregate policy and claims liabilities and the
range and likelihood of possible outcomes. Actuaries can also assess, advise and report on the
current and future capital needs of insurance operations under a range of circumstances.

(a) Dynamic Capital Adequacy Analysis: Capital should be sufficient under realistically
rigorous future scenarios including the impact of operational risk either:

(i) To supplement available funds to cover the cost of policy obligations and
operations; or

(ii) To transfer the liabilities to another carrier.

A number of insurance regulators rely on responsible actuaries to undertake these

functions in insurance operations as this provides a level of detailed and continuous
analysis which the regulators themselves often are not able to provide. When the
responsible actuary also supplies a confidential report to management and the Board as
well as the regulator, this provides a good mechanism for regulatory oversight and query
by the regulator back to the company.

(b) Strategic Capital Adequacy: Total free surplus plus free asset revenues should be
sufficient, according to the organization’s approved medium term business plan, to
finance future expected new business costs and associated solvency requirements.

The involvement of actuaries in general business planning encourages a proper balance of

shareholder and policyholder interests from the outset. This in turn fosters a prosperous
and financially strong insurance industry, which is in the long-term best interests of the
insuring public, without unduly compromising the legitimate financial interests of current
policyholders.

V. Direct responsibility to the Board and to Regulators

In some countries, the law may enable the supervisor to place a specific duty on the responsible
actuary to inform the supervisor when plausible adverse conditions may threaten the solvency of
the insurer, the legitimate interests of policyholders or be otherwise hazardous. In those
situations, the responsible actuary is usually in a senior executive position and may even be
required to hold such a position. However, he or she typically will not have direct control over
all the actions to protect policyholders’ and claims beneficiaries’ interests, either in terms of
company solvency or of policyholders’ reasonable expectations as to the company’s exercise of
contractual discretion.

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For the responsible actuary to determine whether appropriate action is being taken to protect
policyholders and beneficiaries, he or she must have access to the necessary information and the
right as well as the responsibility to present his or her concerns first to management and if
necessary to the Board.

If the Board fails to take reasonable steps to respond to the responsible actuary’s advice, then it
may be appropriate that the responsible actuary have the additional legal responsibility to express
his or her concerns to the supervisor as a last resort when all other avenues for persuading the
insurer’s management have been exhausted. Should the law require such regulatory notification,
it is a necessary part of this regulatory process that any responsible actuary forced to take this
course should have protection from unfair termination of employment (to the extent practical) or
from legal action by the insurer or its owners as a result of fulfilling his or her statutory duties.

Conclusion
The enactment of laws requiring the appointment of a responsible actuary, as one of the
professionals supporting an insurance company, can greatly strengthen the company’s risk and
capital management, to the increased security of policyholders and the benefit of the company
and regulators.
When supervisors adopt other approaches to prudential regulation, appropriate involvement of
actuaries can still enhance the efficiency and effectiveness of the regulatory process. We
encourage supervisors to work with the IAA’s member associations to determine the appropriate
functions for actuaries providing professional services in their jurisdictions.

International Actuarial Association - The Function of the Actuary in Prudential Supervision

Adopted by Full Member Associations of the IAA – September 2002