Chief Actuary Officer

Let's take a look at the governance of financial institutions from a risk management perspective:

Governance Risk Management

Traditional governance focuses on the organisation-structure, decision-structure, influence and power-weights of all stakeholders. Governance Risk Management focuses on how to optimize and monitor risk and value creation for all stakeholders.

Financial Risk Management Monitoring
After defining a companies Mission, Risk Appetite and Strategic Plan, the year-targets and key indicators are not only translated into a tight budget (b) of 'sales targets' and 'profits', but also into 'balance sheet budget targets' (b).

It takes a real well defined 'Governance Risk Management' to split the balance sheet into such parts (Assets, Liabilities & Capital) that responsible officers in the company are able (and can take responsibility) to monitor the actual values (a) monthly or quarterly to the final or adjusted budget values (b).

  

Officer Role Division
In a well managed and structured financial company the risk-financial roles of the companies officers can be defined as follows:

1. CIO
   The Chief Investment Officer is primarily responsible for managing the asset actuals A(a) versus the (adjusted) budget A(b). So the CIO has to manage [A(a)-A(b)] in terms of value and within defined  the investment risk budget.
    
2. CAO
   Although often unremarked, an important part of the role of the Chief Actuary Officer is to manage the actual liabilities L(a) versus the (adjusted) Liabilities budget L(b).
   This is no easy job, as most longevity and (risk free) discounting of the liabilities are hard to influence.
   Wrapping up: The CAO is responsible for managing [L(a)-L(b)].
   
   Often the role of the CAO seems to be limited to insurers or pension funds. However, also banks need an actuarial officer, as more and more (product) risks on the bank's balance sheet become economic, demographic and bio-related (mortality, disability, lifestyle).  
    
3. CRO
   Often the Chief Risk Officer is seen as someone at arms length reporting about risks to the (supervisory) board. However, one of the main roles of the CRO is to monitor Capital and Capital Requirements. He/She is responsible for realizing the sustainability of the company by managing the (adjusted) Capital budget C(b) while being confronted with continuously changinge Capital actuals C(a). So the CRO is responsible for monitoring [ [C(a)]-C(b)].  

AIRCO Management
Once the targets are set and responsibilities are defined, the hard part of managing a financial institution starts: Cooperation between the Actuarial, Investment, Risk and Capital Organisation (AIRCO) Chiefs.

During a budget year, all individual defined AIRCO budgets and actuals continuously change in practice.
As capital risk development is the complex result of Asset and Liability volatility, capital management and monitoring by (primarily) the CRO manager becomes extra complex. Especially in market crises situations (tail risks), where traditional (linear) correlations between AIRCO components fail by definition. It's the responsibility of the CRO to continuously balance between all stakeholders interests in narrow cooperation with the CAO and CIO, while staying on track with regulatory requirements.

This task is not easy, as AIRCO Management is not a one dimensional mission or game:

• Run-off
  Often AIRCO Management is merely based on regulatory AIRCO requirements, based on run-off portfolios and one-year period confidence levels (e.g. 99.5% [Solvency-II] or 99,9% [ Basel-II/III] ).
   
• Continuous business model 
  However this run-off approach is only based on a kind of default situation with a very low probability (< 1%). It's much more likely (> 99%) that a financial company will exist for more than one year.
  
  Therefore, adding one or more variations of 'continuous business model approaches' to the existing run-off approach on a board's table, will give the board a more (realistic) insight on the heavy an balanced decisions to be taken to continue and control a sustainable risk-return strategy. 

ALC-Team
To manage the complex of AIRCO effects, it's often helpful to set up an Asset Liability Capital Team (ALC-Team) within a financial institution. Main task of this team is to manage risk and returns across all AIC-axes in line with the strategic plan, the defined risk-return appetite and actual regulatory requirements.

The ALC-Team consists of the CAO, CIO an CRO and could in practice be chaired by the board's CFO, or CFRO.

This ALC-Team :

• proposes board adjustments and monitors the risk-return targets and matching policy
• makes clear what the often paradoxical and/or conflicting effects of risk-return management are for all stakeholders on basis of different future business continuity models (e.g. Run-off, Continuous business, etc.)
• Makes clear and advises what measures the board can take due to the impact on ALC of different business models views, changes in economic risks and changes in regulation.
• operates on basis of ALC reporting information,"Own Risk Assessment" reports, external Economic Risk Reports and external Regulatory Change Information.

Pitfalls

One of the most tricky pitfalls in capital management is that a financial institution tries to solve all budget variances and regulation changes only by adjusting its investment policy.

If adjusting is done 'on the fly', without considering the risk-return targets and (even worse) through the mental filter of just one of the stakeholders interests (e.g. 'shareholder value), a financial company implicitly risks to lose track of the overall strategic business targets.

If an economic or regulatory change influences the risk-return objectives, all possible instrumental options to respond, have to be taken into account. One of the most forgotten instruments to respond to market changes, is 'product management' or (new) 'product development'.

Yet, nevertheless the fact that existing (product) contracts are (short term) often hard to adapt, 'product management' is one of the most vital instruments to apply regarding the management of long term risk-return objectives.

Therefore AIRCO Management requires a planned an controlled Stakeholder Management Process in a financial institution.

Stakeholder Value (Risk) Management
Managing a company's stakeholder value implies that the effects of the economic, regulatory and own-company changes on the risk-return objectives are continuously balanced across all stakeholders (Shareholders, Clients, Asset Managers, Board/Employees).

Apart from 'HR value management', regarding possible board and employee reward and benefits adjustments, the instruments to manage and  balance Stakeholder Value:

A-1  Asset Value management
C-1. Capital Management
C-2  Shareholder Value management
L-1  Product Value Management
L-2  Client Value management

are presented in the next chart:

Conclusion
Managing a financial institution in this challenging financial decade (2010-2020) is a complex operation with multidimensional regulation and business risk-return targets. Financial Boards have to manage more truths at the same time in a highly volatile economic risk-return environment.

Surviving in this complex world urges boards to step from a traditional predictable managing approach to a more responsive managing approach, where stakeholders value is continuously monitored and adapted to the real world environment.

This new 'survival approach' urges to improve communication, process information and reporting across Assets, Liabilities and Capital Management within the organisation.

Establishing an ALC-Team approach could be a first step to improve the control on risk-return management within the organisation across all stakeholders and actively using all 'stakeholders value tools' in a balanced way.

Last but not least, the role of the Chief Actuary Officer should be more clearly defined. The CAO is, in line with Client Value objectives, primarily responsible for an adequate liability en product management, that's key in balancing the risk-return objectives of a financial institution.

Success!

Links/Sources
- Cartoon: Government Risk Management by Todd Nielsen
- Risky Business – Making Phenomenal Decisions
   (While Not Forgetting the Risk)

How to Stretch 'One Point Estimates'

So called 'One Point Estimates' (OPEs) fill up our lives, but are useless without context. What can we do?

Some common real live OPE examples: 'Speed Limit 100', 'Temperature 70° ', 'Post Stamp 33', etc....

To give 'estimates' meaning, we have to put them in context:

• To define a post stamp value, just a simple number on a post mark isn't enough. We need more information, like currency, country, date, uniqueness and 'stamped' or 'not-stamped' information to determine a more precise value of a certain stamp.
• A speed limit of 100 has only meaning if you know if it's measured in Mph or Km/h.
• If you measure the temperature it's important to know whether you measure in ℃ or in ℉.

Stretching Technique

From now on if you're confronted with a 'One Point Estimate' in life, ask yourself the next question:

How can I stretch a one dimensional One Point Estimate
into a two dimensional graphic in more than one way?

The way to stretch a point, is to stretch your mind.
Let's tak a look at a simple example.

Application:Pension Funded  Ratio

Level 1: Your pension fund reports a 90% Funded Ratio

Just reporting a 90% Funded Ratio (FR) is in fact no-information. It's what I call a 'One Point Estimate' (OPE) that hardly adds any relevant information to you as a pension fund member.

At the best, it only raises questions.

More likely, this information leads to misunderstanding, confusion or even panic.

Level 2: The Funded ratio reported on a time scale

Reporting values on a 'time scale' is often the first attempt to stretch information in order to enable pension fund members to gain insight into the (future) development and direction of the funded ratio.

This kind of reporting gives pension fund members an idea about the short term variance and direction of the funded ratio, but still lacks information about 'how' and 'why'.

Level 3: Reporting values as function of their dependent variable(s)

On this level the added value of stretching an OPE becomes really visible.
Key question you have to ask yourself is:  what are the main variables that influence the outcome (funded ratio) most?
As the expected future return and/or discount rate is one of the most relevant variables, it's illustrative and clarifying to express the funded ratio as a function of for instance the discount rate.

By doing so, every pension fund member can conclude that (in this case) the pension fund needs a future return of at least 4% p.a. to meet its obligations and that the 'solution area' (triangle 'A'), gives visible information about the 'space' or room for future indexation or pension-improvement at higher return rates.

Level 4: Adding additional information 1:Future Longevity Effect

Our two-dimensional diagram is now enriched with additional information of other vital variables that influence the pension funded ratio outcome.
We start with the estimated effect of future longevity development.

As pension fund members can note, the solution triangle area 'A' is now substantially reduced and a minimal return of (in this case) 5% is needed to fund pensions in a sustainable way.

Level 5: Adding additional information 2: Confidence level (CL)

Next, several confidence levels, based upon (future) regulatory demands, are plotted in the diagram.
For example, we may plot:

•  the 97.5% confidence level (CL) as current risk appetite of a specific pension fund (is it enough?)
• the 99.5% CL European insurers have to meet in Solvency II demands. As Solvency demands will probably also apply for pension funds in the near future, this level becomes relevant in a proactive approach.
• The 99.5% CL that's applicable in Basel III demands for Banks.

In this case it becomes visible and clear to every pension fund member (and probably also every pension fund board member!), that 'more secure confidence levels', as well as 'future upcoming regulatory confidence levels' demand unrealistic high returns of this pension fund under study. As the confidence level increases, the solution area 'A' stepwise shrinks to zero.

In this specific case the pension fund has no other choice than to lower its future pension rights or to accept a higher risk of not meeting its pension obligations.   

Key Question
Key question for YOU: Have you done the above exercise with your pension fund?

Pleas answer this question Honestly...
If the answer is NO, just keep on hoping things will turn out for the best......

By the way, you don't need to be an actuary to ask your pension board to inform you by means of the above formulated simple diagrams. I hope you get clear answers...

What's the difference between 'Pension Board' and 'Pension Bored'?

Practice Check: NYSCRF

Let's reflect  the above approach on the third-largest public pension fund in the United States, the New York State Common Retirement Fund (NYSCRF)

First, just watch the next video in which New York State Comptroller Thomas P. DiNapoli tries to explain that based on the fact that NYSCRF has 'worked' for more than 90 years, it will continue to work for many years to come. 


Although Thomas DiNapoli probably does his utmost best and tries to reassure us that  NYSCRF is fully  under control, communication and taken measures unfortunately do not underline this standpoint:

NYSCRF Communication Fact Findings

• Annual reports and additional communication mainly report about the asset side of the balance sheet and not about the liability side
   
• No Mission Statement or Strategic plan can be found on either the NYSCRF-website or in the annual report (how to steer without a general target?)
   
• No risk appetite is communicated and no confidence levels are publicized, communicated or mentioned in the annual reports.
   
• 
  Merely a level-2 kind of information about the 'Funded Ratio' is given in the NYSCRF annual 2011 report, without any consequences.
  
  Although the Funded Ratio is rapidly declining, the annual report does not transparently explains 'why' and 'what can be done about it'.
   
• No mentioning of the possible effects of available PEW information that the Governmental Accounting Standards Board (GASB) is considering new rules that would decrease the funded ration substantially

Redefine Pension Fund Governance
It's clear that not only communication about state pensions needs to be improved (complete, balanced and structured), but also 'pension governance' has to be redefined to  a more general and strategic level where a vision, mission statement and a strategic plan are defined and where responsibilities and power of the comptroller are set  'in line' with these documents.

Until now, Comptroller Thomas DiNapoli 'is responsible for making sure the CRF meets its annual performance benchmarks'.

It's clear that this definition does not cover an overall responsibility to ensure a healthy sustainable pension system in the future.

Comptroller DiNapoli must be given 'full control' in order to do his job well. His responsibilities and targets must not be limited to the performance of just the asset side of the balance sheet.

Last but not Least

If the upcoming GASB rules are adopted, as expected, retirement plan funding ratios would drop dramatically. The Center for Retirement Research (CRR) found that if the new rules had been in effect in 2010, funding levels would drop from 76% percent funded to 57%.

In short the CRR-Report sets (in summary) the new pension tone:

• Under the GASB standards, state and local plans generally follow an actuarial model and discount their liabilities by the long-term yield on the assets held in the pension fund, roughly 8 percent.
• Most economists contend that the discount rate should reflect the risk associated with the liabilities and, given that benefits are guaranteed under most state laws, the appropriate discount factor is closer to the riskless rate.
• The point is not that liabilities should be larger or smaller, but rather that the discount rate should reflect the nature of the liabilities; the characteristics of the assets backing the liabilities are irrelevant

In case of the New York City Employee Retirement System (ERS) new GASB rules would imply a decrease in funded ratio from 77% to 50%.......

Final Conclusions:

1. Take adequate measures before its too late
2. Get realistic and Honest, with ourselves and to others

I guess it all comes down on Honesty, as Billy Joel already stated..




Used Sources & Related links:
- NYSCRF 2011 Comprehensive Annual Financial Report (PDF)
- PEW Report (2012)
- Interactive ' funding of pensions and retiree health care' (2010)
- Wisconsin proves the lie of Pew pension numbers (2012)
- CRR Report: How would GASB affect pension reporting? (2012;PDF) 

Pisa or Actuarial Compliant?

When we talk about actuarial compliance, we usually limit this to our strict actuarial work field.
In a broader sense as 'risk managers', we (actuaries) have a more general responsibility for the sustainability of the company we work for.

Compliance is not just about security, checks, controls, protection, preventing fraud, ethical behavior. Moreover  compliance is the basis of adequate risk management and delivering high standard service and products to your companies clients.

Pisa Compliant
No matter how brilliant and professional our calculations, if the data - on which these calculations are based on -  are 'limited', 'of insufficient quality' or 'too uncertain', we as actuaries will finally fail.

Therefore , building actuarial sandcastles is great art, however completely useless. Matthew 7:26 tells us :  it's a foolish man who builds his actuarial house on the sand....

And so, let's take a look if we have indeed become 'Pisa Compliant' by checking if our actuarial compliance is build on sand or on solid ground. In other words: let's check if actuarial compliance itself is compliant...nd.

Actuarial Data Governance
To open discussion, let's start with some challenging Data Governance questions:

• Data quality compliance
  How is 'data quality compliance' integrated in your actuarial daily work? Have you addressed this issue? And if so, do you just rely on statements and reports of others (auditors, etc), can you agree upon the data quality standards (if there are any). In other words: are the data, processes and reports you base you calculations on, 100%  reliable and guaranteed? If not, what's the actual confidence level of your data en do you report about this confidence level to the board?
  
  
• 
  Data quality Conformation
  Have you checked your calculation data  set on bases of samples or second opinions?
  
  And if so, do you approve with the methods used, the confidence level and the outcome of the data audit? 
  
  Or do you just 'trust' on the blue eyes of the accountant or auditor and formally state you're "paper compliant"?
  
  Did you check if  client information, e.g. pension benefit statement, are not only in line with the administrative data, but also in line with insurance policy conditions or pension scheme rules?
  
  
• Up to date, In good time
  To what quantitative level is the administrative data  'up to date' and is it transparent?
  
  Do you receive administrative backlog and delays reporting and tracking and if so, how do you translate these findings in your calculations?
  
  
• Outsourcing
  From a risk management perspective, have you formulated quantitative and qualitative demands (standards) in outsourced contracts, like 'asset management', 'underwriting'  and 'administration' contracts?
  
  Do you agree on these contracts, do 'outsourcing partners' report on these standards and do you check these reports regularly on a detail level (samples)? 

And some more questions you have to deal with as an actuary:

• Distribution Compliance
  Is the intermediary and are the employers and customers your company deals with, compliant? What's the confidence level of this compliance and in  case of partially noncompliance, what could be the financial consequences? (Claims)
  
  
• Communication Compliance
  Is communication with employees, customers, regulators, supervisors and shareholders compliant? Has your board (and you!) defined what compliance actually means in quantitative terms?
  
  
  
  Is 'communication compliance' based on information (delivery and check) or on communication?
  
  In this case, have you've also checked if  (e.g.) customers understood what you tried to tell them?
  
  Not by asking if your message was understood, but by quantitative methods (tests, polls, surveys, etc) that undisputed 'prove' the customer really understood the message.
  
  
  
  Effective Communication Practice
  Never ask if someone has understood what you've said or explained. Never take for granted someone tells you he or she 'got the picture'.
  
  Instead act as follows: At the end of every (board) presentation, ask that final and unique question of which the answer  assures you, your audience has really understood what your tried to bring across.

Checking Compliance

Now we get to the quantitative 'hard part' of compliance:

How to check compliance?

This interesting topic will be considered in my next blog.... ;-)

To lift a little corner of the veil, just a short practical tip to conclude this blog:

Compliance Sample Test
From a large portfolio you've taken a sample of 30 dossiers to check on data quality. All of them are found compliant. What's the upper limit of the noncompliance rate in case of a 95% confidence level?

This type of question is a typical case of:

“If nothing goes wrong, is everything alright?”

Answer.

The upper limit can be roughly estimated by a simple rule of thumb, called 'Rule of three'....

'Rule of three for compliance tests'

If no noncompliant events occurred in a compliance test sample of n cases, one may conclude with 95% confidence that the rate of  noncompliance will be less than  3/n.

In this case one can be roughly 95% sure the noncompliance rate is less than 10% (= 3/30). Interesting, but slightly disappointing, as we want to chase noncompliance rates in the order of 1%.

Working backwards on the rule of three, a 1% noncompliance rate would urge for samples of 300 or more. Despite the fact that research for 46 international organizations showed that on average, noncompliance cost is 2.65 times the cost of compliance, this size of samples is often (perceived as) too cost inefficient and not practicable.

Read my next blog to find out how to solve this issue....

Related Links:
- Actuarial Compliance Guidelines
- What Is The Right Sample Size For A Survey?
- Epidemiology
- Probability of adverse events that have not yet occurred
- The True Cost of Compliance (2011)
- 'Rule of three'
- Compliance testing: Sampling Plans (accounting standards) or Worddoc