Sarbanes-Oxley, Actuarial Methods and "Best Estimates for Reserves"
- Governance standards demand better information
- Current actuarial methods under public criticism
- Standard link-ratio methods criticised from many quarters
- Letter sent to CEOs, CFOs and Regulators
- "Best Estimates for Reserves" now included in the 2006 CAS Syllabus
- A simple layman's demonstration of why link ratio methods fail
- A common misconception about correlations which is critical to DFA
- Supporting example & technical papers
Casualty Actuarial Society (CAS) argues that in order to comply with Sarbanes-Oxley, the current actuarial methods are not sufficient.
Better information using more rigorous analyses of loss reserving
must be provided to senior management and boards of directors.
"Best Estimates for Reserves" is included in the 2009 CAS Syllabus of Examinations.
Extracted from the Casualty Actuarial Society Review February 2004
"The Influence of Sarbanes-Oxley on the Governance Standards of Insurance Companies and Corporations.Increasingly, insurance company audit committees are requesting a direct meeting and dialog with the reserving actuary, most frequently to help them understand the key risks and uncertainties in the reserves. In addition, the spotlight on corporate governance has increased the demand for Directors and Officers insurance. Casualty actuaries will continue to help properly price this product, reflecting the increased potential for claims against senior management and boards of directors."
"Actuaries Come Under Significant Public Criticism for Perceived Poor Performance in Projecting Loss Reserves. In particular, Standard & Poor's published an article in November stating that "actuaries are signing off on reserves that turn out to be wildly inaccurate. It's an abysmal track record."This is a challenge to casualty actuaries to support the work that we have done historically, to develop more rigorous analyses of loss reserves in the future, and to improve the way that we explain reserves to non-actuaries. We hope all actuaries will respond in a way that enhances our reputations and increases the value actuaries add to the insurance industry."
Click here for the Full Article.
The fact that link ratio methods or any derivatives thereof, can not and do not measure the volatility in the paid losses is supported by comments from various quarters and many actuarial articles, in particular the paper "Best Estimates for Reserves".
Letter sent to the Actuarial Standards Board (ASB) of the American Academy of Actuaries - 31st March 2004
"It has been known for decades that standard link-ratio methods are extremely poor tools for projecting ultimate liabilities for a given block of business. Nonetheless, many opining actuaries rely exclusively on them.”
The letter is co-signed by 18 actuaries. Click here for the complete letter.
"Although the actuarial literature is replete with articles explaining the shortcomings of the traditional link ratio methods, most actuarial reserve analyses mainly rely on link ration methods."
Excerpt taken from a review entitled: "Barnett and Zehnwirth Provide Road Map for Probabilistic Reserve Models", by Frederick F. Cripe, Chairperson, CAS Research Policy and Management Committee.
Click here for the complete review
For additional critical comments on Actuarial Methodologies from different quarters Click here
This means that any information received by senior management
and audit committees of insurance companies, based on standard actuarial methodologies, can be very misleading.
Accordingly, you cannot adhere to Sarbanes-Oxley by basing your information on standard actuarial methods.
Therefore, in order for actuaries "to develop more rigorous analyses of loss reserves in the future, and to improve the way" they "explain reserves to non-actuaries" (CAS Review February 2004), it is crtical that they adopt a scientific probabilistic framework as part of the loss reserving process.
The Paper Best
Estimates of Reserves" explains why link ratios cannot and do not capture
features in real data and provides a "road map" to a scientific probabilistic
Alternatively, for a simple layman's demonstration of why link ratio methods fail.
This demonstration does not require a statistical or insurance background!
Alternatively for a detailed mathematical analysis, please refer to papers listed below:
There is a common misconception amongst actuaries and insurance executives about correlations.
A common misconception with correlated lognormals
Testing the Assumptions of Age-to-Age Factors by Gary G. Venter
Venter as published in the Proceedings of the CAS Volume LXXXV, pp. 807–847 / 1998. (PDF)
Loss reserving with GLMs: a case study by Greg Taylor and Gráinne McGuire
(pdf, approx. 1,389kb). "While the CL can be applied to any choice of data set, there is no apparent criterion for reliable choice of that data set. Moreover, the CL’s phenomenological treatment of the trends is deeply unsatisfying. These trends must have a cause that resides somewhere in the detailed mechanics of loss payment. However, the formulaic nature of the CL renders it incurious as to these details. The CL ... provides a sausage machine, a rigid and unenquiring algorithm. This is an advantage in terms of required resources. ... A serious disadvantage to be set against this is that it may produce a totally wrong result, that it may give precedence to process over substance."
(N.B. CL="Chain Ladder" which is same as volume wighted average link ratio).
Claims Reserving - Should Ratios be Used?
by Drs. Barnett and Zehnwirth (ClaimsReservingRatios.pdf - 138kb)
Best Estimates for Reserves by Drs Barnett and Zehnwirth
as published in the Proceedings of the CAS Volume LXXXVII, Numbers 166 & 167 / 2000 (PDF)