Shadows of success: Despite their low profile, good actuaries make important contributions to the overall success of insurance organizations. (Industry Strategies: Actuaries).

Insurance organizations need four resources to function-customers, workers, money and legal authority. Although often regarded as behind-the-scenes numbers crunchers, actuaries can play a critical role in all four areas. Marketing actuaries can help obtain and keep customers and workers. Financial actuaries can help obtain and keep money. Valuation actuaries can help obtain and keep legal authority.

Insurance organizations come in all shapes and sizes. American Inter- national Group is an insurance organization. So is Joe's Agency. All insurance organizations deal with actuarial management issues; only the type and degree of the issues vary Therefore, valid concepts and models for actuarial management are useful across the board.

Valuation Actuary

Insurance is a promise. An insurance contract promises to pay a certain amount of money (or provide a specific product or service) when and/or if something happens. In a commercial sense, a policyholder is purchasing that promise from an insurance company. The valuation actuary is largely responsible for making sure that an insurance company can keep its promises.

Unfortunately, even the most conservative valuation actuary can't be absolutely certain that an insurance company can keep its promises. Perhaps the biggest challenge that the international insurance market has faced occurred on Sept. 11, 2001. Currently, the insurance industry as a whole appears to be able to keep the promises and pay the claims related to that disaster (although individual company exceptions are certain to emerge). But if 10 planes had hit 10 buildings the size of the World Trade Center, some promises may not have been kept.

This inherent uncertainty in the insurance business creates the need for legal authority. Nations give insurance companies legal authority to sell their promises, even though no one can be 100% certain that those promises can be kept. But in the event that promises are not kept, the legal authority granted to an insurance company protects the company and its management from criminal prosecution, as long as all rules and regulations were followed.

Creating and enforcing rules and regulations for insurance companies to give reasonable assurance that their promises will be kept is a significant challenge. Environments change, economies change and even governments change. Rules and regulations may function perfectly when they are written and be totally obsolete five years later. Many countries have written rules and regulations that place substantial responsibility on valuation actuaries to make sure that insurance companies can keep their promises under some set of specified conditions. For example, insurers are required to have written opinions from actuaries that their reserves are adequate and that the reserves are backed by appropriate investments with sufficient liquidity to pay claims.

This human responsibility is seen as an alternative to detailed requirements that are nearly certain to become obsolete. But without substantial legal authority and protection, the emerging responsibilities of valuation actuaries are sobering, indeed.

The role of the valuation actuary is fundamental to actuarial management of an insurance organization. Valuation actuaries must have sufficient authority and autonomy to assume their assigned responsibility. But valuation actuaries also must be a part of management and not merely an "in-house regulator." Striking a balance is extremely difficult. Perhaps a key element in this balance is active involvement with regulators and other actuaries. Valuation actuaries must not be back-room technicians if an insurance organization is to function effectively within the regulatory framework.

Valuation actuaries must be highly active with professional, industry and regulatory bodies as well as with company management. Valuation actuaries need to influence the establishment of rules and regulations that grant legal authority for insurance organizations. Only then can a valuation actuary help his or her company effectively comply with those requirements.

Financial Actuary

The second resource required by an insurance company is money. People generally control money. Therefore, people and money behave the same way: They go where they are wanted, and they stay where they are treated well. Financial actuaries help insurance organizations decide how much capital they want and make sure that such capital is treated well. The ultimate objective is to optimize the risk/reward trade-off for equity stakeholders.

Insurance organizations can obtain capital from three basic sources: debt, equity and reinsurance.

Debt is generally the most difficult to obtain, but it is also the least expensive. Equity is a bit easier to obtain, but generally it is more expensive than debt. Reinsurance is the easiest to obtain, but it is normally the most expensive source of capital. Financial actuaries can help insurance organizations obtain capital, monitor the use of that capital and report to those who have provided capital.

A critical tool for obtaining capital is the financial projection. Financial actuaries are very good at preparing financial projections. But since insurance organizations assume risk, random fluctuations in experience can cause those financial projections to be wrong, particularly when viewed with hindsight. One approach to explaining this phenomenon is to prepare several projections under various experience scenarios. Multiple projections, however, often create more confusion than understanding with those who control capital.

When possible, a three-step process is often most effective. First, basic flnancial projections are prepared based on expected experience. Then, "what-if" projections can be prepared using assumptions specified by the reader. Finally, results from many stochastically generated scenarios can be presented to help quantify the risk inherent in the organization. In summary, financial projections can create problems and misunderstandings when negotiating to obtain capital. Unfortunately, obtaining capital without financial projections is nearly impossible.

Monitoring the use of capital has become much more important for insurance organizations. Improved computing and data-storage facilities have allowed insurance organizations to monitor their progress much more closely. Comparison of actual results with expected results is the key element of monitoring performance. Thus, insurance organizations must establish expected results for each program. Ideally, such results are established from the financial projections discussed above.

Environments change, however, and expectations need to be reviewed periodically. Also, if actual results vary significantly from expected results, management may have few options available to deal with the situation. Further, random fluctuations are often difficult to distinguish from fundamental problems. Again, comparison of actual results with expected results can create frustration. But failing to compare actual results with expected results can lead to ruin.

Finally, financial actuaries assist in communicating results. This is really tricky for insurance organizations. Actual results from current activities for most insurance organizations depend on future contingent events. The real success of this year's activities will not be known for many years in some situations. Those who provide capital are generally not satisfied with such reports. Thus, models are established to measure results on a "generally accepted" basis in reports to stakeholders. Generally accepted accounting principles (GAAP) represent one such model. GAAP financial statements are supposed to present the results of organizations in any industry on a comparable basis. Thus, the GAAP financial statements of American International Group should be comparable to those of General Motors. Such an objective is, of course, absurd, but insurers have no choice.

Financial actuaries assist insurance organizations in establishing assumptions and methods that comply with the rules of GAAP and communicate results to stakeholders in the desired manner. Sometimes that can be a real challenge. Financial measures outside the GAAP model can be included in various published reports. But any contradictions to the GAAP results can generate confusion. Financial reporting is clearly one of the greatest challenges for financial actuaries.

Marketing Actuary

The challenges faced by marketing actuaries in insurance organizations are even more obscure than those faced by valuation and financial actuaries. Marketing actuaries must consider the reserve requirements established by the valuation actuary, financial objectives established by the financial actuary and realities of the marketplace in designing and operating programs that create value. Value is created when the perceived worth of a product or service by a buyer exceeds the cost of providing that value or service incurred by the seller.

Insurance organizations generally need workers to create value. Those workers must be talented people. To attract, retain and motivate talented people, insurance organizations must be places where their employees can learn a lot, have a lot of fun and make a lot of money. Marketing actuaries help with all of these challenges.

Fundamental to the work of marketing actuaries is a six-step process used in managing insurance programs:

* market definition;

* market research;

* competitor research;

* distribution system analysis;

* product development; and

* experience monitoring.

Most insurance organizations follow these steps implicitly in the marketing efforts. But few document the process; therefore, communication about marketing programs is often poor. Actuaries, for example, are often asked to work on product development (step 5) without the benefit of full understanding of the first four steps.

Markets for insurance products and services are vast and must be segmented into manageable pieces. But if a chosen market segment is too small, sufficient volume cannot be obtained to spread the risk of random fluctuations in experience. Thus, market definition is a balancing act. Generally, the best examples of success or failure can be obtained by examining the operations of established competitors.

Market research serves two functions for insurance organizations. Like all marketers, insurance organizations want to learn the buying preferences of their potential customers. However, insurance organizations also need to understand the risk characteristics of their customers. Thus, market research involves collecting any information that might make predictions of claim experience more reliable.

Competitor research is critical for insurance organizations. Insurance organizations involve people. Thus, competitor research must focus on understanding the people behind competitive programs. Analysis of product offerings is not sufficient in and of itself. Effective marketing actuaries strive to answer the following questions about their competitors:

* Who manages the competitive program, and what is their background?

* Who owns the competitive program, and what is their financial structure?

* Who sells the competitive program, and what distribution approach are they using?

* What has been the recent experience of the competitive program?

* What is the cost structure of the competitive program?

* What risk-selection standards does the competitive program use?

* What coverage and benefits does the competitive program provide?

* What prices does the competitive program charge?

Getting Products to Market

Distribution is the area where insurance organizations are most concerned with attracting, retaining and motivating talented people. Some insurance products are purchased by mail, over the Internet and through other low-touch distribution channels. Most insurance products, however, are purchased through agents and brokers. These are the people that most insurance organizations want to attract, retain and motivate. Doing so can cost a great deal of money. Relative success or failure in distribution is the most important determinant for overall success with most insurance products.

Marketing actuaries can form strong partnerships with strong salespeople to create a team that will maximize value. Strong salespeople can help marketing actuaries achieve the volumes necessary to spread risk and the prices necessary to generate margins. Strong marketing actuaries can help salespeople have the right product available in the right place at the right time and at the right price. Such a partnership is invaluable for an insurance organization.

Once a market is defined and researched, competitors are thoroughly understood and a distribution system is established, product development becomes a mechanical exercise. The insurer knows the coverage and benefits that must be provided. It knows the prices that must be charged. It knows the costs of the distribution system. It knows as much as it can about risk characteristics in the chosen market. It knows the reserve requirements, the legal requirements and the standards for creating value. All of this information is fed into a computer model that determines whether value can be created. If value is not being created in the model, then the insurer goes back to the beginning to see what can be changed.

Once a product is introduced, the insurer must monitor experience. Experience monitoring done by a marketing actuary is much more detailed than that discussed for financial actuaries above. The concept, however, is the same. Actuaries want to compare actual experience with their expectations. They want to make these comparisons as soon as possible. Thus, they might look at things such as agent licensing, applications submitted, underwriting actions taken, premiums collected, claims submitted, claim actions taken and other items that are not purely financial in nature. They know that some of the assumptions included in the product-development model will be wrong. They want to find the problems and correct them as soon as possible.

Actuarial management of insurance organizations is a fascinating process that involves constant creativity and diligence. Those who are successful reap substantial rewards. Those who are unsuccessful don't last very long in the insurance business.

Actuaries on the Job

The American Academy of Actuaries represents U.S. actuaries from all
practice areas. Nearly half of its practicing members work for insurance
and related organizations.

                                               Membership
Employment (*)                         1999      2000      2001

Insurance and related organizations   6,198     6,482     6,964
Consulting practice                   4,786     5,111     5,112
Government                              230       244       113
Academic institutions                    40        47        43
Other                                   663       721       396
Retired                               1,416     1,499     1,367
Unaffiliated                            374       411       429

Total                                13,707    14,515    14,424

(*)As of Nov. 1, 2001

Source: American Academy of Actuaries 2002 yearbook.

Jeffrey D. Miller is a self-employed consulting actuary for life and health insurers. He is based in Overland Park, Kan.