a public market perspective on embedded value...statistics and actuarial science courses. uw...

At the same time, institutionalinvestors—key users of insurancecompany financial statements—can relateto the need for an alternative approach tomeasuring an insurance company’s finan-cial progress. This is due to dissatisfactionwith both GAAP and statutory accounting.Among the issues causing investor dissatis-faction with GAAP are the following:

• The combination of FAS 60 and FAS 97 products in a single income statement makes GAAP income statements for many companies extremely diffi-cult to use in the sense of computing meaningful metrics.

• Intangible insurance assets, such as deferred acquisition costs (DAC) and value of in-force (VIF) are poorly understood.

• While most invested assets are marked to market, liabilities are stated at book value, creating a misleading net equity value.

Just as daunting are the difficulties withstatutory accounting.

• Statutory statements can only be consolidated among themselves, not with non-statutory entities. As a result, it is very difficult, if not impos-sible, to properly understand all inter-company transactions within a corporate structure from statutory statements.

• Statutory principles generally are intended to be more conservative than GAAP, but in some cases seemto be just the opposite, e.g., the treatment of surplus reliefreinsurance and surplus notes.

• There are nuances to the incidence ofstatutory earnings by policy duration and type of transaction that make statutory profits extremely volatile from period to period.

• Although statutory earnings and surplus are the bases for drawing divi-dends from an insurer, other avenues for liquidity, such as management fees and interest on surplus notes, are far less than transparent.

These complications compound the senseinvestors have (rightly or wrongly) thatinsurance company financial statementsare subject to a great deal of managementdiscretion. Sensitivity to this issue hasbeen heightened by the corporate scan-dals of recent years.

The difficulties with insurance companyfinancial statements have often thwartedinvestors seeking to place insurancecompany results into valuation modelsapplicable to the wider universe of stocks,e.g., dividend discount models anddiscounted cash flow models. My work

A public market perspective on embeddedvalueby James Ramenda, FSA

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inside

Insurance company managements,actuaries and consultants are spend-ing an increasing amount of time and

effort preparing and analyzing financialstatements using the concept ofEmbedded Value (EV). Calculating EVfor a life insurance company is a compli-cated undertaking that requires a vastamount of internal company data andactuarial expertise, plus the time neededto construct and validate a model forprojections.

Editorial: Decisions, decisionsby Morris Fishman

Letters to the editor

The new risk management professionalsby Narayan Shankar

Actuaries–profession in crisis?by Valentina Isakina

SOA leads profession-wide effort to promote actuaries as chief risk officers

Getting stronger every day...BOG reviews 2003 organizational results

BOG discusses hot topics atMarch meeting

www.soa.org has a new look

Surprising results from Computer Science Section’scurriculum survey

CE corner

Actuarial foundation corner

Puzzle

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In the course of some research last week,I came across the following question:

“Does the present course of study qualifyan actuary to deal with the problems ofinvestment risk inherent in variable lifeinsurance and annuities providing mini-mum benefits?”

When and where did this appear, youmight ask? This appeared not last week,not last year, but in 1974! Yes, you can findit in TRANSACTIONS OF SOCIETY OFACTUARIES, 1974 VOL. 26 PT. 2D NO.76. The title of the session was, “EXPAND-ING THE ACTUARY'S HORIZONS TOTHE EVALUATION OF A BROADERRANGE OF RISKS.”

Why do I bring this up? There are tworeasons. First, the debates over proper variable annuity guarantee reserves andmethodology are still going strong 30years after this session. The second is the theme of this month’s edition, riskmanagement and the reasons for actuariesto take the lead in this emerging profession.

Should actuaries become involved in riskmanagement? I think so. Our basic train-ing requires comparable mathematicalaptitude as well as practical application.In a way, many of us have acted as de factorisk managers, as we balanced discussionswithin our organizations with the risksinvolved in a new venture, brought up the emerging problems with an existingprogram or otherwise attempted to play devil’s advocate.

What are we, as a profession, lacking totake the lead in risk management? Do we lack the aptitude? No. Do we needmore education? Maybe, but not muchmore than is currently offered throughcontinuing education. So why aren’tbanks, investment houses nor businesses in general beating down our doors to haveactuaries solve their risk managementproblems? Why do they instead turn to,of all professions, rocket scientists who are trained in controlled explosions?

Perhaps our basic training has given us the wrong biases. U.S. Statutory valua-tion’s focus on solvency has trained us that the greater the reserves, the “stronger”the institution. Risk-based capital hasadded an additional level of somewhatdiscretionary reserve which gives companies a feeling of strength and security if theirRBC ratio is high. In current parlance,we are trained in the known knowns and known unknowns and gloss over theunknown unknowns. Think of how ourpast focus on solvency ignored junk bondproblems, real estate liquidity or now thelatest, capital markets pricing of variableannuity guarantees.

Modern risk management is more abouthow to identify and quantify risk, thenlook for ways to mitigate it. It tries tominimize the cost of risk mitigation andaccepts that there are trade-offs betweenacceptable risk and cost. For example,Goldman Sachs has recently increased the amount of value at risk it would take to $70 million per day.

EditorJay A. Novik, FSA

[email protected]

Associate EditorsPhil Bieluch, [email protected]

Morris Fishman, [email protected]

Loretta J. Jacobs, [email protected]

Alan N. Parikh, [email protected]

Assistant EditorsMichael E. Gabon, [email protected]

Contributing EditorsAnna M. Rappaport, FSA

[email protected] D. Shapiro, FSA

[email protected]

Puzzle EditorsLouise Thiessen, FSA

[email protected] Kinsky, FSA

[email protected] Dreher, ASA, [email protected]

Society Staff Contacts: 847.706.3500Clay Baznik, Publishing Director

[email protected] Kirkwood, Communications Associate

[email protected] Barraca, Graphic Designer

[email protected]

The Actuary welcomes articles and letters.Send correspondence to:

The Actuary

475 North Martingale Road, Suite 600Schaumburg, IL 60173-2226

Web site: www.soa.org

The Actuary is published monthly (except July and August).

Neil A. Parmenter, FSA, PresidentBoard Advisory Group on Publications

Shirley Hwei-Chung Shao, FSATom Bakos, FSA

R. Thomas Herget, FSARichard Q. Wendt, FSA

Nonmember subscriptions: students, $15; others, $30.Send subscriptions to: Society of Actuaries, P.O. Box

95668, Chicago, IL 60694.

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the newsletter of the Society of Actuaries

Vol. 38, No. 5 • May 2004

theactuary

Morris Fishman

Editor responsible

for this issue

Copyright © 2004, Society of Actuaries.The Society of Actuaries is not responsible for statements made or opinions expressed herein.All contributions are subject to editing. Submissionsmust be signed.

e d i t o r i a l

Decisions, decisionsby Morris Fishman

qPrinted on recycled paper in the U.S.A.

Now back to variable annuities. Why are we still debating the proper reservemethodology for variable annuities?Shouldn’t we have solved that issue 30years ago when rocket scientists werestill landing men on the moon?Granted, there have been product inno-vations (or mistakes) that made currentguidelines too expensive for companiesto follow. Other guidelines have beendeveloped to not allow charges to bebrought into income until a reservestandard can be developed. Market fluctuations over the past four yearsbrought home the fact that we cannotproject the market to constantly increaseand expect guaranteed benefits to haveno cost. The current reserve recommen-dation has elements of risk managementbuilt in, yet causes concern with somesince it may create non-tax deductiblereserves.

What would a good risk manager dodifferently? Perhaps the answer wouldnot be much different than today’s actuary, but it would certainly come alot sooner. And, it would come not as a requirement, but because it was theproper way to evaluate the risk.

While there is nothing wrong with awell thought out decision, our profes-sion seems to debate minutia wellbeyond the point of diminished returns.Look at the past 30 years. Does anyoneremember what happened when ERISApassed? While the actuarial professiondebated the minor issues, the FederalGovernment established their ownlicensing board, and others stepped upand gained accreditation, which we nowrecognize. It wasn’t just ERISA. Think ofhow we are still debating Guideline XXXimplementation more than 10 years afterit was first proposed. Think of thenumber of committees that have studied

non-forfeiture revision while productinnovation achieved some of the objectives with secondary guarantees on Universal Life. The list goes on.

If we are going to be considered asbroad risk managers, we have to getour own house in order. We need todevelop a framework in which risk mitigation and pricing are as importantas reserving. We need to accept, sell andtrade risk to counterparties to improvethe viability of our organizations. Weneed to lobby for a regulatory frame-work that acknowledges actuaries as riskmanagers and place their trust in them.If not, as we try to expand our tent, wewill find ourselves alone while busi-nesses seek counsel from another tent.

What is the answer? I don’t know. I justdon’t know. Let me think about it for awhile. I will get back to you in 30 yearsor so. ¨

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Education redesignHaving read the letter to the editor,“Will the newly approved educationredesign ruin the actuarial job market”in the November 2003 edition of TheActuary, I would like to contribute adifferent view of the Waterloo programfrom my own experience. This responseis not intended to discuss the merits ofthe proposed system for achieving ASAstatus, but I do feel it is my responsibil-ity to defend both my degree and myschool, as they have been unjustifiablydiscredited by Mr. Chong.

Firstly, his insinuation that students can“BS” on final exams and still obtain highmarks is not accurate when describingstatistics and actuarial science courses.UW statistics and actuarial science finalexams, much like SOA exams, are almostentirely made up of questions with onlyone right answer. From my experiencehere at the University of Waterloo, ifyour approach to a question is wrong,you will almost always receive less than

50 percent on that question, which iswell below a “B.” The suggestion thatour acclaimed actuarial science profes-sors are so easily fooled byundergraduates is an insult, not only to the University of Waterloo, but to the entire actuarial field in general.

Secondly, the suggestion that professorstolerate cheating, or hand marks out to“sweet-talking” students as it is ineveryone’s best interest is simplyuntrue. I have witnessed, on morethan one occasion, other students’backs proverbially pinned against thewall by our professors for copying onassignments worth a measly one percentof a course’s overall grade. Heaven helpsomeone if caught cheating on a finalexam. Moreover, I take strong issue withthe suggestion that UW professors handout unwarranted marks. While everyactuarial science prof I know does wantto see his/her students succeed, I knownone who would sacrifice his/her profes-sional integrity to this end. The UW

actuarial science program pridesitself on the quality of the candidatesboth entering and completing theprogram. Fraudulently awardingstudents is very much NOT in the best interest of the University, as thosestudents will eventually falter in the field,and the eventual backlash could bedevastating for the University.

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Editorialcontinued from page 2

advising institutional investors regardinginsurance stocks has included an approachto fitting insurance company GAAPresults into such models in a way thatembodies the principles of EV. Theapproach is necessarily approximatebecause of certain realities of valuingstocks in the public marketplace. Theseinclude the limitations of public informa-tion, a typically very short timeframe asdictated by trading conditions, and thedesirability of relating the valuation toGAAP financial statements.

Using GAAP as a basis for the approachreflects that GAAP statements are consid-ered far more transparent than statutorystatements by investors. Certainly, GAAPis the basis for the principle metrics usedby institutional investors, e.g., price-to-earnings ratios, price-to-book valueratios, ROE and EBITDA. While thecalculations that follow will be instantlyfamiliar in their form to actuaries whohave performed statutory appraisals,the use of GAAP numbers directly frompublic statements and the simplifyingassumptions that this requires lead to some interesting results.

Although the approach falls far short ofa true EV calculation, EV terminology isused in order to better relate the calcula-tions to their underlying concepts.

Step 1: Calculateadjusted net worth of theinsurance operations

ANWi = BVG - DAC - VIF – GW + DFIT– AOCI + D

Where:ANWi = Adjusted Net Worth of the

Insurance OperationsBVG = Stated GAAP Shareholders’ EquityDAC = Deferred Acquisition CostsVIF= Value of In-Force

GW = GoodwillDFIT = Deferred Federal Income Tax

Liability (Asset)AOCI = Accumulated Other

Comprehensive IncomeD = Debt

The rationale here is to remove (1) theintangibles that are not included insurplus under statutory accounting (DAC,VIF, GW and DFIT based on GAAPtiming differences), (2) accumulated othercomprehensive income which typically

consists mainly of the excess/deficiency ofmarket value vs. book value of assets, netof related DAC amortization and taxes,and (3) corporate debt, which is usuallyissued at the holding company level. Theimplicit assumption is that all corporateassets are related to the underlying insur-ance business. Where disclosure indicatesthat this is not the case, adjustments canbe made.

Step 2: Calculatenormalized operatingprofits

OPPT = PI – RG + A + ID – IANWi

Where:OPPT = Pre-Tax Operating ProfitsPI = Pretax IncomeRG = Realized Gains (Losses)A = Amortization of DAC, VIF (and

Goodwill Amortization, if any)ID = Interest Expense on DebtIANWi = Interest on Adjusted New

Worth of the Insurance Operations

Removing realized gains and lossesnormalizes income to an “operating”basis (other non-recurring items should be removed, as well). Adding back amorti-zation of intangibles adds back the mainexpense item recognized under statutoryprinciples in prior periods. If new businessexpense deferrals under GAAP can beassumed to approximately offset the actualexpense of writing new business, there isessentially no impact from new business.Thus, the net result to this point is meantto approximate statutory earnings for theinsurance operations on a closed blockbasis. Adding back interest expense

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Embedded valuecontinued from page 1

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Certainly, GAAP is the basis for theprinciple metrics used by institutionalinvestors.

incurred on corporate debt reflects that this expense is incurred outside the statutory entities. Subtracting interest on adjusted net worth, as defined above,means that operating profits will includeonly the annual earnings from the book of business, without any earnings attributa-ble from accumulated surplus. At thispoint, operating profits bear an obviousresemblance to EBITDA, a relationshipwhich will be discussed further below.

Lastly, operating profits need to be taxed.We know the taxes on pretax income asreported under GAAP from the GAAPfinancial statement. We subtract thisamount and subtract additional taxes at a 35 percent marginal tax rate on theadjustments to pretax income used inderiving operating profits. The net result is after-tax operating profits, or OPAT.

Step 3: Calculate VIF For each line of business where adequateinformation is disclosed, a run-offassumption is developed based on discus-sions with management, analysis of GAAPand statutory statements, industry andeconomic conditions, etc. In particular,we look closely at lapse data, changes inin-force business, rate of amortization of DAC and the empirical “k” factor (the ratio of DAC amortization to gross profits). The operating profits are thenrun off and discounted at a weighted average cost of capital reflecting an appropriate debt/capital ratio.

If the run-off rate of the profit stream,R, can be assumed to be constant, thenVIFG, the value of the in-force gross ofcost of capital, is:

VIFG = ∑OPATx[(1-R)/(1+WACC)]t

For t = 1, 2, 3…

= OPATx(1-R)/(WACC+R)

Assuming the run off rate to be aconstant, though simplistic, leads to some interesting results. In particular,for investors the preceding equation is a familiar concept, capitalizing forward

earnings using a multiple, in this case1/(WACC + R). Also, when consideringthe similarities of OPAT to EBITDA, thisexpression improves the valuation utilityof this concept by quantifying theexpected longevity of the earnings flow and calculating its present value.

To estimate the cost of capital supportingthe business, we refer to the company’sdisclosure, usually found in the Form 10-K, regarding statutory surplus.Companies generally disclose theirconsolidated surplus position, sometimesincluding AVR and an overall RBC level.This surplus is then run off in proportionto the run-off in the business assumed incalculating VIF. This assumes the elementsof the business that create profits areproportional to the elements that createrisk for which surplus is held.

An allocation by line of business can bemade if necessary, as well as an adjust-ment to the target RBC being used in theanalysis, e.g., 200 percent is common. Fora given business, we’ll use SRBC as thesurplus level that represents the targetRBC percentage at time zero. Thediscounted cash flow and releases attributable toSRBC is then:

CFRRBC = ∑SRBCx(R + (IRBCx(1-T)))x[(1-R)t-1/(1+WACC)]t

For t = 1, 2, 3…

= SRBCx(R + (IRBCx(1-T)))/(WACC + R)

where IRBC is the pretax interest earned onsurplus and T is the tax rate assumption.

The value of in-force net of the cost ofcapital is:

VIFN = [(OPATx(1-R)) + SRBCx(R +(IRBCx(1-T)))]/(WACC+R) - SRBC

In this equation one can see that the manyassumptions made up to this point beginto bear fruit. Note the numerator of thequotient is a forward year amount capital-ized by the multiple identified earlier,

1/(WACC+R), in the same fashion as aprice-to-earnings ratio. Also, using thisexpression, one can easily relate the value of the in-force to changes in earnings,run-out rate, RBC level, taxes and thedesired return on capital.

Step 4: Calculating theconsolidated valueUsing the approximations described earlier, the consolidated Total EV for the corporation is:

TEV = ANWi + VIFN – D

The debt, which was removed in calculatingANWi, just as the interest on the debt wasremoved from operating profits, is nowfactored into to the total valuation. Themarket capitalization of the stock canthen be compared to TEV.

Investor perspectiveWhat does this approach accomplish for an investor?

1. From an analytical standpoint, the approach gives investors a means oflinking the GAAP numbers on which they mainly focus with the concepts underlying dividend discount and discounted cash flow models. The approach provides a quantitative rationale for constructing a relevant multiple for the reported earnings (something a traditional P/E discussion often lacks). As relates to EBITDA,the approach is far more dynamic than traditional EBITDA ratios, e.g.,EBITDA/enterprise value.

2. By removing intangibles, the approach removes a considerable amount ofmanagement discretion, at least in the eyes of investors. At the same time it does not run afoul of the difficulties in statutory accounting that are elimi-nated in consolidated GAAP statements,e.g., surplus relief, surplus notes, inter-company management fees, etc.

3. It provides an absolute value to compare with the observed market value, rather than the relativism ofprice-earnings multiple valuations,which are often justified only in terms of past multiples, peer multiples or overall market multiples.


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The approach provides a quantitativerationale for constructing a relevantmulitiple for the reported earnings.

Introduction

There is a new awakening in theworld of business that analyticaland quantitative methods can be

applied to model and manage risk.Business leaders are beginning to believethat a disciplined approach to managingrisk can create shareholder value byreducing the likelihood of catastrophic“surprises” that damage their corporatereputation and result in financial losses.

This awakening, driven mainly by regula-tory developments, began in the bankingindustry, as we will describe in this article.Recently, it has spread to other industries.The nudging of Congress and regulators,following the recent financial scandals,provided the necessary impetus.

New risk management professionals,recognized for their successes in bankingrisk management, stand ready to serve theemerging needs. These professionals are

well equipped with science and theory.They are supported by a strong intellec-tual base, led by research programs in eliteuniversities as well as some of the largestcorporations in the financial sector.

Many of these practitioners, working ininvestment and commercial banks, holddoctoral degrees in hard sciences (such asnuclear physics, mathematics, economet-rics, etc.) from prestigious universities

around the world. They are very talented,trained in research—through graduateschool and academic experience—andskilled in applying basic principles increative ways to find solutions to manyproblems, including those in the businessworld.

The challenge for the actuarial profession isto join this new movement as a full partner.Actuaries have centuries of practice in riskmanagement, and we describe ourselves asprofessionals who “model and managerisk.” However, the new risk managementprofessionals, with no affiliation whatsoeverto the actuarial profession, are quicklyestablishing themselves as the risk manage-ment profession. “Risk management” is inthe SOA vision statement—somethinghardly anyone reads—but it is squarely inthe title of the new professionals. In thisarticle, we will describe how this cameabout and provide additional backgroundon the new profession.

Actuaries and riskmanagementSince the early years of our profession,actuaries have been involved in modelingcontingent events. The profession devel-oped a repertoire of basic tools andtechniques to support modeling and

analysis. For the most part, a determinis-tic modeling approach was used that didnot capture the intrinsically stochasticnature of contingent phenomena. Thatapproach continues to this day in manyareas of actuarial practice. One exception isthe actuary who faces the highly dynamicproblem of managing investment risk inthe context of liabilities with embeddedoptions. Many actuaries in this area areusing sophisticated stochastic modelingtools.

Now let us consider the flip side ofmodeling and talk about managing risk.Historically, the actuarial approach to riskmanagement was qualitative and intuitive.It depended heavily on “judgment”acquired from experience, rather than on a rigorous quantitative measure ofrisk. In fact, “risk” (or “adverse variabil-ity”) was not often formally measured bythe actuary. This can be contrasted withthe emphasis placed on quantitative measures of variability by the new riskmanagement professionals.

A primary tool used by actuaries formanaging risk was conservatism, i.e., theuse of margins to minimize the risk ofloss. A big area of emphasis has been thecontrol of behavioral risks in contracting,including moral and morale hazards,through sophisticated policy featuresand underwriting techniques. A refinedapproach to the definition of risk classes,combined with precise measurement ofthe expected loss experience of each class,has been a focus of actuaries, rather thanquantitative methods to model and manageportfolio risk. These traditional approachescontinue to be emphasized by actuaries inthe life insurance industry.

Developments since the 1950sTheories of the measure and price ofrisk, as well as new tools for managingrisk, emerged from the work of financialeconomists. They were developed in thecontext of pricing primary and derivative

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r i s k m a n a g e m e n t

New risk management professionals,recognized for their successes in banking risk management, stand ready to serve the emerging needs.

The new risk management professionalsby Narayan Shankar, FSA, MAAA

securities, with variability of returns andintrinsic price volatility taking center stageas formal measures related to investorrisk. In the 1980s these ideas began to be applied in a portfolio context to themanagement of risk in financial institu-tions—primarily in banks—and the newscience of enterprise risk managementwas born.

Risk management inbanksAt the enterprise level, the central riskmanagement issue in financial institutionsis the amount of capital needed to protectagainst adverse business results. Financialinstitutions need to hold capital in orderto give confidence to their customers (bankdepositors, insurance policyholders, etc.)that liabilities will be honored even if theinstitution experiences unexpected losses.

Traditionally, bank liabilities have beenrelatively simple, consisting primarily of checking, savings and time deposits,though more recently, banks do raisefunds in the capital markets. There aregenerally no contingencies with respect to liability cash flows. Interest rates andguarantees can be a factor in raising fundsin the retail market, but most guaranteesare very short term in nature. Theseconsiderations are more an issue for marketing and operations than for risk management.

In most cases, the operating liabilities ofa bank are immediately callable, with orwithout penalties. But there is a normalpattern of withdrawals that is quitepredictable, with some seasonality. Theprimary focus in managing liability risk is to avoid a “run on the bank.” This cangenerally be achieved by avoiding liquidityconcerns, reputation issues or excessivelosses on the asset portfolio.

Hence, the primary emphasis of riskmanagement in banks is on the asset side of the balance sheet. Banks investin marketable securities, currencies,mortgages, retail loans and business loans. They generally do not employ a“buy and hold” approach to investments,but consider them to be part of a tradingportfolio on which they attempt to earn a

spread over the cost of funds. The mainrisks faced by banks with respect to theirinvestments are broadly classified asmarket risk and credit risk.

Risk management forinsurers and pensionfundsSome actuaries are involved in managingenterprise financial risk at insurancecompanies and pension funds. Due to the complex long-term nature of insur-ance and pension liabilities, and thecontingencies involved, risk managers atthese institutions usually cannot take asimplistic approach to the liability cashflows, especially in those cases where the liability cash flows are dynamic.

Actuaries have evolved a sophisticated asset-liability approach for managinginsurance risks and some actuaries are atthe forefront of using these tools in their

practice. However, many actuaries do notemploy these tools for the management ofrisks, and sometimes not even for model-ing them. Often, actuaries play a passiverole, using their considerable talents inthis area only for the fulfillment of thestatutory asset adequacy analysis function.

In order to fulfill the vision and missionof the profession, actuaries need to beactively engaged in managing enterprisefinancial risk. They are clearly positionedto take the lead in this area, if they willonly do so.

In the pension area, the state of theory andpractice in asset-liability management lagsthat of insurance companies. In most cases,pension ALM reduces to the choice withrespect to investment policy of a “60/40”or “70/30” allocation to equity and fixedincome, based on the premise that a heavyweight toward equity is appropriate due tothe long duration and implicit inflationindexing of the liability obligations.

The focus of pension actuaries has beenthe plan sponsors and the management oftheir financial objectives. The incompatiblegoals of the IRS of prohibiting overfund-ing while ensuring funding adequacy haveled to a bizarre set of rules that createanomalous swings in funding levelsthrough the course of a business cycle,complicating the development ofa rational ALM strategy.

The involvement of pension actuaries inasset-liability analysis can be increased.Actuaries need to take a leading role intackling the tough theoretical and practi-cal issues in pension valuation, fundingand ALM.

The solutions may require significantlegislative action to allow a better fitbetween theoretically sound risk management practices and permissiblecontribution strategies. Should there bean RBC measure for pension plans? Weneed thoughtful analysis of the issues and a dialogue on the financial and policyimplications. With their understanding

of the big picture, actuaries are betterpositioned than any other professionalsinvolved with pension plans to do theanalysis and propose creative solutions to the current challenges.

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continued on page 8

The primary focus in managing liabilityrisk is to avoid a “run on the bank.”

Bold, principle-oriented thinking is neededfrom actuaries. This is our turf, and weshould be thought-leaders in this area.Unless actuaries are an integral part of devel-oping solutions to these issues, addressingthe balance sheets of pension trusts as well asplan sponsors, they risk being marginalizedin an area that has historically been a pillarof the actuarial profession.

Like life actuaries, health actuaries facerisk classification and loss estimationissues. They have focused on these micro-level risks and at the same time have triedto get a handle on the tough problem offorecasting health care inflation. At theenterprise level, a major risk faced byhealth insurers and HMOs is the prospectthat cost and utilization of medical serv-ices will exceed the estimates built intopremium rates. Health insurance compa-nies have taken many creative measuresover the last couple of decades to managethis risk. These risk management strate-gies are collectively known as ManagedCare, and primarily address the liability(operating) side. Actuaries have beeninvolved in these efforts. In the future,there may be new approaches that incor-porate asset-based strategies and certainhedging techniques.

Threats and opportunitiesfor actuariesIt’s time for actuaries to step up and be enterprise financial risk managers intraditional industries. The opportunitiesare there for the taking. However, theseopportunities will be there only for solong and we need to act fast, since seniormanagement is beginning to see the need for an active enterprise financial risk function. The new risk managementprofessionals can easily step in and “eatour lunch.” That is already happening,with “chief risk officers” being appointedwithin insurance companies from outsidethe ranks of the actuarial profession.

It is necessary for every actuary to breakout of their passivity, and think consciouslyof themselves as “risk management profes-sionals,” rather than premium or reservecalculators. Chief actuaries need to think at

an “enterprise” level, assessing risk and advis-ing the CEO on threats and opportunities. Itis the responsibility of every actuary to raisethe overall profile of our profession and gainrecognition as risk experts.

Risk management is dynamic and action-oriented. It involves making choices,reaching decisions and taking action. Allthe analysis in the world is wasted if noaction results—the risk does not go awaybecause it is analyzed, it only goes awaywhen action is taken. Actuaries can beguilty of over-analyzing and under-managing. A first step in this process iseffective communication. Actuaries can be the decision makers in some cases, butfrequently they are advisors. Seniormanagement is generally not aware of therisks that are present, nor are they equippedto even ask the right questions. It is notonly the prerogative of actuaries to raisethese questions and provide creative andreliable advice; it is their obligation.

We have emphasized the threat that actuar-ies face from the new professionals in thetraditional areas of insurance and pension.For now, it looks like the nuts-and-bolts jobs in pricing and reserving still belong to actuaries, but the new risk managementprofessionals are a strong competition forthe enterprise-level analysis and decision-making positions. Indeed, they seem to beviewed as better equipped to understandthe big picture and manage risk at themacro (enterprise) level.

Let us examine the other side of this issue.What are the opportunities for actuariesin non-traditional areas, such as banks?For the rest of this article, we will focuson how well actuaries are equipped tostep in, from the perspective of technicalknowledge. What comparative advantagesand disadvantages do we have for successin these new areas?

The gap in the actuarialknowledge baseActuaries are generally not familiar withthe tools and techniques used to managerisk in those cases where enterprise finan-cial risk of the asset portfolio can beseparated from that of the liabilities, as isthe case in banks. While there is clearly alearning curve—and most actuaries willprobably have to bone up on their mathe-matical and statistical knowledge—it iswell within the range of their skills foractuaries to attain a mastery of the stateof the art in asset risk management.Indeed, it is imperative that all actuarieshave a general familiarity with the toolsand jargon in this field.

The following two areas might be a good place to start. One is Extreme ValueTheory, which deals with evaluating theprobability of unlikely occurrences. Bydefinition, capital is held to cushionagainst unlikely occurrences. So, havingthe knowledge to measure and manage risk at the enterprise balance sheet level isimportant. The other area of knowledge is

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New risk management ...continued from page 7

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modeling contingent cash flows on finan-cial instruments, primarily options, futuresand swaps that are frequently used tohedge risk or speculate in the financialmarkets. Derivative instruments areabsolutely integral to asset management, soa working knowledge of them is necessary.However, a mastery of all the mathematicsbehind valuing these instruments is proba-bly not required to work with them in therisk management field. There are softwarepackages that do all the math.

We will provide a quick overview of thevarious types of risk analyzed by the newrisk management professionals in banks,the current state of the art in their prac-tice and the techniques used.

Market riskThe impetus for the birth of the newscience of risk management was the funda-mental question: How much capital does abank need to cushion against market risk,i.e., the possibility of short-term losses onits trading portfolio of marketable securi-ties? The key words here are “short-term”and “marketable securities.” It has beenpossible to develop precise mathematicaland statistical methods to measure thisspecific risk. Note that while these problemsare more tractable than the ones actuaries

work on in the traditional industries, solv-ing them usually requires more advancedmathematical knowledge than mostactuaries have.

Bank regulators proposed risk based capitalrequirements as a cushion against marketrisk. To correctly measure this risk andavoid unnecessarily onerous capital require-ments, banks hired “rocket scientists”holding Ph.D.s to develop the appropriatetechniques. In the 1980s, investment bankshad already discovered the value thatadvanced scientific training can bring—“rocket scientists” had been significant players in the development of new securitiessuch as collateralized mortgage obligationsand complex hedging instruments.

Once again, Ph.D.s with advanced analyti-cal training came through for financialinstitutions. Using mathematical andstatistical tools, including concepts fromtraditional Extreme Value Theory, a solidbody of knowledge has been created formeasurement of market risk. This body of knowledge generally goes under thejargon of Value at Risk (or VaR) methods.Knowledge in this area continues toadvance.

Note that insurance companies also facemarket risk, but from a long-term ratherthan short-term perspective. Hence ALMmethods, including the emerging work oncontingent tail expectations, rather thanVaR methods, are more applicable.

Credit riskMore recently, banks (led by bank regulators) have turned to the other basiccategories of risk they face—credit andoperating risk. The new risk managers are at work, and progress is being made.Credit risk for banks corresponds tounderwriting risk for insurance compa-nies. For banks, credit risk is present inboth the operating portfolio of loans aswell as the investment portfolio of bonds.The issue is being addressed scientifically,incorporating the idiosyncratic risk of

individual customers (i.e., the underwrit-ing risk in the traditional sense) as well as the systematic risk of business cycles.

Measuring and managing credit risk is harder than short-term market risk,which was addressed so successfully in the 1990s. Credit risk involves longer-term economic issues and selection effectsfamiliar to actuaries. It is a harder prob-lem, not so easily solved using advancedmathematics, but it is also one whereactuaries have much relevant knowledge.

Actuaries have much to contribute in thisarea, having worked on similar problemsfor more than 100 years. Indeed, casualtyactuaries, with their experience in manag-

ing underwriting risk through businesscycles, may be in a position to lead theway. The new risk managers are going for the Holy Grail, i.e., the mathematicalmodeling of the business cycle and itsinterplay with credit losses.

Another approach that is being taken is to reduce the credit risk problem to oneof market risk by creating new tradedinstruments such as “credit derivatives”that securitize credit risk. Since marketrisk is already measurable, and creditderivatives provide liquidity, completenessand the opportunity to hedge, these newinstruments offer a powerful way to effi-ciently manage credit risk. An increasingnumber of companies are trying toaddress market and credit risk in onecohesive risk management framework.

Operating riskPerhaps the best area for actuaries tocontribute is in operating risk, whichincludes such issues as fraud, internalcontrols, reputation, litigation liability,marketing risk etc. Casualty actuaries have long made a market in many ofthese risks, and have vast amounts ofinstitutional knowledge, data and experi-ence in this area. The new risk managersare groping their way around, in manycases reinventing “the wheel.” Operatingrisk is a messy area of risk management,where measurement will never be reducedto a science and “experienced judgment”will remain important as a factor in riskmanagement—a skill that actuaries possess.

For operating risk, prevention is often the best form of management rather thanhedging, diversification and other portfo-lio-type solutions, which are the primarytools for handling credit and market risk.To the extent operating risk is managedthrough portfolio approaches, it is oftentransferred through insurance and pooledby casualty insurers, which is the reasonthat casualty insurers have a deep under-standing of the general portfoliocharacteristics of such risks.

Even when insurance is an efficient mechanism for managing certain operating risks, the risk management

The new risk managers are gropingtheir way around, in many cases reinventing “the wheel.”


Back to our roots—getting reacquaintedwith our mission

The uncertain position of the actuarial profession in the riskmanagement area—now and in

the future—is a topic that is getting muchattention at the SOA. Many groups—including the Board of Governors, theEducation and Examinations Committees,the sections and various task forces—aredebating ways to address the cascadingeffect on the profession of developmentsin the past several years, since the issue ofrisk management first made news acrossthe globe.

Some of these developments are a seriousthreat to the future of the profession;others are opportunities. One thing isclear: if we want actuaries to be at theforefront of risk management, we need to stay true to our mission of being “theleading professionals in the modeling andmanagement of financial risk and contin-gent events” (excerpted from the SOAmission statement—http://www.soa.org/ccm/content/about-soa-member-directory/board-bulletin/mission-and-vision-statement/. Achieving this missioncalls for taking a fresh look at our profes-sion, our skills and abilities; acknowledging

the gaps in our knowledge and back-ground; and beginning to makeimportant changes in how we viewourselves and our role in the world of business.

Progress—one personat a timeAn important first step is to becomeengaged—get plugged in to what is goingon around us. The world is moving faster than we think. It is likely that many of us

have been virtually unaware of the devel-opments in risk management describedin Narayan Shankar’s article entitled, “Thenew risk management professionals,found on page 6. These developmentsaffect all of us. It is necessary to be alert to opportunities, and even more impor-tantly, avoid being swept away by powerfulforces while we are fast asleep.

A second step in making progress is to be a part of the solution. For the profes-sion to be strong, each one of us needs to contribute toward influencing ourcollective destiny. We had a strong senseof belonging to the profession when wewere taking exams, but, for the most part,the majority of us are no longer directlylinked to what is happening in our organ-ization. We don’t follow the issues beingdiscussed by our Board of Governors. Wedon’t vote in our elections as much as weused to. We may not even understand thatthe SOA is so much more than just anexamination-and-research machine. If wewant to change the image of the profes-sion and take it to new heights, we needto get involved. A wise person once saidthat decisions are made by those whoshow up. You can all become effectiveagents of change!

Recently, much work has been done byvarious SOA groups on the topic of riskmanagement. Among the most noticeabledevelopments are the Risk ManagementTask Force, the newly created RiskManagement Section and the recentlydeveloped Enterprise Risk Managementextension track for Course 8 Finance.There are other related initiatives in the works as well—the Board, the Strategic Planning Committee, those involved in the E&E redesign and various sections

are working to advance the profession in the risk managementarea in the traditional sectors and beyond.Obviously, members involved and theleaders of the SOA are recognizing theimportance of this topic. But are wemoving fast enough?

Unfortunately, there is a certain degree of a “why should I care” attitude among a portion of the membership. So far, ourprofession has been fortunate. Regulatorydevelopments in insurance and pensionwere instrumental in the rapid growth theprofession experienced in the last severaldecades. But this pattern is showing signsof reversing. Already, the consolidationwave in Canada is manifesting itself in thenew phenomenon of a growing numberof mid-career fellows who have lost theirjobs and are unable to find equivalentemployment, since their insurance skillsare not broadly applicable. The health and retirement systems actuaries in theUnited States are dealing with their ownconcerns, and some insurance companiesare starting to outsource their actuarialfunctions abroad. When the prosperity of a profession is directly tied to the exis-tence of a few regulatory requirements ora lack thereof, and the profession is poorlydiversified across industries, this is a signof trouble just waiting to happen. It’sessential that we be prepared for the big changes that will affect our future—changes that might happen much sooner than we think!

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Actuaries — profession in crisis?by Valentina Isakina, ASA, MAAA, CFA Level II Candidate


For the profession to be strong, eachone of us needs to contribute towardinfluencing our collective destiny.

What it takes to succeedThe SOA has done much work in the lasttwo years to find out more about the actu-arial competition, and now we have plentyof data on this subject (available on theSOA Web site, among other sources). Thedata show that the Chartered FinancialAnalyst designation offered by AIMR(Association for Investment ManagementResearch) and MBA degrees holders posea real competitive threat to actuaries.Market recognition of the Financial RiskManager (FRM) designation offered byGARP (Global Association of RiskProfessionals) is growing, and on thefinancial engineering/analysis side,employers highly value Ph.D.s.

Most actuaries who have studied the situation realize that risk management is the likely future of our profession as a whole—that is, if we act fast enough.There is a strong link between why thegrowth of the risk management field hasbeen occurring without much actuarialinvolvement and the wide perception ofan actuary as a “liability side technician”on account of the existing specifics-oriented, liability-side focus of actuarialeducation/training.

The asset-side professionals currentlyworking as risk managers are excellentcommunicators and think conceptually.Thus, given new professional opportuni-ties—such as those emerging in risk

management—they are able to easilyapply their theoretical and business prin-ciples across various industries with equalsuccess. In both risk management andfinance, the market is defining a standardin terms of the people who are offeredthese jobs—and this definition does nottypically include an actuary.

At the first SOA/CAS Enterprise RiskManagement Symposium (July 2003),we conducted a Chief Officer Roundtableto solicit input from several financial

services executives (both actuaries and non-actuaries) about the skill sets needed to succeed in the current business environ-ment and to be prepared for the future. Thefeedback was blatantly frank: actuaries, as awhole, are lacking these skills! The feedbackfrom the roundtable discussion focusing onthe skills actuaries need to improve follows:

Chief Office Roundtable Feedback: SkillsActuaries Need to Improve• Decisiveness/decision-making abilities

- Improve ability to make decisions with less information

• Increase leadership abilities- Ability to champion change- Assertiveness, ability to say “no”- Ability to recruit top people for

the team

• Increase business knowledge - How a general enterprise is operated,

financed, managed

- Perspective of how the business units are run

- Knowledge of corporate functions

• Education/training/experience- Technical actuarial training is too

centered on expected values- Broader risk knowledge, education,

background are needed- Knowledge of alternatives is needed- “Trial by fire” experience is helpful

(experience of a crisis management)

• Increase ability to translate technical into practical- Ability to communicate with senior

management

This is quite a list. Some of the items mighteven sound like heresy to an actuary, butthe facts speak for themselves. Whether weagree with it or not, this is definitely thedirection in which the market is headed.A few months ago, the SOA released the

results of the member/employer survey—http://www.soa.org/ccm/content/about-soa-member-directory/board-bulletin/strategic-planning/—which confirmedthese trends even further. At the end oftheir discussion, the panel made a strong statement that still resonates with me:“Actuaries would rise in status in thebusiness world if their functions go

outside current traditional areas.” I would take this even further: “Actuariesmust take their functions outside thetraditional scope if the profession is tosurvive.” It is not some distant abstractthreat the profession faces—it could bevery personal, affecting us in our ownworking lifetimes.

Where will risk management spread?During their discussion, the Chief OfficerPanel provided insights on those sectorswhere the need for risk management isgrowing or about to develop. Thefactors—extent of regulation, complexityof business, spectrum of risks undertakenwhether risk is a core competency in thebusiness, and whether the company has to explain its risk profile to its constituen-cies—were used to identify which sectorsare most likely to be affected by thisphenomenon. Overall, the participants

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felt that enterprise-wide risk managementis likely to be quickly adopted by thefollowing industries:• Banking• Insurance• Asset management firms• Energy-related industries• Telecommunications• Government entities• Transportation• Health care

These areas represent a tremendousopportunity for actuaries, and manymembers of the actuarial profession arecurrently searching for guidance on howto prepare for these opportunities. TheSOA market survey—http://www.soa.org/ccm/content/about-soa-member-directory/board-bulletin/strategic-planning/—clearly shows thatactuaries have the necessary quantitativeskills to take on these new roles, but theinfusion of a broader skill set is necessaryfor success. In particular, our educationhas been concentrating on applications ofthe broader concepts of risk managementto a very narrow set of sectors. As a result,having been exposed to only those sectors,we often hit a roadblock when a new opportunity in a non-traditional setting

comes up, not realizing that the underly-ing principles of risk, finance theory andeconomics are still applicable. What weneed to do is be able to go back to theseprinciples and utilize these to take usoutside the “actuarial Berlin Wall,” tomake use of these principles in broaderapplications. Deepening our knowledge of principles and learning a variety ofcutting-edge tools that are applicable to awide range of risk management problemswill help us become formidable players inthis “new” profession.

The next stepsTo capitalize on new opportunities, weneed to acquire the skills, knowledge andexpertise that represent a combination ofthose we currently have and those that the“risk managers” possess. The detailedproduct-level expertise of actuaries withinthe few traditional industries they serve isextensive. However, this is not enough foractuaries to compete for higher-profilepositions in the traditional areas ofemployment and beyond. Within eacharea of practice, actuarial education (basicand advanced professional) needs to stressconceptual thinking and principles on theliability and asset side, so that actuariesare equipped with the necessary knowl-edge to measure and manage risk in anyindustry. If actuarial education empha-sizes the concepts and broad principles ofrisk measurement and management, actu-aries would be better equipped to dissectthe risk management problems of anyentity facing uncertainty.

These efforts need to include the wholespectrum of the learning process—frombasic to continuing education, to self-education and professional advancement.However, without immediate buy-in andinvolvement from the membership, thingswill not progress. Here is how members at various levels can contribute immediately:

• Universities - The academic community must take

the lead in creating new knowledge in the discipline of actuarial science,developing applications of actuarial science in new areas and training students in the broad range of tech-niques and skills that will allow them to expand the profession by entering new industries successfully. This role should not be confused with the role of the SOA exam curriculum, which strives to fulfill the practical short-term needs of a few specific industries and traditional employers of actuaries,and often lags behind the develop-ments in the broader economy. The tradition of universities following the exact SOA curriculum is damaging to the discipline of actuarial science and,ultimately, to the actuarial profession.Understandably, the SOA curriculum will emphasize the needs of current employers. But academic actuarial education should go beyond, to broaden the profession as well as the career options for students.

- Meeting the needs of current employ-ers and educating actuaries on the knowledge needed in newly develop-ing areas are often conflicting objec-tives. The result can be one ofcontentious debates and tradeoffs,with neither objective being achieved satisfactorily. The actuarial examina-tion system cannot be and is not meant to be the driver of the state ofactuarial knowledge. Maybe at some

time in the future, similar to what hashappened in some other countries,actuarial academic and examination systems in North America will converge. If this happens, the appro-priate model is for the examining bodies to accept the university actuarial education provided by the academic

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The academic community must take thelead in creating the new knowledge inthe discipline of actuarial science.

Profession in crisis?continued from page 11

community, get out of the business of the lower level exams and focus on specialty advanced practical education.Until then, it is up to university programs to develop future generations of actuaries who are well-versed in actuarial principles, possess good communicational skills and business sense, and are capable of applyingactu arial knowledge in new areas.

• Individual members and sections - The most effective changes are those

that start from within. We need to change our own behavior with respect to continuing education. We need to acquire knowledge that will expand our horizons and empower us with new tools to do our jobs better, rather than focus only on narrow areas ofspecialty. The SOA sections are one resource to tap into to get this accom-plished. The sections have a great deal of autonomy with respect to the education programs and products they can offer through the SOA. The SOA Web site has information about various sections and how to contact the council members. If you, as section members, speak up, the sections will listen. Let them know what you need and how you are willing to help advance our collective mission.

• SOA Examinations & Education - A new education and examination

system is being introduced in 2005 with some exciting changes to how we approach our educational process.However, we need to realize that our new examination process, although improved, will still be subject to the trade-off issues discussed earlier in this article. We have to accept this as a fact of life and find new ways of fill-ing knowledge gaps, possibly utilizing strategic partnerships or alliances.One approach can be to develop joint credentialing programs to supplement our exams, turning the competition into our partners while filling our knowledge gaps. Another approach can be to listen to what the marketplace tells us and to recognize compet-ing examinations or designations offered by our biggest competitors.

For example, we could investi-gate how such widely demanded asset-based designations as CFA,NASD 7-Series, FRM and others can fit within the actuarial education.This approach could help us leverage the existing market success of our competitors simply and effectively.

• Actuarial associations - One reason competing professions

and designations have been so successful in penetrating the market is that they are international in scope and have pooled their resources by coming together. While grass-roots efforts are crucial in responding flexi-bly to a changing environment, there are areas where coordinated action and effective centralized decision-making are critical for success. For instance, it is vital to present a consis-tent image of the profession in the public arena and to enhance visibility.Practice areas—life, health, casualty,pension and the new ones develop-ing—need to learn from and build on each other’s strengths. This is facilitated when they can build their loyalties around the concept of a single profession. For example, the AIMR—a result of two organizations merging together—was able to achieve its current high profile only after the merge. Our profession has a lot of potential and has much to offer as a whole, but will be less effective iffragmented. Unless we work together towards the same goals, our progress will be hampered.

It is time to be realistic, as the market’smessage to us is clear: the traditional back-office actuary is not in big demand andmight be outsourced. To fill higher-profileroles within and outside the traditional areasof actuarial employment, actuaries need tobe broadly recognized as being able to do so.Such recognition cannot be created withouta consolidated effort by all appropriate actu-arial organizations. It also cannot comewithout a conscious effort by every member,every volunteer and every candidateinvolved in the process. On every front at the SOA—member-level, education, profes-sional development and strategic—we needto effect change. Time is running out.

Valentina Isakina is the SOA finance practice actuary. She can be reached at [email protected]. ¨

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SOA leads profession-wide effort to promoteactuaries as chief risk officers

p r c a m p a i g n

The Society of Actuaries, in coopera-tion with other leading actuarialassociations, has launched a public

relations campaign to promote the estab-lishment of the Chief Risk Officerpositions in businesses throughout theUnited States and Canada. The campaignwill also educate the market about theactuarial skill set to position actuaries asthe best choice for this critical new role.

“The continuing emphasis on trans-parency and corporate governance reform,which is strengthened by the requirementsof Sarbanes-Oxley, creates a window ofopportunity for corporate CEOs anddirectors to build needed credibility withinvestors,” said Juan Kelly, senior actuarialassociate, Mahoney & Associates, and amember of the Society’s Risk ManagementTask Force, CRO Subgroup—the drivingforce behind this grass-roots initiative.

“Employers already recognize our stronganalytical skills and our high ethical stan-dards,” he added, “so we can increase ourvalue proposition—and advance ourprofession—if we seize this opportunity.”

Program goals• Generate business press attention to the

call for corporate boards to require objective, integrated assessments ofrisks in public companies.

• Educate business leaders on the role ofa CRO and how this evolving profes-sion can add strategic competitive value to a business, as well as protect shareholders from significant financial crisis.

• Explain how actuaries are in a unique position to fill the role of CROs and how their training, perspectives and experience bring a distinctive value to this emerging field and specific advan-tages to the governance and manage-ment of companies.

A profession-wide initiativePartners in the publicity program includethe American Academy of Actuaries, theCanadian Institute of Actuaries, theConference of Consulting Actuaries and

the Casualty Actuary Society. Ruder-Finn,an international public relations firm, withstrong experience in financial, corporateresponsibility and ethics issues, is provid-ing professional support to this initiative.

“This program will benefit the professionimmediately in at least two importantways,” added Valentina Isakina, SOAfinance area actuary. “First, it will provideimmediate ‘bang for the buck’ that willhelp to raise the visibility of our professionand second, it will help pave the way for acomprehensive, profession-wide brandingcampaign that is being organized forintroduction later this year.”

For more information, contact Joel Albizo,SOA managing director of communicationsand marketing, at [email protected]. ¨

Employers already recognize ourstrong analytical skills and our highethical standards.

Hear your president-elect candidatesspeak

Join us at one of the SOA SpringMeetings and hear the president-elect candidates address the audienceat the General Session. This is youropportunity to discover their visionfor the actuarial profession and whatcontributions each candidate hopesto make to the SOA during theirtenure.

Watch for a special supplementedition of The Actuary in Junefeaturing interviews with the presi-dent-elect candidates. Also, join theonline discussion forum in June andJuly and pose your own questions tothe president-elect candidates.

Your participation in the selection ofour future leaders is very important.Please vote, and encourage otherFellows to do so as well. For ques-tions about the election, contactKaren Gentilcore at 847.706.3595 or [email protected]. ¨

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4. With the industry in a consolidation mode, it produces a value that can be seen as a base for the company’s value in an acquisition, always a point ofinterest for an investor. The TEV is the amount a buyer would pay, before synergies and without new business, for the total company. There is also good raw material for estimating the effect of purchase accounting for a given business combination.

5. In certain distressed situations, where a stock price has dropped sharply, the approach is useful because it still produces meaningful “floor” values where price-to-earnings ratios may not be meaningful due to sharply diminished earnings. In these situations,traditional price-to-book value ratios may also be useless because the intangible assets that often equate to the bulk of book value are usually what are being called into question. In severely

distressed situations, where the value ofthe book of business is highly conjec-tural, the value of the in-force can be set to zero, leaving ANWi – D to be considered as a potential “floor” value.

6. As TEV progresses from year-to-year,the investor can see whether and how changes in capital structure, acquisi-tions/divestitures and layers of new business have created value.

7. The approach illuminates the reconcili-ation of GAAP and statutory account-ing, making it is a useful educational tool for the investor.

Technical defectsThe shortcomings of this approachadmittedly are significant and would beoverwhelming except for the fact that noapproach using only publicly availabledata can be completely satisfactory. Hereare some of the major drawbacks.

1. The adjustments to GAAP earnings and book value described above clearly do not equate to statutory earnings and surplus. Most obviously, there are differences in GAAP benefit reserves and statutory reserves that are not taken into account.

2. The treatment of deferred taxes addresses GAAP and tax accounting timing differences, but does not address statutory deferred taxes, nor any other tax complications that may arise, e.g.,loss carryforwards.

3. The approach does nothing to deter-mine whether the reserves used in the calculations are adequate, although some inference can be drawn from the pattern of operating profits over time.Of course, if a reserve shortfall is recog-nized via strengthening, the approach does a nice job of placing it in a total valuation context. This is a particular

benefit to GAAP-focused investors who struggle with how much to pay for prospective earnings that are newly created by a reserve strengthening.

4. More broadly, the run-off rates are developed with the best available data,but this is far from the detailed studies that underlie the assumptions in a true EV analysis.

5. The assumption that both profits and surplus supporting the business run offat the same geometric rate is fraught with potential errors. Also, there is yet another layer of approximation involved to refine the treatment ofsurplus to the line of business level because companies usually do not release this data.

6. At the corporate level, the approach assumes that all businesses operated by the company have a profile that can be

put in a life insurance statutory framework unless disclosure allows for a separate vaulation. This is a stretch for companies with property-casualty lines and even more removed from reality for non-insurance busi-nesses, e.g., broadcasting, money management, etc.

Each of these shortcomings can beaddressed through further research anddiscussion with the subject company.Such follow-up is often where key insightsto the business are found. Of course, apartfrom normal time constraints, one willfind that Regulation FD may limit compa-nies’ willingness to go beyond the printeddisclosure in assisting with such narrowlyfocused questions.

From an actuarial standpoint, one couldeasily argue that the shortcomings of thismethodology are so numerous that itwould be better to simply rely on manage-ments to provide EV information as theysee fit. However, interest in EV is alreadyoutstripping disclosure in the UnitedStates, and even as disclosure increases,investors will perform their own verification and analyses to the maximum extent possible.

SummaryEV is already playing a role in the manage-ment of many U.S. insurance companies.We expect to see it become more promi-nent in financial disclosure in the UnitedStates, perhaps even required. As EVincreases in visibility, actuaries shouldexpect external users of financial statements to use the data at their disposal to help them understand, challenge, andjudge the reasonableness of reportedembedded value. This methodologydemonstrates one approach for doing so.

James Ramenda is managing director ofNorthington Partners, Inc. Avon, Conn. Hecan be reached at [email protected]. ¨

Embedded valuecontinued from page 5

EV is already playing a role in themanagement of many U.S. insurancecompanies.

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o r g a n i z a t i o n a l r e s u l t s

Getting stronger every day ...BOG reviews 2003 organizational resultsby Sarah J. Sanford, CAE

The resultsaregreat—

2003 was a yearof continuedstrong financialperformance.Improved investmentperformance

($191,000) coupled with strong opera-tional performance (net operating of$141,000 vs. a budgeted deficit of$105,000) allowed us to increase net assets by $332,000.

The strategic focus of the organizationremains strong, and every strategic initia-tive outlined in the plan was addressed.Here are some of the strategic highlightsof the year:

Organizational effectiveness• Contracted with a nationally recog-

nized vendor to handle elections processing. Members were given the option of using a paper ballot, but the vast majority voted online. First Ballot participation was at a seven-year high of 31.3 percent. Second Ballot partici-pation of 31.7 percent represented a substantial improvement over 2002.

User satisfaction was generally very positive.

• Completed the office move in less time and with less downtime of office systems than anticipated. Renegotiated lease agreement, resulting in lower basic rent per square foot for substantially enlarged and improved space.

• Experienced a staff turnover rate of 9.5 percent, well below the last reported association average of 14 percent.

• Conducted a full assessment of infor-mation technology resources and capacity. A number of immediate improvements as well as a plan to replace the existing computer infra-structure resulted.

• Printed and mailed dues invoices in November in response to members’concerns regarding budget cycles and tax reporting. This was of great benefit to the AAA and to the SOA as it substantially improved cash flow for the month of December.

• Completed the Governance Audit in record time and well within budget.Recommendations were approved in October. Incorporated and relied significantly upon the work of the Task Force on Practice Areas and Sections as well as its follow-up group, the Implementation Task Force in framing recommendations.

• Held three Chief Actuary forums for actuaries from life, small company and health.

• Held employer focus group discussions at both spring meetings (two each) as well as three such groups at the annual meeting.

• Formed a Risk Management Section in record time (from idea to formation in less than seven months!). In part this occurred after more than 150 individu-als indicated an interest in serving on its precursor, the Risk Management Task Force.

• Facilitated the Chief Risk Officers Task Force’s development of a public rela-tions proposal to build corporate and SEC awareness of the need for compre-hensive risk assessments to be a part ofoverall reporting of results as well as on an ongoing basis. The CAS, CIA and AAA are partners in this effort.

• Completed a Risk Management Exam Track (again, in record time!) that will be offered as a Risk Management Extension exam in the fall of 2004.

• Completed comprehensive member and market research that provided guidance and direction to the Strategic Planning Committee as it prepared

recommendations, which were approved by the Board of Governors in October, for moving the organization and profession forward. This research also provided feedback on area ofpractice concerns and satisfaction with member services and products.

• Updated and revised the strategic plan.• Expanded significantly the utilization

of technology in presenting CE programs. This not only lowered expense but added value in such ways as making major meeting presentations freely available on the Web, increasing the speed and accuracy of registration (e.g. Web-based), and allowing more timely responses, via webcasts, to “hot” topics. Savings allowed signifi-cant reduction in registration fees for presenters.

• Continued distance learning program for meeting Qualification Standard.

• Established a Web portal for both E & E and CE courses.

• Embedded seminars with spring meetings.

The strategic focus of the organizationremains strong, and every strategicinitiative outlined in the plan wasaddressed.

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BOG discusses hot topics at March meeting

The Board of Governors met in Phoenixon March 19-20. Significant agenda itemsincluded:

• A mega issue discussion on the relation-ship between the actuarial profession and academia. The background paper distrib-uted to the Board is available on the SOA Web site—see Governance (Board ofGovernors and Organizational Documents). As part of the discussion,the Board reviewed a March 2000 white paper, “A Partnership between the Academic Community and the Actuarial Profession,” prepared by the Joint CAS,CIA, SOA Task Force on Academic Relations. There was general agreement with the directions outlined in the 2000 document which were:

1. To produce a sufficient number ofhighly qualified students and employees.

2. To produce a sufficient amount oftheoretically sound and practical research.

3. To enhance the reputation of actuarial science within the academic community.

4. To enhance to reputation of the academic community within the actuarial profession, the business community and government.

5. To enhance public recognition of the profession.

6. To optimize the use of the combined resources of both the academic community and the actuarial profession.

7. To maintain a flexible and dynamic basic and continuing education system.

8. To support consistency of the rela-tionship between the actuarial profession and the academic communitythroughout the world.

The Board charged the Task Force onAcademic Infrastructure to address theissues raised in the discussion and bringpreliminary recommendations back to theBoard for further discussion.

• The Board also prioritized the 18 barriersto success identified at the January Board meeting. Topics receiving the highest priority ranking will be discussed as mega issues at upcoming Board meetings. They are:

Knowledge management• Completed framework for compre-

hensive Education Redesign that was endorsed by the Board of Governors in June. Several new elements are designed to: improve candidate’s reten-tion of material, reduce travel time (this in direct response to employer concerns), focus on subjects specificto actuarial science (also in direct response to employer concerns) and incorporate the control cycle concep-tual framework in a way that will also introduce candidates to financial security systems using interactive, selfpaced web-based educational tools.

• Implemented new ASA requirements in May. These changes allow greater flexi-bility and choice to candidates, and in addition allows them to incorporate practice specific education earlier inthe process.

• Utilized member and market research to frame recommendations regarding possible new credentials/certificates potentially involving broader business skills.

• Processed a record number of exam registrations with 22.3 percent increase from 2002 on the preliminary exam side; 5.3 percent increase on higher-level exams. Largest FAC ever in November 2003.

• Completed Medicare Drug Claims Cost Study, a project that estimated costs ofvarious plan options for adding prescrip- tion drug coverage to Medicare. The report was the basis of a very well attended AAA/SOA Congressional Staff Briefing.

• Conducted a joint project with LIMRA and the International Foundation for Retirement Education evaluating soft-ware products designed to help individ-uals and practitioners analyze retire-ment risks and issues.

• Published Post-Retirement Risks Analysis and Factors Affecting Retirement Mortality. Both provide practical, valuable information to actuaries and lawmakers.

• Developed information designed to assist actuaries entering the Viatical Settlements market.

• Developed the first ever report on ex-penses used in life insurance products.

• Completed a comprehensive review of the literature on the Troubled Healthcare System.

• Reinforced research-practice link—42 percent of research projects had section involvement.

• Decreased time-to-project completion from 33 to 18 months for all projects started and completed since June of 2000.

• Actively collaborated with research partners—24 of 52 projects, or 46 percent involved collaboration.

Organizational resultscontinued from page 16



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w w w . s o a . o r g

From dramatically improving thelook and feel of the SOA Website, to providing enhanced

features and functionality, we’ve made a host of changes designed to improveyour user experience. Some of the keyfeatures include:

Improved navigationLooking for information specific toyour area of practice? Information onseminars, publications, research proj-ects and more that are specific to yourarea are just a click away.

Site-wide searchThe site-wide search is another greatway to find information. Availablethroughout the site, this tool will enableyou to quickly find content from anyarea with the click of a button.

Quick searchesSave time by searching the membershipdirectory and online library directlyfrom the home page.

Improved discussionforumsVisit the new discussion forums anddiscover how easy and effective it is tocommunicate online with other users.

Online libraryFind documents for all SOA publica-tions, including Special Interest Sectionnewsletters, The Actuary, NorthAmerican Actuarial Journal (NAAJ) and others through the improvedlibrary search.

New joblinkThe SOA has partnered withMonster.com, one of the most recog-nized names in Internet job searches,to create a career site that offers morejob postings, enhanced features andcareer-related content.

Printer-friendly pagesPrinting important documents is mucheasier with pages that enable users toprint documents in an easy-to-readformat.

We’d like to hear from you about our new look. Send your thoughts to [email protected] ¨

www.soa.org has a new look!

BETTER! Discussion forums with enhanced functionality!

FASTER! Access member directory & online library from the home page!

BIGGER! New joblink with more content, more jobs and more features!IMPROVED! Navigation makes finding information fast and easy!

THE NEW,FULLY RE-DESIGNED SOA WEB SITE IS HERE!

NEW

www.soa.org

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o r g a n i z a t i o n a l r e s u l t s

New risk management ...continued from page 9

Organizational resultscontinued from page 17

Advancing the profession• Established a strong relationship

with GARP (Global Association ofRisk Professionals), one of the strongest risk management organizations in the world.Developed a separate track for participants at the 2004 GARP annual convention.

• Evolved Long Term Care Conference into THE industry event on the subject. It is multi-organizational in nature, and attracts numerous professions.

• Partnered with more organizations

than ever (15 up from 7 in 2002) in Continuing Education. Examples include: Enterprise Risk Management with CAS, Investment Actuary with CIA, non-actuarial organization joint partnerships with LIMRA, LOMA, ABA and ACLI, and private company joint programs.

• Presented member and market research to Council of Presidents in November. Profession wide endorsement of need for image program.

• Participated actively in IAA discus-sions to enact comprehensive educa-tional guidelines globally.

• Supported significant involvement

of members and leader (Stuart Wason) in IAA Insurance Regulation Committee completion of a paper on solvency issues.

• Provided educational and technical support as well as publicity for the IAA’s new Health Section.

• Experienced continued high interest by international candidates in the SOA’s exam system and credentials.Non-North American candidates for Course 1 exceeded the combined number of U.S./Canadian candidates in 2003, for the first time. Beijing and Seoul were the second and third largest exam centers respectively in 2003. ¨

tools center around “prevention,” with“insurable interest” and “loss sharing”being the primary devices by which casualty insurers accomplish loss controlobjectives. While life insurers focus onmoral hazard and selection effects, casualtyinsurers are also concerned with moralehazard and prevention effects.

But there are types of operating risk thathave gained attention lately, such as repu-tation risk, for which portfolio solutionsare probably not efficient. Hence, muchof the focus in this area is on developingrobust processes to minimize the likeli-hood of “catastrophe” events. “Six Sigma”is the buzzword, for those familiar withthat concept.

Looking to the futureWhere do actuaries fit into the new riskmanagement profession? Currently, theyare not in the picture. This is regrettablefor two reasons. First, actuaries bring alot to the table, especially in the difficultarea of long-term risks that is the currentfocus of the new risk managementprofessionals. Second, there is an enor-mous amount of dynamic energy andintellectual capital in play within the risk management profession, and

actuaries can learn a lot from thesetalented professionals, and re-energizeour own profession with new ideas,tools and techniques.

The risk managers I meet rely upon basicmathematical ideas and theories, andthink deeply and creatively from firstprinciples. They work in partnership withregulators, such as governors or econo-mists at the Federal Reserve Board, whoare also accomplished and gifted individ-uals. Rather than focus on complyingwith complex and patchwork regulatoryrequirements—which actuaries can gettied up in—risk managers seem to takethe lead on developing the new tech-niques that lead to more efficientregulatory solutions.

Being a part of the bigger picture of therisk management profession might helpour profession break out of its shell.The historical solution in the insuranceindustry for managing enterprise risk has been building a complex regulatorystructure and enforcing compliance,founded on the principle of conser-vatism. This has been used as a substitutefor quantitative measures of variabilityand more rigorous mathematical tech-

niques. Actuaries have approached this system somewhat passively, oftenfocusing their energies on managing to the regulatory rules rather thanmanaging the underlying risk.

The new risk managers are action-oriented, creating dynamic market-based strategies to address some of thesame risks actuaries work with every day. Many complain of the same prob-lems actuaries face, that the managersthey advise don’t understand the theoryand the numbers. But they seem to havethe ear and the respect of their CEOs,based upon a history of success withinthe two short decades this “new” profes-sion has been in existence. Their successand dynamism can serve as a useful inspiration for actuaries, as we seek tostrengthen our profession and position it for an even brighter future.

Narayan Shankar is the SOA staff fellowfor life practice. He can be reached [email protected]. ¨

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In performing their work, ComputerScience Section members utilize awide variety of technical skills. Many

useful “computer science”-relatedsubjects are not covered by the SOAexams, though may be consideredextremely important in the day-to-daywork of actuarial staff.

The Computer Science Section member-ship was surveyed to help understandwhich topics are important for actuarialstaff to have a working knowledge of, ateither the “early career” or “maturecareer” stage. Over 250 memberscompleted the survey.

The results shown here are based on ascoring system from 0 = Unimportant to 5 = Must Have; the results were thenconverted to a percentage. A score of 3.5or more is significant, since it wouldimply a level of importance somewherebetween 1 and 2.

1. 70 percent of the respondents felt that it was 5 = Must Have.

2. 100 percent of the respondents felt that it was 3.5 = Important.

A score of 3.5 or more was achieved in the areas shown in Figure 1 below.

While the importance of system-relatedtopics such as spreadsheets, program-ming languages, database concepts,documentation and project manage-ment were expected, the surprisingresult from this survey is that respon-dents felt so strongly that numericalalgorithms (especially basic calculus,interpolation, extrapolation, estimationand errors) are still considered a “MustHave” in importance.

Yet the traditional actuarial skills ofcalculus, numerical analysis and gradua-tion methods have been removed fromthe E&E syllabus over the last decade, or

if not removed, perhapsmentioned as “pre-requisites.” Thissurvey shows that the membership stilljudges these skills as extremely impor-tant, and the Computer Science SectionCouncil encourages the E&E Committee

Surprising results from Computer ScienceSection’s curriculum surveyby Randall A. Kaye, ASA


Score Early Career

4.7 Mathematical applications, especially spreadsheets (including macros).

3.5 Programming languages, especially procedural languages (C, Fortran, Basic).

3.5 Statistical analysis, especially regression, distributions, standard deviation and Monte Carlo methods.

3.8 Numerical algorithms, especially basic calculus, interpolation, extrapolation, estimation and errors.

3.5 Database concepts, such as hierarchical and relational, queries, unions and intersections.

Score Mature Career

4.0 Mathematical applications, especially spreadsheets (including macros).

3.8 Project management & planning, such as Steering Committee, Project Sponsor, Critical Path, Dependenciesand Gantt Charts.

3.6 Financial Aspects of Information Systems, such as Total Cost of Ownership, Business Risk and Return onInvestment.

Figure 1

3.9 Documentation, such as program comments, system documentation and user documentation.

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to consider reinstating numerical analysisand graduation on both the E&E syllabusand examinations.

Colleges and universities are also encour-aged to review these results, and interpretthem as a “call to arms,” or at least a rein-statement for some of the moretraditional actuarial skills.

The Computer Science Section of the SOArecommends that colleges and universitiesdevelop curricula for actuarial scienceprograms which reflect the results of thissurvey and which enable college and

university students interested in pursuingan actuarial career to select appropriatecourses.

Complete survey results can be found inthe Computer Science Section of the SOAWeb site at www.soa.org/ccm/content/areas-of-practice/special-interest-sections/computer-science/compact-newsletter/.

Randall A. Kaye is principal at arc360 in Toronto. He can be reached [email protected] ¨

Barriers to success of the profession:

1. How do we broaden our skill sets to meet the changing environments and opportunities?

2. How do we align our public image with our strengths?

Barriers to success of the SOA:1. How to grow our membership

and employment opportunities simultaneously?

2. How do we make the SOA more effective as an organization to maximize constituent value?

• The newly revised strategic plan,outcome statements and correspon-ding measurements were approved.The strategic plan is available on the SOA Web site—see Governance (Board of Governors and Organizational Documents).Board-level outcomes supported by measurements are:

- Increasing actuarial employment

- Improving stakeholder satisfaction

- Increasing the value of the credential

- Demonstrated efficiency and effectiveness

- Enhanced “actuary” brand

- More able and employable members

- More outwardly focused organization

- Increased volunteer participation

- Sufficient resources to deliver on the priority projects for the strate-gic plan while maintaining appro-priate membership equity

Other business included:• Approving the 2003 audited financial

statements.

• Establishing a task fforce to oversee the consideration of a business communi-cation skills certification program.

• Endorsing the release of the “Report of the Insurer Solvency Assessment Working Party” as an IAA publication so the report can be used as a basis in discussions on solvency framework with the IAIS and other regulatory and supervisory organizations.

• Reviewing recommendations from the Task Force on Services to Canadian Members, which called for strengthen-ing the communication between the SOA and CIA.

• Authorizing the NonMortality Decrement Task Force to release the 2003 SOA Pension Plan Turnover Study.

Questions can be directed to Neil Parmenterat [email protected] or CherylEnderlein at [email protected]. ¨

meeting notescontinued from page 17

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Covering theglobe with ALMpractices andtechniques forinsurancecompaniesAt the heart of ERMOver the last few years, Enterprise RiskManagement (ERM), which includes anarray of financial and non-financial riskmeasures and tools, has been the center of attention in the banking and insuranceworlds. As the science of ERM hasexpanded, so too has the role of assetliability management (ALM) as a vitalpart of an overall ERM framework.Many people can recall the time whenALM meant “Asset Liability Matching.”However, the “management” of ALM nowgoes beyond measurement and mitigationofthe risk exposure to a broad methodolo-gywhereby companies achieve theirfinancial objectives and gain competitiveadvantage.

Given the rapid evolution of ALM and the different regulatory environments thatsurround life, P&C and pension, a lot ofpractitioners can find very little guidancein current literature. To address this, SOAand Nexus Generations have produced anAsset Liability Management symposiumthat covers ALM theory and reinforces itwith case studies and in-class applica-tions. Initially conducted in Phoenix,Arizona in December of 2003, the coursewas a sell-out. One-quarter of those inattendance were outside of the UnitedStates, strongly suggesting that the needfor information does not know anygeographical boundaries.

A worldwide tour in 2004In 2004, the three-and-a-half-day course,“Asset Liability Management Techniquesand Practices for Insurance Companies,”will be held in four different locationsacross the globe. Participants may alsoregister for one full day of “ALMEssentials” immediately preceding thecourse. Additionally, a post-course,

“Workshop For Senior Management and ALM Practitioners,” will give seniormanagement and ALM practitioners theopportunity to address their specificissues and areas of concern with otherexperts. The dates and locations for thecourses are:

June 20-24, 2004Conrad Hilton Hotel, London, England

July 27-31, 2004Westin Tokyo Hotel , Tokyo, Japan

September 26-30, 2004Fairmont Chateau Frontenac, QuebecCity, Canada

December 5-9, 2004Hilton Tobago, Trinidad & Tobago

All-star faculty line-upEach course will contain some emphasison issues specific to the host region, butany location is an appropriate contentchoice for United States residents. Facultymembers participating in one or more ofthe courses are among the world’s mostnotable contributors to FinancialEconomics and ALM Practice. Theyinclude Charles L. Gilbert, John C. Hull,Moshe Arye Milevsky, Harry H.Panjer,K. (Ravi) Ravindran, Robert R.Reitano, Andrew D. Smith andPeter D. Tilley.

The course is especiallyappropriate for seniormanagement not afraid ofquantitative theoryand lookingto gain afirm graspof thefinancial risksfacing theirorganizations; actu-aries and other ALMpractitioners looking to gaindeeper knowledge into the tech-niques and tools; and newentrants to the field whoare willing to invest someadditional time before thecourse to learn the basicconcepts (or attend ALM Essentials).Course participants learn how to

implement ALM as a strategic decision-making framework and to ensure that appropriate policies andcontrol procedures are in place. Attendeesdiscover the limitations and pitfalls ofvarious risk metrics and how to commu-nicate risk exposure and make moreeffective decisions. Some of the morespecific course objectives include formu-lating an ALM strategy for Universal Life,executing a dynamic hedging strategy fora variable product, and participating in amock ALM Committee meeting.

For complete registration information andcourse agenda, go to http://www.soa.org/content/ce-meetings-seminars/conference-and-symposiums/asset-liability-management/. ¨

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Seven Life-Defining FinancialDecisions

The Actuarial Foundationpartnered with theWomen’s Institute for a Secure Retirement(WISER) to produce a booklet as part of its

consumer education efforts. Seven Life-defining Financial Decisions discusseshow decisions made throughout a life-time—choosing a career, getting married,having children, buying a home, startingto save and invest—can have an enormousimpact on your future financial security.

This 60-page guidebook is available for $6 from the Women’s Institute for aSecure Retirement by calling 202.393.5452or visit their Web site at:

www.wiser.heinz.org. The guidebook andbackground paper can also be viewed ordownloaded from The ActuarialFoundation’s Web site at:http://www.actuarialfoundation.org/consumer/wiser051503.htm. ¨

actuarial foundationcorner

Whatever Mr. Chong says, I know thatmy transcript accurately reflects theskills and knowledge I have gained inactuarial science. I have worked hard for my degree, and I take pride in it.

Matthew [email protected]

Exams editorial(To Phil Bieluch) I saw your editorial inThe Actuary (March issue—“All I reallyneed to know I learned on the actuarialexams”). I like your emphasis on educa-tion above and beyond that which is“forced.” The ethics of a responsibleactuary should spur him on to learnwhat he can to carry out his work trulycompetently. I applaud you for bringingup this issue.

David [email protected]

Variable annuitiesThe article by Phil Bieluch and HubertMueller in the March 2004 issue of TheActuary (“Managing the risks from variable annuities—the next phase”)contains an incorrect analysis of theinterest rate risk in variable annuities.They claim that an increase in interestrates can cause difficulties if not hedged.

In fact, the Rho for embedded optionsin variable annuities is generally nega-tive. If interest rates go up, the value of the embedded option goes down.

Typically the minimum guaranteerelated embedded options in a variableannuity behave like a put option. Putoptions become more expensive asinterest rates drop. There are tworeasons for this. First, a lower interestrate environment means the expectedgrowth rate of equities under capitalmarket assumptions is reduced accord-ingly. This means there is a higherprobability that the put will finish in the money. Second, lower interest ratesmeans that the present value of payoffswill be greater.

Because interest rates impact the probability of payoff, the amount of the payoff, and the present value of the payoff puts tend to have highconvexity. This is similar to the convexityin mortgages and swaptions. In variableannuities with living benefits, thisconvexity can be further increased by dynamic customer behavior.

These factors far outweigh the issuesassociated with interest rates raised byBieluch and Mueller. A mention is alsomade of put futures. Futures contain no optionality, so they are not referredto in terms of calls or puts. If you wantprotection from a rising stock market you buy futures. If you want protectionfrom a falling stock market, you sell (or short) futures.

Mark Evans, [email protected]

Bieluch and MuellerrespondMr. Evans offers further evidence forone of the conclusions of the article,“Matching Rho should also be consid-ered.” In the article, we focused onmatching Rho with examples basedupon interest rates. Mr. Evans expandsthe discussion to include the considera-tion of the correlation of interest ratesto the equity markets with the furtherassumption that lower interest ratesimply lower equity prices, a point that is best, outside the scope of this article.

Mr. Evans is correct that there are no“put futures” available. Our usage wasintended for the casual reader to under-stand that the right to sell an index at a predetermined price was what wascontemplated by the buyer of thefutures.

We thank Mr. Evans for furthering thediscussion of this current topic. ¨

Philip J. Bieluch, FSA, MAAA, FCA [email protected]

Hubert [email protected]

Letterscontinued from page 3