Actuarial Transformation

Disrupting mental models and renewing the profession Mark Birdsall

Photo caption: “My Wife and My Mother-in-Law,” a famous optical illusion by illustrator W.E. Hill, has two possible visual interpretations.

Mark Birdsall, FSA, MAAA, FCA, MBAMany years ago, I took an organizational behavior class from Stephen R. Covey, Ph.D., author of The Seven Habits of Highly Effective People. He wanted his students and readers to understand and experience the influence of mental models on the ways we communicate and act.

One phrase he used to describe this phenomenon was “the map is not the territory.” In other words, the mental model we have in our minds is a map—and not reality. In some cases, we need to experience a “paradigm shift” in our mental model, which he illustrated through a simple demonstration. He showed readers and students a line drawing of an image for which two possible visual interpretations could be made, and asked, “What do you see?” One interpretation was the image of the back of a fashionable young woman’s head and shoulders. The other image was the face of an old woman tilted downward.

At first it was easy to see one of the images, but sometimes help was needed to see the jawline, eyes and so forth of the second image. Eventually, it became easier to flip back and forth between the two images. Dr. Covey pointed out that when there are two individuals, each of whom “sees” only one of the images, communication about the line drawing becomes very difficult, and the individuals may even begin to question the integrity of the other person. Have you ever been unable to see another’s perspective or effectively communicate what you see?

Another author and teacher, Clayton Christensen, has introduced a term of art into the business lexicon: disruption. In the preface to The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Christensen states: “… two principles of management taught in business schools: that you should always listen and respond to the needs of your best customers, and that you should focus investments on those innovations that promise the highest returns. But these two principles, in practice, actually sow the seeds of every successful company’s ultimate demise … That’s why we call it the innovator’s dilemma: Doing the right thing is the wrong thing. This dilemma rears its head when a type of innovation that we’ve termed disruptive technology arises at the low end of the market, in the simplest, most unassuming applications.”

Are there disruptive factors emerging in actuarial work that we hope we will not need to adopt, and instead are we relying on the mental models we’ve developed throughout our careers?

In referencing these two thought leaders in the business world, I would like to draw attention to some of the mental models we may possess as actuaries and describe some technologies we may need to embrace in order to thrive as a profession in the future.

The following is a partial list of possible mental models life insurance actuaries may have that could benefit from fresh consideration:

  1. I am free to use almost any assumption in asset adequacy testing and other modeling that seems reasonable to me as an experienced actuary, because I can indicate in my documentation that I am using actuarial judgment.
  2. I can use industry average experience in setting my assumptions and be confident that I am not mispriced or underreserved.
  3. Asset adequacy analysis is purely a regulatory exercise. Sensitivity testing is a necessary part of the documentation for asset adequacy analysis, but generally it is not used for making decisions.
  4. Policyholder behavior functions are educated guesses, and as long as the direction and magnitude of change by scenario look “reasonable,” that is the best that can be expected.
  5. To develop a company’s target surplus formula to use for pricing, I can use a multiple of regulatory risk-based capital (RBC) requirements, then do a top-down allocation of target surplus to lines of business and product types, and that will be close enough.
  6. Regulatory “guardrails” using implicit margins that “stack” levels of conservatism in different individual assumptions are an inevitable part of statutory reserve calculations.

In general, with how many of these statements do you agree?

The objectivity of assumption-setting by company actuaries is a subject discussed frequently by regulatory actuaries. Unfortunately, my experience as a regulator caused me to become more doubtful of the objectivity of some company actuaries. However, new tools are becoming available that could improve the objective measurement of risk through the use of multirisk scenario generators in cash flow projections; provide for the objective development of margins at a moderately adverse level; build more useful policyholder behavior functions using predictive models and cluster analysis; develop measures of target capital from the bottom up, based on specific product risk profiles; and provide the basis for new regulatory guardrails that are founded on understanding of risk rather than mistrust.

This issue of The Actuary examines a range of issues and tools related to actuarial transformation. Cluster analysis will be used to develop customer clusters for variable annuities with guaranteed living withdrawal benefits. Actuarial transformation for health insurance actuaries, the basic education of new actuaries and the continuing education of experienced actuaries also will be discussed.

George Bernard Shaw is quoted as stating: “You see things; and you say ‘Why?’ But I dream things that never were; and I say ‘Why not?’”

With new tools and better data, as actuaries we can explore possibilities that were not practical before. We can reshape experience studies to include new predictors. We can develop practical methods to approximate the fully stochastic distribution of the present value of future cash flows. We can bring meaningful risk analysis to smaller organizations. We can disrupt our mental models and renew our profession for the future, and provide great value to the organizations and people we serve as professional actuaries. Why not?

Mark Birdsall, FSA, MAAA, FCA, MBA, is a vice president with Lewis & Ellis in Overland Park, Kansas. He has previously served as chief actuary for the Kansas Insurance Department, and as a life insurance company chief actuary, appointed actuary and illustration actuary.