TRANSACTIONS OF SOCIETY OF ACTUARIES 1992 VOL. 44 PRINCIPLES LAOIF RAUTCA SCIENCE SOCIETY OF ACIRJARIES COMMITI'EE ON ACTUARIAL PRINICPLES* ABSTRACT The Committee on Actuarial Principles is charged with identifying, cir- culating and organizing actuarial principles (as distinct from standards) and recommending the resulting statements of principles to the Board of Gov- ernors for review and adoption. In October 1991, the Board accepted the Committee's statement entitled "Principles of Actuarial Science." This statement, which constitutes the following paper, is an expression of opinion by the Committee on Actuarial Principles and has been authorized by the Board of Governors. It has not been submitted to the vote of the membership and thus should not be construed as an expression of opinion by the Society of Actuaries. Editor's note: ehT Committee believes that continued publication of dis- cussions of Principles of Actuarial Science is appropriate and may prove beneficial. Therefore, written discussions of this paper will continue to be considered for publication. For publication in Volume XLV of the Trans- actions, discussions must be received by March I, 1994. ELBMAERP Actuarial science, the foundation for the actuarial profession, is an applied science. As an applied science, its theory is grounded in certain observations about the real world. The practice of any profession is shaped by the experience of its members, as well as by accumulated scientific knowledge. The practice of the actuarial profession is based on: Principles--Statements grounded in observation and experience. Prin- • ciples will be subject to change only if fundamental changes occur in our understanding of the observed world. Methodologies--Descriptions of applications of the Principles to defined • areas of practice. Since Methodologies represent the state of the art, they Note: This paper has been written by members of the Society of Actuaries. Its application should be limited to the areas of actuarial practice which fall within the purview of that Society. It si not intended to include the areas of property and casualty insurance. dlonrA* .A ,ekciD Chairperson, Wayne ,tsiuqgreB treboR .P Clancy, treboR A. Miller ,1II yrraH .H Panjer, dlanoD .M ,nosreteP selrahC yrraB .H Watson, dna nerraW ,renkcuL AOS Staff .nosiaiL 565 566 TRANSACTIONS, VOLUME XLIV are likely to change as new techniques are developed in various practice areas. Standards--Rules of behavior, including, in particular, directives as to • when and how professional judgment should be employed. Some Stan- dards are prescriptions of professional conduct and are not usually subject to change. Others involve judgments needed to apply Principles or Meth- odologies to circumstances of practice and may change as practice cir- cumstances change. L Principles This paper attempts to set forth the fundamental principles that underlie actuarial science. Their statement is intentionally broad and rather formal. The intended audience is practicing actuaries, researchers and others, such as regulators and standard-setting bodies. Care has been taken to define terms with precision. Since actuarial science is rooted in mathematics, the expo- sition is similar in style to that of a mathematical monograph. To improve understanding, however, numerous clarifying Discussions of both Principles and Definitions have been provided. The Principles have been grouped according to their basic subject matter. Statistical and Economic and Financial Principles have been borrowed from related disciplines and are limited to those necessary as background to ac- tuarial science. Actuarial Modeling and Risk Management Principles delin- eate the foundations of the profession common to all practice areas. The subject matter of this paper is similar to that of the 1989 monograph, Fundamental Concepts of Actuarial Science, by C.L. Trowbridge 1. The purpose and thus the organization and content are somewhat different, al- though not conflicting. The Trowbridge monograph is intended for a broad spectrum of readers, including nonactuaries, who are interested in the de- velopment of the fundamental concepts of actuarial science from its philo- sophical, economic and sociological roots. On the other hand, this paper is written to meet the practical needs of those for whom precise definition and formal development are essential, including, in particular, those involved in the standard-setting process. .11 Methodologies Application of the Principles to situations encountered by practicing ac- tuaries leads to new and continually evolving models and techniques. Each such model or technique applies one or more of the Principles to the practice situation. These applications are referred to as Methodologies. PRINCIPLES OF ACTUARIAL SCIENCE 567 Each practice area has its own Methodologies. It is intended that a series of papers will be developed to formalize the Methodologies pertaining to the various practice areas of Society of Actuaries members. IlL Standards The proper application of Principles and Methodologies to actuarial prac- tice situations requires the exercise of judgment regarding the choice of methods and assumptions. Standards are statements which define the meth- ods dna assumptions believed to be reasonable for particular situations. When adopted and promulgated by professional organizations, regulators, law- makers, or others in authority, these become Guides to Professional Conduct, Standards of Practice, Technique Papers, Regulations, etc. The development of Standards is beyond the scope of the work assigned to the Committee on Actuarial Principles. PRINCIPLES OF ACTUARIAL SCIENCE The following table gives the organization of the remainder of the paper. 1. Statistical Principles 1.1 Statistical Regularity 1.2 Stochastic Modeling 2. Economic and Financial Principles 2.1 Diversity of Preferences 2.2 Time Preference 2.3 Present Value Modeling 3. Actuarial Modeling Principles 3.1 Modeling of Actuarial Risks 3.2 Validity of Actuarial Models 3.3 Combinations of Cash Flows 4. Risk Management Principles 4.1 Risk Classification 4.2 Pooling 4.3 Antiselection 4.4 Induced Experience 4.5 Insured Experience 4.6 Avoidance of Ruin 4.7 Actuarial Soundness Glossary Principles of Actuarial Science Definitions 568 TRANSACTIONS, VOLUME XLIV .1 Statistical Principles DEFINITIONS. Phenomena are occurrences which can be observed. An experiment is an observation of a given phenomenon made under specified conditions. The result of an experiment is called an outcome; an event is a set of one or more possible outcomes. 1.1 PRINCIPLE (Statistical Regularity). Phenomena exist such that, if a sequence of independent experiments is held under the same specified conditions, the proportion of occurrences of a given event stabilizes as the number of experiments becomes larger. DEFINITIONS. A phenomenon to which Principle 1.1 applies is said to display statistical regularity. Probability is a measure which takes on values from zero to one and gives the likelihood of occurrence of an event. A rule which assigns a numerical value to every possible outcome is called a random variable. The probability-weighted average of the numerical values taken on by a random variable is called the expected value of the random variable. DISCUSSION. If a phenomenon displays statistical regularity, an estimate of the probability of an event associated with the phenomenon is the pro- portion of occurrences of the event in a long sequence of experiments. Alternatively, the probability of an event may be estimated subjectively using other criteria. A random variable is a variable that takes on each of a set of numerical values with a given probability. DEFINITIONS. A scientific model is an abstract and simplified represen- tation of a given phenomenon. A mathematical model is a scientific model in which the representation is expressed in mathematical terms. 1.2 PRINCIPLE (Stochastic Modeling). A phenomenon displaying sta- tistical regularity can be described by a mathematical model that can estimate within any desired degree of uncertainty the propor- tion of occurrences of a given event in a sufficiently long sequence of experiments. DEFINITION. A model satisfying Principle 1.2 is called a stochastic model. PRINCIPLES OF ACTUARIAL SCIENCE 569 DISCUSSION. A stochastic model cannot predict with certainty the out- come of a single experiment prior to its being carried out. A stochastic model can estimate the expected value of a random variable, provided the sequence of values that arises from the sequence of experiments converges. DEFINITION. A deterministic model is a simplified stochastic model in which the proportion of occurrences of a given event estimated by the sto- chastic model is assumed to occur with probability one. DISCUSSION. The stochastic aspect of a model may not be relevant to a given application; in such situations a deterministic model might be used. A deterministic model is a stochastic model with degree of uncertainty zero. The uncertainty associated with a stochastic model has two distinct sources: • the inherent variability of the phenomenon, and • incomplete knowledge and/or inaccurate representation of the probabil- ities of alternative sets of outcomes. Sometimes these are referred to as "process risk" and "parameter risk," respectively. The terms "risk" and "uncertainty," respectively, have also been used; however, in this paper, these terms have been assigned other meanings. Stochastic models may be based on results obtained from previous ex- periments or may utilize initial assumptions about the probabilities of various sets of outcomes which may be systematically revised as results of experi- ments are obtained. Before a model is used, it must be checked for consistency with available information. This process is commonly referred to as "validation." DEFINITION. A mathematical model is said to be valid within a specified degree of accuracy relative to certain observed results if it reproduces these results within that degree of accuracy. DISCUSSION. Observed results involving the phenomenon which is rep- resented by a model may not be available or sufficiently voluminous to allow the model to be validated within a specified degree of accuracy. In this case, the usefulness of the model may be established initially by comparison with 570 TRANSACTIONS, VOLUME XLIV results of the observation of some similar phenomenon. It would be expected that such "judgmentally validated" models could be validated if sufficient data were available. Not all observable aspects of the modeled phenomena must be reproduced in order for the model to be valid. For example, a model used in the appraisal of an insurance company may be validated only with respect to a few quan- tities, such as aggregate reserves and total policy count. DEFINITION. A mathematical model is potentially valid if it produces results that are consistent with available observations of the modeled phe- nomena and of similar phenomena and is capable of being validated relative to the specified observed results when sufficient data are available. DISCUSSION. The statistical definitions and principles of this section are important to actuaries for two reasons: • Most phenomena studied by actuaries are assumed to exhibit statistical regularity. In the real world, "experiments" cannot be replicated pre- cisely. The idealized model which serves as an approximate represen- tation of real world phenomena has the property of statistical regularity. • Stochastic models (along with other mathematical models) are among the actuary's key tools. They are used to draw conclusions about real world phenomena. Specifically, a stochastic model can be used to make probability statements in connection with a single experiment or multiple experiments. .2 Economic and Financial Principles DEFINITIONS. An economic good is something which has value to a person and which the person may consider exchanging for something else. Money is a means of exchange which may be traded for economic goods. The amount of money a person is willing to trade for a good at a specific point in time is the good's current monetary value to that person. 2.1 PRINCIPLE (Diversity of Preferences). Different people may as- sign different current monetary values to the same economic good. 2.2 PRINCIPLE (Time Preference). Money has time value; that is, people tend to prefer receiving money in the present to receiving that same amount of money in the future. PRINCIPLES OF ACTUARIAL SCIENCE 571 DISCUSSION. Time preference is normally represented by an interest rate, or a system of interest rates, used to discount future receipts or dis- bursements of money so that they may be compared to amounts of money currently held. The appropriate representations of time preference for a given application will be covered under Methodologies. DEFINITIONS. A cash flow is the receipt or disbursement at a point in time of an amount of money (or of an economic good with a monetary value). A cash flow whose occurrence or amount depends on the occurrence of an event that is not certain to occur is said to be contingent. An asset is money or economic goods held, or a right to receive future cash flows; an obligation is a duty to provide current or future cash flows. 2.3 PRINCIPLE (Present Value Modeling). For many persons, there exists a mathematical model that can estimate the current mone- tary value that the person would assign to any future cash flow. DEFINITIONS. A model described by Principle 2.3 is called a present value model. The estimate of the current monetary value of a future cash flow given by a present value model under a fixed assumption regarding future economic conditions is called the present value of the cash flow relative to that assumption. Such a fixed assumption regarding future eco- nomic conditions is called a scenario. DISCUSSION. If there is uncertainty regarding future economic condi- tions, the estimates made by a present value model may represent expected values. Such expected values may be thought of as averages of the present values over various scenarios. In this case, the present value may be thought of as a random variable whose expected value is the current monetary value. .3 Actuarial Modeling Principles DEFINITIONS. An actuarial risk is a phenomenon that has economic consequences and that is subject to uncertainty with respect to one or more of the actuarial risk variables: occurrence, timing and severity. 3.1 PRINCIPLE (Modeling of Actuarial Risks). Actuarial risks can be stochastically modeled based on assumptions regarding the prob- abilities that will apply to the actuarial risk variables in the future, including assumptions regarding the future environment. 572 TRANSACTIONS, VOLUME XLIV DEFINITIONS. A model described by Principle 3.1, together with a pres- ent value model if applicable, is called an actuarial model. The assumptions upon which an actuarial model is based are called actuarial assumptions. DISCUSSION. An actuarial model generally must include a present value model if it is intended to determine economic values. A present value model included in an actuarial model is often based on assumptions concerning aspects of the future economic environment, such as interest rates and in- flation rates. The present value model may reflect the preferences of the actuary constructing the model or of the actuary's client. However, in certain situations, the actuary's choice may be constrained by regulations or other Standards. Historically, actuaries have often used deterministic actuarial models. Such deterministic models may, however, be dynamic in nature, reflecting as- sumptions about the future environment. For example, surrender rate as- sumptions for some life insurance and annuity products are often taken to be functions of the market interest rate. In recent years, models based on nontrivial distributions for actuarial risk variables have been needed in some situations. Actuarial methodologies in- elude such strictly stochastic models, as well as deterministic models. The choice of model and the degree of sensitivity testing required are subject to judgment and are thus matters for Standards. Recall that the validity of a mathematical model depends upon its ability to reproduce observed results. As time passes and more observations are made, the degree of accuracy of the model may change, or, in the case of a model which was initially validated only judgmentally, it may become possible to determine the degree of accuracy. 3.2 PRINCIPLE (Validity of Actuarial Models). The change over time in the degree of accuracy of an initially valid actuarial model de- pends upon changes in: a. the nature of the right to receive or the duty to make a payment; b. the various environments (regulatory, judicial, social, finan- cial, economic, etc.) within which the modeled events occur; and c. the sufficiency and quality of the data available to validate the model. PRINCIPLES OF ACTUARIAL SCIENCE 573 DEFINITION. The actuarial value of a future cash flow that is contingent upon actuarial risk variables is the present value developed by an actuarial model associated with the actuarial risk variables. DISCUSSION. Recall that the present value, and hence the actuarial value, of a future cash flow is, in general, a random variable. The actuarial value of any asset or obligation is determined by the actuarial value of the asso- ciated cash flows, including money currently held. In general, the component cash flows not only have uncertain values but also are not independent of one another. 3.3 PRINCIPLE (Combinations of Cash Flows). The degree of uncer- tainty of the actuarial value of a combination of cash flows reflects both the uncertainties affecting each underlying actuarial risk var- iable and the process of combination. .4 Risk Management Principles DEFINITIONS. A person or object involved in an event associated with an actuarial risk is called a risk subject or risk. Risk identification is a process for determining whether a given person or object is a risk subject for a given actuarial risk. Risk control is a process that reduces the impact of one or more of the actuarial risk variables associated with the actuarial risk. Risk transfer or risk financing is a mechanism that provides cash flows that are contingent upon the occurrence of an event associated with the actuarial risk and that tend to offset undesirable economic consequences. A risk manage- ment system is an arrangement involving one or more of risk identification, risk control, and risk transfer or risk financing. A financial security system is an arrangement for risk financing in which one person assumes the obligation to make a payment (or series of pay- ments), called a benefit (benefits), that offsets undesirable economic con- sequences that may be experienced by a second person in return for the payment, by or on behalf of the second person, of one or more amounts, called considerations. DISCUSSION. "Person" may indicate either a human being or a cor- porate or other entity. The term "financial security system" applies to in- surance, annuity, retirement, and health care financing systems. 574 TRANSACTIONS, VOLUME XLIV In general, there is a period of time between the date a consideration is received under a financial security system and the date a benefit is paid. During this period, at least part of the consideration may be invested in one or more types of assets. For annuities and retirement systems, benefits are provided to reduce the uncertainty regarding the availability of income during part or all of the remaining lifetime of one or more persons. The event referred to in the definitions above is survival to a succession of specified ages following the commencement of income or the date of retirement, and the undesirable economic consequence is outliving one's resources. DEFINITIONS. An event is said to be insurable if: a. it is associated with a phenomenon that is expected to display statis- tical regularity; b. it is contingent with respect to number of occurrences, timing and/or severity; c. the fact of its occurrence is definitely determinable; d. its occurrence results in undesirable economic consequences for one or more persons; and e. its future occurrence, timing and/or severity are neither precisely known nor controllable by these persons. A person is said to have an insurable interest in an insurable event to the extent that the occurrence of the event creates an economic need involving that person. DISCUSSION. An insurance policy may pay "benefits" related to oc- currences that do not fit the definition of "insurable event.'" For example, a group health plan may pay for elective surgery or annual physicals. In such cases, the "premium" for the plan may contain a pass-through of charges that arise from events other than insurable events; or it may be that, while the event is not insurable on an individual basis, it is insurable on a group basis, since the number of participants who will utilize the benefit each year is not precisely known. While an insurance policy or contract may combine payments resulting from insurable events and other payments, it nevertheless may be desirable to be able to distinguish between them. The term "economic need" covers a wide range. For example, the future welfare of a person's family is an economic need involving that person, and the increased longevity of a group of retirees could create an economic need for a pension plan sponsor.