Ethical Issues is written by members of the CAS Committee on Professionalism Education (COPE). The column’s intent is to stimulate discussion among CAS members. Therefore, positions are sometimes stated in such a way as to provoke reactions and thoughtful responses on the part of the reader. Responses are welcomed. The opinions expressed by readers and authors are for discussion purposes only and should not be used to prejudge the disposition of any actual case or modify published professional standards as they may apply in real-life situations.
Editor’s Note: This article was published previously in the Ethical Issues column in the February 2002 issue of Actuarial Review. COPE made some small adjustments and updates, but the title and topic addressed are essentially unchanged.
The Lack of Surplus Fund (Fund) was established five years ago to provide a medical malpractice self-insurance program for participating members of the Hospital Association. John D. Actuary, a consulting actuary, has been hired by the Fund to provide an actuarial estimate of the Fund’s liabilities. The Fund intends to book John’s loss reserve estimate in its financial statement.
Over the past few years, the Fund has operated in a deficit position (i.e., assets are insufficient to cover liabilities). As of the end of this year, John estimates the Fund’s undiscounted loss reserves at $100 million. The Fund’s corresponding assets are only $35 million.
Fund management has asked John to provide his loss reserve estimate on a discounted basis. John is concerned about discounting the loss reserves to present value because the Fund clearly does not have enough assets to generate the investment income needed to cover any projected investment return.
Can John produce a report to management presenting the needed loss reserves on a discounted basis?
Actuaries providing loss reserve estimates are not required to incorporate an analysis of assets. Actuarial Standard of Practice (ASOP) No. 20, Discounting of Property and Casualty Loss Adjustment Expense Reserves, does not mention a need for valuation calculations since such calculations may be unrealistically burdensome in a reserving context. The scope of John’s assignment did not include an analysis of assets, so he is not in a position to opine on the Fund’s financial condition.
John intends to include a disclaimer in his report stating: “I have not examined the assets underlying the liabilities and have formed no opinion as to the validity or value of those assets.” John believes disclaimers such as this allow him to accommodate the client’s request and provide adequate warning to the reader of the report regarding discounting issues.
Reserve estimates should be able to stand on their own, regardless of the Fund’s retained assets. Reserve estimates are often presented in terms of a “market value” by using a risk-adjusted discount rate independent of the unique characteristics of the Fund’s assets. According to ASOP No. 20, “Discounted unpaid claim estimates may be used in a variety of contexts and the appropriate selected discount rates are a function of the context. A range of discount rates may be reasonable.” Common approaches itemized in the standard include a “risk-free approach”, a “portfolio approach”, or the use of “discount rates requested by another party” (Section 3.4.1).
It would be inappropriate for John to discount the loss reserves. Principle 1 of the Statement of Principles Regarding Property and Casualty Unpaid Claim Estimates states: “An unpaid claims estimate…is reasonable if it is derived from reasonable assumptions and appropriate methods….” It is unreasonable to assume the Fund’s liabilities are backed by valid assets and there is no cash flow problem—especially since John is aware this is not the case.
This position is further supported in ASOP No. 20, Section 3.1, which states, “The actuary should be aware of the context in which the discounted unpaid claim estimate is to be used. The actuary should use a methodology and assumptions in the discounting process that are appropriate for that context.”
Also, John should not discount reserves for use in the financial statement because the Fund’s financial condition would be presented in a manner that is misleading. Precept 8 of the Code of Professional Conduct states: “An Actuary who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.”
Finally, the disclaimer suggested above, in favor of discounting, is unacceptable because it will warn only the most informed reader. Besides, a disclaimer’s intended use is not to allow the actuary to perform services known to be inappropriate. Actions such as this do not help the actuarial profession fulfill its responsibility to the public.