In the PBRAR, VM-31 3.D.2.e.(iv) requires the actuary to discuss “which risks, if any, are not included in the model” and 3.D.2.e.(v) requires a discussion of “any limitations of the model that could materially impact the NPR [net premium reserve], DR [deterministic reserve] or SR [stochastic reserve].” ASOP No. 56 Section 3.2 states that, when expressing an opinion on or communicating results of the model, the actuary should understand: (a) important aspects of the model being used, including its basic operations, dependencies, and sensitivities; (b) known weaknesses in assumptions used as input and known weaknesses in methods or other known limitations of the model that have material implications; and (c) limitations of data or information, time constraints, or other practical considerations that could materially impact the model’s ability to meet its intended purpose.
Together, both VM-31 and ASOP No. 56 require the actuary (i.e., any actuary working with or responsible for the model and its output) to not only know and understand but communicate these limitations to stakeholders. An example of this may be reinsurance modeling. A common technique in modeling the many treaties of yearly renewable term (YRT) reinsurance of a given cohort of policies is to use a simplification, where YRT premium rates are blended according to a weighted average of net amounts at risk. That is to say, the treaties are not modeled seriatim but as an aggregate or blended treaty applicable to amounts in excess of retention. This approach assumes each third-party reinsurer is as solvent as the next. The actuary must ask, “Is there a risk that is ignored by the model because of the approach to modeling YRT reinsurance?” and “Does this simplification present a limitation that could materially impact the net premium reserve, deterministic reserve or stochastic reserve?”
Understanding limitations of a model requires understanding the end-to-end process that moves from data and assumptions to results and analysis. The extract-transform-load (ETL) process actually fits well with the ASOP No. 56 definition of a model, which is: “A model consists of three components: an information input component, which delivers data and assumptions to the model; a processing component, which transforms input into output; and a results component, which translates the output into useful business information.” Many actuaries work with models on a daily basis, yet it helps to revisit this important definition. Many would not recognize the routine step of accessing the policy level data necessary to create an in-force file as part of the model itself. The actuary should ask, “Are there risks introduced by the frontend or backend processing in the ETL routine?” and “What mitigations has the company established over time to address these risks?”
Author(s): Karen K. Rudolph
Publication Date: July 2022
Publication Site: SOA Financial Reporter