JFAR Risk Perspective 2022
The Joint Forum on Actuarial Regulation (JFAR) is a collaboration between regulators to coordinate the identification and analysis of risks to which actuarial work is relevant. As well as the Institute and Faculty of Actuaries (IFoA), JFAR also comprises the Financial Conduct Authority (FCA), the Financial Reporting Council (FRC), the Prudential Regulation Authority (PRA) and The Pensions Regulator (TRP). Every year, JFAR publish their Risk Perspective, which sets out their collective view on the current risks to high-quality actuarial work. The theme for the 2022 Risk Perspective was the interconnectedness of risk, and what follows is a summary of the five key areas of risk that the report identified: sustainability, inflation, mortality & morbidity, unfair outcomes for individuals and technology. This article is intended as a digestible summary of these five areas, and the full report is available here.
Sustainability and climate related risks are becoming more and more prevalent in actuarial work. Insurance claims are affected by the changes to frequency and intensity of natural disasters. There is a material financial risk from geophysical impacts such as loss of agriculture or biodiversity, as well as from natural disasters.
There is also political and societal pressure on long-term investors (such as life insurers and pension schemes) to take climate change into consideration when investing.
Companies also face risks from the need to transition their business model to be sustainable in a low-carbon setting. Actuaries will need to communicate the effect of this risk when advising on which investments to include in portfolios, the asset class, sub-asset class and individual investment performance.
Actuaries must also be careful to note the risk of greenwashing, where misleading information about a country or organisation’s environmental impact is provided and should consider where products and services do not match their claim.
The UK government and JFAR member regulators are also taking action to improve transparency regarding sustainability. For example, from 2023 financial institutions and listed companies are required to publish transition plans that take the government’s net zero commitment into consideration or provide an explanation if they have not done so.
The IFoA is incorporating climate change and sustainability into areas for career lifelong learning, including a Climate Risk and Sustainability course, and a Reflective Practice Discussion toolkit as part of CPD requirements.
The PRA had previously published a Climate Change Adaptation report in 2021 which covered climate-related financial risk management and the role of capital requirements. They will now more actively supervise rather than just assessing PRA-regulated firms on these implementations.
From the start of 2022 (2023 for smaller firms), the FCA has required that asset managers, life insurers, and FCA-regulated pension providers disclose how climate related risks are incorporated when managing investments.
The FCA’s target outcomes are:
• High-quality climate- and sustainability-related disclosures
• Trust and consumer protection from misleading marketing and disclosure
• Governance arrangements for effective environmental and social governance (ESG)
• Active investor stewardship
• Integrity in the market for ESG-labelled securities
• Innovation in sustainable finance.
The TPR have set out to drive trustees’ actions on climate related risks and to take part in the net zero transition.
The FRC have proposed changes to Technical Actuarial Standard 100, to require actuaries to incorporate climate-related risks in technical actuarial work.
In 2020, the International Actuarial Association (IAA) put in place a five-year plan to increase actuaries’ awareness regarding the necessity to include the financial effects of climate change into their work.
The European Insurance Occupational Pensions Authority (EIOPA) have outlined expectations on supervision, by national supervisory authorities, of incorporating climate-related risk scenarios into insurers’ ORSAs (Own Risk and Solvency Assessments).
Overall, climate change is understood to be a threat, and it is important there is reliable information regarding it. It is also imperative that actuaries and other professionals understand how to integrate its impact into work.
Inflation, long minimal, increased significantly in 2022; this was primarily due to a sharp rise in energy costs and a strain on supply chains. Measures to manage inflation, specifically those aimed at dealing with strains to energy supply, may have a knock-on effect on other risks. It is important to note that some governments are putting coal, fracking and natural gas back under active consideration, which may lead to increased climate-related risk in the future.
There are two major types of inflation which are prudent for us to consider:
· Price inflation: this is the most commonly used definition of inflation and is the rate at which prices are rising over a given time. This can be measured by indexes such as the Consumer Prices Index (CPI) or the Retail Price Index (RPI). The main difference between these measures is that the CPI doesn’t include housing costs and has typically been lower than the RPI by 1 to 1.5 percentage points.
· Social inflation: this is the impact on future cashflows due to reasons other than price inflation. For example, fewer drivers were on the road during the pandemic, resulting in fewer claims on motor insurance policies. Another example would be new and safer healthcare technologies resulting in an increased number of people being treated, thus increasing the number of claims.
There are four types of cashflow which are typically considered in actuarial work:
1) Benefits and claims cash outgo arising from GI policies
Claims inflation is typically made up of two components: severity and frequency. It is preferable to consider these separately when possible. Claim size inflation is primarily a price inflation, whereas claim frequency is typically based on social trends. However, there may be an element of the other in both. For example, court awards for suffering of a third-party action might be affected by changes in social attitudes. Similarly, policies with an excess may see an increase in claims frequency due to an
increase in claim size as more claim events will exceed the limit required causing an increase in the number of claims overall.
2) Benefits and claims cash outgo from life or pension business
The most obvious case to consider here is one where the benefit payments are linked to a public measure of inflation, such as RPI or CPI. Usually, these measures of inflation are then capped and floored (for example, benefit payments from a pension scheme might be capped and floored at 5% and 0%, respectively). In these cases, it is important to also remember the inflation on cash in-flows (e.g., premiums or pension contributions).
Secondly, it is important to mention that the UK Statistics Authority plan to replace the RPI with the CPIH (CPI including owner occupiers’ housing costs) by 2030. Few argue against the shortcomings of the RPI, but the CPIH has typically been lower than the RPI, and pension schemes which hold RPI-linked gilts may be negatively impacted.
3) Expense cash outgo
An insurance company’s expenses may be largely driven by wages. These are typically highly sensitive to inflation as employees may choose to leave for greener pastures if not offered inflation-linked raises.
4) Investment cash income
The most important types of investments to consider are the ones where the cash flows are directly linked to inflation, either explicitly (e.g. index-linked bonds) or implicitly (e.g. equities). Using the market price of inflation-linked gilts or inflation swaps, it may be appropriate to try and form a view of the market expectations of future inflation measures. When doing so, one must bear in mind that the yield on these instruments might not be solely dependent on the market’s view of inflation expectations, but also supply and demand. For example, a limited supply of long-dated inflation-linked bonds may mean that pension schemes are willing to pay a premium for them.
In conclusion, it can be tempting to rely on past experience when determining the rates to assume; however, it is clear that future developments, such as the fight against climate change, pandemics, mortality etc. are likely to have big impacts on inflation. Not only is there a great deal of uncertainty in those factors, but they can rely on each other in an interconnected way.
Mortality & Morbidity
The mortality rate measures the number of deaths per thousand people of a particular population, whereas morbidity rates track the rate at which chronic diseases impact a population. Changes in the global economic situation and uncertainty regarding long-term effects of the pandemic are all projected to affect these rates over time.
Generally, both rates have steadily improved over time, especially life expectancy. However, there’s a strong correlation between the economic situation and mortality rates, and the upcoming recession is likely to lead to a further slowdown in mortality improvements. This is evidenced by the decline in the speed the mortality rate decreased in the UK and other western countries that were greatly affected by the 2008 recession, whilst countries like Japan weren’t as affected by the recession and were able to increase growth in healthcare expenditure and saw mortality improvements accelerate over the same period.
Alongside the recession, geopolitical tensions in Russia and rising energy costs are also likely to disproportionately affect low socioeconomic households. Socioeconomic conditions generally lead to larger changes in morbidity rates than mortality rates. The Slope Index of Inequality identifies the most and least deprived areas in England, and men in the lowest decile live 74.1 years with only 52.3 years of them being in good health, whilst men in the top decile live 83.5 years with 70.7 of them in good health. Women live 78.7 and 86.4 years respectively with 51.4 and 71.2 in good health. So, whilst the life expectancy gap is around a decade, poorer people spend an extra decade in poor health, which would increase pressure on public healthcare services like the NHS.
In 2022, Covid-19 global mortality rates reduced significantly due to vaccine deployment, which may at first indicate no long-term effects. In the UK, the CMI announced in March 2022 that it put no weight on the data for 2020 and 2021 in its most recent mortality calculations. However, there are several indicators that there could be potential long-term disabilities from serious cases of Covid, known as Long Covid. The lack of an objective diagnostic test for Long Covid will lead to uncertainties in underwriting, a higher risk of misdiagnosis, and possible fraudulent claims.
Lockdowns also affected people going outdoors and exercising, which could also lead to potential future health conditions. Researchers at the University of Sheffield found that up to 25,000 more people may die in the next 20 years in England due to drinking habits that began during the UK lockdown because of loneliness and isolation. The strain on public health services and delays in people seeing their GPs led to a fall in diagnoses of early-stage cancer in England and non-Covid-related deaths were still significantly above the five-year average during the Summer of 2022 in the UK.
Overall, these indicate high uncertainty in future mortality and morbidity projections, with people potentially living shorter than projected and having more health conditions. These unidentified long-term risks need to be accounted for, and allowances need to be made for future events like Covid, which have long term repercussions.
Unfair Outcomes for Individuals
This risk focuses on the possibility that actuaries may not act in the best interest of consumers – either intentionally or unintentionally – which may lead to the unfair treatment of some individuals or groups, in favour of others.
Unfair outcomes could be seen to arise when individuals are affected in different ways from the output of actuarial work. For example, with the rise of digitalisation and increasing access to ‘Big Data’, actuaries are able to leverage sophisticated technologies to identify ever-smaller homogenous groups, which can result in the reduction of risk pooling in favour of risk-based individual pricing. This may lead to a reduction of choice for consumers who are now classed as riskier than before; it may also lead to some products becoming unaffordable to certain consumers.
It is therefore clear that actuaries must stop to consider the ultimate effect that their work has on consumers, particularly when having to apply their judgement to novel situations. Below, we look at some of the most recent developments in actuarial work and detail how unfair outcomes for individuals can arise.
The traditional way for an employer to sever their link to a defined benefit (DB) pension scheme is through purchasing a bulk annuity from an insurance company. Pension superfunds now offer an
alternative route – these funds are occupational pension schemes regulated by TPR. The premium required to secure a pension scheme’s benefits in a superfund is expected to be lower than that required by an insurance company to buy out the scheme’s benefits. Superfunds offer new risks, as well as new opportunities for delivering DB pension promises.
Whilst TPR have published guidance, setting out their expectations for superfunds, as well as for pension scheme trustees and sponsoring employers, this falls short of any specific legislation. This may lead to potential providers promoting consolidation propositions which create new and untested risks for actuaries, potentially culminating in unfair outcomes for some members.
In July 2022, the FCA issued their new Consumer Duty rules and guidance, which will require firms to consistently ensure and evidence that their products and services meet the needs of their customers and ensure good outcomes. Under the rules, firms must consider the characteristics and objectives of their customers and how they behave. The Consumer Duty is significantly broader in its application than previous product governance and fair values rules for insurers. Insurance companies and actuaries must now ensure compliance across the entire lifecycle of their products and services.
These new rules create novel challenges for actuaries. Take life insurance, for example: in the with-profits market there are inherent conflicts between different generations of policyholders. Actuaries will therefore inevitably need to make decisions which lead to more favourable outcomes for some policyholders than others. They must now consider how they are able to show that their product still ensures good outcomes for all policyholders in such situations.
Prepaid Funeral Plans
There are over 1.5 million prepaid funeral plans in existence in the UK; these promise a funeral service for an individual in return for an up-front payment made during the individual’s lifetime. In July 2022, regulation transferred from the Funeral Planning Authority (FPA) to the FCA, with the aim of bringing in higher standards and greater protections for consumers of authorised funeral plan providers.
As part of this transition, the FRC is in the process of updating its relevant Technical Actuarial Standard (TAS 400) to ensure high quality actuarial work for funeral plan trusts. The IFoA will also be consulting on updates to their professional regulatory requirements for IFoA members who are involved in advising on UK prepaid funeral plans.
Unfair outcomes for consumers could arise from this transition for customers of funeral plan providers who did not meet the FCA’s authorisation requirements (or those who chose not to apply). Such providers had until 31 October 2022 to transfer their funeral plans to providers who were authorised or refund their customers. Crucially, as these providers aren’t authorised by the FCA, their members do not benefit from the protection of the financial ombudsman service (FOS) or the Financial Services Compensation Scheme (FSCS). Furthermore, providers who are authorised by the FCA may not be appropriately resourced to receive transferred funeral plans from providers who aren’t authorised.
Technological advancements, particularly in the areas of artificial intelligence (AI), machine learning (ML) and big data, have enabled solutions to mitigate global shocks, such as work-from-home arrangements and digital social care as responses to Covid-19. For the insurance sector, they could enhance existing processes (e.g. claims processing), as well as open up new lines of business (e.g.
cryptocurrency insurance). Actuaries must therefore keep abreast of the latest developments and modelling techniques to identify and mitigate their potential risks.
Starting with artificial intelligence, its subfield of natural language processing involves getting computers to “interpret” and produce human-like texts. This points to applications in general insurance claims management, processing and fraud detection. When it comes to automated decision making with AI, particularly in the fields of driverless vehicles and medical diagnoses, there are opportunities for new business lines to cover these risks that didn’t exist before. However, the AI ecosystem is highly complex, and risks can be difficult to understand and underwrite. That said, various regulators like the FRC and the PRA have published guidance on AI and machine learning, and the IFoA has also reviewed its GI syllabus in 2021 and are looking to update its GI exams to reflect the recent developments.
Moving onto machine learning, it’s having an increasing presence in augmenting or even replacing existing pricing models. Compared to most current generalised linear models, machine learning is more efficient in feature selection, identifying variable interactions and adaptability to real-time data. However, its data-intensive nature means that insurers face increased data quality risk, especially when dealing with external vendors and the risk of deliberate data attacks on the automated models. There are also ethical concerns related to implicit discriminations of the models’ outputs, which are harder to detect than with traditional models.
Next, blockchain technology and cryptocurrency have both been under the spotlight in recent years, particularly because of their decentralised (yet supposedly secure) nature. This means that for the insurance sector, blockchain could potentially increase efficiency by automating claims processes and preventing frauds. The increased activity in cryptocurrencies means that cryptoasset insurance could be an emerging line for insurers as currently only 3% are estimated to be insured. However, its cryptic and visibly volatile nature poses a significant challenge for actuaries to fully understand the risks involved, for example when a company accepts cryptocurrencies as payment or holds cryptoassets on their balance sheet. Lastly, the fact that regulatory positions are uncertain at best, and inconsistent between geographies, is another challenge when modelling future developments in this area.
The final area of development is in pension dashboards, which are expected to be accessible to the public in 2024. Essentially, this comprises a nationwide consolidation of pension pots including those that are forgotten, so that every individual can have a complete and current picture of their pension without hunting down lost pots over the years. Actuaries will play a critical role in this project by ensuring that expected future values of different pots are consistent.
Sustainability, Inflation, Mortality and Morbidity, Unfair outcomes for individuals and Technology written respectively by:
Samin Khan, Raafid Burhani, Asees Sachdev, Joynal Ahmed and Dyon Dong
Article consolidation & coordination by: