ACST1052 Introduction to Actuarial Studies

2020 Course Notes 1A – What do Actuaries Do?

Overview
According to the Actuaries Institute (which is the professional association for Australia
actuaries),
Actuaries evaluate risk and opportunity – applying mathematical, statistical, economic and
financial analyses to a wide range of business problems.

Actuaries are trained to deal with problems which involve a combination of Risk, Money, and Time.

Usually, actuaries will have to build models, which can then be used to assess the risk that a
specified events will occur (events such as epidemics or an earthquakes or a stock market crashes);
and then estimate the financial impact of those events.

Actuaries will then provide advice about the best way to manage risks (risk management). Can the
risky event be avoided? Can we reduce the risk that an event will occur, and how much will it cost to
do so? If the risk can’t be avoided, can we transfer the risk to someone else (e.g. via insurance)? If
so, how much will it cost to transfer the risk? If we are uninsured, the undesirable event occurs, how
can we fund the costs arising from that event?

Actuaries are professionals. Actuaries have an obligation to help their employer or client. But
actuaries also have an obligation to act in the public interest, providing honest and independent
opinions.

Risk
Historically, the first actuaries worked for life insurance companies. In 1762, life insurance companies
in England started selling long term life insurance policies. Life insurance companies would collect
insurance premiums from their customers each year; when the customer died (possibly many years
later), the insurance company would pay a death benefit.

In order to calculate the correct premiums to charge each customer, insurance companies had to
assess mortality risks, i.e. risks relating to death). For example:

 Suppose a customer comes in the door and asks for a 20-year policy. How can we work
out the probability that this person will die during the next 20 years? What questions
should we ask this customer, in order to assess this risk? How can we work out the
correct premium rate to charge for this policy? (This is called the risk classification
problem).

 Suppose that a life insurance company has collected premiums for several years and has
assets of $10 million. Suppose the life insurance company has 10,000 customers, who all
have different probabilities of death and different size policies. What is the probability that
the death claims in the next year will exceed $10 million (hence making the company
insolvent)? (This is called the probability of ruin for the year.)

These task requires skills in data analysis and statistics.

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These days, life insurance is still a major area of work actuaries. As shown in the graph below, in
2015, about 23% of Australian actuaries worked for life insurance companies.

Source: This graph, showing practice areas for Australia actuaries inn 2015, is taken from the
Actuaries Institute website at

However, over time, actuaries realised that their risk-analysis skills could be applied to many
other types of risk (the same statistical techniques are relevant). Actuaries started to branch
out into new areas.

For example, general insurance companies sell policies which compensate policyholders
against damage to their property and/or the cost of compensating people for injuries which
are caused by various types of accidents. Examples include

o Household insurance (Fire, Storm, Earthquakes, Burglary, etc)

o Motor vehicle insurance (cars, trucks, taxies, etc)
o Marine insurance (ships)
o Aviation insurance (airplanes)
o Worker’s compensation (paid by employers when employees are injured at work)
o Product liability insurance (paid by manufacturers for people who are injured by
defective products)

In Australia, insurance companies which sell this type of insurance are called general
insurers. In the United States, they are called property and casualty insurers.

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General insurance problems are often more difficult than life insurance problems, because (i)
general insurers cover such a wide variety of risks; (ii) the occurrence of these events is often
less predictable (for example, earthquake risks are difficult to predict, compared to mortality
rates); and (iii) the cost of the damages arising from any event is also difficult to model.

As shown in the graph, about 24% of Australian actuaries work for general insurance
companies.

Actuaries are also involved in health insurance. Health insurers pay medical and hospital
benefits to their policyholders – so actuaries need to assess the risk that different customers
will need each type of benefit (everything from obstetrics to hip replacements to dental care).
Once again, health insurers need actuaries to analyse their data and estimate the
probabilities of different types of health-related claims.

Banking is another growth area for actuaries. Banks take many different types of risk,
including (for example)

 Credit Risk – the risk that borrowers will not repay their loans and this will cause losses to
the bank (Q. How would you predict the risk that any customer will default in their home
loan?)

 Technology risks – the risk that the bank’s computer systems will fail or the bank’s data
will be hacked (Note: the risk of loss due to cybercrime is currently a growth area for
insurers, although the risk is very difficult to assess)

 Exchange Rate Risks – banks provide services to customers who are travelling and/or
doing business overseas, which involves management of foreign currency exchange rate
risks.

The graph shows that about 7% of actuaries work in the banking industry.

Traditionally, actuaries have applied their data analysis skills to the management of financial
institutions (life insurers, health insurers, general insurers, banks, etc). However in recent
years, actuaries have become more and more involved in applying these skills to a wider and
wider set of problems. This change has been driven (at least in part) by the growth in the
collection of data. Businesses are now collecting and storing more and more data about their
customers. They want to use that information to make better business decisions. Often data
analysis will help them with marketing decisions. For example, a mobile phone company
might want to know:

 Which customers are most likely to switch to a different service provider?

 How much of a discount should we offer those particular customers, to persuade them to
remain loyal to our company?
 What form of advertising is most effective in attracting new customers?

The growth in the collection and storage of data has led to a growth in data analytics – and
many actuaries are now working in this area. The graph shows about 3% of actuaries work in
this area, but the number is expected to grow in the future. In recent years, data analytics
companies have been hiring a lot of actuarial graduates.

Note: The graph shows the practice areas of actuarial graduates who are MEMBERS OF
THE ACTUARIES INSTITUTE. People who work in the traditional areas – e.g. insurance,
superannuation, and banking – are more likely to be members of the Actuaries Institute.
People who work in the non-traditional areas, such as data analytics, may decide that they do
not want to pay the annual membership fees (about $1000 p.a.) and hence drop out of the

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 Institute. Hence the number of actuarial graduates working in non-traditional areas, such as
data analytics, is probably significantly higher than the number shown in the graph above.

Summary: Actuaries must be very good at applying statistical theory to solve practical
business problem. Your actuarial studies will include a lot of statistics.

Money

(a) Actuaries are usually interested in the financial consequences of risky events.

Often, the actuary is working for an insurer, so the actuary will look at each event from an
insurer’s perspective. That is, if a specified event occurs, how much is it likely to cost the
insurer in claims payments?

For example, suppose that there is a storm, and 200 homes are damaged. The actuary will
want to know:

 How many of these homes were insured with my insurance company?

 What is the probable size of the claims cost for each home? Perhaps some homes had
minimal damage, and the cost of repairs will be small. Perhaps some homes were
completely destroyed and insurer will have to pay the cost of rebuilding the entire home
and replacing the entire contents. How much will this cost ? {Note that building and repair
costs usually go up after a disaster, because there is such a high demand for such
services]

The actuary will also want to know the probability distribution of the total claims cost (e.g.
what is the probability that the claims from one storm will exceed $X?) – just to make sure
that the company has enough money to pay all the claims; and to understand the impact of
each event on the company’s profits

(b) Actuaries must understand the Time Value of Money [Mathematics of Finance]

Historically, life insurance companies would often sell long-term life insurance policies. The
customer would pay premiums every year, year after year, until death. The benefit would be
payable whenever the customer died – which might be 10 or 20 or 50 years later. The life
insurance company would need to invest the annual premiums, earning investment income
on that money, until finally the benefit would become payable.

Similarly, many general insurance companies also sell long-term policies. For example,
suppose that a general insurance company sells worker’s compensation insurance for a
company which makes kitchen benchtops out of stone. These workers might be at risk of
silicosis, a deadly disease. But the symptoms may not appear for 5 or 10 years, and the
benefits might be payable for many years after diagnosis. So the general insurance company
which sells a worker’s compensation policy this year, should save up some of the insurance
premiums, and invest those premiums, for many years, until the claim is finally paid out.

Therefore, typically, actuaries need to know how to estimate the accumulated value of a
fund, at any date in the future, allowing for

incoming payments into the fund (e.g. premiums in investment income) and

outgoing payments (benefits and expenses) payable at various times in the future;
and

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 allowing for investment income earned on the fund.

In ACST1052, we will spend the first few weeks calculating accumulated values for various
different sets of incoming and outgoing payments.

Typically, actuaries will also want to “work backwards” to find present values. Suppose we
know that at some date t in the future, we will have to make a payment of $X (that is, we have
a liability of $X due at time t). How much should we put into our fund now, to be sure that we
will have enough to pay $X in the future? In actuarial terminology, we want to find the present
value of $X payable at time t. The problem becomes a bit more difficult if you have liabilities
to make several different payments, for different amounts, at different future dates.

In ACST1052, we will also be looking at the calculation of present values for various different
sets of incoming and outgoing payments.

The problem becomes more complicated if the amount $X is not known with certainty.
Perhaps $X is the cost of repairing a house damaged by storm – it is not a fixed amount, it will
depend on the circumstances. In that case, we refer to the payment as a contingent
payment – i.e. the payment depends on some the occurrence of some risky event.

Your actuarial studies will include the calculation of the accumulated value and present values
of various types of contingent payments.

In ACST1052 we will be studying the “Mathematics of Finance” and “Contingent Payments” –

this involves the calculation of the accumulated value and present values of various different
sets of incoming and outgoing payments, allowing for the different methods which may be
used to calculate the investment income for any fund, and allowing for the variability of future
payments which depend on the occurrence of risky events.

{Students who studied mathematics in New South Wales high schools have already studied
some simple financial mathematics – this is called “Consumer Arithmetic” in the high school
syllabus. We will be revising some of that work in ACST1052, for the benefit of students from
other states/countries who have not studied the same topics. We will also be looking at some
more complicated payment patterns.}

Summary: Actuaries must be good at working out accumulated values and present values,
for both fixed and variable payments. So you will study Mathematics of Finance and
Contingent Payments

(c) Investment

As we have seen, insurance companies and superannuation funds often accumulate large
funds, saving up to pay future benefits. They need to invest that money wisely. They wanted
to earn returns on their investments, but without taking too many investment risks.

Therefore, the actuaries who worked for life insurance companies also developed some
expertise in managing investments.

Luckily, actuarial training in statistics was also useful in managing investment risks. There are
many different types of asset (shares, bonds, property, etc). Each type of asset has some
potential rewards and some potential risks. The management of an investment fund, which
has a mixture of many different types of assets, has some similarities with management of a

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 group of different insurance policies. That is, we will need to use statistics and models to work
out the best investment strategy for each company.

Time – and the Actuarial Control Cycle

Actuaries often deal with very long term financial products.

 A life insurance company might sell a product to a 20-year-old, which will pay a benefit
when the customer finally dies at age 110.
 A superannuation fund member might pay contributions into a fund while he is working
(age 20 to 70) and then use the money to provide a retirement income from age 70 to age
110.

To manage these products, the actuary often has to create financial models which include
some projections about future events, looking many many years into the future.

Of course, actuaries do not have crystal balls. They do not really know what will happen 10 or
20 or 50 years into the future. [In fact, it is surprisingly difficult to predict economic variables,
such as interest rates or stock market returns, even one year into the future].

A famous actuary (Frank Redington) referred to the “Expanding funnel of doubt”. The further
ahead you make your projections, the more likely it is that your projection will be seriously
wrong (i.e. actual outcomes will be a long way from your forecasts.)

Therefore, when managing any financial institution over the long term, actuaries must apply
the actuarial control cycle.

 Step 1: Collect data and build a model which includes assumptions about the probability
of future events.
 Step 2: Use this model to make reasonable decisions about business management
 Step 3: As time goes by, monitor the experience – is it in line with expectations?
 Step 4: Go back to Step 1, revising your model after taking account of the new
information you have collected.

You will eventually have to study the Actuarial Control Cycle, and apply this approach to
various practical business problems – most students doing double degrees will study
Actuarial Control Cycle units in the 4th year of study.

Models
Usually, actuaries will have to build models, which can then be used to make decisions and assess
risks.

For example, a financial model might help a life insurance to decide

 Which products to sell (which products are most profitable)?
 What price to charge for the products (premium rates)?
 Which customers are the most risky (e.g. elderly male smokers vs young female non-
smokers)?
 How much money is needed to pay expected future claims from existing policies?

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  How the money should be invested (Shares? Bonds? Property? Or a mixture?)
 How much money can be paid to shareholders? How much should be held in reserve in
case of emergencies?

Macquarie University’s actuarial program will teach you how to build many different types of financial
models.

Some actuarial models are fairly standard – over the years, actuaries and statisticians have
developed some standard models for the most common types of problems (such as the valuation of
the liabilities of a life insurance company, or the projection of a superannuation fund savings account).

However, the world is constantly changing and actuaries often have to work out ways to develop new
models for these new situations. For example, at present actuaries are working on models which

 Compare the costs and benefits of different types of medical treatment – this may be
used by government agencies to decide which treatment should be recommended and/or
funded.

 Provide projections of the economic impact of climate change - for example, if the
average temperature in the Australian summer season increases by 1 degree, what is the
expected increase in bushfire insurance claims? [General insurers are naturally very
interested in this question]

Note that it is often extremely difficult to make a good model. History is full of models which were
seriously flawed; and then these models were sometimes used to make decisions which had very bad
outcomes. In ACST1052, we will look at several examples of disastrous modelling mistakes.

Therefore it is very important to

 Be aware of common sources of model error

 Test your models – e.g. are the assumptions reasonable, compared to past data?
 Criticise your own model – be aware of possible weaknesses in your model

In your actuarial studies, you will build many models – and you will be expected to identify the
strengths and weaknesses of each model you build.

It is not enough to build a model which says

“Our model says that our claims cost will be $72.6 million”.

You must also be able to answer the question:

“How sure are you that this is the correct answer?”

“What is the probability that the claims cost will really be over $75 million? Or over
$80 million? Or less than $60 million?”

Summary: If you look at your recommended program, you will see a lot of units include the word
“Modelling”. You will be building a lot of models.

Human Error

Note that models are often flawed because the people who created the model are biased.

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The bias may be unconscious – people might simply ignore evidence which conflicts with their own
beliefs. If the model comes up with an “undesirable” answer, there is a temptation to think that the
model must be wrong; and then “adjust” the model to give a “better” answer. People tend to cling to
their opinions, even against the evidence. [Can you think of any examples of this tendency?]

As actuaries, we want to produce answers which are based on evidence. In the United States, the
Society of Actuaries is the professional association for actuaries. Their motto is:

“The work of science is to substitute facts for appearances

and demonstrations for impressions."

Sometimes there is a temptation to make models which are deliberately biased. The actuary might
be under pressure to come up with an answer which will please the actuary’s client or employer. It is
usually fairly easy to “adjust” the model to come up with the “right” answer. This sort of behaviour has
caused a lot of trouble in the past (you will see some examples in your actuarial studies). The actuary
should always remember that he/she has a professional responsibility to provide opinions which are
based on the evidence – models should not be manipulated to produce biased results.

Risk Management
The models will also be used for risk management. Models can be used to identify which risks might
be likely to cause serious problems for the insurance company. The model might also be used to
identify alternative methods for managing these risks – and then identify the pros and cons of each
alternative.

For example, suppose the actuary builds a financial model of a life insurance company. The model
will show the expected cash flows – money coming in from premiums and investment income, money
flowing out in claim payments and expenses. The model can be used to test the impact of different
events, such as

 The potential impact of an epidemic on the number of death claims (this is extremely
relevant at the moment – see the newspaper article on iLearn, headed “APRA probes
bank, insurer virus plans”, The Australian, February 28, 2020, page 17)

 The potential impact of an economic downturn on the company’s investment returns

 The potential impact of a Royal Commission which damages the company’s reputation
(hence leading to cancellation of a lot of policies and a reduction in income) [Note: In
2019 the government held a Royal Commission which identified a lot of unethical
behaviour in the financial services industry]

 The potential impact of a Royal Commission which leads to more stringent regulation,
affecting the profitability of the company

Note that one event might affect several different aspects of the business – for example the
coronavirus might cause an increase in death claims AND at the same time cause a downturn in
investment returns (because the coronavirus affects the tourism industry, the university sector, and
any business which buys products made in China or sells products to China). A good model should
allow for such inter-relationships.

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In ACST1052, we will be looking at some of the problems which are currently plaguing Australian
insurance companies. We will look at the causes of the problems, and consider some of the solutions
which have been proposed.

Integrity and Professionalism

In the early days of life insurance, companies which sold life insurance often became insolvent. The
insurance company would collect premiums from their customers for years and years, but would then
fail to pay the benefits to their customers.

Naturally, when people were considering the purchase of a life insurance policy, they were concerned.
Which insurance company should they choose? How could they know which companies were well-
managed, and which ones were likely to fail?

Naturally, each company tried to attract new customers by boasting about the strength of their own
company, and by denigrating the financial status of their competitors. (In fact some of the early
Australian life insurance companies were forced to sue their competitors for slander, for spreading
false rumours).

In order to solve this problem, insurance companies hired actuaries with good reputations. Actuaries
would calculate the amount of money which would be needed to pay the expected future claims (the
contingent liability). If the company’s assets comfortably exceeded the liabilities, then it was likely that
the company would be able to pay future claims.

So having a favourable report from the actuary was important for marketing purposes.

Of course, this meant that it was very important that the actuary was a person with excellent
qualifications, and the highest level of integrity. The reputation of the actuary was extremely important.
Some companies would put the actuary’s name in their marketing brochures, explaining that there
could be no doubt about the solvency of the company, because an actuary with an excellent
reputation had vouched for their financial strength.

Professional associations were formed to set standards for the actuarial profession. The Institute of
Actuaries was set up in England (in 1848), and the Faculty of Actuaries in Scotland (in 1856). In order
to become a Fellow of a professional associations, you have to meet certain standards, for both
knowledge and reputation. Each professional association has

 Educations standards for membership (Lots of exams)

 A Code of Professional Conduct which sets standards for honesty and integrity (an
actuary who fails to meet the requirements of the Code of Conduct might be expelled
from the professional body, although this happens very rarely).

Of course, as soon as the professional association was created, the well-run life insurance companies
wanted to employ actuaries who were Fellows. If your actuary was a Fellow, he was obviously more
likely to be a competent and honest person. This provided the company’s policyholders with some
assurance that the actuarial reports were likely to be accurate and reliable.

Of course, some of the weaker companies might be tempted to hire someone who was not a Fellow –
perhaps an unqualified actuary, and/or someone who could be pressured to understate the
company’s liabilities (thus making the insurance company look stronger than it really was).

Eventually, the government stepped in. The Australian government passed legislation to insist that
actuarial valuation reports should be written by QUALIFIED actuaries. In most cases, this means that
these actuarial valuation reports must be written by someone who is a Fellow of the Actuaries Institute
in Australia, or an Accredited Member (an Accredited Member is someone who is a Fellow of an
actuarial professional association in another country, who has been recognised as having

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qualifications which are equivalent to an Australian Fellow). [If you are interested in the details, you
can look up APRA’s Prudential Standard CPS 520 Fit and Proper Person].

Eventually, the government also realised that life insurance companies were less likely to become
insolvent if they had good advice from a well-qualified actuary, about issues such as setting
premiums, holding emergency reserves, and managing risks. So the legislation was improved, so that
each life insurance company is required to obtain a lot of advice from an Appointed Actuary, who is
usually a Fellow of the Actuaries Institute (there are some exceptions, e.g. if the regulator, APRA,
gives permission). The Appointed Actuary has numerous legal responsibilities – including warning the
regulator if he/she thinks the insurance company is likely to become insolvent.

For many years, this Appointed Actuary system seemed to work very well for life insurance
companies. Over the years, very few life insurance companies became insolvent. The regulator
clearly believed that actuarial advice was very valuable in keeping insurance companies in good
shape. [In fact, there has been some controversy about this over the last few years. The regulator has
suggested that companies should be paying more attention to their actuaries – “actuaries should be
the key strategic advisors to the Board of Directors”. See https://www.apra.gov.au/news-and-
publications/apra-proposes-revisions-to-role-of-appointed-actuary-and-actuarial-advice-for 21 June
2016]

Eventually, after a few general insurers became insolvent, the government decided that general
insurers should ALSO have Appointed Actuaries.

And later, after a few health insurers became insolvent, the government decided that health insurers
should ALSO have Appointed Actuaries.

Certain types of superannuation funds ALSO need to have a qualified actuary provide specified
reports – making sure that the superannuation contributions are calculated correctly and the fund will
be able to pay the promised retirement benefits.

As noted previously, the professional association can expel someone who does not meet their
standards for competence and integrity. In Australia, the government regulator (APRA) can also
impose bans on actuaries who do not meet their standards. Sadly, in the past, a few actuaries have
been banned – usually because the actuary has done a poor job in advising an insurance company or
superannuation fund which as subsequently failed.

In summary:

 An actuary’s good reputation is a very valuable asset.

 Professional associations should uphold standards for competence and integrity. If you
want to be a Fellow of the Actuaries Institute, you must follow the Code of Conduct (you
will learn more about this later). The Code of Conduct says

o The Institute is a professional body that seeks to enhance the actuarial

profession and to serve the public interest. In order to achieve this, it is essential
that Members maintain proper standards of professional conduct and
performance.

 Actuaries have a responsibility to act in the public interest when performing their
professional responsibilities. The Code of Conduct says:

o A Member must act with integrity, honesty and due care, and in a manner that
seeks to uphold the reputation of the profession. [This means …] requiring that a

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 Member, in engaging in conduct, or providing advice, a report, communication
or other information, does so in a way which is not knowingly false, misleading
or deceptive.

 Under Australian law, actuaries have been given specific legal responsibilities to advise
insurance companies and superannuation funds about various matters (In ACST0152, we
will be giving you more information about actuarial responsibilities).

Should you aim to become a Fellow?

As we have seen, Australian legislation says that certain tasks must be performed by Fellows of the
Actuaries Institute. So if you become a Fellow, you have some career opportunities which are not
available to other people.

However, you certainly do not have to become a Fellow of the Actuaries Institute in order to be a
successful actuarial studies graduate.

In order to become a Fellow, you must pass lots and lots of exams (Part 1 Foundation, Part 2
Actuary, Part 3 Fellowship). The Part 3 exams are notoriously difficult to pass (i.e. the exams often
have quite low pass rates). So is it really necessary?

During the first three years of your University career, you will study Part 1 Foundation units. These
units will give you strong quantitative skills in mathematics of finance, financial modelling, risk theory,
etc.

If you are doing a double degree, in your fourth years of study, you can also complete some of the
Part 2 Actuary units (e.g. Actuarial Control Cycle). Alternatively, if you are doing a three-year degree,
you can study the Actuarial Control Cycle units after you graduate (as non-degree units, with evening
classes or distance-study classes). The Actuaries Institute also teaches some of the Part 2 units,
include the Communications unit (see https://actuaries.asn.au/education-program/actuary-
program/subjects-and-syllabus). When you finish the Part 2 subjects, you will be an Associate
Member of the Institute and you can call yourself an Actuary.

If you want to work in traditional areas of work, you might decide that you DO want to study Part 3
Fellowship units and then become a Fellow. The Part 3 Fellowship Units tend to focus on life
insurance, general insurance, health insurance, superannuation, investment, banking, and risk
management. See https://actuaries.asn.au/education-program/fellowship/subjects-and-syllabus

However, you might decide that you don’t need to study all of the Part 2 and Part 3 units. If you work
in non-traditional areas, such as data analytics or electricity markets or derivatives trading, you
probably don’t need to study all of the Part 2 and Part 3 units. You can choose to study other
disciplines which will be more useful for your chosen career path – that might include more advanced
statistics, more advanced mathematics, more advanced computing skills, or areas of specialist
knowledge such as health economics or electricity markets - instead of insurance and
superannuation. There is a lot of flexibility. After you complete your first year of actuarial studies, you
will probably have a better understanding of your own preferences.

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