A friend who?s in the pre-need and insurance industries has e-mail in response to a reported comment from Juan Miguel Vasquez, the president of the Philippine Federation of Pre-need Companies of the Philippines, that apparently pins the blame on his industry?s actuaries for the mess it?s in.

For those who still don?t know what an actuary is, he?s someone who crunches numbers to determine probabilities, like life expectancies and that sort of thing. An actuary?s mathematical models, assumptions and studies are very useful for the insurance, banking and pre-need industries, as well as other sectors that rely heavily on computations to predict future events.

It seems that Vasquez has been quoted as saying that the nation?s actuaries are also partly to blame for the problems besetting the pre-need companies. Or, to quote Vasquez himself: ?The major mistakes in our assumptions of investment?who made those assumptions? The actuaries were involved. Now naghuhugas kamay sila [they are washing their hands]. They forgot that they they?re the ones who made the studies that we all applied with the [Securities and Exchange Commission] and that the SEC approved.?

Here?s the reply and pre-need industries:

Let?s begin with assumptions, how they are set, why they are set and what their role is. In the pre-need industry, assumptions are made during two critical activities. First, when a plan is first priced. Second, when liabilities are valued.

Let?s begin with the first one. During pricing, assumptions must be made concerning the investment rate of return that can be made on funds. Now, there is nothing too magical about this. Many professionals do this, including those in the banking and in the insurance industry.

Here is how this is used in the pre-need industry. We take a product?let?s say one that will mature in 15 years and that will be paid in five years. This means that the plan holder will pay for five years, wait for 10 years and then begin to receive the benefit.

All the actuary does is figure out how much of what the plan holder pays is left after expenses (taxes and so on), how much that can earn in investment income and then compare it to the benefit that is promised. The price is set so that there is enough money left both to provide the benefit as well as to provide a level of contingency and profits to the pre-need company.

What you should keep note of is that this is really a balancing of the equation that goes:

Payments made + investment income = benefits + expenses + contingency and profits

What this means is that the higher the investment rate of return assumed, the higher the investment income and, all else remaining equal, the lower the payment that must be asked of the plan holder.

One of the things that this equation hides is that benefits are paid out of the trust fund. What really happens is that payments are made, a portion is contributed into the trust fund and whatever is left is used by the pre-need company for expenses, contingency and profits.

So, really there are several equations and they go like this:

Payments made=Trust Fund Contribution plus Excess

Excess = Expenses plus Contingencies plus profits

Trust Fund Contribution plus investment income earned =Benefits

This means that if you are too aggressive with your investment rate of return assumption, you will underestimate your trust fund contribution and even your pricing. Since these are long-term contracts (20 to 25 years) and the terms of the contract are fixed at the issuance of the contract, this is a very important assumption. This is why most actuaries will tell you that it is best to be conservative in setting the investment rate of return assumption.

Note that the level of trust fund contributions are set at pricing?but should be reviewed each year and adjusted depending on what the annual actuarial review and valuation shows.

An investment rate of return assumption is made the second time, for valuations. Each year, as part of the preparation of annual financial statements, each pre-need company is required to have an actuarial valuation performed of their contracts. This includes contracts that are still in force as well as those that are in a period when they are lapsed (usually because of an unpaid payment) but reinstatable (can be made in force by payment of the delayed premium). The valuation is meant to calculate what amount must be in the trust fund taking into account the benefits promised and the contributions still to be made. Essentially again, we are solving the following equation:

?Actuarial Reserve Liability? + Future Trust Fund Contributions + Expected Investment Income = Expected Benefits to be Paid Regulations require that the trust fund be at least equal to this Actuarial Reserve Liability. Now, if you think about it, that makes a lot of sense.

Now, here is the thing. Most professionals will tell you that, for this valuation, you must choose an investment rate of assumption that is realistic as at the time of the valuation, with a bias toward conservatism. In fact, before the infamous SEC notice of April 2007, the position of the SEC was even a little more conservative.

***

Let us now go to whose responsibility assumptions are. Much like financial statements, assumptions are, at the end of the day, a management responsibility.

By SEC regulation, the investment manager of the trust fund is required to provide an investment outlook to provide a basis for developing the investment rate of return assumption. The actuary who signs either pricing or valuation is professionally responsible for the assumptions he uses ? unless he specifically explains that he is uncomfortable with them, has been instructed to use them and does not believe they are reasonable.

Note that all actuarial valuation reports will have a professional opinion concerning reasonability of assumptions?in the same way that all audited financial statements will have a professional opinion concerning fairness and soundness.

Management of the company is also responsible for these assumptions as, at the end of the day, they are the ones who finally approve these assumptions and let them become part of their financial statements as well as part of the basis for such major decisions as their decisions concerning contributions to their trust fund. This is especially true of companies who do not have full-time actuaries. And it is certainly especially true of CEOs and CFOs.

The SEC is also responsible for vetting these assumptions and finally approving them.

The Actuarial Society of the Philippines provides guidelines concerning how to set assumptions and members are expected to follow them.

But whose responsibility is it to make sure that the value of assets in the trust fund are in fact equivalent to the amount that should be there?the actuarial reserve liability? There?s also an even larger question: Say you priced a product during 1981 when everything seemed fine. Interest rates were in the high double digits. Then interest rates begin to decrease to low single digits following a planned scaling down of bank reserve rates (this actually happened).

You would have repriced your products and increased your schedule of contributions to the trust fund. If the decrease in rates was gradual and not too large, you would be OK. You would, maybe, have to deal with much lower profits, but you would not have to renege on your promise. In fact, that happened for many life insurance companies?who, by the way, have almost exactly the same sort of predicament except that they invest their own funds (plus, they are much more conservative and more rigorously regulated).

That is the entire point of the annual valuation. The annual valuation is an early warning device. In the insurance industry, if you do not have enough high-quality assets to cover your reserve liabilities, you are given a few months to fix it. If you don?t, you lose your license, you cannot sell new policies and, if you cannot show that you have a good plan for fixing your problem, you are put under an Insurance Commission-supervised receivership.

The question you should really ask is this: When did pre-need companies first become aware of the problem and how did they deal with it? You can even actually ask how the SEC handled this.

These questions should be asked individually of each pre-need company because, I assure you, not all companies are in trouble. Every company?s situation is unique.

For the pre-need industry, there were two large problems. First, some companies issued plans that did not have a fixed, stated benefit amount. Instead they promised that they would pay tuition fees?regardless of how much those fees were.

While this worked during the time when tuition was regulated (meaning held to very near inflation by law), the entire business model blew up when tuition fees became deregulated (when tuition went up by as much as 20 to 30 percent in a year). This meant that the benefit side of the equation went up?and, hence, they needed to make this up some other way. For many companies, this increase was so high, it was impossible to make it up in improved investment returns. (Concluded Tuesday)