Proposed Revision of Actuarial Standard of Practice No. 25
STANDARD OF PRACTICE
TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Interested in Credibility Procedures
FROM: Actuarial Standards Board (ASB)
SUBJ: Proposed Revision of Actuarial Standard of Practice (ASOP) No. 25
This document is a second exposure draft of a revision of ASOP No. 25 now titled, Credibility Procedures.
Please review this second exposure draft and give the ASB the benefit of your comments and suggestions. Each written response and each response sent by e-mail to the address below will be acknowledged, and all responses will receive appropriate consideration by the drafting committee in preparing the final document for approval by the ASB.
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ASOP No. 25 Revision (Second Exposure)
Actuarial Standards Board
1850 M Street, NW, Suite 300
Washington, DC 20036
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Deadline for receipt of responses in the ASB office: September 30, 2013
The original standard, adopted in 1996, was a product of the Health Committee and the Casualty Committee of the ASB. The scope of the standard was limited to accident and health, group term life, and property/casualty coverages.
In 2011, the ASB asked the Life Committee to consider whether the scope of ASOP No. 25 should be expanded to incorporate additional practice areas. The Life Committee agreed that the scope of the ASOP could be expanded. The Board asked that a multi-discipline task force be formed under the direction of the General Committee to begin drafting an exposure draft. A task force was then created that included actuaries from the life, health, pension, and property/casualty practice areas.
First Exposure Draft
The first exposure draft of this revised ASOP was issued in September 2012 with a comment deadline of December 31, 2012. The Credibility Task Force carefully considered the 20 comment letters received and made changes to the language in several sections in response. For a summary of the issues contained in these comment letters, please see Appendix 2. The most significant modifications from the first exposure draft are as follows:
1. The scope of the standard has been clarified in section 1.2.
2. A definition of “credibility procedure” was added.
3. The purpose and use of credibility procedures was clarified, in particular regarding the continued need for professional judgment.
4. “Method(s)” and “methodology(ies)” were replaced with “procedure(s)” throughout the ASOP.
The ASB thanks everyone who took the time to contribute comments and suggestions on the first exposure draft.
Request for Comments
The ASB encourages comments on all sections of this second exposure draft and is particularly interested in receiving comments on the following areas:
1. Does the revised language in the standard clarify the application of the standard?
2. Does the standard allow for the appropriate consideration of professional judgment in the application of the standard?
The ASB approved this second exposure draft at its June 2013 meeting.
Credibility Task Force
Barbara L. Snyder, Chairperson
Joan C. Barrett Steven C. Erickson
Kevin S. Binder James B. Milholland
David A. Brentlinger Mary H. Simmons
Steven C. Ekblad Jonathan White
General Committee of the ASB
Michael S. Abroe, Chairperson
Maria M. Sarli, Chairperson
Albert J. Beer Martin M. Simons
Paul Braithwaite Barbara L. Snyder
Raymond Brouillette Thomas D. Snook
Charles Cook James E. Turpin
Mary H. Simmons
Actuarial Standards Board
Robert G. Meilander, Chairperson
Beth E. Fitzgerald Thomas D. Levy
Alan D. Ford Patricia E. Matson
Patrick J. Grannan James J. Murphy
Stephen G. Kellison James F. Verlautz
The ASB establishes and improves standards of actuarial practice. These ASOPs identify what the actuary should consider, document, and disclose when performing an actuarial assignment. The ASB’s goal is to set standards for appropriate practice for the U.S.
Section 1. Purpose, Scope, Cross References, and Effective Date
The purpose of this actuarial standard of practice (ASOP) is to provide guidance to actuaries when performing professional services with respect to selecting credibility procedures and the application of those procedures to sets of data.
This standard applies to actuaries when performing actuarial services involving credibility procedures in the following situations:
a. when the actuary is required by applicable law (statutes, regulations, and other legally binding authority) to evaluate credibility;
b. when the actuary chooses to evaluate the credibility of subject experience, or states in any related actuarial communication that credibility has been evaluated in accordance with this ASOP;
c. when the actuary is blending or considering blending subject experience with other experience; or
d. when the actuary represents the data being used as statistically or mathematically credible.
If the actuary determines that the guidance in this standard conflicts with ASOP No. 35, Selection of Demographic and Other Noneconomic Assumptions for Measuring Pension Obligations, ASOP No. 35 will govern. If the actuary departs from the guidance set forth in this standard in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to section 4.
1.3 Cross References
When this standard refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this standard to the extent it is applicable and appropriate.
1.4 Effective Date
This standard will be effective for any professional services with respect to credibility procedures performed on or after four months following adoption by the Actuarial Standards Board.
Section 2. Definitions
The terms below are defined for use in this actuarial standard of practice.
A measure of the predictive value in a given application that the actuary attaches to a particular set of data (predictive is used here in the statistical sense and not in the sense of predicting the future).
2.2 Credibility Procedure
A process that involves the following:
a. the evaluation of subject experience for potential use in setting assumptions without reference to other data; or
b. the identification of relevant experience and the selection and implementation of a method for blending the relevant experience with the subject experience.
2.3 Full Credibility
The level at which the subject experience is assigned full predictive value, often based on a selected confidence interval.
2.4 Relevant Experience
Sets of data, that include data other than the subject experience, that, in the actuary’s judgment, are predictive of the parameter under study (including but not limited to loss ratios, claims, mortality, payment patterns, persistency, or expenses). Relevant experience may include subject experience as a subset.
2.5 Risk Characteristics
Measurable or observable factors or characteristics that are used to assign each risk to one of the risk classes of a risk classification system.
2.6 Risk Classification System
A system used to assign risks to groups based upon the expected cost or benefit of the coverage or services provided.
2.7 Subject Experience
A specific set of data drawn from the experience under consideration used for the purpose of predicting the parameter under study.
Section 3. Analysis of Issues and Recommended Practices
3.1 Purpose and Use of Credibility Procedures
There are two purposes of using credibility procedures: 1) to evaluate subject experience for potential use in setting assumptions without reference to other data; and 2) to improve the estimate of expected values. Examples where credibility procedures may be used include tasks such as pricing, ratemaking, prospective experience rating, and assumption setting for valuation and modeling.
3.2 Selection of Credibility Procedure
The actuary should use an appropriate credibility procedure when determining if the subject experience is fully credible or when blending the subject experience with the relevant experience. The procedure selected or developed may be different for different practice areas and applications. Additional review may be necessary to satisfy applicable law. In selecting or developing a credibility procedure, the actuary should consider the following criteria:
a. whether the procedure is expected to produce reasonable results;
b. whether the procedure is appropriate for the intended use and purpose; and
c. whether the procedure is practical to implement when taking into consideration both the cost and benefit of employing a procedure.
The actuary should consider the predictive value of more recent experience as compared to experience from earlier time periods.
3.3 Selection of Relevant Experience
The actuary should use care in selecting the relevant experience. Such relevant experience should have characteristics similar to the subject experience. Characteristics to consider include items such as demographics, coverages, frequency, severity, or other determinable risk characteristics that the actuary expects to be similar to the subject experience. If the proposed relevant experience does not meet and cannot be adjusted to meet such criteria, it should not be used. The actuary should apply credibility procedures that appropriately consider the characteristics of both the subject experience and the relevant experience. The actuary should consider the extent to which subject experience is included in relevant experience. If subject experience data is a material part of relevant experience, the use of that relevant experience may not be appropriate. In some instances, no relevant experience is available to the actuary. In this situation, the actuary should exercise professional judgment, considering available subject experience, in setting an estimate of expected values.
3.4 Professional Judgment
The actuary should exercise professional judgment when using a credibility procedure. The use of credibility procedures is not always a precise mathematical process. For example, in some situations, an acceptable procedure for blending the subject experience with the relevant experience may be based on the actuary assigning full, partial, or zero credibility to the subject experience without using a rigorous mathematical model.
3.5 Homogeneity of Data
In carrying out credibility procedures, the actuary should consider the homogeneity of both the subject experience and the relevant experience. Within each set of experience, there may be segments that are not representative of the experience set as a whole. The predictive value can sometimes be enhanced by separate treatment of these segments.
Section 4. Communications and Disclosures
Whenever appropriate in the actuary’s professional judgment, the actuary should disclose the credibility procedures used and any material changes from prior credibility procedures. The actuary should also include the following, as applicable, in an actuarial communication:
a. the disclosure in ASOP No. 41, Actuarial Communications, section 4.2, if any material assumption or method was prescribed by applicable law (statutes, regulations, and other legally binding authority);
b. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and
c. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.
Appendix 1 – Background and Current Practices
Note: This appendix is provided for informational purposes and is not part of the standard of practice.
The concept of credibility has been a fundamental part of actuarial practice since the beginning of the profession. Applications of credibility procedures have recognized the traditional concerns regarding the proper balance between responsiveness and stability. Early discussions of credibility tended to focus on estimating mean claim frequency using classical and empirical credibility procedures. The earliest recorded paper on this subject, “How Extensive a Payroll Exposure Is Necessary to Give a Dependable Pure Premium,” was published by Albert H. Mowbray in Volume I of the Proceedings of the Casualty Actuarial and Statistical Society (published by the Casualty Actuarial Society in 1914). Later writers have developed formulas for the credibility of claim severity and for the credibility of total losses including Bayesian credibility procedures. Credibility concepts have also been used in other actuarial work.
A variety of approaches are used in credibility procedures. In some cases, the approach is based on judgment; in other cases, mathematical models are used. Some selected mathematical credibility procedures are discussed below.
Classical Credibility Procedures
Classical credibility procedures make assumptions as to the form of the underlying probability distribution. From this probability distribution function, the appropriate number of claims, amount of premium, or other measure of volume is calculated such that the probability that the subject loss experience is within a specified percentage (r) of the expected value is equal to a specified parameter (p). This measure of volume is the full credibility standard. One such approach that assumes that claims follow a Normal distribution is Limited Fluctuation Credibility. In this approach, the credibility assigned to the subject experience is based on the square root of the ratio of actual claims to the full credibility standard.
Empirical Credibility Procedures
Empirical credibility procedures measure the statistical relationships of the subject experience to its mean and to comparable experience of prior experience periods, without reference to the underlying distribution.
Bayesian Credibility Procedures
Bayesian analysis procedures merge prior distributions representing the statistical information of the relevant experience with the statistical information of the subject experience to produce posterior distributions that reflect both. Bayesian credibility procedures provide a least squares approximation to the mean of a posteriori distribution that would result from a Bayesian analysis. One example of the application of Bayesian credibility is Greatest Accuracy Credibility, which is also referred to as linear Bayesian credibility or Bühlmann credibility. In Greatest Accuracy Credibility, partial credibility is assigned to the subject experience using formulas of the form n/(n+k), where n is the volume of subject experience and k is a parameter that may be derived from variances in the subject and relevant experience.
Emerging Practice Involving Generalized Linear Models
More recent advancements in the application of credibility theory incorporate credibility estimation into generalized linear models or other multivariate modeling techniques. The most typical forms of these models are often referred to in literature as generalized linear mixed models, hierarchical models, and mixed-effects models. In such models, credibility can be estimated based on the statistical significance of parameter estimates, model performance on a holdout data set, or the consistency of either of these measures over time.
The most commonly used bases for determining credibility are numbers or amounts of claims, losses, premiums, and exposures.
Credibility Procedures for Ratemaking/Pricing
The sample size used for full credibility sometimes is based on the variance of an assumed underlying probability distribution. If using an assumed frequency distribution, the actuary usually adjusts the required sample size to recognize variation in claim size or other factors.
Credibility Procedures for Prospective Experience Rating
Prospective experience rating formulas assign credibility to actual experience of a single risk or a group of risks (the subject experience). In some instances, the subject experience may be subdivided into different components, for example, primary and excess losses, with different credibility levels appropriate for each piece.
Expanded discussion of the use of credibility procedures by actuaries setting assumptions can be found in various publications of the American Academy of Actuaries, the Society of Actuaries, the Casualty Actuarial Society, and other similar actuarial professional organizations.
Appendix 2 – Comments on the Exposure Draft and Responses
The exposure draft of ASOP No. 25, Credibility Procedures, was issued in September 2012 with a comment deadline of December 31, 2012. Twenty comment letters were received, some of which were submitted on behalf of multiple commentators, such as by firms or committees. For purposes of this appendix, the term “commentator” may refer to more than one person associated with a particular comment letter. The Credibility Task Force and the General Committee of the Actuarial Standards Board carefully considered all comments received, and the General Committee and ASB reviewed (and modified, where appropriate) the changes proposed by the Task Force.
Click here to view Appendix 2 in its entirety.