Actuarial Pricing vs Valuation
We’ll discuss two main actuarial jobs (or roles) for actuaries in insurance companies. These are actuarial pricing vs valuation. During your actuarial career, you may have experience in both pricing and valuation, and some companies have rotation programs where you will rotate between different actuarial jobs so you can gain diversity. Having experience in both pricing and valuation will benefit your overall actuarial career by helping you understand the bigger picture.
Valuation actuaries work on estimating the cost associated with a potential future risk transfer.
An example is the hotdog analogy. When you sell a hotdog, you know how much to sell it for because your costs are relatively known. You know how much you pay in rent for your hotdog stand space, how much the materials cost (gas, bun, meat, etc.) and how much labor costs ($X/hour). Therefore if you estimate selling a certain amount of hotdogs per month, you know how much to charge to have a certain amount of profit.
Insurance doesn’t work like that. When you sell insurance, for example a health insurance policy, you don’t know how much the client will cost you. That’s where the pricing role comes in. For each type of client, how much will insuring this person with a specific policy cost on average? Actuaries try to predict costs based on the coverage and who’s being covered. For example a 60 year old smoker will cost more than a 20 year old non-smoker. It’s estimating a future cost of a type of client so you can provide a price If enough clients sign up (so that the law of large numbers work) and rates are adequate, it should provide adequate profit overall.
Valuation actuaries work on estimating the future liabilities associated with past risk transfers. How much does the company need to set aside to pay for all the claims it says it will?
In the above example of a health insurance policy sold, how much money should be set aside to pay for future claims? The difference from a pricing role is that as a valuation actuary, you are working on estimating liabilities for a company given that the risk transfer has already occurred (there are some prospective projects but we’ll mainly discuss the typical actuarial job here).
The complexity is that for some types of insurance policies such as liability, it could be a long time before the amount of claims is known. For example, someone might slip and fall at someone’s place of business, and then only successfully win the lawsuit years later. Or pollution might have occurred at a company’s factory but it isn’t discovered until the factory gets sold and inspected 15 years later.
How do actuaries do this? They use a variety of valuation methods. For property and casualty insurance, we have 3 common valuation methods: the loss ratio method, the chain ladder method and the Bornhuetter Ferguson method.
Which role is better?
Should you become a valuation actuary or a pricing actuary? The debate of pricing vs valuation has merits on both sides. Pricing tends to be viewed as more on the business side for an insurance company since it is critical in getting new business profitably. Valuation on the other hand is required by regulators not just for insurance companies but also for self-insured operations such as workers compensation. The key to deciding between a pricing role and a valuation role is to try both and see for yourself which you like better!