Who is an actuary?
That’s probably the first question that you may ask given that not many people know about actuaries.
An actuary is a highly qualified professional who assesses the financial impact of future uncertain events and advises on the necessary steps to be taken to manage the various emerging risks. He does this by adopting complex mathematical models involving application of probability and finance.
There are limited number of actuaries in the world (approximately 70,000 as per some estimates) and they typically work in organisations such as the insurance companies, pension funds etc., which offer long-term products to their customers and therefore require the expertise of actuaries in managing the associated risks.
Given the long-term nature of the business of these organisations, decisions taken based on short-term outlook may prove to be disastrous. Armed with their critical mindset, analytical thought process and long-term outlook, actuaries are considered to be best suited to forecast future uncertain events and evaluate the financial impact of the same on businesses and individuals alike. In fact, they are considered to be the backbone of such organisations offering long-term products.
But what does the phrase ‘long-term’ really mean?
How long is ‘long-term’?
The phrase ‘long-term’ has different connotation to different people.
In an era wherein people are attracted to day-trading on the stock markets for making (or rather hoping to make) some quick bucks, the phrase ‘long-term’ may be an alien concept!
On the other hand, for the slightly less speculative individuals, anything beyond a year may be ‘long-term’, whereas many serious investors may consider 3-5 years period to be ‘long-term’.
Seasoned investment professionals / financial planners / investment advisors, however, may argue that ‘long-term’ means at least 10 years and an individual should be taking all financial decisions by having this outlook. Indeed, it may be extremely difficult for most of us to even imagine, let alone plan for, a future beyond 10 years.
But actuaries are a very different species! They are tasked to price insurance policies, which may last for several decades; and to also manage the emerging risks faced by the insurance companies over such a long period. To them, the phrase ‘long-term’ may well be 25-30 years or beyond. For most of us, it is indeed extremely difficult to think about and plan for a future that is so many years away, especially in an external environment that is ever changing.
Nevertheless, whether it is about investing for wealth creation over the long-term, or planning for retirement, or systematically investing for certain financial / life goals etc., it is important to develop a ‘long-term’ outlook the way actuaries have. The reason is simple - if one takes decisions based on short-term considerations, such decisions may prove to be very costly in the long-term.
Imagine the following scenarios:
- You are not able to send your child for higher education in the desired university because you were lured by the new swanky car launched in the market and diverted your earnings in buying the same, instead of systematically investing for your child’s education over the past 10-15 years.
- You do not have sufficient corpus built up for your retirement, only because you didn’t invest in the ‘right’ asset categories that would deliver a high enough post-tax investment return during your working life.
- Your family is facing financial hardship upon your untimely death, only because you didn’t buy adequate insurance protection, thinking that the premium you would have to pay would be a wasteful expenditure.
These examples highlight why developing a long-term outlook is important in everything that we do. But how does one develop such a long-term outlook?
Do what the actuaries do!
The best way to understand what developing a long-term outlook really means in practice, is to learn from examples illustrating the work of actuaries.
| How can you develop a long-term outlook? Learn from the work of actuaries |
| Key attributes |
Examples of work of an actuary |
What can we do? |
| Develop a critical mindset |
- When tasked to develop a new insurance product, the first thing actuaries do is to think about what all can go wrong! For example, they may consider the risks that the product won’t sell in sufficient volumes; or the agents may mis-represent the benefits, leading to unhappy customers; or the cost of distribution would be too high, making the product expensive; or there may be large scale cheating by the customers themselves, leading to the insurer making losses; or the insurer may not earn sufficient returns on the invested assets and hence may be unable to pay the benefits to the policyholders etc.
- Such critical thinking, right at the outset helps the actuaries in taking the necessary mitigating steps in addressing any such risks the insurer may face in the long-term, before it is too late.
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- It is important for us to develop a critical mindset about all our financial matters – our expenditure, earnings, investments etc. Asking questions such as “what could go wrong” may force us to think about “how could we minimise the impact, should things go wrong” or “what could be the alternatives”.
- If necessary, we can seek help from our financial advisors. However, we should accept their advice only after applying our critical mind. Questioning everything and learning in the process allows us to take decisions that are in our best long-term interest.
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| Plan for the next 20-30 years (or longer) |
- Actuaries estimate the future outgo and liabilities of the insurer, for as long as the policies are expected to last (which may be several decades). They ensure that the company’s investments today, together with the investment income thereon and premiums expected to be received in the future, would be sufficient to meet all such future outgo and liabilities.
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- It would be important for us to identify all our future outgo and liabilities – some of which may well be beyond 20-30 years (e.g. our expenses in retirement) and start investing today, to be able to accumulate sufficient corpus to meet all such outgo and liabilities. Not planning for such a long-term may mean that we could face financial difficulty in the future.
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| Match your future liabilities with appropriate assets |
- For an insurer, although some outgo and liabilities in the future are contractually ‘guaranteed’ in nature, some may be ‘non-guaranteed’. Actuaries identify the nature of such future outgo (i.e. whether ‘guaranteed’ or ‘non-guaranteed’) and advise on an investment strategy that is aimed at reflecting the nature and characteristics of such liability outgo.
- Such matching of liabilities with suitable investments of similar characteristics allows the insurer to not only meet these future liabilities, but also maximise the future investment income. For example, if an insurer has to pay the guaranteed sum assured under the policy in a year’s time, it may be disastrous to invest in equities, as any adverse movement in the stock markets in a year could result in the insurer not having sufficient funds to pay the guarantees. However, to declare a high maturity ‘bonus’ (which is not guaranteed in advance) on its policies after 15-20 years, the insurer may invest in equities to generate a high investment return.
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- We should identify our outgo in the short to medium-term that we are certainly going to incur (e.g. Children’s university admission fees that are due in three years from now), and invest sufficient amounts in assets that would definitely generate the required corpus to pay the fees in three years.
- For the long-term outgo, which we may or may not incur (e.g. funding required for an overseas holiday planned in 10 years); or which is required very many years in the future (e.g. the corpus required for retirement funding in 25 years), we can invest in asset classes that are expected to generate a higher investment return over the long-term.
- Such matching of liabilities and assets on a regular basis would secure our financial future and also result in a superior financial outcome.
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| Actively manage the emerging risks |
- For an insurer, the actual future outgo or liabilities may not necessarily be the same as the estimates made in advance. This creates the risk that the insurer’s investments today may be insufficient to meet all future outgo and liabilities.
- Actuaries actively manage such risks by taking various measures such as having additional buffer investments; or transferring some of the risks to another insurer (called a reinsurer) etc.
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- When we need to plan for the long-term, it would be impossible to estimate the future outgo and liabilities with certainty – after all, no one can predict the future. It is advisable, therefore, to keep some extra buffer in our investments. Also, to protect against the risk of unforeseen expenses in the future (e.g. due to hospitalisation or medical emergencies) or the untimely death resulting in the loss of future income, we may need to transfer the risks to an insurer – by buying appropriate insurance cover for ourselves.
- Through active monitoring of the emerging risks and taking appropriate steps in managing them, we can ensure that we will have a secured financial future and would not go bankrupt in the long-term.
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| Regularly monitor the actual experience and revise the future plans |
- The work of actuaries involves estimating future outcome by making various assumptions. However, the actual outcome in the future may not be the same as these estimates. Given this, actuaries regularly monitor the emerging experience of an insurer and also the external environment, to revise their estimates of future outgo and liabilities based on revised assumptions. This is a continuous process that allows the insurers to take any corrective steps at an early stage before it is too late, so that they can meet all their future outgo and liabilities.
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- It is impossible for us to be confident about what may actually happen to our finances in the long-term. However, regular monitoring of the ‘actual’ against ‘estimates’ of our expenses, incomes / earnings, investment income etc. would allow us to take any corrective steps necessary (e.g. bringing down our expenses; or revising our investment portfolio to earn a higher investment return etc.) This would ensure that we remain on course to achieve our long-term financial goals.
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Conclusion
Although you may not be a qualified actuary, you don’t need to be one to start thinking like an actuary! To ensure that you have a secured financial future, you need to have a critical mindset, analytical thought process and a long-term outlook.
Of course, you can always seek help from the professionals in managing your financial matters. However, there is no substitute to developing the necessary skills yourself. By gaining an insight into your personal financial health and how it may develop in the long-term, you may be able to take any corrective actions early on and achieve a secured financial future.
Sign into your Fin4sight™ account today, and start developing a ‘long-term’ outlook by gaining an insight into your current and future financial health.
Email : contact@wisdom2wealth.co.in
