In a world of transition for all our disciplines, actuaries can get and keep ahead of the changes by, first, getting our thinking right. Right behaviour and actions will follow. We will think about the needs of our employers and clients and present our findings more in the business context; we will look through their needs to the needs and interests of their employees and customers. We will grasp financial economics and learn banking thinking. The profession will raise issues of public interest and inform the debate.

The trustees and sponsors of defined benefit schemes rely on the advice of the Scheme Actuary to make important decisions concerning the funding of the scheme, the investment of its assets, and the use of surplus assets to improve benefits. These decisions have to be made in the face of considerable uncertainty about financial and demographic factors that will affect the future experience of the scheme and its success in meeting various objectives.

The traditional actuarial valuation combined with actuarial judgement has played an important role in guiding decision making; but we argue that stochastic methods can add value in certain crucial areas, in particular the financial risk management of defined benefit schemes. Rather than dealing with risk by incorporating margins in the valuation basis, a stochastic approach allows the actuary to evaluate specific and quantifiable risk and performance measures for alternative funding and investment strategies.

This paper recommends a framework that, when combined with a suitable stochastic model, measures the risks inherent in contribution rate and asset allocation decisions, allowing better decisions to be made. In doing this, we suggest and apply various risk and performance measures that may be thought appropriate, although our intention is to illustrate their use rather than prescribe them as objective standards. The framework provides the means to explore the trade-offs involved in possible contribution and asset allocation decisions, and points to decision strategies expected to give improved outcomes for the same level of risk. A feature of the approach that marks it out from current asset/liability techniques is that it examines the funding and investment decisions together. It does not derive a contribution rate in the traditional way, but leaves this as free variable, in the same way that the investment decision is taken to be a free variable. Another distinctive feature of our framework is that it is based on projection rather than on valuation, involving stochastic simulation of the experience of the scheme over a time horizon reflecting the concerns of the trustees and the sponsoring employer.

The paper provides a case study (based on a model final salary pension scheme) showing the advantages of the framework, and goes on to explain how the results may practically be communicated to trustees and scheme sponsors.

This Presidential Address is a call for a debate about change, to meet the demands of the 21st century. Change in how actuaries are educated to encourage wider thinking and more flexible careers. Change in how the profession is governed, to introduce more external input, to encourage more challenge of accepted practices and standards and to encourage a greater readiness to embrace change itself. To boost our public image and our influence on public policy. Change in the United Kingdom's social security and pensions systems, the better to achieve a secure retirement for tomorrow's pensioners. Change in how insurers are regulated, ensuring that consumer protection is not diminished in the process. The importance of research is emphasised, as are our relationships with other professions. These are areas where the Faculty is particularly well placed to play its part in taking the U.K. profession forward.

In this paper we consider reserving and pricing methodologies for a pensions-type contract with a simple form of guaranteed annuity option. We consider only unit-linked contracts, but our methodologies and, to some extent, our numerical results would apply also to with-profits contracts.

The Report of the Annuity Guarantees Working Party (Bolton et al., 1997), presented the results of a very interesting survey, as at the end of 1996, of life assurance companies offering guaranteed annuity options. There was no consensus at that time among the companies on how to reserve for such options. The Report discussed several approaches to reserving, but concluded that it was unable to recommend a single approach. This paper is an attempt to fill that gap.

We investigate two approaches to reserving and pricing. In the first sections of the paper we consider quantile, and conditional tail expectation, reserves. The methodology we adopt here is very close to that proposed by the Maturity Guarantees Working Party in its Report to the profession (Ford et al., 1980). We show how these policies could have been reserved for in 1985, and what would have been the outcome of using the proposed method.

In a later section we consider the feasibility of using option pricing methodology to dynamically hedge a guaranteed annuity option. It is shown that this is possible within the context of the model we propose, but we submit that, in practical terms, dynamic hedging is not a complete solution to the problem since suitable tradeable assets do not in practice exist.

Finally, we describe several enhancements to our models and methodology, which would make them even more realistic, though generally they would have the effect of increasing the required contingency reserves

The approaches to liability valuation, assessment of prudential capital and measurement of profit for life offices are undergoing radical change. A common thread runs through all of these proposed changes — each change represents a move away from traditional actuarial approaches towards a more economically coherent, market-consistent approach. These changes should encourage a general improvement in the life industry's risk management processes. However, they will come at a cost. The measurement of the economic risks generated by the complex guarantees written by life offices is far more difficult than applying the latest resilience test equity fall. This will require a step change in the sophistication of life offices' risk and capital measurement and management know-how. The measurement of value, risk and capital will soon demand the application of ‘stochastic’ modelling tools. In this paper, we explore some of the issues raised by the application of these approaches to the valuation and risk management of with-profits business.

The International Accounting Standards Board is undertaking a project to develop an Accounting Standard for Insurance. The basis for these proposals is that assets and liabilities should be shown at fair values (market values for quoted instruments). This is an updated version of a paper, prepared by a Working Party established by the General Insurance Research Organisation (GIRO) of the General Insurance Board of the actuarial profession of the United Kingdom, which was first presented to the GIRO Conference in October 2002. This paper summarises and comments upon the principal features of the proposals as they have emerged up to February 2003. The paper considers the implications for general insurance companies of these proposals. In particular, it examines the concept of market value margins, and the practical issues that insurance companies are likely to encounter in implementing them. The emphasis of the paper is on reporting for general insurance business, although many of the principles apply equally to life assurance.

The text of the Presidential Address is printed in this part of British Actuarial Journal on pages 1-33.

The paper introduces a setting in which each business in an economy faces considerable uncertainty about the cost of providing its service and therefore needs risk capital to give consumers confidence in its solvency. The paper then explores the operation of the capital market under conditions where businesses charge for this service dependability by setting an entity specific profit margin.

This entity specific profit margin is associated with an optimal, arbitrage-free investment portfolio for investors and, as they optimise their portfolios, generates a market equilibrium. Under these conditions it is shown that the entity specific risk premium for investors is the same as the premium for non-diversifiable risk relative to the market portfolio. This reconciles an entity specific approach with the capital asset pricing model, and in this setting would allow the use of the former without having to explicitly take the latter into consideration.

A consequence of this is that entity specific pricing and valuation are fair in such an setting and, for example, the fair value accounting of insurance liabilities can be performed on an entity specific basis.

Rapid developments in genetic science have been accompanied by confusion regarding the predictive power of DNA-based tests and in the impact of such tests on the insurance industry. The United Kingdom actuarial profession has begun to engage in the associated social policy issues and to try to throw some light on the issues through quantitative research and objective analysis. At the same time, many insurance industry actuaries have been involved in work on behalf of the insurance industry to develop a sound basis for permission to be sought to make use of the results of certain predictive genetic tests. This paper briefly outlines some of the history of the development of the debate in the U.K. and draws together some of the debates and discussions which have taken place within the Genetics Group of the Social Policy Board of the U.K. actuarial profession, as well as providing some pointers to the directions which the debate might take in the future, with some important potential consequences for the insurance industry and for actuaries.

The paper highlights the role of risk budgeting — how risk is ‘spent’ — in the investment management process and some of the practical issues encountered. Risk budgeting has received a great deal of interest from the investment management community recently, but no clear consensus has emerged on how it should be implemented. In this paper we outline a pragmatic risk budgeting method that can be applied at the portfolio level, and show that it can produce superior results when used in conjunction with cluster analysis techniques. There are practical implications for chief investment officers and chief executive officers on how they allocate human resources and capital in the investment management process.

A statistical factor model for stock returns is used to build a risk model of the market that separates the factor components (representing the market, investment themes and styles) and the stock specific component. Then cluster analysis techniques provide a visualisation of the changing risk structure of the market. Natural groupings of stocks emerge within the market often different to the classical industrial classification systems widely used today. These natural groupings clearly change over time reflecting the changing nature of equity markets, e.g. these techniques show very clearly the emergence of the telecommunications, media, technology phenomenon in the late 1990s and its subsequent demise in early 2001.

Using the framework of a statistical factor model, risk budgets can be aggregated or dis-aggregated. Aggregation can be to country, sector or any other group. Dis-aggregation will be to common factors (e.g. the market, growth, value and other styles) and stock specific factors, derived from a multi-factor model.

Traditional and standard discounted cash flow valuation techniques are unable to deal with a variety of options contained in lease contracts. In the United Kingdom the most important embedded option is the upward-only rent review. This becomes more valuable to the landlord in an era of low demand and low inflation, as nominal market rents are more likely to fall. Lease contracts are freely negotiated between landlord and tenant, and alternative forms of rent review clause would fundamentally change the investment characteristics of property. Many other less common options also exist in lease contracts and these create further valuation difficulties. It is essential that property valuation techniques be developed that explicitly value the options in lease contracts.

The United Kingdom life industry is going through a period of unprecedented change and challenge. This is set to continue, driven, among other things, by economic conditions, market forces, regulatory change and new accounting standards.

The profession has an important role to play in helping the industry to respond to these challenges, and ensuring its future success. This meeting is a chance to meet and discuss these issues and explore what we, as actuaries, can do.