Actuary

An actuary is a business professional who deals with the measurement and management of risk and uncertainty. Think of them as the mathematical wizards of the financial world, using statistics, financial theory, and probability to forecast the financial impact of future events. While their skills are used in various fields, they are the bedrock of the insurance and pension plan industries. For an insurance company, an actuary's job is to calculate the likelihood of a car crash, a hurricane, or a person's lifespan, and then translate that risk into a price—the premium you pay for your policy. They also determine how much money the company must keep in the bank to pay out future claims, a critical pool of money called reserves. For a value investor, understanding what an actuary does is not just academic; it’s essential for analyzing one of Warren Buffett’s favorite hunting grounds: insurance companies.

Value investing is about understanding a business inside and out, and for an insurer, the actuary is the chief engineer of the profit engine. Insurance companies are unique because they receive cash upfront (premiums) and promise to pay out later (claims). This creates a large pool of money called float, which the insurer can invest for its own profit. The genius of this model, however, hinges entirely on sound actuarial work. If an actuary sets premiums too low, the company won't collect enough money to cover future claims, leading to underwriting losses. If they underestimate the reserves needed, the company might look profitable today but face a catastrophic shortfall tomorrow when the bills come due. A great insurance company, the kind value investors seek, is built on a foundation of conservative and skilled actuarial practice. It’s the difference between a money-printing machine and a ticking time bomb.

Actuaries don't use a crystal ball, but their tools are just as focused on predicting the future. Their discipline, actuarial science, is a blend of rigorous mathematics and practical business judgment.

At its core, an actuary’s work is to build models that predict the frequency and severity of future events. They analyze vast amounts of historical data to find patterns. For a life insurer, this involves using mortality tables to estimate how long people will live. For a property and casualty insurer, it means studying decades of data on car accidents, workplace injuries, or natural disasters. The “art” comes in adjusting these historical models for new trends—like the effects of climate change on hurricanes or advancements in medicine on lifespans. Their predictions are the foundation upon which the entire insurance business is built.

The actuary's predictions are channeled into two critical functions:

• Pricing Premiums: This is the offensive part of the job. Based on the expected cost of future claims, the actuary calculates a premium that is high enough to cover those claims, pay for the company’s operating expenses (like salaries and marketing), and, ideally, leave a profit. This is the essence of profitable underwriting.
• Setting Reserves: This is the defensive part. The actuary estimates the total cost of claims for events that have already happened but haven't been fully paid yet. This includes claims that have been reported but not settled, and even claims that have occurred but have not yet been reported to the company (known as IBNR, or Incurred But Not Reported). These estimates form the loss reserves on the company's balance sheet. Conservative reserving is a hallmark of a well-managed insurer.

You don't need to be an actuary to invest in an insurance company, but you do need to know what to look for. Think of yourself as a detective looking for clues about the quality of a company’s actuarial work.

When you pick up an insurer's annual report, you can find evidence of their actuarial discipline.

1. Check the Ratios: Look at the loss ratio and the combined ratio over a long period (5-10 years). A consistently profitable and stable ratio suggests the actuaries are pricing risk correctly. Wild swings might indicate they are chasing market share with risky, underpriced policies.
2. Watch Reserve Development: This is a crucial test. The annual report will have a table showing how the reserves set in previous years have developed. If a company consistently has to increase its prior-year reserves (known as reserve strengthening), it's a major red flag. It means their initial estimates were too low. Conversely, if a company regularly releases old reserves because claims were lower than expected (reserve release), it's often a sign of prudent, conservative management.
3. Read Management's Commentary: Pay close attention to how management discusses its underwriting and reserving philosophy. Do they emphasize discipline and profitability over growth at any cost? Their words can reveal a lot about the company's culture.