Actuaries

Actuaries are the financial world's professional risk assessors. Think of them as mathematicians with a crystal ball, but instead of seeing the future, they use powerful statistical models to calculate its probability. Their primary job is to analyze the financial costs of risk and uncertainty. They use statistics, mathematics, and financial theory to study uncertain future events, especially those of concern to insurance and pension programs. For an insurance company, an actuary calculates the likelihood of a car crash, a house fire, or a person living to 100, and then helps set the premium you pay. For a company pension, they figure out how much money needs to be invested today to cover retirement promises made to employees decades from now. They are the unsung heroes (or potential villains, if they get their math wrong) behind the financial stability of some of the largest companies in the world. For investors, understanding their role is key to peeling back the layers of a company's financial health, especially in the insurance and banking sectors.

At its heart, an actuary's job is to price risk. They are the ultimate oddsmakers for life's most significant events. They don't guess; they calculate. Using vast datasets and sophisticated models, they build a picture of the future to help businesses prepare for it financially. Their toolkit includes some fascinating instruments:

  • Mortality Tables: Statistical charts that show the death rates for a population at different ages. Essential for pricing life insurance.
  • Morbidity Tables: Similar to mortality tables, but these track the incidence rates of sickness and injury. Crucial for health and disability insurance.
  • Compound Interest: The magic of finance. Actuaries use it to determine how much money needs to be set aside today to grow into a much larger sum needed to pay future claims.

While most famous for their work in insurance and pensions, actuaries are increasingly found in all corners of finance, helping banks and investment firms manage their complex risks.

For a value investor, who treats buying a stock as buying a piece of a business, understanding the role of actuaries is not optional—it's essential. This is especially true when analyzing two specific areas.

There's a reason investment legends like Warren Buffett love the insurance business. At Berkshire Hathaway, he has masterfully used the “float.” The insurance float is the cash collected from premiums that has not yet been paid out in claims. An insurer can invest this float for its own profit. The best insurance companies generate this float at a low cost or even a profit. This is where actuaries come in. Their skill in calculating risks and setting premiums determines the quality of an insurer's underwriting.

  • Good actuaries: Lead to profitable underwriting. The company collects more in premiums than it pays in claims and expenses, meaning they get paid to hold and invest the float. This is an investor's dream.
  • Poor actuaries: Underprice risk, leading to underwriting losses. The company pays out more than it collects, turning the “magical” float into a very expensive loan. This can quickly sink a company.

When you analyze an insurer, you are, in effect, placing a bet on the competence and integrity of its actuarial department.

Many older, established companies have a huge liability that can be tricky to spot: their pension plan. These are promises to pay retirees for the rest of their lives. An actuary's job is to estimate the total size of this promise and tell the company how much to save for it each year. The problem is, these calculations are built on assumptions about the future. A slight tweak to an assumption—like expecting higher investment returns or assuming employees will retire later—can make a massive pension deficit look smaller, or even disappear from the balance sheet. This makes the company's earnings look better than they truly are. A savvy investor knows to read the footnotes of an annual report to check the actuarial assumptions. An overly optimistic pension calculation is a major red flag, as it can be a financial time bomb waiting to explode and destroy shareholder value. It's a classic threat to your margin of safety.

Actuarial science is as much art as it is science. While the math is rigorous, the inputs are often educated guesses about a very uncertain future. The integrity of an actuary's entire calculation rests on the reasonableness of their assumptions. Key assumptions include:

  • Interest Rates: A critical assumption. Higher expected interest rates make future liabilities seem smaller in today's money (a lower present value), making a company look healthier than it might be.
  • Longevity: How long will a group of 65-year-olds live? Underestimating this can be catastrophic for a company paying a lifetime pension or annuity.
  • Claim Frequency & Severity: How many hurricanes will hit the coast next year? How bad will they be? For a property insurer, getting this wrong is a nightmare.

As an investor, you don't need to be an actuary. But you do need to be a skeptic. When you see a company whose assumptions look rosier than its competitors or reality, you should ask why. Often, the answer lies in a management team trying to paint a prettier picture, and that's a business you may want to avoid.