Techniques for Taming Model Risk

By Bill Cember, Scott Houghton and Dylan Strother

By the end of 2022, many major accounting regimes commonly used by actuaries will have significantly changed. Most of these changes are material and will increase the complexity of models needed to calculate actuarial-related balances. New regimes like Principle-Based Reserving (PBR), GAAP LDTI, and IFRS 17 require detailed cash flow projection models, often with multiple assumptions sets that need to be updated frequently, increasing model complexity and risk.

As actuaries begin to use more complex models, it’s not enough just to have the right risk governance in place. The right infrastructure will also help reduce risk by making models easier to maintain and manage. The following techniques will help build a reliable infrastructure and increase model management:

  • Modular design
  • Model consolidation
  • Model documentation
  • Modeling roles & model change management

BUT AREN’T OUR MODELS ALREADY REALLY COMPLICATED?

For products like variable annuities, this type of modeling
and the associated model risk has been part of reserve calculations
for years, and models supporting these products
are the focus of the existing model governance framework. For
many other products, especially traditional life, and health
products, reserve calculations have traditionally been classified as low-risk models,
as the calculations are generally formulaic, and assumptions are prescribed or locked in. While more complex models for these products typically exist within insurance companies, they are generally used for applications such as pricing, forecasting, and pass-fail type tests such as cash flow testing or loss recognition testing. Using more complex models to calculate reserves directly extends the model risk inherent in these models to the financial statements.

MODULAR DESIGN

Actuarial models are made of many parts. There are inputs, such as liability enforce extracts, asset investment accounting extracts, scenario data, and assumptions. Once the model has its inputs, the next step is coding the methodology for calculations such as reserve calculations, cash flow projections, and capital calculations and projections. A model run processes these inputs and calculation methodologies and produces outputs, which are then taken by an end-user or utilized as input by another model (See Table 1).

Designing models as a set of model components, also known as modular design, offers several advantages:

  • Reusability: Components can be reused across models and can be developed and tested once rather than multiple times.
  • Change Management: Management of models is easier when model components are modular. Having distinct and well-defined components streamline development and testing, allowing model changes to be done once and then leveraged in multiple ways.
  • Model Releases: It’s easier to show progress to users of the model when they are designed out of smaller components, which can be changed and released more quickly. More frequent releases allow the user of the model to more quickly use it and provide feedback and also decrease the probability of projects going over time and over budget. As an example, Figure 1 contains modules needed for a cash flow testing model. A model needed for VM20 deterministic/ stochastic projections may use the same modules (with different assumptions) but not require a formulaic reserve projection. In addition to the advantages listed above, modular design can increase the ability to consolidate, document, and manage changes within models.MODEL CONSOLIDATION
    Using components across models leads to the idea of model consolidation. While it’s tempting to consolidate models as much as possible—after all, who doesn’t want to minimize work

and maximize sharing?—there can be challenges with sharing components. These are summarized in Table 2 (Pg. 11).

MODEL DOCUMENTATION
Documentation is a very effective tool to manage risk from models as not all team members are involved with the technical aspects of a model. Model documentation helps stakeholders and other business partners understand what the model does, what it doesn’t do, and what the input, output, and calculations are.

Key items to include in model documentation are shown in Table 3 (Pg. 11).

In addition to items in the Model Documentation chart, it is also helpful to have a “Day 2 list” of potential future improvements to the model. What goes on this list? Everything that someone might want that isn’t there now. This list can include:

• Functionality desired at the time the model was built that is not currently present, perhaps due to complexity or software limitations

• New business requirements due to new regulations and new products

• New experience studies to improve model assumptions

• New and improved data elements and data feeds

• Approximations that are in the model now that could be removed

Designing models as a set of model components, also known as modular design, offers several advantages:

  • Reusability: Components can be reused across models and can be developed and tested once rather than multiple times.
  • Change Management: Management of models is easier when model components are modular. Having distinct and well-defined components streamlines development and testing, allowing model changes to be done once and then leveraged in multiple ways.
  • Model Releases: It’s easier to show progress to users of the model when they are designed out of smaller components, which can be changed and released more quickly. More fre- quent releases allow the user of the model to more quickly use it and provide feedback and also decrease the probability of projects going overtime and over budget.As an example, Figure 1 contains modules needed for a cash flow testing model. A model needed for VM20 deterministic/ stochastic projections may use the same modules (with different assumptions) but not require a formulaic reserve projection.In addition to the advantages listed above, modular design can increase the ability to consolidate, document and manage changes within models.

    MODEL CONSOLIDATION
    Using components across models leads to the idea of model consolidation. While it’s tempting to consolidate models as much as possible—after all, who doesn’t want to minimize work

and maximize sharing?—there can be challenges with sharing components. These are summarized in Table 2 (Pg. 11).

MODEL DOCUMENTATION
Documentation is a very effective tool to manage risk from models as not all team members are involved with the technical aspects of a model. Model documentation helps stakeholders and other business partners understand what the model does, what it doesn’t do, and what the input, output and calculations are.

Key items to include in model documentation are shown in Table 3 (Pg. 11).

In addition to items in the Model Documentation chart, it is also helpful to have a “Day 2 list” of potential future improve- ments to the model. What goes on this list? Everything that someone might want that isn’t there now. This list can include:

• Functionality desired at the time the model was built that is not currently present, perhaps due to complexity or soft- ware limitations

• New business requirements due to new regulations and new products

• New experience studies to improve model assumptions

• New and improved data elements and data feeds

• Approximations that are in the model now that could be removed

Figure 1
Example Cash Flow Testing Model as Viewed as a Set of Components

 

 

 

 

 

 

 

 

Table 2
Advantages and Disadvantages of Sharing Model Components

Table 3
Model Documentation—Key Items

MY DAY 2 LIST IS AN EXCEL FILE ...

The Day 2 list is a helpful tool to set priorities at a company level, not the level of a single stakeholder—it ensures the company’s priorities for the model are set correctly.

To help ensure there is a single source of truth—i.e., one Day 2 list—enterprise project management software such as Jira or Trello are much better tools than multiple Excel files being emailed back and forth.

MODELING ROLES AND MODEL CHANGE MANAGEMENT

Model development, including design, documentation, and consolidation, takes a lot of effort. It is not practical for a single actuary to design, implement, and validate a model. Generally, a model development and maintenance process involves roles borrowed from IT application development. Roles can include:

  • Developer—Responsible for coding the model according to specifications
  • Tester—Unique from the developer and responsible for testing model development
  • User—Specifies model requirements and uses model results
  • Steward—Responsible for governance and change management of the model many actuaries may be working on a model at a given time, which can make the model steward function challenging. Many IT application developers use programs such as GitHub and Subversion to manage changes made to source code. These programs allow control and documentation over the model development process to help reduce model risk. For example, a developer or tester can check out a copy of the code, simultaneously make changes or perform testing, and check the model in

with documentation. The management section of the program allows the model steward to review sequential changes to the model and assess whether the proper change management steps were followed and then decide whether to accept changes into a master version.

This type of change management functionality is starting to gain traction in the actuarial world but has not yet gained widespread adoption. Actuaries can learn from tools typically used in IT settings and advocate for the integration of similar tools to their model development process.

CONCLUSION
In this article, we walked through techniques that can help manage model risk and complexity. As regulatory change increases the complexity of our models, utilizing best practices and tools from software development such as modular design and software-assisted change management reduces the risk of making complicated changes to our model. Our models don’t have to take us to the moon (at least not yet)—but let’s build them as if they should. ■

bill-cember-headshot

Bill Cember, FSA, MAAA, is a director and actuary at Prudential. He can be reached at william.cember@ prudential.com

scott-headshot

Scott Houghton is a vice president at Valani Global. He can be reached at shoughton@valaniglobal.com.

dylan-strother

Dylan Strother is a senior consultant at the Actuarial Practice of Oliver Wyman. He can be reached at dylan.strother@oliverwyman.com.