The LF method utilizes the Central Limit Theorem, and assumes that withdrawal frequency and severity are independent, and that withdrawals are mutually independent. RCL believes that these assumptions are reasonable for this study, and that investors’ regular review of their financial plans and product performance with their financial advisor tend to mitigate the potential dependency effects of systematic withdrawal programs from year to year.

The LF method ascribes full credibility when the number of withdrawals is such that, with a high degree of probability, the actual total withdrawals should fall within a narrow confidence interval around the expected total withdrawals. The number of withdrawals is a natural choice for this purpose, as it implicitly reflects key factors that intuitively affect credibility – both credibility and the number of withdrawals tend to increase when exposure increases and when withdrawal frequency increases.

To read more, please refer to the complete white paper contained in the pdf document below.

Limited Fluctuation Credibility and Variable Annuity Benefit Utilization Study

Estimate = Z * [Mean of current observation] + (1-Z) * [Prior mean],

where 0<=Z<=1.

Z is the credibility ascribed to the mean of the current observation.  The prior mean may be based on prior observed data or some type of benchmark.  The question is – how do we determine Z?

Three approaches are commonly used:

• Under the Limited Fluctuation (LF) approach, also referred to as classical credibility or American credibility, it is assumed that the current observation of data includes independent trials and that the Central Limit Theorem holds.  In order to limit the effect that random fluctuations may have on the estimate, a confidence interval approach is used to determine how much data is required in the current observation in order to assign full credibility (i.e. Z=1), and how partial credibility (i.e. Z<1) should be calculated with smaller amounts of data.

• With the Greatest Accuracy approach, also referred to as Bühlmann’s approach or least squares credibility, the objective is to minimize the square of the error between the estimate and the true expected value of the quantity being estimated.  The credibility Z increases asymptotically toward 1 as the amount of data in the current observation increases, but also depends on an analysis of variance – how is the total variance comprised between the expected value of the underlying process variance and the variance of the hypothetical means?  As the former increases, Z decreases, but as the latter increases, Z increases.

• Bayesian Analysis utilizes Bayes’ Theorem, conditional probabilities, and distribution hypotheses to develop the estimate.  It can be shown that estimates using the Greatest Accuracy approach provide the best “least squares fit” to Bayesian estimates.

Each credibility approach includes subjective elements, and the actuary is often free to choose the approach that he or she deems appropriate for the situation and data.  Key considerations include the existence or reliability of the prior mean, the reliability of distribution hypotheses, the desired accuracy of the estimate both in overall terms and with respect to sub-classifications, regulatory or industry conventions, computational convenience, and ease of communication to technical and non-technical audiences.

In our recent work with VA industry studies, we have found that the LF approach provides a reasonable balance of technical sophistication, computational convenience, and ease of communication.  Importantly, we have also found that with appropriate choice of parameters, the LF approach produces results that are reasonably consistent with our intuition and that of our clients.  We believe that these attributes are particularly important in this type of situation, where we are trying to use the current observation to develop highly credible industry benchmarks where none existed before.

Hence, we view the LF approach as a natural starting point, and we will likely continue to use it in our ongoing VA industry studies, but this does not preclude further refinement or utilization of other credibility approaches as circumstances warrant.  In the next article, we will share details about how we have applied the LF approach to our VA industry studies.

At RCL, we have been particularly mindful of credibility during the course of our VA industry studies, starting with our mortality study in 2007, our surrender study in 2008, and continuing with our benefit utilization study (in progress) in 2009. We believe that credibility theory has an important part to play in studies such as these, and in subsequent articles we will describe the considerations and approaches we used in applying credibility theory to our work.