Jun 13, 2015

Professional Empathy of an Actuary

The most important hard skill in any profession is a soft skill called Empathy.
Without empathy, any project or business goal is doomed to fail.

Just a small humorous illustration to get the picture....

Adding Rabbits

One day, the math teacher asks six year old Johnny, "If you have 200 rabbits and you add another 100 rabbits, how many rabbits would you have?"

Johnny thinks for a moment and then answers: "I think the answer is 337 Sir".

"No, Johnny. That's the wrong answer. Try again.

Johnny takes another five seconds and answers: "Still probably 337 Sir" "

Now the math teacher slightly loses his temper and baffles: "No Johnny, wrong again. You know nothing about mathematics!".

Immediately Johnny answers: "And you know nothing about rabbits Sir"

Actuarial Skills
A recent (May 2015) Investopedia article sums up the five skills every actuary needs
  1. Analytical Problem Solving Skills 
  2. Math and Numeracy Skills 
  3. Computer Skills 
  4. Knowledge of Business and Finance 
  5. Communication and Interpersonal Skills
Although in a classical sense this powerful summary of an actuary's professional competences is perfectly in line wit more detailed descriptions as given by several actuarial associations, something essential is missing.

To be successful as an an actuary you'll need to develop what is called

Professional Empathy

What is Professional Empathy?
Professional empathy is the ability to see the world through the eyes of other professionals.

As actuaries we're trained to view and resolve our projects, challenges and issues in a primarily quantitative manner with the help of actuarial techniques, models and formulas.

Through study and experience we can develop "Professional Empathy" that allows us to look through the eyes of other professionals or clients and feel and understand what their view and perceptions are.
In doing so, we're able to optimize our advice, support or project performance.

Understanding and response
Professional empathy implies two elements: understanding and response.

To understand other professionals and clients, we need to develop the ability to be sensitive to the needs and feelings of others. To do so, it helps to develop technical skills in other professional fields, read other than just actuarial literature and join other than pure actuarial conferences.

As graduated actuaries we already developed a broad multi-professional basis that includes professional areas as: mathematics, statistics, finance, insurance, asset management, pricing, administration, business analytics, ict, organization, marketing, etc. Therefore, if we continue to develop this multi-professional ability, we - as actuaries - are are ideally suited to organize combined professional expertise (innovation) projects.

Besides the traditional actuarial areas as insurance, pensions, statistics, and actuarial techniques we'll have to focus and develop skills in the surrounding areas of the actuarial work field:

In order to understand we need to develop the ability to read verbal, paralinguistic and non verbal cues of professionals in other professional fields.

Secondly, our response and attitude to other professional should be in such a way that other professionals recognize that we understand them, appreciate that we speak their (professional) language and invite us to share their professional issues or doubts with us.

Interpersonal communication skills 
This way of responding requires to bring out a professional attitude that's based on interpersonal communication skills like:
  1. showing interest, respect and appreciation
  2. active listening
  3. showing understanding, being accessible, 
  4. having a flexible attitude 
  5. operate steady on basis of ethical principals.

Intrapersonal skills
It also forces us actuaries to continuously work on our intrapersonal skills like: 
  1. Knowing what drives, angers, motivates, frustrates, inspires you
  2. Knowing your own strengths and limitations
  3. The ability to stay calm and balanced in stressful situations
  4. Self confidence

How to start with Professional Empathy?
You can start with developing your professional Empathy as follows:
  1. simply pick out one of the communication issues as mentioned above (e.g. 'active listening')
  2. After a conversation with a trusted professional you work with, simply ask for honest feedback by asking for example: "I try to develop a more active listening style. May I ask you: Do you think I really listened to your arguments. If so, in what way? If not, 'why' and 'when' not? What would you have expected of me?

If it seems difficult for you to ask these questions, congratulations! You now know for sure this approach is applicable to you.

If you think it makes no sense to ask these questions once in a while. Just keep doing what you always did until the final reality check!

SOA Self Assessment
The Society of Actuaries has developed a Competency Framework Self-Assessment Tool. The self-assessment asks you to rate a series of statements about the skills that actuaries should have to be valued for their professionalism, technical expertise and business acumen.

It's a 45 minute test that gives first impression of you improvement areas. However, interpersonal en intrapersonal skills are only limited measured.........

May 14, 2015

Risk Management Ground Rule

Risk Management is a awkward and hard to grasp discipline. Not only in boardrooms, but also in the practice of our professional risk management discipline.

Once you think you've captured risk management, it captures you...... again and again...

By definition risk management is a paradox.

Once you fully 'control' and 'manage' a certain risk, it's no longer really a 'risk' in the sense that it can surprise you.

However..., did you check and do you manage the following risks?

Meta Risk Management Risks

  1. Risk Framework Risk
    All (regulatory) rules and principles you apply in risk management are filters that cause new risks. Therefore every kind of risk management framework is also a source of risk and should be part of your risk management framework.
    Have you identified weak spots in your risk management framework?
  2. Risk Measures Risk
    Every risk measure taken, causes a new risk.
    Have you identified what the risks of risk management measures are?
  3. Model Risk
    All models you use in risk management are dangerous and risky approximations.
    Therefore, always use at least a second 'Challenger Model' to fully understand, check, calibrate and control your risks and risk measures.
    Do you have at least one challenger risk model in place?
  4. Unknown Risk Preparedness
    In the heart of the matter 'managing risk' is not primarily  'risk management'. Preparing for unknown risks is what risk management is really about.
    Do you have a procedure in place for managing unknown risk events?

Congratulations if you have successfully passed the above Meta Risk Management Test.

Ground Rule
Yet, there's still one risk management  ground rule you could have violated.... Denying this ground rule is the same as the ground rule itself!

Never classify any event or reported risk as not relevant  


A. Example Challenger
One of the most classic examples of violating this ground rule is the disaster of the space-shuttle Challenger back in 1986. Engineer reports about the failing two rubber O-rings that caused the accident, where denied by management.

Just recently we can observe another possible example of violation.

B. Stress Test  
On 11 may 2015 the supervisory authority EIOPA launched its first 'stress test' for European pension funds (IORPs;Institutions for Occupational Retirement Provision).

Now take a look at the initial response of a spokesman of the Dutch pension fund association (Source: IPE; translated):

  1. Not happy
    The Dutch pension sector is not happy with a stress test for pension funds, as issued by the European regulator EIOPA.
  2. Unnecessary
    According to the Pension Federation the test is 'not necessary' for Dutch pension funds and the test could lead to "unnecessary European rules'. The test is just a burden for the funds. A waste of their time. Besides the Pension Federation fears that the results lead to all kinds of EU rules which do not require in the Netherlands. We must be careful that there will not draw the wrong conclusions.
  3. Dutch Pension funds cannot Topple
    From a Dutch perspective, the test unnecessary, because Dutch funds cannot topple by what is regulated here in The Netherlands. 

It's clear that this kind of reactions are counterproductive and violate the ground rule of risk management.

To put it in a different way: Perhaps Dutch pension funds cannot topple, but they sure can collapse!

As experts in risk management we're all confident that we can identify, understand and manage risks. Unfortunately, nothing less is true...
We all have our blank space.......

Apr 6, 2015

Indecisiveness: the Risk of Risk

Behavioral Economic Stress Testing at Symetrics, a FinTech50 company that keeps me on the flow of life, kept me from blogging last months. Nevertheless, here's a new blog to chew on.....

Low Interest Rates
In traditional investment models, low and even negative interest rates are seen as simple stochastic outcomes, that eventually converge to the mean of the historical data as time progresses.

The well-known answer to the question "how long will interest rates stay low?" is mostly: don't worry, interest rates will rise again!

In our long term investment models the output equals the input. If we 'believe' that the average interest rate is 5%, than on the long term that's where we we'll be at....
At least, in our model, certainly not in reality.
Unfortunately, there is no such thing as 'mean reversion'. The reason why interest rates got down, is due to monetary, regulatory and economic drivers, that will keep and push interest rates down, as long as there's no substantial debt relief in combination with real (not paper-financed!) economic growth.

In a world with extreme low and even negative interest rates, financial (long term saving) institutions have no future. Based on one year default probabilities, traditional regulatory frameworks eventually force those long term guarantee institutions (e.g. mortgage banks, life-insurers and pension funds) to derisk their balance sheets and raise the price of their products. However, consumers are prepared to make a risk-return assessment on different grounds and are no longer willing to pay the price for risk.

Let's illustrate this risk-return dilemma with a simplified practical example in a (unlikely?) long low interest world.

We consider the following portfolio investment case:
  1. Bonds (US) with average return of 1% and a standard deviation of 4%
  2. Stocks (S&P 500) with an average 8% return and 16% standard deviation

Next, we take a look at the Efficient Frontiers of the asset-mix combinations of Bonds and Stocks:

To prevent endless discussions we simply compare two possible portfolio investment strategies:
  1. Portfolio A: 80% Bonds & 20% Stocks
  2. Portfolio B: 20% Bonds & 80% Stocks
Obviously Portfolio A (PF-A) with an annual expected return of 2.4% and a (non-correlated) risk of 4.6%  looks less risky than PF-B. On the other hand PF-B with an expected 6.6% return and a (non-correlated) risk of around 13% looks promising on the long run. What to do? What is more or less risky?

The Risk of Risk
What is more risky, also depends on the risk premium. One traditional way to judge the pay out on risk, is to compare the 'Sharpe ratios' of the two portfolios. Major problem is to determine the appropriate 'risk free interest rate level', as the risk free rate is risky (volatile) itself and declining on average the last years.

So in fact we have to judge:

The Risk of Risk

To get an impression of the risk of risk free interest rates, we calculate the Sharpe ratios of the efficient frontiers.

Here are the outcomes:

The above charts illustrate that at nearly every (0% - 3%) free risk interest rate, Sharpe ratios of PF-A are lower or somewhat equal to those of PF-B. Only in the case that Bonds are clearly negatively correlated with Stocks at a 0% or 1% risk free interest level, a PF-A strategy is less risky than PF-B.

As in 'normal' crisis situations most asset-classes (excluding Gold of course...) tend to be extremely positively correlated, PF-B is - also in this case - the preferred strategy. In other situations, the Bonds-Stocks correlation only changes incrementally, so your portfolio asset-mix can be adapted timely. There's no need for anticipation.

Another remark is that in case of an 0% risk free interest rate and an expected neutral to positive correlation between Bonds and Stocks, the Sharpe ratio values all converge between 0.4 and 0.5.
This implies that a clear criterion for taking an underpinned investment decision is absent. Investors become indecisive and that's just the situation we're in mid 2015, where all we seem to have are 

Investment Beliefs

Wrap up:

Return Analysis
On top of, it's interesting to analyse how PF-B makes its return as opposite to PF-B.
Without further comments, I'll give some illustrations. Make your own analysis with help of the Excel spreadsheet.

As expected the PF-B performs better in the [9%,∞] segment. PF-A gets its returns in the [0%,9%] segment and quite surprisingly PF-B performs better in the [-5.25,0%] segment.....

All this reasoning leads to a kind of 'informed decision' conclusion that in the current economic situation PF-B would be the best (preferred) strategy. However, there's another question to be answered....

Key question with regard to PF-B:

Can you absorb the extra yearly volatility? 

In 'normal'' regulatory frameworks, like Basel-III, Solvency-II and the upcoming 'Holistic Balance Sheet' for pension funds, the answer will mostly be:


One of the big issues in all of these frameworks is that risk and solvency margins are defined on basis of a one year default probability. This leaves no room to absorb one year standard asset deviations of around 12%. A commonly used solution is to 'hedge' these risks 'away'. However, hedging has its price and introduces new (collateral, clearing, systemic) risks. Hedging 'one deep' could perhaps be a solution, but as the market changes, soon you'll be 

Hedged to Hedging...

A better approach than hedging or the alternative of deleveraging balance sheets, would be to adapt and redesign our regulatory frameworks to the long term scope of financial institutions. This could be done by stretching the 'one year default criterion' to an 'n-year default criterion', where "n" is in line with a financial institution's ability to timely readjust company's liabilities and assets.

For a mortgage bank, a life insurer, "n" could in the order of 5 years. In case of a pension fund, "n" could vary between 5 and 10 years.

In this approach, the current different 'one year default probabilities'

Financial Institution Default Probability
Banks 99.90%
Insurers 99.50%
Pension Funds (Dutch) 97.50%

could be replaced by one uniform default probabilities of (say) 99.9% for n-years.

Here's the wrap up outcome for a 5 year average:

Notice that the expected average 5-year risk (standard deviation) has declined from 12.8% to 5.7% (= 12.8/ (√ 5)). This would roughly (rule of thumb) reduce capital requirements to a level of 19% (=5.7*3.27) of the balance sheet net-total, which is of course still substantial.

Low interest rates force financial institutions and regulators to rethink and redesign their business model.

Regulatory default rates have to be uniformed and the regulatory (EIOPA) system of 'one year default rates' has to be extended to a 'n-year default approach', where "n" is in line with a financial institution's ability to timely readjust company's liabilities, assets and capital.

After all these technical adjustments, also our investment models and methods have to be redesigned. Models, like demonstrated in this blog, that only rely on past observations are too limited for sound investment analysis.

Traditional investment models cannot cope with current market conditions and lead to indecisiveness or the next best alternative : 'Investment Beliefs'.

We have to develop models where we can risk risk...

How can we build more expressive models? Well, that's something for my next blog.....

Until then.... Keep believing...

- Excel Spreadsheet Risk Analysis Portfolios