2011: Happy Risk Year!

Life is full of Risk..  We can not deny or totally exclude risk. Have you ever thought about living a (professional) life without taking any risk? What kind of life would that be?

There's this great actuarial risk quote of the famous economist John Maynard Keynes that states:

On the long run, we are all dead.....

So if you want some 'return' in life, you might as well take 'somewhat' risk before you 'certainly' die.

A nice illustration of total risk aversion is the 2004 movie "Along came Polly" were Reuben Feffer (actor Ben Stiller) is an actuary who, since his job involves analyzing risk for insurance purposes, likes living life in complete safety and free from any unnecessary risk.

This movie urges to ask yourself a simple question:

What's the risk of a riskless life?

Living life without risk if for dummies! Optimize the risk-return in your life.

Risk Guidelines

At the end of 2010 some simple Maggid 'Risk Guidelines' for 2011:

1. As long as there are no risks that'll kill you on the 'middle' or 'short' term: Take risk if you like the return outlook.
   
   
2. Think about how much bad luck or suffering you're willing to accept for a desired return.  Key question here is:
   Why does a marathon runner punish his body every day for weeks on end for an individual race?
   
   
3. Take a small risk every day! Invest small 'good things to do' by helping others without expecting a return. Soon you'll harvest some of your sowed investment seeds.....

Riskless Investment
Remember..., the only one riskless investment in life is.....

YOU

Anyhow, make 2011 a happy and healthy risk year!

Related Links:
- "Watch the movie 'Along came Polly' online !
- Learning about Risk and Return: A Simple Model of Bubbles and Crashes 

Discounting the future

Actually, who are we actuaries to pretend that we can discount the future? Who's able to predict the future 50 years or more ahead in case of a pension fund?  No, we're not crystal ball discounters, we're risk managers 'pure sang'. And as discounting risk managers we're pretty sure about two things:

1. The increasing uncertainty (fogginess) of future cash flows slowly kills its discounted predictability in time
   
   
2. Risk free discount rates doubtlessly include the risk of changes in future discount rates, but nevertheless vary in time.
   
   Risk free discount rates are volatile and are unpredictable on the long run.
   

Historical development

Let's take a look at discounting developments from a helicopter's perspective...
A few decades ago, discounting was simple:

Discounting Around 1980
Whether you were in the insurance or pension business, way back in the last century actuarial business was simple. All you had to do as an actuary, was discounting the assets and liabilities at an explainable 'long term average' and 'realistic save' (whatever this means in today's perspective) discount rate and it was done. Subtracting discounted liabilities from the discounted assets, also resulted in a clear undiscussable equity size:(E= A - L) and - in case of a pension fund, the coverage ratio : (CR=A/L).  

Discounting Around 1990
As computer and calculation capacity increased around 1990, actuarial models became more complex. Instead of as single projected cash flow, more complex cash flows and scenarios entered the actuarial model scene. With more sophisticated computer calculation power we were able to calculate and underpin risk-return investment scenario's that led more to more risky 'risk controlled' investment policies.

'Risk' was translated into (replaced by?) 'volatility' and 'volatility' was translated into 'variance'. Thus future risks where estimated on basis of projected historical variance and (later) with help of VaR models.

However, 'Risk' was mainly defined on (and restricted to) the left side of the balance sheet: the assets. In line with this view, the insurer's  equity could be simply expressed as : E= A - k_A.σ_A - L  (mp= minimum position) , or in case of a pension fund, the coverage ratio: CR=(A - k_A.σ_A) / L   (mp).


Discounting Around 2000
More than a decade later, beginning 2001, fair value accounting and market value broke through. Not only stocks had to be valued at Market Value, but also bonds. As a consequence the volatility of the left side of the balance sheet increased more than ever.

As actuaries we thought we would be save on the right side of the balance sheet were things were steady and calm as always... However, a few years later the 'Actuarial Sleeping Beauties' were kissed to life as Market (consistent) Value was introduced with regard to discounting liabilities. This development fired the starting gun to a swapping right size of the balance sheet.

Now insurers (minimum) equity got squeezed up between two volatility monsters, assets and liabilities:  E= A - k_A.σ_A - L -k_L.σ_L (mp).
Pension funds had to become real acrobats to manage their new wobbly coverage ratio: CR= (A - k_A.σ_A ) / (L + k_L.σ_L)     (mp).

No wonder pension funds and insurers got into trouble when the credit crises caused the final blow.....

Rebuilding stability
In Europe insurers are trying to rebuild stability by means of "Solvency II". Pension funds are trying to find their way out by suggesting more conditional pension rights. Some have even suggested to steer (valuate?) pension funds on basis of a kind of "moving average method" (asset returns or coverage ratio).

Other  'actuarial pension experts' have told me that we should stick to market value and accept the consequences, e.g. just accept that coverage ratios can stay below minimal level for several months, without anyone panicking..... Simply explain to pension fund members that the pension fund is long term well funded and there's no reason for panic if the coverage ratio breaks down for a short period....

Don't Panic......

This reaction reminds me of a weird family experience, when we where on holidays many years ago in a village called Ballyheigue (west(ern) Ireland).

Don't panic!

That afternoon my wife, the kids an I arrived in Ballyheigue. We stayed in a lovely local hotel near the fantastic west coast of Ireland.

The local assistant manager welcomed us and pointed out that there was a small minor (2x!) problem that could occur: Last week, at irregular moments, the hotel alarm had gone off several times, this could probably happen again. Reassuringly, he explained  that in the unfortunate case the alarm would go off, we shouldn't panic and just stay calm, as it would probably be a false alarm.....

That night we confidently went to bed early......

Then, at 01.30 AM that night, suddenly the fire alarm goes off. An ear piercing sound cuts through our ear drums... Within 2 minutes we - all hotel guests including my family - are all outside, despite the reassuring words of the hotel assistant earlier that night.

Conclusion

From this simple experience we can conclude that 'reassuring words' don't help in panic circumstances. Ergo, it's impossible not to panic in case coverage ratios go down for several months....

Convincing people 'not to panic' in case of 'clear panic signs' is an almost impossible task.  Once one mentions the word 'panic', all human systems get in a kind of  non stoppable alarm mode. It's like the famous scene from Fawlty Towers :

Don't mention the war...... 

Related Links:
- Pension Actuary's Guide to FINANCIAL ECONOMICS (2006)
- Pension contracts and developments in pensions in The Netherlands (2009)
- One of those superb hotels in Ballyheigue: White Sands Hotel

Goodhart's Law

Back in 1975 professor Charles Goodhart stated:

Goodhart's Law

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes

More in general Goodhart's Law is Goodhart's law is a generalized social science expression of the so called 'Lucas Critique'. Named after Robert Lucas who argues that it is naive to try to predict the effects of an (economic) change entirely on the basis of relationships observed in historical data.

Actuarial examples...
Some remarkable actuarial examples of Goodhart's Law are:

• Using coverage ratios to control pension funds
• Using z-scores to control banks or pension funds
• (Under)estimating longevity risk for decades
• Measuring (long term) rates (stocks, bonds, inflation ) for valuation purposes

Historians...
Early 2009 Goodhart proclaimed : “One of the lessons of the recent crisis, a lesson for bankers and for regulators, is, hire fewer mathematicians (actuaries) and physicists who build models on the basis of data that they can observe over relatively short period, and hire a few more historians who know what can go wrong even if they don’t necessarily have a good data basis to put into particular models”.

Although Goodhart is probably right, actuaries should keep an eye on the process....


Future developments are a function of Data, Probability, Uncertainty, Experience and above all Common Sense.

Just like the Roman God Janus, actuaries should look at the future, with the past in mind. And to do just that, we need all the help in the world, especially from historians....


Related links:
- Performance Persistence of Dutch Pension Funds (2010)

Actuarial Thought Leadership: What is success?

What is success? Are you a successful actuary?

Simple questions, easy to answer you would think. Right?

Wrong!

To illustrate the deeper  meaning and the nuance of success, let's take a look at the next 'Best Practice of Success'. A real life story from Joshua Maggid.....

'Best Practice of Success'

That day, together with my new colleague James, I entered the Pension Board's holy board room. All eight pension board members welcomed us with a hopeful smile and a firm handshake.

After introducing James as our company's brand new super professional, an unbeatable actuary and a seasoned specialist in asset liability matters, all seemed set for a successful presentation by James. Todays subject: Board decision on the new - next year's - asset allocation.

As expected, in a more than splendid and fluently short presentation, James handled everything a pension fund board member could possible think of or ask for. From headlines to all the important details. In roughly half an hour James showed his outstanding technical skills and impressed all board members. They were flabbergasted. What a knowledge, this was what one would call real Thought Leadership!

After James finishes his presentation, silence fills the board room. A kind of holy silence... Every board member is overwhelmed by James' stunning presentation. The Pension Board President quietly  looks around and breaks the profound silence as he softly says: "Thank you James.... Gentleman... (a lack of ladies in pension fund board rooms still teases us)...., is there anyone who has a question?......  (silence continues..) .  If not..... Do we all agree on James' new asset allocation proposal? (silence continues, some board members nod their head..). Does anyone disagree with James' proposal?.....(no one replies verbal or non verbal)... If not... Thank you for your continuing support. As a pension board, we've just agreed to the new asset location for next year... Congratulations!.... Dear advisory actuaries - James in particular - thank you for your effective presentation and corresponding proposal."

Aftermath

As always after I visit a client with a colleague, we meet shortly after in a nearby coffee shop to evaluate the meeting as well as each other's performance, irrespective of any form of hierarchy.

When I meet James shortly after the successful pension fund board meeting in the local Starbucks, he comes in walking with a smile....

"Peace of cake ", he opens our conversation. "What do you mean?, I ask him. "Well, making a $ 0.2 million turnover in a 30 minutes presentation, without any questions or comments, seems like a dream. I couldn't have done any better. I surpassed myself. This was one of my most successful presentations ever", James replied.

I looked him in the eye as I dropped an uneasy silence..... "This was as bad as it could get", I answered James. "How do you mean, 'Bad'? It was great, everyone agreed on my proposal, no questions at all.", James responded agitated.  

"Well - in short - It was YOU that took the decision and not the board. That's whats wrong", I stated. James again: "That's not true, I only advised, the board took the decision, not I. Let's keep things clear here, please!".

"No", I answered, "It was actually you!.... You took the actual decision. And if things in practice turn out different from your proposal (as most likely will be the case), this pension board will blame you for a wrong advice two years from now.......  

By demonstrating your enormous technical power in a half hour monologue, you've overpowered the board in such a way that they could not raise any questions or give comments without the risk of showing a form of incompetence or loss of face.

As we discussed in our preparation, you should have presented at least three different scenarios. Each scenario with a a different risk appetite. You should interactively have helped the board with choosing a well understood risk-return scenario. Asking questions, wrapping up opinions, leading the discussion to a point where the board feels that they've clearly understood what's on the table and 'feels comfortable' with the common decision taken."

James replied with anger: "When I have to do it that way, my presentations would take two hours and my preparation as well.  Above all, I have to deal with ten similar clients next week. I simply don't have the time to pick it up the way you suggest."

Moral of the story
From the above example it's clear that 'short term success' is not the same as 'long term success'.

To prevent ending up only in the reality of our own believes, constructive peer reviewing each other's performances is key to keep delivering long term top quality.

So don't forget to discuss your 'actuarial eggs' with one of your actuarial colleagues.....

Finally....
It takes 'new ethics' actuaries (and quants) to make pension fund business successful again.
Are you that actuary?

Related links:
- Making Decisions in the Pension Fund Board Room (PDF,2010)
- Investmentmentor:
   expectation, a force that will release either success or failure

Actuarial Simplicity

What is simplicity? What's the power of simplicity?

Goethe
It was Johann Wolfgang von Goethe ( listen), a German writer (poet), but also a polymath (!), who
stated:

Everything is simpler than you think 

and at the same time more complex than you imagine

And indeed Goethe was right, in (actuarial) science and  practice it's the challenge of overcoming (transcending) this paradox of simplicity and complexity.

The art of actuarial mastership
As models become more and more complex, it takes the art of actuarial mastership to condense this complexity into an outlined, understandable and (for the audience) applicable outcome.

A 'best practice example' of condensing complexity into a powerful inspiring statement, is Einseins famous equation E=MC² :

Like Paulo Coelho states in his blog about Einstein:
A man (actuary) should look for what is, and not for what he thinks should be. Any intelligent fool can make things bigger and more complex… 

It takes a touch of genius – and a lot of courage to move in the opposite direction.

Or, to quote Einstein:

Everything should be as simple as it is, but not simpler

How to cut through the actuarial cake?

Just three simple examples on how to cut through the complex actuarial cake. Examples that might help you to simplify complexity:

1. Think more simple

A perfect example of 'thinking more simple' is finding the solution of the next math problem (on the left), grabbed from an old high school math test.

Can you solve this problem within 10 seconds?

Found it? Now move your mouse over the picture or click it, to find the refreshing simple answer.....


Remember however not to oversimplify things. Sometimes problems need the eye of the actuarial master to identify important details...

2. Visual Results

Second example is to visualize the outcome of your models instead of power-point bullet conclusions or explaining how complex your model really is.

A nice example is the online dollar-bill-tracking project "Where's George?" from Research on Complex Systems, that measures the flow of dollars within the U.S. (over 11 millions bills, 3109 counties).
About 17 million passengers travel each week across long distances. However, including all means of transportation, 80% of all traffic occurs across distances less than 50 km.
One picture says it all and 'hides' the complex algorithms used, to get  stunning results.

On top of, George collects relevant data about 'human travel' that could be used for developing models of the spread of infectious diseases.

Just take look at the video presentation of George called Follow the Money to find out how to extract simple outcomes from complex models.

One of the simple results (by Brockmann) of this project is that the probability P(r) of traveling a distance (r, in km)  in a short period of time in days (max 14 days) can be expressed as a power law, i.e.:

P(r)= r ^-1.6

 3. Listen better

Every (actuarial) project outcome fails if there's no well defined goal at first.

Main problem is often, that the client isn't really capable of defining his goal (or problem) very precise and we - actuaries - start 'helping' the client.  In this 'helping' we are imposing our thoughts, beliefs and experiences onto others, by what we think 'is best' for the client. The outcome might often be an actuarial solution that fits the problem in our own actuarial head, but fails to meet the clients problem.

Main point is that we - as advisors - don't really listen well.
Of course that doesn't apply to you as an actuary personally, but it does apply to all other qualified actuaries, doesn't it?

Just to test if you're part of that small elite troop of 'well listening qualified actuaries' (WLQAs), just answer the next simple Client Problem:

Client: I'm confused about 'distances'. It turns out that measuring the distance between two points on earth is really complicated math, as the world is round and not flat.

But even in a 'flat world' I find measuring distance complicated. As an actuary, can you tell me:


What’s the shortest distance between two points in a flat world?

O.K. Now think for a moment.....

Have you got the answer to this complex client problem?

Now that you're ready with your answer, please click on the answer button to find out the one and only correct answer.

The answer is: the shortest distance between two points is zero

Hope you safely (without any mental damage) passed the above WLQA-test......

A Simple Application

A nice demonstration of actuarial simplicity is the well known 'compound interest doubling rule' that states that an investment with compound interest rate R, doubles itself in N≈72/R years.

So it'll take (p.e.) approximately N≈ 12 (=72/6) years to double your investment of $100 to $200 at an compound interest rate of 6% p.a.

While the precise equation of the doubling time is quite complex to handle, it's approximating equivalent, N≈72/R, is simple applicable and will do fine for small size compound interest rates.


It's our actuarial duty and challenge to develop simple rules of thumbs for board members we advice. We actuaries have to master the power of simplicity. Let's keep doing so!

Related links:
- The Complexity of Simplicity
- Where's George?: Wikipedia
- The scaling laws of human travel (2006)

God’s Definition of Risk

To snap things in the right perspective, now and then it's good practice to consider how actuarial science really started:

Yes, like Laplace stated in his masterwork 'Théorie Analytique des Probabilités', it all began with 'games of chance'... and - today -  perhaps it still is.....

From 'gaming', probability theory developed to 'actuarial science' and finally to 'risk management'.

Risk Levels

Today we distinguish three main types of risk levels:

Risk Level 1
In fact what we are modeling mostly, are the risks we know, the 'known risks'... These risks are the familiar operational, financial and compliance risks

Risk Level 2
These are the strategic risks. Risks related to new markets, mergers and acquisitions, investments, but also business development, brand and reputation risks.

Risk Level 3
These are the unpredictable, the so called 'unknown, unknown risks'.

The Rumsfeld definitions of risk levels

A similar more humorous, but also interesting definition of risk levels, has been given by the United States Secretary of Defense  Donald Rumsfeld  during the Iraq War:

1. Known Knowns
   There are known knowns; there are things we know that we know
   
2. Known Unknowns
   There are known unknowns; that is to say, there are things that we now know we don’t know
   
3. Unknown Unknowns
   But there are also unknown unknowns; there are things we do not know we don’t know."
   

If we're honest, we'll have to admit that even our 'known known' and 'known unknown' risks in our models in reality have a high 'unknown unknown' origin.

Or, as Barry du Toit at Riskworx shows in an excellent paper called 'Risk, theory, reflection: Limitations of the stochastic model of uncertainty in financial risk analysis' : our stochastic model of uncertainty is powerful but limited.

It's (p.e.) an illusion to use 'standard deviation' as a stand alone measure for risk. We must be aware to apply our models without a healthy portion of 'common sense'. Or, to put it in air-plane words:

The danger inherent in 'altimeter usage' is that its unquestioning use will stop pilots from using a range of more intuitive risk measures, such as looking out of the window!

God’s definition of risk
There is no ultimate "God’s definition of risk", we'll have to manage with our limited models as a help to our Risk Insight. Success!


Sources and related links:
- Limitations of the stochastic model of uncertainty in financial risk analysis
- Laplace: analytic theory of probabilities (English)
- Strategic Management of Three Critical Levels of Risk
- Managing Projects in the Presence of Unknown Unknowns