Humor: Past Performance is...

To protect (!) the customer more and more, investment funds feel the need  - or are obligated - to communicate about the expectation of their funds' future return.

One of the most used non- or disinformation statements funds use, is the line:

Past performance is no guarantee of future results

A general lesson is that all prefab communication lines and static communication tools are doomed tot fail, as communication is context and time dependent.

Models

Just as Communication, your Actuarial, Investment or Financial Models are also context (economic, fiscal, ethics) and time dependent.


Change them upfront, as 'performance of yesterday's models is no guarantee for the future.....'  ;-)

Sources:
- Free Flash Animations - Smilies by Adrian Wilman

Related:
- Disinformation: Everything You Know Is Wrong

A Better Life

The new (June 2011) 'OECD Health Data 2011' report shows the latest insights in health spending costs. Here are some results for the main OECD countries:

Health Costs

Total health spending accounted on average for 9.5% of the GDP for all OECD countries (main countries: 9.8%).

Public health is  a substantial  part  of  health  funding  in  all  OECD  countries.

Control Health Costs
Key question is: will relative 'big rising spenders' like The Netherlands and the U.S., be able to control their health costs in the near future?

Besides the fact that health costs undoubtedly rise sharply with age, the bulk of 'annual health spending growth' depends mainly on overall population growth, increases in the health prices and the introduction of new high-cost medical products and treatments used by all age groups. 

In controlling health costs, the most difficult an challenging question is in fact:

What are we trying to maximize
with the help of health investment costs?

Our first answer could be : Maximize Health.

In practice we (countries in the world) haven't explicitly defined what we try to maximize... Unfortunately discussing health costs without a clear goal, is an endless road, leading nowhere.... A Health Mission Impossible.....


On top of, 'Health'  is - at its best - a non defined subjective perception.....
Let's dive deeper on this theme of perception. Can we grasp it?

Health Perception
As in every corner of (your) life

Perception = Reality

Therefore let's take a look at how health is perceived by people in different countries. For a global 'health perception picture' we have to fall back on self-reported health status  figures of around 2006-2007:

As is clear Canada and the U.S. are clear 'feeling healthy' champions, with Japan as poorest performer.

Quality and Quantity of Life
To examine whether the self-reported health status indicator  (representing the quality of life) also indicates a 'longer life expectancy' (representing the quantity of life),  here is the 'life expectancy indicator'.

Surprisingly the results are - at first sight - counter intuitive:

• Japan, with the poorest health perception, scores best in longevity
• The U.S.,  with the almost best health perception, scores worst in longevity

'Good health' and  'life expectancy' 
It is known that elderly people report a less than average good healthy condition.

Unfortunately, as the next diagram indicates, there's no convincing direct relationship between 'perceived good health' and  'life expectancy' or 'median age' (as explaining variables) :

Reference: Japan Explained?

To find  out 'what drives a health perception', we may examine one of the rare underpinned studies : "The Surveys on the Japanese National Character".

First of all there's a relationship between Economy and Health:

Though declining, more than 50% of all respondents in this survey say that "people's health will get worse".

What's even of more concern, is that younger people are experiencing an increasing feeling of nervousness during the last decades.


This survey supports the idea that perceptions of 'health' and 'happiness' are more or less embedded in a nations' culture and not related to the investments in health.

Find out more on what's going on in Japan beneath the surface on:
Assessment of the Japanese Economy

It's all about Happiness

What remains is that it's all about happiness in life....
And of course happiness and good health are 'somewhat' and 'somehow' related: 

Conclusion
Maximizing or optimizing Health in on basis of 'health investments' (health costs) is tricky business. Although Happiness and Health Perception are related, they both don't relate to health investments.

The maximum price for 'good health' is subjective. Governments will have to border the maximum public financed costs of health on basis of objective goals of health condition (eg. max % obesity, BMI, etc) in relation to what's "bearable" in terms of costs in relation to the strength of their national economy.

Let's conclude with some positive news...


Your Better Life Index
I would like to invite you to take part in the Your Better Life Index.

'Your Better Life Index' was designed as s an interactive tool that allows you to see how countries perform according to the importance you give to each of 11 topics – like education, housing, environment, and so on – that contribute to well-being in OECD countries. Your Better Life Index allows you to put different weights on each of the topics, and thus to decide for yourself what contributes most to well-being.

It is a pioneering, interactive tool combining OECD substance with modern
technology in order to educate, promote dialogue and encourage consensus on the balance between societal and economic well-being. Your Better Life Index will be maintained on an ongoing basis.

Here's MY Better life index as an eample.




Live a healthy and - above all - happy life..... A Better life!

Sources
- OECD Health Data 2011 How Does the Netherlands Compare?
- OECD Health Data 2011 
- Health Self-Reported Health Status 
- Assessment of the Japanese Economy: A Continuing Downward Trend
- Why Does U.S. Health Care Cost So Much? ( An Aging Population Isn’t the Reason)
- The Surveys on the Japanese National Character

 Related
- Does Medicare Work Better Than Private Insurance?
- Balancing Affordability and Value: The Universal Challenge in Health Care Delivery

- Spreadsheet with all health data of this blog

Humor: Peanuts: Risk Free

Risk free rates are an illusion. Risk free is an illusion. Everything in life is 'Free Risk'.... . Don't think about Risk as 'Peanuts'... It's not, as Charlie Brown, Snoopy and Woodstock show...

How to catch Risk?

Desperate attempts to catch Risk in new regulatory standards like Basel (II/III) for banks and Solvency (II) for insurers seem a dead end street....

What is happening?

That's the question we're about to answer in this blog!

Here are some observations:

• Risk Weighting
  All new risk valuating standards are based on Risk Weighting. Some assets (or liabilities) are assumed to be more risky than others. In practice, every asset class that has been identified as more or less 'safe', has turned out to be risky after all. E.G., government bonds  where - until the 2011 crisis  in Greece - assumed to be risk free. Unfortunately, nothing could be further from the truth...
  
  
  Nothing in life is risk free
• Tier Ratio's
  Instead of simple 'Equity to Asset Ratios', Tier 1 & 2 ratios where developed. These Tier ratios only take a fraction of the total assets into account. This leads to 'Equity to Risk-Weighted Assets Ratios' that insinuate adequate, substantial and reassuring 10-15% Capital ratios, while - in fact - they're not! These kind of ratios are misleading and create a false sense of safety....
  
  
  Tier Ratios lead people up the garden path
  
  
• Tail Hide and Seek
  As more and more risks are valued, regulated and urge for extra capital requirements, financial institutions will try to create extra return on risks that are formally not or only 'light weighted' measured. This way substantial risks are 'pushed' into the tail, fat risk tails are created and the sight on the real risks in the company becomes misty.
  
  
  Overregulation decreases the effect of good risk management

Illustration: Comparison 'Deutsche Bank' - 'Bank of America'
To illustrate what is happening, let's compare a giant like "Deutsche Bank" (DB) with the number one on the banking list, the "Bank of America" (BOA).

Financial Ratios	Deutsche Bank		Bank of America
(x 1 bn $)              Year:	2010	2009	2010	2009
Assets (A)	1906	1501	2265	2230
Liabilities (L)	1855	1463	2037	1999
Shareholder Equity (SE)	49	37	228	231
SE / A - Ratio	2.6%	2.4%	10.1%	10.4%
---------------------------------
Risk-Weighted Assets (RWA)	346	273	1456	1543
Assets (A)	1906	1501	2265	2230
RWA / A - Ratio	18%	18%	64%	69%
---------------------------------
Regulatory Capital (RC)	49	38	230	226
Risk-Weighted Assets (RWA)	346	273	1456	1543
Total Capital Ratio	14.1%	13.9%	15.8%	14.7%
---------------------------------
Tier 1 capital	43	34	164	160
Risk-Weighted Assets (RWA)	346	273	1456	1543
Tier 1 Capital Ratio	12.3%	12.6%	11.2%	10.4%

Although both banks have more or less the same 'Tier 1' and 'Total Capital Ratio', their individual risk profile is completely different. 

In the case of DB only 18% of the assets are assumed (marked) risky, while in the case of BOA around 64% is assumed risky and taken into account for a risk weighted solvency approach.

Notice that the simple gross 'Equity to Asset' Ratio (E/A-Ratio, or in short 'EAR')  of DB is only 2.6%, while the similar ratio of BOA is around 10.1%. If DB would be hit by an 5% impact loss, it would be in deep trouble.

Reflections

Our risk models have become too sophisticated and don't cover the area of 'Unkown Risk' enough. Unintentionally rand controversially, risk regulations and models make us implicitly sweep our real risks under the carpet. In principle Risks can be categorized as:

1. Known Risk Measured
2. Known Risk Unmeasured
3. Unknown Risk
4. Hidden Risk (knowingly or unknowingly)

It's time to admit that no asset or liability is completely free of risk and there's an overall substantial probability that risk - by definition - will hit eventually from an unexpected corner. To put things in perspective: In the 19th century, banks funded their assets with around 40-50% equity.

Conclusion
Including 'Unkown Risk', a simple gross E/A-Ratio (EAR) of a magnitude of 15-25% (across the total assets) would probably be the best kind of guarantee to accomplish a more sustainable financial system in the world. The new EAR could be best defined as the sum of an actuarial underpinned percentage on basis of the underlaying calculable covered risks and a TBD overall 10% 'add up' for unknown risks:

E/A-Ratio = EAR =  EAR_{[ calculable risk ]} + EAR_{[ unknown risk ]}

Until we've included Unkown Risk fully in our risk models, we'll stay in deep trouble.

Aftermath: 'Avatar Ratios'
To rate a company (bank), often it's not enough to look at just the traditional financial ratios. An interesting way to additionally rate a company in a more sophisticated way, is with the help of so - by me - called 'Avatar Ratios'.

Additional to financial ratios, 'Avatar Ratios' tell you more about what the intentions, (real) important issues and the 'drive' of a company and its employees are.

An 'Avatar Ratio Analysis' gives you more or less 'the embodiment' of all what drives a company. It can be constructed by making a word analysis of a crucial document or annual report of a company. In short: You simply download the annual report (or any other company characteristic document) and analyze it with a  'Word Frequency Counter' like WriteWords.

IAA Demo
As a demo, let's analyze the IAA's Strategic Plan

Frequency	Word
21	actuarial
10	strategic
10	develop
8	associations
6	standards
6	priorities
6	plans
6	objective
6	action
5	promote
5	profession
5	member
5	international
5	iaa
5	association
4	practice
4	maintain
4	key
4	global
4	encourage
4	education
3	worldwide
3	statement
3	relationships
3	plan
3	including
3	identify
3	establish
3	common
3	discussion
2	world
2	values
2	supranational
2	support
2	services
2	risk
2	relevant
2	provide
2	program
2	professionalism
2	professional
2	prioritize
2	principles
2	organizations
2	organization
2	mission
2	march
2	management
2	links
2	issues
2	internationale
2	help
2	fields
2	facilitate
2	countries
2	contact
2	conduct
2	areas
2	area
2	approved
2	among
2	actuaries
2	actuarielle
1	voluntary
1	vision
1	understanding
1	transparency
1	traditional
1	stakeholders
1	soundness
1	society
1	social
1	skills
1	sections
1	scope
1	scientific
1	role
1	review
1	research
1	reputation
1	relationship
1	regional
1	recommended
1	recognized
1	recognition
1	quality
1	public
1	protection
1	promotion
1	process
1	procedures
1	presidents
1	offered
1	objectivity
1	objectives
1	needs
1	model
1	members
1	knowledge
1	jurisdictions
1	involvement
1	integrity
1	improve
1	guidelines
1	forums
1	forum
1	financial
1	feasibility
1	experiences
1	expansion
1	examine
1	ensure
1	enhance
1	disciplinary
1	developing
1	developed
1	designation
1	decisions
1	decision
1	credential
1	create
1	cooperation
1	convergence
1	contributing
1	continuing
1	constructing
1	code
1	changing
1	availability
1	audiences
1	active
1	achieve
1	accountability
1	access

With the help of WriteWords we first create (on line) a frequency table. Next we cut out irrelevant words like 'and', 'the', etc. 

Here are the results:
(1) a  scrollable frequency table of all relevant words
(2) a 'Top 22 words' frequency table



In most cases - like this one - the result of simply putting the first 10 to 15 words in the top of the frequency table behind each other, is astonishing: It creates a kind of 'Identity Statement'. Here's the result for IAA's strategic plan, where even more than 20 words give a beautiful comprised identity statement:

IAA's Strategic Plan (Identity Statement comprised with WriteWords) Actuarial strategic develop associations. Standards, priorities plans objective action. Promote profession member international. IAA association practice maintain key. Global encourage education worldwide.

Avatar Analysis: Comparison 'Deutsche Bank' - 'Bank of America' 

Let's now go back to our banking case and compare 'Deutsche Bank' (DB) and the 'Bank of America' (BOA) with the help of a simple Avatar Ratio Analysis.

The Avatar Ratio Analys presents the word frequency (absolute numbers) and their relative frequency (= word frequency / total number of word in document). Here is the result:

Avatar Ratios	Deutsche Bank			Bank of America
	Freq.	Perc.		Freq.	Perc.
Governance	109	0.06%		25	0.02%
Risk	1458	0.79%		852	0.53%
Control	273	0.15%		156	0.10%
Total G+R+C	1840	1.00%		1033	0.64%
------------------
Client/Customer	359	0.20%		250	0.15%
Shareholder	169	0.09%		162	0.10%
------------------
Transparent	15	0.01%		2	0.00%
------------------
Employee	153	0.08%		63	0.04%
Director	40	0.02%		23	0.01%
------------------
Profit, Income	1001	0.54%		835	0.52%
------------------
Tot. nr. of words	161579	100%		184048	100%

Although I'll leave the final conclusions up to you, here are some remarkable observations:

• Total number of words
  
  
  Both companies (DB and BOA) need an enormous amount of words to explain their environment (clients, shareholders, rating agencies, etc) the essentials about what's going on in their company in a modest calendar year.
  
  To read an annual report of about 170,000 words, it would take an average reader (reading speed 200 to 250 words per minute) about 10-12 hours.
  
  Perhaps you, as an actuary, can read faster ( test it!: speed reading test ), but even at a speed of 500 wpm it would be an enormous task (5-6 hours) to fulfill.
  
  
• Governance, Risk & Control
  It's clear that DB puts much more energy (+60%) in communicating about themes as Governance Risk and Control than BOA. Also is clear that DB is far more transparent in its communication than BOA. This does (of course) not imply that BOA's risk and control frame is inferior to DB's. It could even be the opposite. It just shows that (and how) BOA handles and communicates differently (less open) from DB.
  
  
• Profit, Income, Shareholders + Clients and Employees
  DB and BOA weight Profit, Income and shareholders on more or less the same level. Both rank client/customer above shareholders. DB gives 'clients/customers' as well as employees double the attention of BOA!
  

At last
Next time you report to your board, include an Avatar Analysis of your report in your presentation!

Related Links, Sources:
- The biggest weakness of Basel III (2010)
- The Banker top 1000 list (2011) 
- Word Frequency Counter : WriteWords
- IAA's Strategic Plan  
- Bank of America: Annual Report 2010
- Deutsche Bank: Annual report 2010
- On line speed reading test 
- Spreadsheet containing this blog's DB and BOA analysis

Humor: FoxTrot Actuarial Models

Sources:
- Foxtrot Comic Strips
- Foxtrot on Gocomics

Sustainable Discount Rates

Steering pension funds on a 'one point' Coverage Ratio is like trying to proof global warming on a hot summer day...... It's useless.

Why?

First of all the complete pension fund balance sheet is based on market value.

As there is no substantial market for pension liabilities, this implies that pension liabilities have to be valued on basis of some kind of arbitrary (artificial) method.

In the U.S. this has led to the (irresponsible) high discount rate of 8% for state pension funds based on the 'expected' long term return without a kind of correction (subtraction) for 'risk'.

In de Dutch market, pension funds have to rate their liabilities on basis of a maturity dependable risk free interest rate, the ‘Nominal interest Rate Term Structure’ (RTS), as ordered by DNB (the Dutch Regulator).

Here's the outcome of this risk free interest rate (RTS) over the past 10 years, including the 10-y average RTS...

Ever since DNB ordered this 'artificial discounting method', pension fund board members didn't get a good night sleep. As the RTS juggles on a daily basis, every morning pension members wake up with the latest 'RTS news surprise of the day'.

You can play the RTS juggle (worm) here:

As coverage ratios are based on the RTS, they shuttle hither and thither as well and executing a long term pension fund strategy becomes more or less like riding the famous (market) bull in a rodeo show.

On a Dutch IPE congress, Angelien Kemna - chief investment officer of the €270bn asset manager APG - warned that the current swap-curve discount criterion forces pension funds to take unwise "significant long-term measures".

Kemna favors an average yield curve or a more straightened version of the current one for discounting liabilities.

The new Dutch Pensions Agreement foresees that pension funds can choose their own discount rate, as pensions are no longer guaranteed!

Indeed, it's time to stop this complex discount circus. But it's also time to stop 'one point estimate' Coverage Ratio steering.

A new look
Let's take a look at a characteristic discount rate dependence of a traditional pension fund like ABP.

Valuing ABP at an (derived average) RTS of 2.69%  (September 2011), ABP's discounted assets fail to meet the discounted liabilities, leading to a coverage ratio of around 90%.

However this kind of risk free valuing is - for sure - too conservative, as ABP's aims at an underpinned strategic expected return of 6,1% on the long term and has a convincing track record of  5 and 10-year moving average returns:

Returns (%) Pension Fund ABP 2993-2010
Year	1993	1994	1995	1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010
Yearly Return	16.5	-1.0	16.4	11.8	11.9	12.9	10.0	3.2	-0.7	-7.2	11.0	11.5	12.8	9.5	3.8	-20.2	20.2	13.5
5Y MA Return					10.9	10.2	12.6	9.9	7.3	3.4	3.0	3.3	5.2	7.2	9.7	2.7	4.2	4.4
10Y MA Return										7.1	6.6	7.8	7.5	7.3	6.5	2.9	3.8	4.8

Or in Graphics:

As long as a pension fund (like ABP) continues to perform (on 5 or 10-years moving average) rates that outperform the (derived average) risk free discount rate, it's seems ridiculous to force such a pension fund to discount at a 'risk free rate', as this obliges the fund to change his strategic asset mix to a less risky mix and an suboptimal return.
In turn, these suboptimal returns will lead to an asset shortage. With a vicious cycle of decreasing risk as a fatal result in the end.

Sustainable Discount Rates
In an excellent discussion paper (2006) Jürg Tobler-Oswald proves that the optimal discount rate lies between the risk free rate (RFR) and the investment strategy’s expected return (ER) depending on how good the hedge against the fund’s cash  flow  provided by its investments  is:

Discount Rate₁ = RFR + F_{Cash Flow}(RFR-ER)

Another - more simple and practible - discount rate could be defined as the average between the free discount rate and the X-year (e.g. X=5, or 10) Moving Average Return of the last X-Years (MAR(X)).

Discount Rate₂ = [ RFR + MAR(X) ] /2

As long as MAR(10), MAR(5) and ER stay larger than the interest rate that matches a coverage ratio of 100%, discounting by means of one of the new sustainable discount methods seems sound and safe......

Whats left is that the average (geometric) risk premiums during the last 10 years have turned out negative:

Historical Equity Risk Premiums (ERP)
	ERP: Stocks minus T.Bills		ERP: Stocks minus T.Bonds
Period	Arithmetic	Geometric	Arithmetic	Geometric
1928-2010	7.62%	5.67%	6.03%	4.31%
1960-2010	5.83%	4.44%	4.13%	3.09%
2000-2010	1.37%	-0.79%	-2.26%	-4.11%

This implies (moreover) that it is important that the discounting rate of a pension fund should be based on a sustainable sound weighted mix of:
(1) proven historical performance
(2) a 'save' risk free rate
(3) realistic future return assumptions


Related Links/ Sources
- Kemna IPE article (2011)
- An investment based valuation approach for pension fund cash flows (2006)
- Ignoring the risk in risk premium in State Pensions(2011)
- DB: What went wrong? (2011)
- Actuary.org: Pension Fund Valuation and Market Values (2000)
- Aswath Damodaran: Equity-risk-premiums-2011-edition
- Dutch: ABP coverage ratio