Perhaps the most important challenge of an actuary is to develop and train the capability to explain complex matters in a simple way.
One of the best examples of practicing this 'complexity reduction ability' has been given by David Einhorn, president of Greenlight Capital. In a nutshell David explains with a simple example why VaR models fail. Take a look at the next excerpt of David's interesting article in Point-Counterpoint.
The Real Risk Issues What. besides the 'art of simple communication', can we - actuaries - learn from David Einhorn?
What David essentially tries to tell us, is that we should focus on the real Risk Management issues that are in the x% tail and not on the other (100-x)%.
Of course, we're inclined to agree with David. But are we actuaries truly focusing on the 'right' risks in the tail?
I'm afraid the answer to this question is most often: No!
Let's look at a simple example that illustrates the way we are (biased) focusing on the wrong side of the VaR curve.
Example Longevity
For years (decades) now, longevity risk has been structurally underestimated.
Yes, undoubtedly we have learned some of our lessons.
Today's longevity calculations are not (anymore) just based on simple straight-on mortality observations of the past.
Nevertheless, in our search to grasp, analyze and explain the continuous life span increase, we've got caught in an interesting but dangerous habit of examining more and more interesting details that might explain the variance of future developments in mor(t)ality rates.
As 'smart' longevity actuaries and experts, we consider a lot of sophisticated additional elements in our projections or calculations.
Just a small inventory of actuarial longevity refinement:
If we - actuaries - would take longevity and our profession as 'Risk Manager' more seriously, we would warn the world about the global estimated (financial) impact of these medical developments on Pension- and Health topics. We would advise on which measures to take, in order to absorb and manage this future risk.
Instead of taking appropriate actions, we hide in the dark, maintaining our belief in Fairy-Tails. As unworldly savants, we joyfully keep our eyes on the research of relative small variances in longevity, while neglecting the serious mega risks ahead of us.
This way of Ostrich Management is a worrying threat to the actuarial profession. As we are aware of these kinds of (medical) future risks, not including or disclaiming them in our models and advice, could even have a major liability impact.
In order to be able to prevent serious global loss, society expects actuaries to estimate and advise on risk, instead of explaining afterward what, why and how things went wrong, what we 'have learned' and what we 'could or should' have done.
This way of denying reality reminds me of an amusing Jewish story of the Lost Key...
Let's conclude with a quote, that - just as this blog- probably didn't help either:
Risk is not always apparent, but its invisibility is no longer an excuse for ignoring it.
Interesting additional links:
Why Var fails
A risk manager’s job is to worry about whether the bank is putting itself at risk in unusual times - or, in statistical terms, in the tails of the distribution. Yet, VaR ignores what happens in the tails. It specifically cuts them off. A 99% VaR calculation does not evaluate what happens in the last1%.
This, in my view, makes VaR relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs.
A risk manager’s job is to worry about whether the bank is putting itself at risk in unusual times - or, in statistical terms, in the tails of the distribution. Yet, VaR ignores what happens in the tails. It specifically cuts them off. A 99% VaR calculation does not evaluate what happens in the last1%.
This, in my view, makes VaR relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs.
VaR is like an airbag that works all the time, except when you have a car accident
By ignoring the tails, VaR creates an incentive to take excessive but remote risks.
Example
Consider an investment in a coin flip. If you bet $100 on tails at even money, your VaR to a 99% threshold is $100, as you will lose that amount 50% of the time, which obviously is within the threshold. In this case, the VaR will equal the maximum loss.
Compare that to a bet where you offer 127 to 1 odds on $100 that heads won’t come up seven times in a row. You will win more than 99.2% of the time, which exceeds the 99% threshold. As a result, your 99% VaR is zero, even though you are exposed to a possible $12,700 loss.
In other words, an investment bank wouldn’t have to put up any capital to make this bet. The math whizzers will say it is more complicated than that, but this is the idea. Now we understand why investment banks held enormous portfolios of “super-senior triple A-rated” whatever. These securities had very small returns. However, the risk models said they had trivial VaR, because the possibility of credit loss was calculated to be beyond the VaR threshold. This meant that holding them required only a trivial amount of capital, and a small return over a trivial capital can generate an almost infinite revenue-to-equity ratio. VaR-driven risk management encouraged accepting a lot of bets that amounted to accepting the risk that heads wouldn’t come up seven times in a row. In the current crisis, it has turned out that the unlucky outcome was far more likely than the backtested models predicted. What is worse, the various supposedly remote risks that required trivial capital are highly correlated; you don’t just lose on one bad bet in this environment, you lose on many of them for the same reason. This is why in recent periods the investment banks had quarterly write-downs that were many times the firm-wide modelled VaR.
Compare that to a bet where you offer 127 to 1 odds on $100 that heads won’t come up seven times in a row. You will win more than 99.2% of the time, which exceeds the 99% threshold. As a result, your 99% VaR is zero, even though you are exposed to a possible $12,700 loss.
In other words, an investment bank wouldn’t have to put up any capital to make this bet. The math whizzers will say it is more complicated than that, but this is the idea. Now we understand why investment banks held enormous portfolios of “super-senior triple A-rated” whatever. These securities had very small returns. However, the risk models said they had trivial VaR, because the possibility of credit loss was calculated to be beyond the VaR threshold. This meant that holding them required only a trivial amount of capital, and a small return over a trivial capital can generate an almost infinite revenue-to-equity ratio. VaR-driven risk management encouraged accepting a lot of bets that amounted to accepting the risk that heads wouldn’t come up seven times in a row. In the current crisis, it has turned out that the unlucky outcome was far more likely than the backtested models predicted. What is worse, the various supposedly remote risks that required trivial capital are highly correlated; you don’t just lose on one bad bet in this environment, you lose on many of them for the same reason. This is why in recent periods the investment banks had quarterly write-downs that were many times the firm-wide modelled VaR.
The Real Risk Issues What. besides the 'art of simple communication', can we - actuaries - learn from David Einhorn?
What David essentially tries to tell us, is that we should focus on the real Risk Management issues that are in the x% tail and not on the other (100-x)%.
Of course, we're inclined to agree with David. But are we actuaries truly focusing on the 'right' risks in the tail?
I'm afraid the answer to this question is most often: No!
Let's look at a simple example that illustrates the way we are (biased) focusing on the wrong side of the VaR curve.
Example Longevity
For years (decades) now, longevity risk has been structurally underestimated.
Yes, undoubtedly we have learned some of our lessons.
Today's longevity calculations are not (anymore) just based on simple straight-on mortality observations of the past.
Nevertheless, in our search to grasp, analyze and explain the continuous life span increase, we've got caught in an interesting but dangerous habit of examining more and more interesting details that might explain the variance of future developments in mor(t)ality rates.
As 'smart' longevity actuaries and experts, we consider a lot of sophisticated additional elements in our projections or calculations.
Just a small inventory of actuarial longevity refinement:
- Difference in mortality rates: Gender, Marital or Social status, Income or Health related mortality rates
- Size: Standard deviation, Group-, Portfolio-size
- Selection effects, Enhanced annuities
- Extrapolation: Generation tables, longitudinal effects, Autocorrelation, 'Heat Maps'
- Calorie Restriction
The extend of lifespan due to a 'caloric restriction diet' - The development of 'Longevity medicines'
Already medicines are developed that prevent a number of diseases from causing premature demise at 60 or 70.
The risk that an advanced Longevity medicine will be discovered in the near future becomes more and more likely.
If you doubt this, just take a look at the American Academy of Anti-Aging Medicine (A4M), where (global) more than 20.000 professional researchers and members take longevity seriously.
If we - actuaries - would take longevity and our profession as 'Risk Manager' more seriously, we would warn the world about the global estimated (financial) impact of these medical developments on Pension- and Health topics. We would advise on which measures to take, in order to absorb and manage this future risk.
Instead of taking appropriate actions, we hide in the dark, maintaining our belief in Fairy-Tails. As unworldly savants, we joyfully keep our eyes on the research of relative small variances in longevity, while neglecting the serious mega risks ahead of us.
This way of Ostrich Management is a worrying threat to the actuarial profession. As we are aware of these kinds of (medical) future risks, not including or disclaiming them in our models and advice, could even have a major liability impact.
In order to be able to prevent serious global loss, society expects actuaries to estimate and advise on risk, instead of explaining afterward what, why and how things went wrong, what we 'have learned' and what we 'could or should' have done.
This way of denying reality reminds me of an amusing Jewish story of the Lost Key...
The lost Key
One early morning, just before dawn, as the folks were on their way to the synagogue for the Shaharit (early morning prayer) they notice Herscheleh under the lamp post, circling the post and scanning the ground.
“Herschel” said the rabbi “What on earth are you doing here this time of the morning?”
“I lost my key” replied Herscheleh
“Where did you lose it?” inquired the rabbi
“There” said Herscheleh, pointing into the darkness away from the light of the lamp post.
“So why are looking for your key in here if you lost it there”? persisted the puzzled rabbi.
“Because the light is here Rabbi, not there” replied Herschel with a smug.
Let's conclude with a quote, that - just as this blog- probably didn't help either:
Risk is not always apparent, but its invisibility is no longer an excuse for ignoring it.
-- Bankers Trust on risk management, 1995 --
Interesting additional links:
- Increase of Human Longevity: Past, Present and Future (2009)
- Understanding, Modeling and Managing Longevity Risk
- Mortality: Standard deviation (Stephen Makin, 2009)
- Lifemetrics Netherlands, Lifemetrics J.P. Morgan
- Longevity: Mortality improvement (2008)
- Why governments should issue Longevity Bonds
- Survival models in actuarial mathematics: From Halley to longevity
- The Business of Ageing (2008)
- Transforming Pensions and Healthcare in a Rapidly Ageing World (2009)
- 30 seconds Risk Quiz: What is Risk?
- Why VAR Fails (2004 !!!)
- Calorie Restriction (CR) Society International
- Calorie Restriction Calculator
- Online book: Living Healthier and Longer, What Works and What Doesn't
- Longevity Medicine Review™
- Youtube: Insta Tapes Digital Media
- Medicine: Resveratrol
- Jacob Klamer: The Lost Key
In 1967 he revived the original formula, earlier developed by 
The constant D also stands for 'Dimension' and in 1975 Mandelbrot develops this Dimension- idea to what is called the 
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