On Line DIY European Stress Test

Thomson Reuters' Breakingviews now presents an on line DIY stress test. Change the Tier 1 ratio and haircuts of the PIIGS countries and find out the capital shortfall of Europe and the shortfal of individual European banks.

An explanation can be found here and there is also an Excel spreadsheet.

Enjoy stress testing!

Humor: Actuarial Stress Test

Calvin and Hobbes as Manager and Actuary....

Original source: Tonks17
Homepage UK Calvin and Hobbes

Stress test stress test

How did you interpret the title of this Blog......? 

Can you read it in more than one way? In how many ways can you read it?

Still confused?

Enough questions to start this blog.

In short: the more ways you are able to read this title, the more successful you'll probably be in defining and executing 'Stress Tests" in practice.

Let's dive a little deeper to illustrate this important 'multi interpretation talent' you need, to make stress testing a success.

Although there are far more ways (please add some interesting suggestions as comments to this blog) to interpret the title 'stress test stress test', we'll analyze in this blog two interesting  interpretations that follow from the fact that 'stress test' can be interpreted as a noun or as a verb.

1. stress test [noun] stress test [noun]

Interpreting the title as two nouns could:

• make you aware of the importance of stress tests
• emphasize the importance of repetitive execution of stress tests
• illustrate the feeling of disinterest and apathy that occur when important words are repeated to often without enough plowing depth..
  
  

2. stress test [verb] stress test [noun]

This perhaps the most interesting interpretation.
How can you really stress test your stress test?  

The way we stress test at financial institutions like banks, insurance companies and pension funds, is basically more or less as follows:

• Project historical crisis crash-data into the future. Simulate what would happen and take a look at the consequences
  
  
• Test crash scenarios on basis of the question: What would happen if.... (prices go down, S&P 500 collapses, etc., etc.)
  
  
• Take several economic scenarios. Project them on your balance sheet and see what happens.

To stress-test a stress test we have to develop a different view on stress tests.

A view based on the answer of the next leading question:

How many sides has a coin?

Let's demonstrate this new crucial view on a stress test.

A Different View on Stress Tests
Some examples:

• Inverted Stress Test
  An interesting way of stress testing is 'working the other way around': Try to define financial situations where you never want to end up in (e.g. equity< -5%, etc.) and try to imagine scenarios that could lead to this unwanted financial situation  Paul Duijsens, ALM Principal Mercer Investment Consulting, mentions this approach).
   
• Idiot Proof Stress Test
   Andrea Enria, chairman of Europe’s new banking regulator stated recently:
  
  A stress test is only as good as the scenarios you plug into it
  
  Therefore, make stress tests 'idiot proof' as much as possible.
  Once a stress test is developed, don't present it to the board directly. Organize a 'second opinion' from a professional company that's undependable and critical enough to seriously test and analyze your stress test and its assumptions.
  
  Presenting a stress test without clear statements about the limits, vulnerabilities, constraints and shortcomings (every test has shortcomings) is like playing with fire and  offering your board 'the wrong end of the stick'.
  
  So we can add another conclusion quote:
  
  A good stress test transparently presents its weaknesses
  
  If nobody can find a weak spot spot in your stress test: ask a 5 year old child to ask some simple questions.....
  
  
• Compare Stress Tests
  Please  think about :
  
  'One stress test' = 'No stress test'
  
  Comparing successively executed stress tests on assumptions, methods and outcomes is essential for a correct understanding of the impact and consequences.
  
  Not only compare tests of your own company, compare also with tests of other financial institutions. Questions like: why do we as a [pension fund]  have different assumptions and methods than an international [bank], are key to a correct understanding of your own risks.
  
  
• Surpass Regulator Constructed Stress Tests
  Regulator Constructed Stress Tests(RCS-tests) seem relatively easy to implement.
  As a risk manager or board member you don't have to think about scenarios or methods. That's all been taken care of by the Regulator. Easy, isn't it?......... Wrong!
  
  Heedlessly implementing RCS-tests is risky. First of all, the regulator's principles are partly biased. As an example, take the risk of treasury bonds on your balance sheet.  Treasury bonds are commonly seen (and valued) as save (AAA-rating). However, some countries (Greece, Spain,Ireland etc.) have already been downgraded. Which countries will follow? Does the RCS-test includes this non-hypothetical risk? No? Does your own test includes this risk?
  

• By definition regulators have to act and communicate in a responsible and 'prudent' way about government financial issues. If they wouldn't, world wide financial chaos would be the inevitable result.
  
  
  The other side of this 'prudent coin' is that the actual risks are probably larger than can be concluded from the government (treasury) interest rates and interest spreads in a particular country. Here you'll have to develop your own risk model or - if data fail - formulate  your own risk approach (get out!).
  
  Key is that, given the general level of  systemic risk, all financial institutions must be able to withstand haircuts on all their own sovereign debt holdings.
  
  A 'third side' of this coin is the fact that regulators (in time) might decrease risks on certain asset categories that are not in line with your own risk view. Stay awake to prevent from becoming 'Supervisory Stress Compliant'.........
  
  

• Unmask Derivatives
  Market valuation with respect to derivatives is tricky business and probably only valid as long as there's a 'normal' market activity. Nobody is able to value derivatives under severe market conditions as is the case in stress tests. So, depending on the size and characteristics of a stress test, don't hesitate to to unmask your derivatives by applying a large discount on the value of your derivatives.
  
  

Conclusion
Stress testing is not for dummies, but for professionals.
It turns out that the more you're able to look different, critical and 'out of the box', the more stress testing will be successful.

Making your audience aware that a coin has three sides instead of two, is probably the essence of an actuary's or risk manager's profession. 

It has become clear that analyzing assumptions, models, outcomes,constraints and shortcomings of a stress test is no superfluous luxury. So stress test your stress test!

Related links:
- KAS BANK develops stress test for UK pension funds
- Concerns over latest EU bank stress tests
- EU bank stress tests, a joke (2011) 
- Lateral Thinking:  US Economy Stress test (2011)
- World Wide Interest Spread by Country (2011) 
- Government Bonds yields 10 Year Notes 
- How many sides has a coin? 
- Worst-Case Scenario Survival Card Game 

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)

What kind of actuary are you?

We all know plain actuarial skills are not enough to be(come) a successful professional actuary.

Time and time again we have to conclude that it takes more than average communication skills to overcome the persistent communication gap between actuaries and their audience.

In a 2008 workshop Matthias Bonikowski (Senior Manager at Milliman) presented the outcome of a German survey.

Here are the stunning results:

Proposition		Actuaries' opinion	Non-Actuaries' opinion
1.	Actuaries are pessimists	85%	85%
2.	Actuaries are not opportunists	70%	70%
3.	Actuaries communicate clearly and transparently	15%	5%
4.	Actuaries think out of the box	50%	15%
5.	Actuaries live in an ivory tower	10%	50%

The Copy Paste Actuary

From the Bonikowski survey it's clear that non-actuaries (including: board managers, sales directors, product managers, coaches and headhunters) don't speak highly of actuaries.

It looks like most of the 'actuary species' are perceived as a kind of 'Copy Paste Actuary'. One who's not able to think out of the box.

We are congenital pessimists, trained to do a sort of one trick pony act. An act we can't explain or communicate, like 'normal' people seem to be able to do. 

On top of this  - just like the famous Baron Münchhausen who was unable to escape from a swamp by pulling himself up by his own hair - we actuarial poor devils seem unable to lift ourselves to the next level.

We're obviously trapped in our 'non-communication' addiction, smoke gets in our eyes and nobody around us seems capable of helping us to move from our alien planet to the world of real people, business and social life.

The non-actuaries' view in Bonikowski's survey emphasizes this image...

The non-actuaries' view
The non actuaries' view on actuaries comes down to::
- They explain complex terms as complex as possible
- Inability to make actuarial things clear to non-actuaries
- They are not able to take a bird‘s eye view
- They are missing empathy for non-actuaries

As possible reasons for this view, non-actuaries notice:
- They are isolated from decision processes…
- High expectations about actuarial knowledge – deep and broad
- Communication skills are not a part of actuarial education

As a 'solution', 7 suggestions for successful communication are developed:

1. Point out key messages
2. Leave out details
3. Use more pictures and examples
4. Explain more in “black and white”
5. Avoid academic language/technical jargon
6. Pick up non-actuaries earlier
7. Define target-group specific communication rules

As we all know, these issues and solutions are not really new or surprising. Why is this issue of non-communication and 'Ivory Tower Effect' so hard to solve?

Actuaries are invisible

In 'My Opinion' of the Actuarial Review 2010, Grover Edie shows that we 'actuaries' are not in any way involved in important (political) decisions.

Important decisions that society has to take in coping with challenges as aging, longevity, health, etc.  Grover Edie explicates: 'they don’t ask us (actuaries) because we are not visible'.

My view is that the 'invisibility of  actuaries' is more or less a global issue.

Undoubtedly this theme of invisibility finds his roots in the actuary's attitude. This is well illustrated by Grover Edie's summarized reactions of actuaries on the issue:

• “If I do good work, others will ask me for more of it.”
• “I don’t need to advertise or to sell my work: My work speaks for itself.”
• “I certainly don’t need to sell others on the value of my work, and if they are too stupid to know the value of what I do, that’s their problem.”

Supply and Demand
Grover Edie thinks that this underlying 'laissez-faire  attitude' is the basic problem. A problem that - in his view - can be solved with a simple sales training approach.  With all due respect...., the invisibility of actuaries has probably a deeper cause than this superficial laissez faire attitude only, that is mainly the effect of the Law of Supply and Demand.

Most actuaries had to study hard to achieve their goal of becoming a qualified actuary. Once they'd become an actuary, there was, still is and will be, more than enough well paid work. In other words: The Demand side of the market market exceeds (by far) the Supply side of the market. Why should actuaries develop a commercial sales attitude if they don't need it?

In this situation the risk that an actuary eventually becomes a 'Mirror Actuary', is not inconceivable.

A mirror actuary, one who just reflects and gives back what the environment offers him.

He looks a bit like the invisible actuary. Without a real own opinion,  the mirror actuary just reflects the financial impact and consequences of decisions taken by others.  He  acts without sincere social engagement or conviction. Hence he's unable to generate a critical positive feedback viewpoint, necessary to make what its takes, the difference.

What does it takes?
Convincing actuaries to become more visible and socially or publically involved, takes more than a professional sales approach. Actuaries have to be made conscious of why and where they are and what they really want to achieve in life.
In other words:

What kind of actuary would you (really) like to be?

In this case the answer is not a traditional one like 'Pricing Actuary', 'Pension Actuary', 'Health Actuary; or the humorous answer 'very kind'. No, the answer to this question hits our actuarial soul....

The good old actuarial horse
Would you like to be the well paid 'actuarial horse' in front of the wagon, that gets his orders from the coachman and does his calculation work every time he's being asked to do deliver some?

Or do you want to sit on the wagon, next to the coachman, discussing and advising on the best route of the wagon?


Answering these simple questions is key in solving the persisting actuarial mind setting issue.

Visibility? Select at the gate!
This invisibility issue deals with the fundamental structure of an actuary's personality.  It's not something that can be easily learned or changed during or after achieving a (long term) study. If we want visible actuaries who are socially and publically involved, we'll have to select them on that attitude at the gate, before they undertake an actuarial study. Just like we test their arithmetic talent and other mental capacities, before actuaries start their study.

The Dancing Actuary

If we don't act upon this new 'visibility insight' and keep trying to beat the famous dead horse, things will never change.

In this situation there's a tricky risk that we enjoy our salary and comfortable position so much that we suppress our critical view and potential power to change things. In which case we become totally dependable on our monthly paycheck and the opinion of our boss or manager.

In doing so, we might gradually become implicitly susceptible to extortion and eventually things will escalate.

Ultimately in this situation, we could even develop to a kind of 'dancing bear', in this case a 'Dancing Actuary'.

Try to keep your eyes open. If you feel completely 'chained' or if our environment constantly forces you to support actions or decisions you can not really account for, seek help or step out before it's too late.

The Wise Actuary

Wrapping up this warning blog about invisibility, you could get the wrong impression that black swan actuaries doe not exist at all.

Of course we know better. There are lots of wise and visible actuaries around the world and as you've made your way to the end of this blog, you'll be probably one of them....

Wise actuarial owls that want to make the difference in life and society. Actuaries who are not for sale and who know their personal limits. Actuaries that know when and where to say 'no' or 'yes'.

Actuaries that don't just want to talk about a better world, but want to act(uary) on it.

Are you that 'wise actuary', who's visible, socially active and leading society to the next level?

Test

If you want to find out if you're a wise, invisible, mirror or dancing actuary, take the next 5 minutes 15 questions test called:

What kind of actuary are you?

Good luck with this 'actuary stress test'!


Related links/ Resources:
- Workshop Actuarial Communication (2008) Presentation (pdf)
- Article: They Don’t Ask Us Because We Are Not Visible
- Test:What kind of actuary are you?