Systemic Risk

In an excellent paper called 'Defining and Measuring Systemic Risk', professor Sylvester Eijffinger of the Tilburg University discusses actual developments around one of the most interesting risk topics of this moment: systemic risk (not to be confused with systematic risk).

Just a short warming up to actually download and read this excellent article:

ESRB
Main target of the 2010 launch of the European Systematic Risk Board (ESRB) is trying to identify and avoid future financial crises before they start. This implies that ESRB's main issue is 'how to detect systemic risks '. All this -of course - under the lead of the European Central Bank (ECB).

First of all the ECB does not have a clear concept of systemic risk, nor in the academia there exists a generally accepted definition. However, the G10 definition provides a good starting point:

Systemic risk
Systemic risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy

This still sounds pretty complex, and it is.
To get the right feeling, take a look at the next diagram illustrating a network of Credit Default Swaps (CDS) contracts:

In his blog 'complexity is our enemy' Steve Hsu, Professor of physics at the University of Oregon, explains in short and in simple words the principles and problems of the Credit Default Swap Market.

Hsu perfectly illustrates why some financial institutions are 'too connected to fail', as opposed to 'too BIG to fail'. Systemic risk is all about complexity.

New early warning models
There are several new models that can predict a financial crisis. Key challenge is to find a model with an indicator that predicts a potential crisis (just in time) with high probability, while at the same time minimizing errors of type I errors (missing crises) and type II false alarm).

One indicator can be qualified as the best current performing indicator: 'The global private credit gap', by Alessi and Detken (2009). This method predicts 82% of the crises correctly and has a 32% share of false alarms. 95% of the crises (price boom/bust cycles) are signaled in at least one of the 6 preceding quarters and the difference in the conditional and unconditional probability of a boom following a signal is 16%

Individual Institutions’ Contribution to Systemic Risk
For measuring risks of individual banks, a measure called CoVaR was developed by Adrian and Brunnermeier. The CoVar model measures the marginal expected shortfall (MES) as used in Value at Risk (VaR) as well as the systemic expected shortfall (SES).
Eijffinger's Conclusion
Finding new early warning instruments that are effective, easy to use, and independent of the interest-rate instrument seems to be an impossible task. And yet there is a solution according to Sylvester Eijffinger: "Central banks should give the growth of (broad) money supply more prominence in their monetary policy strategies."

The ECB with its often criticized monetary pillar may have a head start. Important central banks, such as the Bank of England and the United States Federal Reserve, kept their key interest rates too low for too long leading to a long period of double-digit growth in money supply.

The ECB was more cautious. To be sure, the fall of he risk premium on financial markets, the development of all kinds of exotic derivatives, and these derivatives’ subsequent misuse sowed the seeds for this crisis, but those factors could not have caused the crisis without the plentiful rainfall that allowed those seeds to grow.

Finally
What can pension funds and insurers learn from this?
The answer is simple:

• Make Risk Management top priority nr. 1
• Develop and implement in advance - cross financial institutions - early warning models.
• Insist upon regulators to create a world wide central registration data base that registers and reports all possible derivate transactions in the financial market. Every financial institution has to report every transaction in a preformatted form.
• New financial products are subject to approval ('no objection') by the regulator before market launch.

This way regulators will have a complete transparent view cross financial institutions. Systemic problem solved.

Sources
- Eijffinger:Defining and Measuring Systemic Risk
- The global private credit gap
- CoVaR modelM
- Steve Hsu: complexity is our enemy

Out of the Box Actuary

So you're one of those rare actuaries who thinks he really can think outside of the box?

Well, this is your lucky day. Out of the dark chambers of Actuarial Science, professors developed a brand new test for financial experts like actuaries, to find out if you qualify for the new title

Actuarial Master
Out of the Box Thinking

Most remarkable is that this test consists of only one simple question.

If you manage to give the right answer to this question within 10 seconds you'll qualify for the title. If it takes up to one minute, you'll qualify for your bachelor's degree. If it takes longer, don't be ashamed, just stay "Qualified Actuary".

However, if you don't succeed at all, simply change your title to Actuweary...., nobody will notice ;-).

In case you need help to find the right answer, you are allowed to use this tip.

Now, I will no longer keep you in suspense, here is the key question:

Just click the picture, to find out the right answer!

If you unexpected failed to come up with the right answer, please read the next fabulous blog to escape your expert view:

Are you stuck in a rut? Run from the experts!

Insolvency and GDP

Global insolvency rises further in 2009 and will stabilize at a high level in 2010.
Those are the main conclusions of the world’s leading credit insurer Euler Hermes.

Euler Hermes is forecasting a 33% rise in corporate insolvencies worldwide in 2009.

In 2008, half the global increase in insolvencies resulted from financial restrictions whereas in 2009 the main factor has been the economic recession. Due to unemployment and weak recovery, business insolvencies will remain at high levels in 2010.

Insolvency growth champions with rocket growth of 75% or more are Spain, Ireland and the Netherlands (as well as the Baltic countries).


Insolvencies have soared by more than 35% in the United States and Northern and Eastern Europe.

Relationship GDP & Insolvency

The relationship between GDP and insolvency is quit interesting.

Corporate insolvency turns out to be different from one country to another.

Although there are differences, the change in insolvencies over time - rather than their absolute numbers - turns out to be strongly related to the change in GDP.




In short one might conclude:

Declining GDP implies inclining insolvencies

Strong local differences
The strong GDP-Insolvency relationship of the Global Insolvency Index (GII) is also - in a slightly different way- visible on zone or country level.


For each of the 33 countries that are analyzed by Euler Hermes, the insolvency index is calculated using a basis of 1997=100.

Next, the GII is calculated as the weighted sum of the national indices.

Each country is weighted according to its share of total aggregate GDP (at current exchange rates).



As actuaries we're all interested in in 'credit spreads'...

Questions:

1. Is there any relationship between 'credit spreads' and 'insolvency rates'?
2. Would insolvency rates influence our business in any way....?

Sources:
- Press release, Euler Hermes Nov. 17, 2009
- Insolvency Outlook Euler, Hermes February 2009

Actuarial Health Care Reform Puzzle

From a European perspective it's hard to understand why the US Health Care Reform creates such a fuzz.

Behind Health Care Reform
At first sight one might think American values were somehow at stake, as UCLA's Dr. Marc Nuwer, a leading expert on national health care reform, stated back in 2008:

• "To heal our ailing health care system, we need to stop thinking like Americans."
  
  
• "Americans prize individual choice and resist limiting care"
  

As one-sixth of Americans are uninsured and especially elderly people are in need of good (insured) health care, one would expect this group to support this new health reform. Think again, the majority of elderly people voted against a guarantee of health insurance for all Americans:


Not a surprise for actuaries of course, because we were already aware of the interesting age-distribution of the uninsured.



Recently, Tyler Cowen, a economics professor at George Mason University additionally stated : Further health care reform doesn’t now seem to promise much to old people, except spending cuts on them. Given their limited time horizons, old people don’t so much value systemwide improvements, which invariably take some while to pay off.

For those of you who are interested in the background and consequences of pay offs regarding limited time horizons, (generation) discount rates and 'Gamma Discounting', the article Caring about the Distant Future: Why It Matters and What It Means from professor Tyler Cowen is a joy to read.

Certainly a 'must read' for actuaries.

Future Health Care Reform

Anyhow, the House of Representatives passed the sweeping health care bill recently.

Puzzle is that this bill has nowhere to go in the Senate, as the stumbling block is that government will have to compete with the private insurers.

The solution to this problem is as simple as can be:

Implement the headlines of the Dutch Health Care Model

Key elements of the new (2006) Dutch Health Insurance Act are:

• All adults are obliged to buy health insurance and can choose any insurer
• Children (under 18 years) are insured for free
• Low income groups receive financial compensation by tax reduction
• All insurers must offer a (governm. def.) policy to anyone who applies
• Basic benefit package is almost comprehensive
• Insurers get compensation for taking on higher risk patients from the risk equalization fund
• Insurers can offer complementary health insurance packages under free market conditions
• Consumers have the right to change insurer at the end of every calendar year if not satisfied or if they change employer
• Insurers have the role of prudent purchasers of health care
  (value for money)
• Providers are encouraged by insurers to deliver high quality care at low costs

In a 2009 Irish (Dublin) Health Actuary Seminar called 'More for less', the Dutch health actuary Enne Osinga explains more of the consequences of this new (2006) Dutch Health Care Model in a presentation called: The Dutch Experience .

I trust the US succeeds in making this important turn around!

Sources:
- Tyler Cowen: Caring about the Distant Future: Why It Matters..
- Economics
- Yahoo
- CNN
- UCLA
- Health Coverage & Uninsured (2009, 2007)
- RIVM Article:Regulated competition behind the dykes?
- Enne Osinga: The Dutch Experience

Invest or laugh

Every crisis generates his own new quotes. Currently, investment quotes are the top.

Perhaps two of the best investment quotes ever are from AIG Vice Chairman Jacob Frenkel:

"The left side of the balance sheet has nothing right and the right side of the balance sheet has nothing left. But they are equal to each other. So accounting-wise we are fine."

--------------------------------------------

"Credit markets do not function. Why not, because the word credit comes from credibility"

But there's more... A nice summary of investment ROFL quotes can be find on Ian Thomson's blog Investor Jokes.

As actuaries, let's profit from Ian's latest insights and gain some extra education points by studying the next new investment definitions:

• A long term investment: Short term investment that failed.
• Momentum Investing: The fine art of buying high and selling low.
• Value Investing: The art of buying low and selling lower

Probably investors and actuaries will have a hard time understanding each other, as the difference between them is in the 'tail' .....

Also large-cap fund managers have a hard time these days. No wonder everybody starts looking for a small-cap fund manager....
But how do you find one? Ians' answer is simple: Find a good large-cap fund manager, and wait...

Anyhow, keep up your good mood and laughs, as more investment 'animals' will show up next months.....


Let's conclude this blog with an old actuarial warning:

"Where there's smoke, someone gets fired"

P.S. For some more 'serious' investment quotes take a look at 52 Must Read quotes from the legendary Investor Warren Buffett. I'll quote some of the best here:

• I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.
• If past history was all there was to the game, the richest people would be librarians (actuaries?).
• It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
• It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.
• It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
• Price is what you pay. Value is what you get.
• Risk comes from not knowing what you’re doing.
• Risk is a part of God’s game, alike for men and nations.

How can actuaries profit from Buffett's quotes?

Sources:
- Greekshares Jokes
- Ian's Investor Jokes
- Warren Buffett: 52 Must Read quotes

CERA: Actuaries on a new track

Actuaries are taking a new step towards professional risk management.

After the U.S. started in 2007 the initiative for this new direction in the actuarial profession, this month the Society of Actuaries (SOA) signed a treaty with 13 other international actuarial organizations to establish the Chartered Enterprise Risk Analyst (CERA) as the globally recognized enterprise risk management (ERM) credential.



The designation will recognize actuaries globally who meet stringent education requirements in ERM and are governed by a strong code of professional conduct. The “CERA” letters after an actuary’s name indicates to the business world that there is no other type of risk professional better equipped to take a 360-degree view of an organization’s risk profile.

CERAs don’t merely speak to what we can lose, they focus on what we can gain.

Enterprise Risk Management isn't just about dealing with financial risk. ERM is an attitude, a new way of thinking. CERAs will become the boards most reliable advisors, they can't do without.

Sources:
- SOA
- CERA

Reward Wisdom

We all know the quote

'If you pay peanuts you get monkeys'

Unfortunately the opposite is also true:

"If you pay bonuses, you get donkeys"

There is nothing against an attractive yearly bonus reward, based on challenging but nevertheless realistic (long term) goals in line with a confirmed and balanced risk approach.

Excessive bonus rewards however, seduce people to inferior (selling) methods or taking unacceptable (covered) risks.

An excessive bonus reward system always poisons the company and attracts the 'wrong' people. Your company doesn't need high risk takers or 'luck seekers'. Think twice....

Risk IQ Test

What's your Risk IQ?

In a few minutes you'll know by taking this RISK IQ Test.

Actuaries are often born CROs (Chief Risk Officers), so this test will probabely be a peace of cake for any actuary with CRO aspirations.....

Simply scroll through the next Powerpoint presentation from Fintools.

Each slide contains a multiple choice question.
Think about the answer and then scroll (click on the right part of the presentation) to the next slide for the final answer...
RiskIQ

Hope you succeeded....

If not... get some training at Fintools

Original Source: Fintools

The first Actuary

As the story goes, insurance began around 1688 at a coffeehouse in London called Lloyds, where shipman discussed and divided their risks.

That 'explains' the birth of non life insurance.

But what about life insurance?

Who developed the first life table?

Answers...
The answer to this question depends on who you ask...

• Definitely Graunt in 1662 (statistical analyzes of data)
  
• Surely De Witt in 1671 (life insurance tables)
• Undoubtedly Halley: 1693 (life insurance tables)

Depending on what you define as a life table, answering this question often leads to a never ending semantic discussion.

Don't worry, there's help... In his Google-book, "A history of probability and statistics and their applications before 1750", Anders Hald explains the origin and development of life tables.

First Life Tables
An indeed, the 'first' life tables, based on more or less empiric data and interest rates were developed at the end of the 17th century.
The first actuary....
However, already in the 3rd century the Roman jurist Ulpian devised a table for the legal conversion of a life annuity to an annuity certain.
It was pointed out by Greenwood that the valuation (duration) of the annuities was deliberately chosen to high, in order to protect the interests of the legal heir.

This would implie that Ulpian not only did a tremendous job by estimating life annuities, but also developed and applied the first primitive 'Solvency Zero' principles...

With his 'simple table', Ulpian was more than ahead of his time.

So, we may rightfully conclude that the one and only first actuary was a jurist: Domitius Ulpianus, alias Ulpian

Strange that it took more than 1500 years to develop more sophisticated life- and annuity tables.

Related links & Sources:

• Early uses of Graunt's Life Table
• A history of probability and statistics and their applications before 1750
• Early Insurance Mechanisms and Their Mathematical Foundations

Pension Fund Market Valuation ParaDox

Is Market Valuation (MV) the right tool for pension funds?

Mid 2009, the new appointed ABP chairman Nijpels and - previously - the ABP CFO ten Damme (picture on the right), stated that the relatively new method of MV is inadequate for pension funds.

Both think that valuation of pension funds could be better based on a (seven year) moving average interest rate.
Nijpels en Ten Damme are supported in their view by Albert Röell, Chairman of KAS BANK, who advises the Dutch regulator DNB to reassess its policy.

Nevertheless DNB doesn't seem to respond.
Neither Roëll nor the world's third-biggest pension fund gets an answer. Is ABP crying over spilt milk?

Why MV?
At first sight, there seems nothing wrong in calculating the value of a pension fund, on MV basis. Market (consistent) valuation implies that the value of an asset or liability is defined by it's market price. If the market is too thin, a mark-to-model approach can be used....

Clearly MV increased the transparency and accountability of pension funds. However, 2008/2009 show that MV, based on the actual term structure of interest rates, leads to excessive volatility in funding ratios.

Is MV the best method?
Of course MV can be a best practice method in helping to define the pension fund value in case of a merger, a takeover or with regard to managing assets. But is MV also the best method for managing the pension fund as a whole, from a board, regulator or 'pension fund member' perspective?

• Future certainty
  The first fundamental question is :
  
  
  can we define the value of long-term
  ( 60 years or more) cash flows at all?
  
  
  The answer is: No, we can't!. Just take a look at an average CFO, who's proud to present his next quarterly company result with 60% certainty. What would be the certainty of the long-term company result of - let's say - 20 years ahead. Exactly: Almost zero.
  
  It's impossible for anyone, no Nostradamus Actuary included, to predict the compound and correlated long term effects of interest rate, stock market, derivates, inflation, salary increases, mortality, disability, longevity and costs. Therefore, if it's not possible....., don't pretent you can.
  
  
• Pension fund: Not for Sale
  Second important subject for consideration is that a pension fund (in general) is not listed on the stock market. Also, in general, it is not for sale on the market. Therefore, the hourly, daily or monthly calculated MV is only of limited interest with regard to the pension fund's strategy, policy or control.
  
  Neither is MV the right base for monthly adjusting of the contribution rates, funding rates or indexation capacity.

Principles
Simply stated, it's important that a pension fund:

1. can meet its obligations "on the long-term"
2. is sufficiently liquid to pay his annuities "on the short-term"

Moving average
The first statement implies that if you take the funding ratio as steering/testing parameter (there are more!), there is - given the mentioned long term uncertainty - no other option than to base the valuation on a more (term dependent) 'moving average' of interest rates in combination with the moving average value development of other asset classes. The choice of the moving average period is critical.

Dead Money
Even more, if the pension fund is forced to act on basis of MV, it has to keep extra (non-volatile) buffers to withstand the possible effects of non-relevant short-term market fluctuations. On top of this many pension funds tried to downplay their indexation ambition.

The consequence of all this is that MV generates a substantial amount of structural "dead" capital into the balance sheet. "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.

Paradoxical measures
In case - due to market developments - the MV goes down , short-term prudential constraints (as enforced or stimulated by the regulator) will moreover endanger the long-term objectives of pension funds. Consequently leading pension funds from the frying-pan into the fire.

There's another interesting aspect that pleads against MV. In general (Dutch) pension funds cannot go bankrupt, as they are allowed to cut back on the participants’ entitlements in extreme (emergency) situations. So the key question is what kind of minimum security level we enforce upon ourselves. Just an example to illustrate this:

Example
What would you prefer:

1. 100% of the yearly pension that you have been promised, on basis of a 125% funding ratio
2. 125% of the yearly pension that you have been originally promised, at a 100% funding ratio target

Remember there is no ultimate warranty whatsoever in either situation.

The only difference is that in scenario A the chance that your entitlements will be cut down is slightly smaller than in scenario B. But this last situation is as hypothetic as it can be, as contributions will be raised first, before any cut down scenarios will be considered.

So its better to use the funding ratio surplus for legalized controlled indexation and pension benefits improvement than as 'dead' money.

A final argument in the war against MV for pension funds is the next illustration .....

ParaDox
Let's take a look at a company called ParaDox.... ParaDox produces parasols (sunshades) for the high season.

In winter, ParaDox produces at full speed in order to achieve a top level inventory at the start of the summer.

In winter, however, hardly any parasols are sold. During this cold season the price of the parasols on the market (in the shops) drops to about 50% of the summer price. Even more, parasols sales go 80% down in winter (cf. long-term investment market).

If ParaDox would apply MV based techniques, it would have to depreciate their current stock to 50% of the (summer)value. Surely ParaDox would go bankrupt. No, every sensible human being, including actuaries, would decide that in this situation it's best to value the stock of ParaDox on basis of the 'moving average' (realized) sales price over one or more recent years.
N.B. Even if ParaDox would have one or two 'bad summers', deprecation would not be considered.

If in this ParaDox case it's clear that market valuation (i.c. deprecation) is unwise, the more it must be clear that in a company with long-term obligations and high uncertainties , like a pension fund is, it's naive to operate and steer on basis of MV.

Moving Average Period
Now that's illustrated that the Moving Average Method (MAM) is preferable above the MV method (MVM) for pension funds, there's still one thing to decide: the 'MAM period'.

If the MAM period is chosen too short, it will suffer the same disadvantages as the MVM.

If it's chosen too long, there's the risk of not being able to adapt fast enough to realistic contribution levels, if needed. In this situation there's also the risk of unintentional intergenerational financial effects. However, these effects can be yearly calculated and translated into a sound policy.

From this perspective it seems reasonable to fix the MAM periode to the average duration of nominal pension liabilities, which is (in The Netherlands) about fifteen years (in real terms, it is even longer).

Hope
Let's trust that DNB listens to ABP and KAS BANK, so that 'pension funds' and 'pension fun' become one again!

Related links:
- P&I/Watson Wyatt World 300 Largest Pension Funds
- Market-consistent valuation of pension liabilities (must read!)

Actuagram

If you want something to chew on, something that challenges your actuarial brain and associative power, try to solve the next Actuagram.
This actuarial brain teaser is a mix of an actuarial crossword puzzle and a cryptogram.

How to play the puzzle:

1. Click on the word you would like to solve.
2. Fill in your suggestion, click on OK
3. Only if you do not know the answer, click on the 'solve button'

Can you manage, without using the 'solve button' ?

Congratulations! Actuaries, have fun!

[ If your browser doesn't allow you to play here, click on this link]

Actuagram

by Joshua Maggid
EclipseCrossword © 2000-2007

This interactive crossword puzzle requires JavaScript and a reasonably recent web browser, such as Internet Explorer 5.5
or later, Netscape 7, Mozilla, Firefox, or Safari. If you have disabled web page scripting, please re-enable it and refresh
the page. If this web page is saved to your computer, you may need to click the yellow Information Bar at the top of
the page to allow the puzzle to load.

Actuarial Sustainability Alarm

Recently the European Commission launched the 'Sustainability Report 2009", investigating the long-term (2010-2060)sustainability of public finances.

This report clearly shows the long-term economic effects of the aging society and the continuous increasing life expectancy.

Financing increasing pension and health costs in the next decades, will be a real challenge for almost all European countries. Even more, the current financial crisis and unsure financial outlook urge for severe short term measures in order to prevent much more unpleasant other measures in the next decades.

The report claims that the ability to meet public pensions liabilities is a higher long-term risk for governments than ever before and in most cases reform of member states’ pensions systems is 'must' and can no longer be delayed.

Although the report manly focuses on the increase (the so called delta) of the sustainability gap, I would like to take a look at the development of the aging costs in relation to the debt development of each country.

Development Aging costs
Let's start to take a look at the development of the public pensions liabilities (pension costs) and health costs from a slightly different angle as published in the report:

On average the total aging costs are increasing from 25% in 2010 to about 30% in 2060 on bases of a no-policy-change assumption.But there a countries (BE, EL, LU, SI) that grow way above this average to a level that's even above the current level of countries with high social standards, like Sweden and Finland.

To conquer this development, some member countries are trying to tackling the longevity issue by raising retirement ages.
Not only the pension costs increase, but also the projected long-term increase in healthcare spending is large and constitutes on its own a risk to sustainability.

Countries whose regimes are listed by the report as 'high-risk' in terms of sustainability are: The Czech Republic, Cyprus, Ireland, Greece Spain, Latvia, Lithuania, Malta, the Netherlands, Romania, Slovakia and the UK. In many countries the age-related expenditure is expected to climb quickly against existing financial imbalances.

Development gross debt ratio
As is clear from the next table, the mentioned next decades increase in health and pension costs, in combination with the unhealthy financial situation - due to the credit crisis - cumulates in a clear desperate debt situation for most of the European countries:

The table shows the government gross debt ratio in 2008 and 2009, and the projections for 2010, 2030 and 2060, once the costs of servicing debt and paying for age-related expenditure are taken into account.

As mentioned before, the long-term debt projections have been prepared under a no-policy-change assumption and in partial equilibrium. Given these assumptions, the projections are not robust forecasts and are not meant to be realistic scenarios of what may happen in the future.

The aim of the debt projections is to illustrate the long-term trends and the size of the required remedial action to avoid government debts to enter into an exponentially increasing spiral.

Actuary Involvement
It's clear that the debt and social costs developments are not heading in the right direction..... Actuary involvement to analyze, advice and create new social systems seems necessary.
Actuaries on the bridge, please!

Sources
- IPE
- EC
- Sustainability Report 2009
- Report 2009
- Download: Maggid Excel tables Aging Costs and Debt Development