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

Longevity Swaps: The Next Bubble

Last century our Human Footprint Index (the relative human influence in each terrestrial biome on Earth) increased exponentially.

According to the Human Footprint Index, not only Europe (left picture), but also India and the North East of the U.S.  are  'humanized'.......  Step by step we - human beings - are 'amazingly' filling up every little corner of the world.

Just a few more years and - as a species - we'll be 'omnipresent'.

.

Yes, we are crowding this good old earth at an immense speed, as our health increases and we keep living longer every year. The social and financial effects of this population growth will be enormous.

Nevertheless we're very unsure about how our population will grow in the future...

Key point is that population growth will strongly differ per region and country. The growth in the western countries will be driven by the aging population, while the growth in developing countries, like Africa, will be driven by new births. In the' aging countries' population growth will undermine our social and first pillar pension systems....

Pension Fund Transform
This aging society development implies that our mature pension funds will have to transform from pension-saving to pension-paying.

Secondly 'longevity risks' become more and more important and can not be 'financed' anymore from the declining funding margin.

Example: The Longevity Trap
Let's take a simple example.

Rule of Thumb Nr. 1
In the so called developed countries, every year we live, our life expectancy increases (on average) with 3 months! Or, as Harry de Quetteville from the Telegraph stated it more humorous:

For every year we live, we are only really nine months closer to death!

Rule of Thumb Nr. 2

This rule of thumb states the financial impact of longevity:

One year increase in life expectancy from age 65 equates to approximately a 3% to 5% increase in pension value liabilities.

Combining  rule I and II leads to the conclusion that on average the pension liabilities of mature pension funds currently urge for a yearly 1% increase of liabilities, just for financing the cost of extended longevity.

A decade ago, the slowly increasing 'sniper costs' of extended longevity could easily be financed out of the pension fund's margin.

Nobody (not even an actuary!!!) could imagine that longevity would become a substantial issue.

Later that decade, disappointing stock returns and low long term liability discounting rates shrinked the pension margin and even turned it negative. This pension margin reduction put the cost of extended longevity in quite a different perspective. The 'Actuary Longevity Trap' had become a fact!

What really had happened was that the high returns and interest rates of recent decades masked the (increasing) costs of extended longevity.

'Once bitten, twice shy', one would think.... But not for actuaries, as
the next bubble is coming up........

Longevity Swaps

The Next Bubble

Reinsurance

Not only pension funds but also Life insurers are facing significant longevity risks as mortality rates are still declining. Reinsurance companies like Swiss Re and Münchener Rück try to fight the underestimated longevity effects of pension funds with so called ‘Longevity Swaps’.

The essence of a longevity swap is that a pension fund trades the - due to longevity - uncertain estimated future pension payments until death (floating leg) against the actual future pension payments for the scheme’s pensioners payments (fixed leg).

Why a Longevity Swap is a bubble?....
The Longevity Swap only transfers the risk to a counter party (reinsurer), but this counter party in general doesn't have a complementary risk to match the accepted risk of the longevity swap. The counter party bases his underwriting only on a more 'safe' calculation. 

This implies that whoever is sitting at the end op the swapping chord, will finally pay the bill (systematic risk!) in case longevity risks are structurally being kept underestimated. Now if one thing is a fact, it is that - for decades - longevity risks are underestimated en this underestimating behavior will continue in the future, as we actuaries are apparently ignorant at this point.

Just like the high interest rates in the past masked the actual cost of the extended longevity, current longevity swaps wrap' long term unsure and underestimated  future mortality rates' in interest-discounted derivatives. 

Whatever reinsurers are discounting after 30-50 years at interest rates above 2% doesn't really count anymore in terms of present value. but will reveal itself in the coming decades....

By the way, is a 90% (asymmetric?) confidence level resulting in a 11 year life expectation spread in 2050 consistent with a 97,5% or 99,5% confidence level used as basis for a longevity swap?

Probably not.........

But who cares about consistency, when 'short money' is on the table?
You? (Hope you do..)


Conclusion
We're left with no other conclusion than that it will turn out that longevity swaps in their current form are the new systematic risks of the future!

Any solutions? 
The only solution to prevent longevity swaps from becoming a bubble is to find complementary 'matching' risks that compensate the accepted risk (profile).

It's hard to find matching risk profiles for the reinsurer. The fact that longevity mainly applies to older people (top around age 80-85) makes it hard/impossible to compensate longevity risks with mortality risks at younger ages.

Perhaps a kind of solution could be that pension funds could offer the relatives of a pensioner the possibility of insuring (life insurance) the calculated liability of the pensioner (or the remaining annuities until the age of 80) at the moment of death  (a kind of liability legacy life insurance).

Perhaps some creative actuaries have some other ideas? Please let me know...


Sources & Related Links:
- Life Tables United States Social Security Area (2005)
- The Human Footprint Index Graphics
- World Population Growth
- Wapedia: World Population
- A model for longevity swaps
- Understanding Modeling and Managing Longevity Risk
-  The pros and cons of longevity hedging(2010)
- Longevity Risk in Pension Annuities (2005)
- Increasing Longevity: Effects on Pension (2009)
- Longevity swaps as an investment (2010)
- Pensions: Change management (2009) 
- Pensions: On the wrong track? (2009)

What's that, an actuary? Kamikaze Investors

'Housing' is probably one of the most complex assets and also one of the most interesting.

Wake up...
At the next birthday party when somebody asks you the regular line: 'What's that, an actuary?....'  Don't answer the obligatory way, but demonstrate your actuarial risk management abilities in an interactive way....

Just ask who of your birthday friends would call himself a private - non professional - risky investor?........

After some hesitation and discussion, probably all of them will answer something like:  'No, I would not dare to risk much money, I put most of my savings in a 'safe - as possible - bank account'.

Than, your next question is: "Who owns a house?"
Now, probably more than 60% of your friends will raise their finger......

Congratulations! Now you may congratulate this 60% of your friends with the fact that they are probably a more risk taking investor than an average pension fund, because they are most likely (by far) overfunded  in the asset category "Housing".

After grasping the point of your little quiz, most of your friends will first laugh, than think, and after a while some of them will ask you what they should do about being a Kamikaze-investor?

Now you get to the tricky part of being an actuary:

1. Never tell anyone what to do, 
2. Just show them the possible scenarios
3. Point out and quantify the risks, and 
4. Help them take their own decisions 

House-Pricing
 A lot of research has been done around House pricing and risk.

Although their seems to be a positive relationship between interest rate and housing-price growth, the housing risk is much more complicated than that.

Also housing prices differ strongly by country, as the next Economist table shows:

And because as actuaries, we're little Kamikaze-investors as well, the Economist has developed an interactive application to get sight at the housing-price development in your country relative to others.

Have fun with this House-Price Calculator

Related links:
- Economist House-Price Development Calculator 
- Housing consumption-based asset pricing and residential mortgage default risk. (2009) 
- Home Values and Household Debt Present Global Risks
- Running on funds: Complete (2007) Fitch Table