Life is full of Risk.. We can not deny or totally exclude risk. Have you ever thought about living a (professional) life without taking any risk? What kind of life would that be?
There's this great actuarial risk quote of the famous economist John Maynard Keynes that states:
On the long run, we are all dead.....
So if you want some 'return' in life, you might as well take 'somewhat' risk before you 'certainly' die.
A nice illustration of total risk aversion is the 2004 movie "Along came Polly" were Reuben Feffer (actor Ben Stiller) is an actuary who, since his job involves analyzing risk for insurance purposes, likes living life in complete safety and free from any unnecessary risk.
This movie urges to ask yourself a simple question:
What's the risk of a riskless life?
Living life without risk if for dummies! Optimize the risk-return in your life.
Risk Guidelines
At the end of 2010 some simple Maggid 'Risk Guidelines' for 2011:
As long as there are no risks that'll kill you on the 'middle' or 'short' term: Take risk if you like the return outlook.
Think about how much bad luck or suffering you're willing to accept for a desired return. Key question here is:
Why does a marathon runner punish his body every day for weeks on end for an individual race?
Take a small risk every day! Invest small 'good things to do' by helping others without expecting a return. Soon you'll harvest some of your sowed investment seeds.....
Riskless Investment
Remember..., the only one riskless investment in life is.....
Actually, who are we actuaries to pretend that we can discount the future? Who's able to predict the future 50 years or more ahead in case of a pension fund? No, we're not crystal ball discounters, we're risk managers 'pure sang'. And as discounting risk managers we're pretty sure about two things:
The increasing uncertainty (fogginess) of future cash flows slowly kills its discounted predictability in time
Risk free discount rates doubtlessly include the risk of changes in future discount rates, but nevertheless vary in time.
Risk free discount rates are volatile and are unpredictable on the long run.
Historical development
Let's take a look at discounting developments from a helicopter's perspective...
A few decades ago, discounting was simple:
Discounting Around 1980
Whether you were in the insurance or pension business, way back in the last century actuarial business was simple. All you had to do as an actuary, was discounting the assets and liabilities at an explainable 'long term average' and 'realistic save' (whatever this means in today's perspective) discount rate and it was done. Subtracting discounted liabilities from the discounted assets, also resulted in a clear undiscussable equity size:(E= A - L)and - in case of a pension fund, the coverage ratio : (CR=A/L).
Discounting Around 1990
As computer and calculation capacity increased around 1990, actuarial models became more complex. Instead of as single projected cash flow, more complex cash flows and scenarios entered the actuarial model scene. With more sophisticated computer calculation power we were able to calculate and underpin risk-return investment scenario's that led more to more risky 'risk controlled' investment policies.
'Risk' was translated into (replaced by?) 'volatility' and 'volatility' was translated into 'variance'. Thus future risks where estimated on basis of projected historical variance and (later) with help of VaR models.
However, 'Risk' was mainly defined on (and restricted to) the left side of the balance sheet: the assets. In line with this view, the insurer's equity could be simply expressed as : E= A - kA.σA- L (mp= minimum position) , or in case of a pension fund, the coverage ratio: CR=(A - kA.σA) / L (mp).
Discounting Around 2000
More than a decade later, beginning 2001, fair value accounting and market value broke through. Not only stocks had to be valued at Market Value, but also bonds. As a consequence the volatility of the left side of the balance sheet increased more than ever.
As actuaries we thought we would be save on the right side of the balance sheet were things were steady and calm as always... However, a few years later the 'Actuarial Sleeping Beauties' were kissed to life as Market (consistent) Value was introduced with regard to discounting liabilities. This development fired the starting gun to a swapping right size of the balance sheet.
Now insurers (minimum) equity got squeezed up between two volatility monsters, assets and liabilities:E= A - kA.σA- L -kL.σL (mp).
Pension funds had to become real acrobats to manage their new wobbly coverage ratio: CR= (A - kA.σA) / (L + kL.σL)(mp).
No wonder pension funds and insurers got into trouble when the credit crises caused the final blow.....
Rebuilding stability
In Europe insurers are trying to rebuild stability by means of "Solvency II". Pension funds are trying to find their way out by suggesting more conditional pension rights. Some have even suggested to steer (valuate?) pension funds on basis of a kind of "moving average method" (asset returns or coverage ratio).
Other 'actuarial pension experts' have told me that we should stick to market value and accept the consequences, e.g. just accept that coverage ratios can stay below minimal level for several months, without anyone panicking..... Simply explain to pension fund members that the pension fund is long term well funded and there's no reason for panic if the coverage ratio breaks down for a short period....
Don't Panic......
This reaction reminds me of a weird family experience, when we where on holidays many years ago in a village called Ballyheigue (west(ern) Ireland).
Don't panic!
That afternoon my wife, the kids an I arrived in Ballyheigue. We stayed in a lovely local hotel near the fantastic west coast of Ireland.
The local assistant manager welcomed us and pointed out that there was a small minor (2x!) problem that could occur: Last week, at irregular moments, the hotel alarm had gone off several times, this could probably happen again. Reassuringly, he explained that in the unfortunate case the alarm would go off, we shouldn't panic and just stay calm, as it would probably be a false alarm.....
That night we confidently went to bed early......
Then, at 01.30 AM that night, suddenly the fire alarm goes off. An ear piercing sound cuts through our ear drums... Within 2 minutes we - all hotel guests including my family - are all outside, despite the reassuring words of the hotel assistant earlier that night.
Conclusion
From this simple experience we can conclude that 'reassuring words' don't help in panic circumstances. Ergo, it's impossible not to panic in case coverage ratios go down for several months....
Convincing people 'not to panic' in case of 'clear panic signs' is an almost impossible task. Once one mentions the word 'panic', all human systems get in a kind of non stoppable alarm mode. It's like the famous scene from Fawlty Towers :
Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes
More in general Goodhart's Law is Goodhart's law is a generalized social science expression of the so called 'Lucas Critique'. Named after Robert Lucas who argues that it is naive to try to predict the effects of an (economic) change entirely on the basis of relationships observed in historical data.
Actuarial examples...
Some remarkable actuarial examples of Goodhart's Law are:
Historians...
Early 2009 Goodhart proclaimed : “One of the lessons of the recent crisis, a lesson for bankers and for regulators, is, hire fewer mathematicians (actuaries) and physicists who build models on the basis of data that they can observe over relatively short period, and hire a few more historians who know what can go wrong even if they don’t necessarily have a good data basis to put into particular models”.
Although Goodhart is probably right, actuaries should keep an eye on the process....
Future developments are a function of Data, Probability, Uncertainty, Experience and above all Common Sense.
Just like the Roman God Janus, actuaries should look at the future, with the past in mind. And to do just that, we need all the help in the world, especially from historians....
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