Groupthink

IMF evaluated its role and performance in the recent financial and economic crisis.

Cause

In a 2011 crisis report with the short title: 'IMF Performance in the Run-Up to the Financial and Economic Crisis:IMF Surveillance in 2004–07 ', IMF concludes that the main cause of their inadequate response during the crisis was:

Groupthink

IMF’s ability to detect important vulnerabilities and risks and alert the membership, was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed.

The IMF’s ability to correctly identify the escalating risks was hindered by:

1. A high degree of groupthink 
2. Intellectual capture
3. A general mindset that a major financial crisis was unlikely
4. Inadequate analytical approaches
5. Weak internal governance
6. Lack of incentives to work across units and raise contrarian views
7. A review process that did not “connect the dots” or ensure follow-up
8. Some impact of 'political constraints'....

Recommendations

IMF suggests some recommendations on how to strengthen its ability to discern risks and vulnerabilities and to warn in the future. Main point is to enhance the effectiveness of surveillance: it is critical to clarify the roles and responsibilities of the Board, Management, and senior staff, and to establish a clear accountability framework.

Looking forward, IMF needs to

1. 
   Create an environment that encourages candor and considers dissenting views
    
2. Modify incentives to “speak truth to power”
    
3. Better integrate macroeconomic and financial sector issues
   
   
4. Overcome the silo mentality and insular culture; Deliver a clear, consistent message on the global outlook and risks.

Recognize Groupthink
Groupthink is not just something happening to IMF or 'other organisations'. We, financial institutions, all suffer somehow or somewhat from the Groupthink Virus.

How can we recognize Groupthink?
Derived from an article by Irving Janis, the inventor of the word Groupthink, let's take a look at some explicit signs of Groupthink:

1. Winning Mood syndrome
   A common illusion of success (Folie à deux), invulnerability, over-optimism, unanimity and risk-taking as a consequence.
2. Collective rationalization
   Managers, employees discount warnings and do not reconsider their assumptions
3. 
   Repression or Ridicule
   Direct pressure on and ridicule of  individuals who express disagreement with or doubt about the majority view or the view of the leader
4. Fear
   Fear of disapproval for deviating from the group consensus. Fear from or doubt about expressing your opinion.
5. Manipulating
   Remaining silent in a discussion is implicitly interpreted as agreeing.Obviously 'wrong' arguments are used to achieve a certain goal or policy.
6. Disrespect
   Stereotyped views of out-groups or enemy leaders as evil, weak or stupid. Good or serious ideas of colleagues are rejected on basis of the source instead of 'judged by the facts'.
7. Moral Blindness
   Unquestioned belief in the inherent morality of the in-group. Lack of discussion about ethical or moral aspects of certain decision.
8. Miscommunication and Misinformation
   Information, bottom up or top-down is (deliberately) strongly filtered
9. Idolization
   Idolization of the leader or of certain five star employees.

Lessons Learned
If you recognize some of the above signs in your organization, it is time for action.
Discuss it, do not accept it and if you cannot change it... LEAVE!

A humorous example of Misinformation are the quotes of Iraq's minister of (Mis)Informaton, Al-Sahaf, during the 2003 Iraq war.
Enjoy, laugh and learn.....



Make sure your board presentation is not based on' sahaf-statements' but on simple provable actuarial facts....

Related links/sources:
- 8 signs of groupthink
- What is Groupthink?
- IMF Crisis Report 2011

Actuary Bill Gates

For those of you that -just like me - didn't know that Bill Gates is actually a qualified actuary....



Bill Gates.., a man with a great vision and the same size of philanthropic heart. More information about Bill on the 'Bill and Mellinda Foundation' website, were another actuarial statement is launched:

All Lives Have Equal Value

With all due respect for Obama: Bill gates for president!

Links:
- 2010 Annual Letter from Bill Gates

Supervisory Compliant, is it enough?

Risk management is tricky business... Being 'Officially Compliant', 'Just Compliant' or in other words "Supervisory Compliant", is not enough to help your CEO survive with your company in the complex market battle!

Whether you're an Actuary or Risk Manager of an Insurance company, Bank or a Pension Fund, the risk of being 'Supervisory Compliant' is simply : bankruptcy!

Becoming 'Supervisory Compliant' in complex programs like Solvency-II, Basel III or Legal Pension Fund Risk Frameworks, consumes so much time and effort, that almost no time seems to be left for contemplating or doing the essential Risk Management work properly.

Just being 'Supervisory Compliant' implies:  constantly running after the Supervisor to become  'just in time' officially compliant and not having enough time to think about the (f)actual relevant risks.

Supervisory Compliance becomes very frighting when Risk Appetite and Valuations are rashly based upon the minimum Supervisory requirements, as is (e.g.) the case in the Dutch Pension Fund legal framework. Boards stop thinking about the actual risks and feel compliant and satisfied once the Supervisory Compliance Boxes are checked.

A new look at compliance
Let's take a look from a new point of view at the complete Risk Management Compliance Field:

In basis there are three types of 'being compliant':

1. Supervisory Compliant
   When you're Supervisory Compliant, you officially comply to all legal Risk Management compliance requirements. Your Supervisor is happy...
   
   
2. Professional Compliant
   You comply to your own professional Risk Management standards. You are happy...  but what about your Supervisor? Comply or Explain....
   
   
3. Success Compliant
   Being Success Compliant implies that all Risk Management requirements that are key to have success - e.g. key to survive in the market on the long run - are met.

Let's zoom in at some specific areas in this chart:

Bias areas

It's perhaps hard to admit, but in our attempt to be complete, we define and manage a lot of (small) risks that do actually exist, but are in fact not really or limited relevant with regard to company continuity.

Distinctive Character area

The Distinctive Character area is perhaps the most interesting area. To get grip on this area urges us to 'Think outside the Circle'.

By doing so we'll be able to manage risks that  our competitors fail to do. Here we can achieve 'Distinctive Character' by managing risks more efficient or by turning risks into profits. Examples are: Derivatives that limit our investment risks. Specialized experience rating (rate making) on your portfolio on basis of characteristic and unique risk profiles.

Tricky area
The tricky area is the area that consists of Supervisory Risks you tend not to find important, but that are very important for achieving success in the market. Tricky areas could e.g. be: Deflation Risk, Longevity Risk or Take Over Risk.

Reversed Thinking area
This is perhaps the most interesting risk area.

To explore this area you'll not only have  to 'think outside of your circle', but - just like in reversed stress tests with Banks - try to think backwards, to find out what could cause a certain event or loss.

This reversed thinking process succeeds best as a group. Group members should be professionals and non-professionals from different types of business, education and background.

A successful group mix could e.g. consist of : an actuary, an accountant, a manager, a marketing manager, a compliance officer, an employee, a client, a shareholder representative and last but not least the receptionist.

Finally.....
Try to find time to manage your company to new heights and stop being just 'Supervisory Compliant'.....

Gold: Risk or Rescue?

For those of you who are still doubting...we live in a crazy world....

The Dutch Central Bank (DNB) has ordered (by court !) the glass-workers pension fund (SPVG) to decrease its 13% Gold allocation to less than 3% within two months.

DNB and Court arguments in short:

1. An investment of 13% is not in line with the Prudent Person Rule, which includes the principle that: assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
   
   
2. Gold is a commodity and holding 13%  is classified as 'overweight' in comparison to the 2.7% average that Dutch pension funds have invested in commodities.
   
   
3. 15% allocation in Gold is a 'concentration risk' that could lead to a coverage shortage if the gold price imploded (volatility of Gold is relatively large).

At first, it seems unbelievable that important decisions, with substantial financial impact  - even in Court - are not based on financial facts, but on 'general principles' and the way the market 'used to do it'.

A decision based on an argument that refers to 'the average pension fund,' would more or less imply that pension funds would not be allowed to base their investment strategy on their own specific situation or a changing market outlook. Pension Fund Boards appear to be  'captured' by the market and a Supervisor who obviously has a hard time to develop 'own standards'....

Secondly, DNB actually takes over the investment responsibility of the pension Board. One could wander if DNB is (sufficiently) aware of the possibility that it can be hold financially responsible for the effect of a negative outcome if it turns out in the near future that SPVG has suffered a substantial financial loss, caused by this DNB-designation.

Is Gold really a risk?....  or a rescue?

Checking the facts.... 
Let's just check if DNB's and Court's arguments are valid.....

Yearly Return
We start by comparing the yearly returns of Gold, the S&P-500 Index and '10-Y Treasury Bonds' over the period 1971-2010.

To make Bonds risk-comparable with Gold and the S&P-500 Index, the yearly average Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in a specific year are valued, and sold at the average interest rate one year later (approximation).


Here is the result:

To bring some sense and order into this chart, we calculate the 'Moving Compound Annual Growth Rate' (MCAGR).
We start in 2010 and calculate the  compound average yearly return backwards moving up (year by year) to 1971. This is the result:

Now, this looks better... and a bit surprising as well!!! On the long term Gold (μ=9.2%) and the S&P-500 (μ=10.2%) are tending to a rough 9-10% yearly return......  A little bit Surprising is that Bonds (μ=7.6%) get along very well with their big risky brothers...
Take your time to 'absorb' the impact of this chart.....

Risk
Next, we take a look at Risk. We define Risk at first as the Standard Deviation (SD). We directly cut trough to the 'Moving Risk' (Moving SD).

We might conclude here that during recent years there was an increase of risk with regard to the S&P-500 (the 'red' crisis 'Mount K2' is clearly visible). Note that also for a longer period, i.c. the last 30 years, the S&P-500 Risk is substantial higher than the Risk of Gold and much higher than the Risk of Bonds. Only looking at a period of 40 years, Gold shows 'optical' up as more risky (SD=σ=25.8%) than the two other asset categories, Bonds (SD=σ=6.9%) and S&P-500 (SD=σ=18.1%).

However this way of presenting Risk is strongly discussable. Another view of Risk that comes closer to what we naturally 'perceive' as Risk, is to define Risk as only as the Downside Standard Deviation (look up : Sortino ratio ), where all positive yearly returns are eliminated (DSD) or set to zero (DSDZ).....
Let's have a look:

Now, these charts give us a quite a different sight on Risk-reality....
It shows that -on the long term -  not Gold (DSD=Dσ=7.5%) is the riskiest asset, but the S&P-500 (DSD=Dσ=10.6%). Bonds (DSD=Dσ=0.5%), as aspected, have the least volatility and are therefore less risky.

Perhaps the Risk of Bonds is a bit underestimated (very few observations) by the DSD-method (excluding positive yearly returns). In this case the downside deviation of yearly Bond-returns, replacing positive returns by zero, which generates a standard deviation of 3.2%, gives a better indication of a more likely standard deviation on the long run.


Why Gold? 
Although these simple calculations already put the DNB conclusions in a different light, let's get to the main point that should be addressed in defending why Gold should be a substantial part of any Pension Fund portfolio:
 

 Gold Reduces VaR

In a 2010 (october) publication the World Gold Council published a document called Gold: Hedging Against Tail Risk. This interesting report concludes:

1. Gold is first and foremost a consistent portfolio diversifier
2. Gold effectively helps to manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances such tail-risk events (VaR).

Following this excellent WGC report, let's test the balancing and risk-reducing  power of Gold by analyzing (classical) Risk (SD) in combining Gold with different allocations (0% up to 100%)  in an asset mix with Bonds, respectively investments in S&P-500 stocks.

This chart clearly shows that Gold has the power to reduce the S&P-500 Risk (SD) from18.1% to 13,3% with an optimal asset location mix of  approximately 60% S&P-500 and 40% Gold. 

In case of Bonds the Risk (SD) is reduced from 6.9%  to 4.8% with an optimal mix of 80% Bonds and 20% Gold.

Asset Liability Model (ALM)
In practice it is necessary to optimize, by means of an adequate ALM study, the  allocation mix of stocks, Bonds and Gold. Just as a 'quick & dirty' excercise, let's take a look at the next asset-combination scenarios, based on data over the period 1971-2010:

Just some head line observations:

• From scenario M1 it becomes clear that even a 100% Bond scenario is't free from Risk. So diversification with other assets is a must.
  
• Looking at M2-M5 we find that the optimal mix, defined as the mix that best maximizes Return (Compound Annual Growth Rate)  and Sharpe Ratio (at a Risk free rate of 3% or 4%) and minimizes Risk (Standard deviation), is something something in the order of: 70% Bonds, 15% stock and 15% Gold.
  
• Scenarios M6-M8 and M9-M11 take todays most common (but strongly discussable!) practice as a starting point. Most pension funds have allocated around 50% or 40% to Bonds and 50% or 60% in more risky asset categories (stocks, etc.). It's clear that even in this situation Risk can be reduced and Return can be optimized, if Stocks are exchanged to Gold with a maximum allocation of 20% or 30%.

Notifier

Although this 'rule of thumb exercise' on this website provides some basic insights, please keep in mind that finding the optimal mix is work for professionals (actuaries).

A serious ALM Study is always necessary and should not only take into account a broad range of diversified asset categories, but should also focus and optimize on:

• The impact of the liabilities (duration) and coverage ratio volatility
• The Timing: Mean values and Standard Deviations are great, but the expected return highly depends on the actual moment of  investment or divestment in the market.
• Future expectations. In the current market situation (2011) the risk of interest rates going up and therefore Bond market value going strongly down, isn't hypothetical. Secondly, the stock market has been pumped up by trillions of 'investments' (?) in the US economy. Once this crisis-aid definitely stops, the question is if these 'cement investments' will be strong enough to keep stocks up. Personally I fear the worst...
  Not to mention a scenario with declining stock rates in combination with increasing interest rates and inflation......
  Who said the life of an actuary was easy???

Conclusion
We may conclude that:

• Investing in Gold up to a 10% to 15% allocation, reduces the Risk of a portfolio consisting of Bonds and S&P-500 Stocks substantially. 
• Gold is less Risky than investing in S&P-500 Stocks

Therefore the 'not with facts' underpinned intervention of DNB looks - to put it euphemistically -  at least strongly discussable....

A wise and modest underpinned allocation of Gold is no Risk, it's a Rescue!

Related Links:
- Spreadsheet with Data used in this Blog
- Prudent person Rule
- IPE: Dutch regulator orders pension scheme to dump gold
- GOLD: HEDGING AGAINST TAIL RISK
- Downside Risk:Sortino ratio
- Dutch Central Bank Orders Pension Fund To Sell Its Gold
- Pension Fund Benchmarking 
- Strategic Risk Managment and Risk Monitoring for Pension Funds

Bonus: Gold, Hedging against Tail Risk Video

Pension Fund Weigh House

Investment Benchmarking of Pension Funds has been made extremely difficult.

Just ask your Pension Fund's actuary whether your Pension Fund has achieved a 'market conform investment performance'... For sure you'll get a dazzling multiform and relative answer. It's all about 'market indexes' (stock and bond indexes), risk appetites, asset mixes, derivatives, uncertainty and lots of other interesting complex stuff that underpins the fact that the final answer to this simple question is nuanced, complex and relative.

A simple question
Ahead of all this growing complexity and 'levels of detail', a first key question has to be answered by every Pension Fund:

Was it worth setting up a complex multi fund investment plan instead of simply investing in 10-Years Government (Treasury) Bonds over an arbitrary period of (at least) the last 10 years?


Even this simple question, will probably not lead to a simply answer from your fund's investment manager or actuary.

Pension Fund Weigh House Help
This is where the help of the 'Pension Fund Weigh House' comes in...

Just look up the yearly return over the last ten years in your Pension Fund's annual report. Next, do the test at 'Pension Fund Weigh House'  (PFWH) and see for yourself whether your Pension Fund has  performed better than the simple benchmark: 10-Y Bonds.

 

Did your Pension Fund perform better than Bonds? (the compound mean over the last 10 years) Congratulations!
Was it worth the risk? Well..., just look at the Risk (Standard Deviation) or - even better - the Sharpe Ratio at different levels of possible 'Risk Free Rates' to find out. The Higher the Sharpe Ratio, the more it was worth to take the risk.

Market Value

To compare Bonds 'fair' with Market Value based Pension Fund performance, the yearly Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in January of a specific year are valued, and sold at the interest rate one year later.

Do it yourself

The standard example as presented on PFWH concerns the performance of the Dutch pension fund ABP, the third largest pension fund of the world. Answer the key question 'Was it worth?' for ABP for yourself.

ABP (Pfd-R) Performance 2001-2010

 

Go to PFWH and change the numbers and 'heads' in the application to fit the numbers of your own (pension) fund or change both columns (Bonds & PFD-R) to compare two pension funds .
Compare your pension fund to either  '10-Y Euro Government Bonds', '10-Y US Treasury Bonds' or the 'S&P 500 Index'.

From now on you may answer this extremely difficult question "How did my pension fund perform?" yourself in a  5 minute weigh house test.

Have (professional) fun!

Dutch Pension Muppet Show

There's a lot of fuzz about the performance of the largest (€ 246 billion assets) Dutch Pension Funds ABP and the somewhat smaller (€ 91 billion) PFZW (former PGGM). According the Dutch television program Zembla and Bureau Bosch Asset Consultants, Dutch pension funds would have consistently underperformed.

ABP commented: "The yearly return of 7.1% on average since 1993 is much higher than returns on government bonds would have been and is in part thanks to our equity investments."

PFZW overshoots ABP wit the comment: "PFZW's calculations show a return of 8.4% on average during the past 20 years which is much higher than the 10-year Dutch government bonds of 5.3% on average during the same period."

Great statements, but who's right?

Performance Test
Let's quickly "do the proof" by comparing (benchmarking) the 'modest' yearly performance of ABP with the yearly performance of 10 year Government Euro Bond Yield Benchmark as provided by the ECB.

Both pension funds are not limited to  the Dutch market, therefore  performance is not related to Dutch Government Bonds, but to 10-Y Euro Government Bonds.

As the yearly performance of ABP in a particular year is in fact a kind of 'compound performance' of the years before, it's more realistic to relate ABP's (yearly) performance to the 10-years moving average of 10-Y Euro Bonds.  

What becomes clear from is that ABP's volatility overshadows the 10-year Bond's volatility by far. As a consequence ABP's out-performance should be significant.

Let's test this by looking at the YTD (Year To Date) performance of ABP on the long run:

The average performance of ABP 1993-2010 indeed turns out exactly 7.1% as published, but hardly outperforms the 10-year Euro Bonds Moving average of 6.8%.

0.3% '18-years out-performance' (OP-18) for such a high volatility is strongly discussable. The long term out-performance 1994-2010 (OP-17) was 0.0%. The out-performances of shorter periods (OP-[18-x]) are not stable and strongly swap from positive to negative.

Benchmarking Pension funds performance with Euro Bonds 0f 20 years or longer would be even more adequate and in line with the duration of pension fund's liabilities. Taken into account that 20 year Bonds on average score a 0.25% à 1.00% higher return than 10 year Bonds, it can be concluded that Dutch pension funds on average do not out-perform Government Bonds. Not to mention the influence of the yearly investment-costs of at least 0.2% on the returns.....

Pension Fund PFZW

Pension Fund PFZW is completely lost on their non-transparent and backwards changing performance of 8.4% over the last 20 years.

From their annual (inconsistent) accounts it can be concluded that their 2001-2010 performance came down to 4,8%. This performance is exactly the same as the performance op ABP in that period and underperforms the moving average 10-years Euro Bonds with 0.7% !!!

Conclusion

It's clear that pension funds don't convince in the outperformance of Government Bonds and that the pension industry is in desperate need for an impartial benchmark with regard to out or underperformance of Bonds.

The comments from ABP and PFZW, Boenders and Cocken are like 'shooting from the hip' and must be qualified as highly unprofessional.

Dutch pension fund members are watching an extra edition of the Muppet show. Who's gonna stop this pension media madness and bring some order in the pension room?


Related Links and Sources:

- Source: 10 year Government Euro Bond Yield Benchmark
- 'grave miscalculations' in Zembla (Boender aand Kocken
- Watch: Zembla 
- Download: Spreadsheet with calculations as presented
- IPE: Heavyweights ABP, PFZW come out swinging against Zembla
- Bloomberg: 10-year, - -  30-year performance Gv. Bonds

Solvency II: Standard or Internal Model?

Solvency II is entering the critical phase.Time is running out!

But...., as a wise proverb states:

"When The Actuaries Get Tough,

The Tough get Actuaries"

However, the market for actuarial resources is limited and Solvency II Actuaries that  combine strategic and technical knowledge with 'common sense' are like  white ravens.

In the case of Solvency II, actuaries and models are moving forward in a particular way.

Standard Model
Originally, the 'standard model' was foreseen as a simple model for small and mid-size insurers (apart from very small insurers that were excluded). Big insurers, with more developed actuarial models, larger scale and more resources, were expected to work out a more sophisticated 'internal model'.

As the Solvency II Time Pressure Cooker gets up steam, things start turning.

Small and mid-size insurers found out that the 'standard model' was highly inefficient and the wrong instrument to steer adequately on risk management and to determine adequate solvency levels in their company.

Just because of their limited size and product selection, small and mid-size insurers often already have a well tuned risk management system in place and implemented throughout the organization. The manager, actuary (being the risk manager as well) and CFO of such companies therefore have enough time to develop a formal Solvency II 'internal model' that could be easily implemented throughout their organization.

Internal Model
Quit the opposite happens in the world of big insurers.

Big insurers coordinated Solvency II at Holding level and started to challenge their business-units around 2009 to develop and implement Solvency II programs on basis of an 'internal model'.

Collecting homework at the Holding in 2010, it became clear that a lot of technical issues in the models were still unclear. Moreover, models were not integrated (= condition)  in the business and counting up several 'internal models' showed up several consolidated inconsistencies. 

The complexity of developing a consistent risk model turned out to strong. Some big insurers are now considering to fall back on the 'standard model' (or partial model) before it's too late: the shortest errors are the best.

Looking back it's not surprising that big insurers need more time to operationalize a fine tuned risk model. It took specialist Munich Re 10 years to implement an internal model.

This development is also an indication that some big insurers are strongly over-sized. In order to keep up with the speed of the market, big insurers have to be split up into a manageable and market-fit size.


Related Links:

- Surviving Solvency II (2010)
- The influence of Solvency II on an insurer’s strategic policy
- White Ravens and Black Swans (Math Fun)

Actuarial Chess?

As actuaries we often have to explain HOW variables like profits, mortality, investments or costs will develop in the future.

In doing so, it would really help and strengthen our credibility if we were able to explain also WHY these variables developed in the past as they have developed, as a result of certain circumstances (other 'explaining' variables).

On basis of these WHY-arguments and the specific expected future circumstances, we could increase the credibility and diminish the volatility of our predictions.

This HOW-WHY-Insight urges us for example to analyze "medical developments" in case of predicting longevity and to study "economic developments" with regard tot predicting future costs, inflation or investment rates.

Moreover this understanding obliges us to develop our capabilities and competence to explain certain given outcomes like "increasing longevity" and "increasing stock return volatility".

Test Your 'Outcome Explanation Competence'

This 'Outcome Explanation Competence' (OEC) is key in actuarial science. No actuary can do without!

To test your OEC level, solve the next chess problem.

Black has made the last move... Which move?

You'll find the solution of this chess problem as a part of the next 5 minute 'Thinking Out of the Box' test ( on SCRIBD)......

5 Minute 'Thinking Out of the Box' Test

Just like in 'climate change predictions', our OEC (the 'competence to explain past phenomena') is necessary for us actuaries to be confident about our theories and predictions about the future.

However, developing OEC might not be enough as the explanations of the past could turn out to be fundamentally invalid with regard to the future. New techniques  like High-frequency trading (HFT) might come up. Or... in chess vocabulary: 'A pawn may promote to a Bishop' (frequency: 0.2%)

The conclusion must be that Actuarial predictions are a kind of 'Actuarial Chess':
So start practicing as an Actuarial Chess Master by Explaining the past and Guiding the future.

In control through better communication!

End of November 2010 the Dutch Regulator (DNB) met with certifying actuaries as well as external auditors. Both meetings were dominated by the theme of "accuracy of reporting" for pension funds, an important DNB monitoring theme.

DNB stressed that all pension fund reports are a key source of surveillance information. With confidence, every Pension Fund stakeholder should be able to rely on the accuracy and completeness of the information in pension fund reports. In practice, this is not always the case. DNB will increasingly hold pension fund boards, certifying actuaries and accountants responsible for taking appropriate actions and - if  necessary - DNB will enforce action.

Topics
Main topics on the accountant-Actuary table are:
- the valuation of technical provisions
- the valuation of the required equity and
- compliance with the prudent person rule.

In control through better communication

The introduction in 2011 of so called 'multi-party meetings' (ie consultation between pension fund management, actuary, accountant (auditor) and regulator DNB) with some larger pension funds will certainly help to improve communication between all concerned parties.

This excellent initiative will also certainly help pension funds to increase control.
Key issue is that the pension Board has (to keep) final responsibility and DNB has to take care that they do not implicitly take over part of this responsibility. Secondly DNB is responsible for an efficient and clear regulation/governance structure. Too many informal consultation meetings might not be efficient and bear the risk of unclear responsibilities. 


Sources:
- Newsletter Pensions DNB (Dutch, 2011)
- Source: Four leaved clover Coin

Twitter Fair Value Accounting

Do you still believe in 'Fair Value Accounting' or 'Market Value' as an excellent accounting principle?

After reading this blog you'll probably have developed a more distinguished view....

Yes...,Fair Value is hard to define...

Probably 'The Fair Value' as such, doesn't exist.

What's 'fair', is often subjective. Therefore 'Fair Value' must be imaginary.


How to earn $9 million by investing '50 cent'?
Answering this question is easy. Look at the next example:

According to 'Business Insider', rapper and business man 'Curtis James Jackson III', alias '50 Cent', promoted the almost worthless HNHI shares during the first weekend of 2011 on Twitter with success!
In no time HNHI shares, including Curtis' 30 million own shares, went up by $.29 a share. Result: almost $ 9 million gain in market cap for just one weekend of tweeting. Not bad!

What actually happened, was:

Don't replicate these kind of dangerous investment marketing jokes...

It's like playing with fire and (therefore) not without risk.

The SEC's attention for Curtis James Jackson's discussable marketing promotion has already been drawn...

Twitter is great, but use it for social activities. Always 'Mind your Steps' at Twitter, especially with regard to financial issues.


Fair Value
This controversial simple Twitter-Investment example shows the weakness of our accounting system. 'Fair values' are of course by definition 'fair', but can be easily influenced by major media players like celebrities or large investment companies in the financial markets.

Controversial Investment marketing
The wrong receipt (Fraud?) to make profit in the investment market is:

1. Select a listed company XYZ in your portfolio that didn't perform well during last years and is clearly undervalued.
2. Hire a celebrity (on basis of a limited fee) to promote XYZ on Twitter.
3. Wait for the shares to go up
4. Cash out before shares go down, ahead of a total collapse. 

Large Investment Companies
Of course - just like me - you might think: large companies don't get mixed up in these matters.  But what to think of the next, slightly changed, approach where large investors makes use of the effect that a lot of small investors follow (or try to outperform) a large investor by flocking (following) or anticipating a large investor's investment strategy without an own investment policy or model (Fair or Fraud?).

A large investor can easily use this flocking effect in a kind of double trick:

1. As a large investor: Select a listed company XYZ in your portfolio that didn't perform well during last years and is likely undervalued.
2. Simulate in the market that your large investment company is interested in buying XYZ shares (spread the rumor, place a non binding call, etc.) or invest a small amount in XYZ.
3. Wait for the shares to go up.
4. Cash out before shares go down on their way to a total collapse.

Case 'Deutsche Bank'
Again, if you don't believe these kind of methods are applied, just go to sleep early tonight and please don't read the 2010 introduction in FT of new computerized trading model called 'Super X' by 'Deutsche Bank'. This new model is all based on 'dark pools'. Nobody really knows or fully understands what is happening in these dark pools and their corresponding algorithms. What about transparency rules? Unfortunately you'll find not a single word about Super X ethics in press articles by Deutsche Bank.

Understandable, because Deutsch Bank doesn't have to worry about transparency or ethics at all. Despite of its ethical code, ominous named 'Passion to Perform', Deutsche Bank admitted criminal wrongdoing over fraudulent U.S. tax shelters by the end of 2010.  Instead of firing those who where responsible, DB simply agreed to pay $554 million to avoid prosecution. After that it was business as usual......

How far does 'passion' go? What seems 'fair' to you and what can we actuaries, learn from this?????

Ethical?

Like in the example(s) above, large investors are able to influence and manipulate the market (price) by acting, fake-acting or non-acting.

From an ethical point of view it gets more and more complicated to earmark such actions as unethical.

Computer programs simply register effects as "if I (computer) do (invest or not-invest or disinvest) 'so', 'this effect' will be 'the result'.

As a consequence these computer programs simply apply and execute these found market principles and structures in the financial markets without a 'moral view' or any form of perception: Fair!, so to speak(??).

Monetary Policy Influence 
Another form of influencing financial markets is by the monetary policy  (read:intervention) of the central Banks. The 2010 Fed intervention could be such an example.

Conclusion

It's clear that the financial markets can be easily influenced by short term media effects, indirect value related investment strategies of large investment companies and Central Bank's monetary policy.

Irrespective from the question wetter it's "Fair Value or Not Fair Value", we'll have to deal with 'temporary unfair market effects' that can have a major impact on a company's value.

As a consequence it's not 'fair' nor 'wise' to base a company's value on the 'fair value' on December 31th 24.00 hours. Temporary market volatility should - one way or the other - be excluded in valuations (moving average?).

With regard to your own private investments or life, keep in mind:

If something sounds too good to be true …
it probably is...

Related Links/Sources:
- How To Make $10 Million From Just One Weekend Of Tweeting
- "If it's good enough for Buffet, it's good enough for me"
- "No Amount Of QE Will Be Able To Keep The Current Stock Market Bubble From Bursting"
- Fair Value or Not Fair Value
- How Much Influence Does The Fed Have?
- Fraudwatchers
- The Latest Celebrity Stock Promoter / Pump and Dumper? 
- CurtKoCool 
- Cartoon '50 Cent' 
- MarketWatch HHI
- FT: Deutsche Bank unveils new trading model (2010) 
- Daffy Duck 

The Life Expectancy Variance Monster

After 'age', what would be the most important explanatory factor with regard to mortality rates or constructing life tables?

As actuaries we've demonstrated our innovation capabilities by developing life tables not only based on 'age' and 'gender', but also (two dimensional) on 'time', 'generation' and 'year of birth'. This helped us to extrapolate future mortality rates in order to predict future longevity with more accuracy.

However, despite our noble initiatives, these developments turn out to be insufficient to put the Longevity Variance Monster back in his cage.

Modern 'life expectancy at birth' predictions for periods of 40 to 50 year ahead, lead to 95% confidence intervals of 12 years or more. Unusable outcomes .....

Let's not even discuss more necessary accurate confidence intervals of 99% or more ....

In our attempt (duty?) to moderate and diminish future life expectancy variance, we'll have to develop new instruments.

The more we know which risk factors 'are responsible for the increase in 'life expectancy', the better we can estimate and diminish future variance.

One of those new approaches is to calculate life expectancies on basis of postcodes.

This new insight can be helpful, but there's a much more important risk factor that has to be included in our life expectancy predictions to definitely kill the Longevity Variance Monster:

Self-perception of aging

In a 2002 research "Longevity From Positive Self-Perceptions" by Levy ( et al.) it became undeniable clear that:

• negative self-perceptions diminish life expectancy;
• positive self-perceptions prolong life expectancy.
  

Older people with more positive self-perceptions of aging, measured up to 23 years earlier, lived on average (median survival) 7.6 years longer than those with less positive self-perceptions of aging. This advantage remained after age, gender, socioeconomic status, loneliness, and functional health were included as covariates.

Top 6 Life Expectancy Risk Factors

Here's Levy's top 6 list of risk factors on life expectancy (ordered from greatest to least impact on life expectancy):

1. Age
2. Self-Perceptions of aging
3. Gender
4. Loneliness
5. Functional health
6. Socio-economic status

As we can not change 'age' nor 'gender', let's put some more research on the other risk factors.

Once we achieve to 'explain' the cause of increase of life expectancy on basis of 'new' (soft) risk factors, we - as a society - will also be able to manage life expectancy better (information, education, training, coaching, etc.).

In this way actuaries can help society so that people live longer and stay happy in good health. All on basis of of a sound financial pension and health system, as predicted life expectancy will show a smaller variance.

Help to kill the Life Expectancy Variance Monster.....

Happy 2011, with better expectations and smaller variance!

Sources/related Links:

- Why population forecasts should be probabilistic
- On line Postcode Life Expectancy Tool
- Longevity From Positive Self-Perceptions
- Predicting successful aging (2010)

2011: Happy Risk Year!

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:

1. 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.
   
   
2. 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?
   
   
3. 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.....

YOU

Anyhow, make 2011 a happy and healthy risk year!

Related Links:
- "Watch the movie 'Along came Polly' online !
- Learning about Risk and Return: A Simple Model of Bubbles and Crashes 

Discounting the future

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:

1. The increasing uncertainty (fogginess) of future cash flows slowly kills its discounted predictability in time
   
   
2. 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 - k_A.σ_A - L  (mp= minimum position) , or in case of a pension fund, the coverage ratio: CR=(A - k_A.σ_A) / 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 - k_A.σ_A - L -k_L.σ_L (mp).
Pension funds had to become real acrobats to manage their new wobbly coverage ratio: CR= (A - k_A.σ_A ) / (L + k_L.σ_L)     (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 :

Don't mention the war...... 

Related Links:
- Pension Actuary's Guide to FINANCIAL ECONOMICS (2006)
- Pension contracts and developments in pensions in The Netherlands (2009)
- One of those superb hotels in Ballyheigue: White Sands Hotel

Goodhart's Law

Back in 1975 professor Charles Goodhart stated:

Goodhart's Law

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:

• Using coverage ratios to control pension funds
• Using z-scores to control banks or pension funds
• (Under)estimating longevity risk for decades
• Measuring (long term) rates (stocks, bonds, inflation ) for valuation purposes

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....


Related links:
- Performance Persistence of Dutch Pension Funds (2010)