Pension Egg Choice

Imagine you're a new pension fund member and your pension fund offers you the next simple proposal regarding your future pension income.

With closed eyes you are allowed to take out two 'pension eggs', either from nest I or nest II. Which nest do you choose?

Think about this proposal and remember: your complete financial old age depends solely on the nest of your choice.

I discussed the above dilemma  last week (august 2013) in a presentation with an across-section of Dutch pension representatives. This dilemma illustrates in a simple way the precarious choice Dutch pension funds and their members have to make in deciding between a traditional Nominal Pension with conditional CPI-indexation (nest I) and a fully CPI-indexed 'Real' Pension (nest II).

Key point is that to achieve a higher Real Pension, you have to put your Nominal Pension 'at risk'.

And who is consciously willing to put 'future income' substantial  at risk?

As 'pension income' is in fact 'deferred income', there's also a kind of implicit understanding that your future retirement income security should be 'in line' with your actual income security and not substantial lower.

Retirement Income Security  ≈ Actual Income Security ?

No wonder that all of the 23 attendees at my presentation chose Nest I (Nominal + Indexation) as favorite.

Remark

After the meeting one of the attendees stated that the '10'-valued egg in Nest II should have been valued at at least a value of 20 or higher to create an equal or higher average expectation, as higher risk would implicate also higher return.

I positively smiled for a moment... told him that his remark (and many others that followed) was formally right and suggested that he would test the 'Pension Egg Choice' in his pension board, including an extra voting with an 20-valued egg instead of a 10-valued egg. A day later he called me back and told me the extra voting didn't substantial change the voting outcome.......

Remember that more risk doesn't automatically imply more return. If volatility (risk) increases without a well-argued expected increase in 'average return', the 'compound average return' will (even) decrease with half of its variance.

Worldwide Pension Funds Alert

Not only Dutch pension funds face the Pension Egg Dilemma, but in fact all pension funds worldwide do. To fund their pension liabilities they have to make average returns of more than 5%, 6% or even 7% for more than 50 years on a row or more. And to achieve those kind of return levels with a (nominal) risk free rate and a treasury bill outlook, both varying between 2 to 3.5 percent, implies that they'll have to invest in risky asset classes.

As a consequence the ultimate pension outcome could be lower than on basis of a risk free approach that guarantees a nominal pension. In other words: your Nominal pension is at risk.

Example

To illustrate what is happening, let's look at a 30 year old Dutch pension fund member (Tom) with an retirement age of 65.

The pension fund (theoretically) offers Tom the next options. Tom values these options on basis of a 20 year period:

1. Option 1
   Tom's contribution is invested in totally risk free assets at 3% (orange line), resulting in a sure (€,$,£,¥)  10000 yearly pension
    
2. Option 2
   Tom's contribution is invested in 30% risk free and 70% risky assets (purple line), resulting in a 25.9% (100%-74.1%) change of an outcome below his yearly 10000 (nominal) pension, but also an almost 50% probability of a pension of around 23904 or more.
   
   Looking closer at the downside, there's also a 10% probability of ending up with a negative return, corresponding with a yearly pension of 4255 a year or less.

However, Tom suddenly realizes the limitations of a linear model approach. If the 'risk free asset part' of his investment  is really completely independent (can't be dragged down) from the risky part and also insensitive to market conditions, there's a downside risk limitation.  A 30% really 'completely market valued risk free' would in Tom's case  imply a total minimal guaranteed portfolio return of nearly 1% (30% of 3% = 0.9% ≈ 1%) , corresponding with a minimal yearly pension benefit level of around 5645.

In case of 70% risk free investment approach (green line), the downside return risk would be limited to a minimal 2.1% return corresponding with a minimal pension of around 7506, approximately 75% of Tom's nominal pension target.

This 70% risk free approach could be quite acceptable for Tom, as he realizes there'll be no extra return without taking extra risk...

Nevertheless..., pension fund life and its member's choices ain't easy. So Tom asks the pension fund's actuary what his pension outcome would be on a 50 year evaluation basis.... here it is

Now Tom's risk of ending up with a yearly pension outcome of 10000 or less has decreased to a 15.3% (100-84.7). Tom could decrease this downside risk further to 8.6% by choosing a less risky asset mix of 70% risk free and 30% risky assets. However, this drops his upside potential. On average (50%) his pension outlook of around 23904 will drop to a little less than 17850.

Now Tom fully starts to grasp the impact of long term return assumptions...  After all, is assuming a 6% or 7% 50-year return not way to optimistic?

Your own Pension Confidence Level Calculator

As shown in the examples above the key questions are i.a. :

1. How much of your guaranteed* nominal pension P are you willing to risk to end up with a higher pension P+U
2. How much uncertainty (100% - confidence) are you willing to accept that your pension is lower than a certain amount?
3. What's the real (nonlinear) downside risk of my pension?

To find the answers to these kind of questions and to calculate your own pension perspective, you may download the

Pension Confidence Level Calculator

in Excel.

With the Pension Confidence Level Calculator you may calculate your pension confidence with all kind of asset mixes, co-variances, (pension) ages and several user definable life tables.

Remember the calculations are only illustrative and indicative approximations, to be used for instructional purposes. Ask your pension fund to make a more detailed and personal calculation.

Next

Now that you've experienced that most pension funds need an ambitious return that may put your nominal pension at risk, the question is what to do?

Main problem is that pension funds do not act in this alarming situation. As a kind of sitting duck they play a kind of 'waiting game' in the hope that bond yields and other markets recover.

Meanwhile you could at least do something to get the fuzzy pension picture clear. Simply follow this Cookbook :

Pension Fund Restructure Cookbook

1. Your Retirement Income is not a one point estimate, so ask your pension fund's actuary:
• to calculate what future average return rate is needed to (100%) fund the liabilities, given the actual market value of the assets of the pension fund
• to calculate (estimate) your future pension at different constant future return rates
• to estimate the probability level of achieving each future return rate or more (confidence level) for the rest of your life, in accordance with the applied actuarial models
2. Next, ask your actuary to formulate his advised investment risk approach in line with the Pension Eggs presentation as presented in this blog, but now with more nests.
3. Now let your board and pension members determine their risk appetite by voting which nest they choose
4. Finally, let the actuary in cooperation with the investment advisory committee, propose an 'investment strategy' that is completely in line with the new defined risk appetite 
5. Take a decision to (phase-wise) implement this new investment strategy.

Result

Perhaps the outcome of the above exercise will be a lower pension than you expected, but:

• probably not as low as you would have got if you kept on gambling on uncertain high returns 
• and certainly not lower than what you need and define as a decent minimum pension income 

Anyhow, enjoy the Pension Confidence Level Calculator....

Links/Downloads

- Download the Pension Confidence Level Calculator

- Long-range confidence interval projections and probability estimates

- Portfolio-optimization by the mean-variance-approach

- 'Employee Retirement Income Security Act - ERISA'

Humor: How Actuaries Can Help

Sources/Downloads
- Original artist Meera Sapra at Toondoo
- Blog 'Life is a Comic Strip' by Meera Sapra
- Download Powerpoint Version of this comic strip
- Download PPT-JPG Version of this comic strip

Actuarial Public Debt

The current definition of Public Debt is very poor. Only accrued past debt and current budget deficits are measured; no future obligations.

Hot from the press, the 'actuaries' behind the 83rd BIS Annual Report 2012/2013 show us the impact of the commitments to future spending on pensions and health care that are missing in current measure of public debt.

Age-related liabilities as a share of GDP, are projected to rise considerably between 2013 and 2040 in a number of countries.

Please notice that reforms enacted after December 2011, are not included in the next graph.

Actual Public Debt
End 2012, the impact of age-related liabilities on the actual public debt was calculated and analyzed by Stiftung Marktwirtschaft, in cooperation with the Research Centre for Generational Contracts.

In a report called "Honorable States? The Sustainability of European Public Finances in Times of Crisis" they calculated the effects for Europe as follows:

Reforming Social Security 
Without going into details, this graph makes perfectly clear that even an attitude of 'just managing debt' is hopeless and doomed to fail.

'Restructuring public debt' will only be possible if we have the courage to fundamentally restructure our social security system of pensions and health care. The sooner, the better.....

For those who still had hope on a positive U.S. outcome, just take a look at the debt-outcome of two non-EU countries:

Concluding Reflections
To get a sound picture of a country's financial sustainability, a first step would be to annually report real(istic) balance sheets on basis of actuarial public debt, e.g. debt including age related future obligations like state pensions and health care.

Ultimate, we need new market value based 'country state accounting principles' that include a complete set of  "future obligations" and "natural resources" (oil, gas, water power, etc.) on the asset side.

One of the main issues will be how to value a virtual and information society including fast changing and new future developments on basis of outdated valuation methods, developed in last decades of the last century.

Of course THE big challenge with such an ultimate country balance sheet will be how to value "human resources" as an asset. Why?

Because flexibility, responsiveness, education and entrepreneurship will eventually make the big difference in adapting a country's economy to a sustainable future. I suggest we start by valuing actuaries ;-).

Links/Sources:
- Spreadsheet with data used in this blog (xls)
-  83rd BIS Annual Report 2012/2013
- Report Honorable States? (2013)

Confidence Level Crisis

When you're - like me - a born professional optimist, but nevertheless sometimes worry about the unavoidable misery in the world, you ask yourself this question:

Why does God not act? 

Think about this question and try to answer it, before reading any further..

The answer to this question is very simple:

God does not act because he's conscious of everything  

The moral of this anecdote is that when you're fully aware of all the risks and their possible impact, chances are high you'll not be able to take any well-argued decision at all, as any decision will eventually fail when your objective is to rule out all possible risks.

You see, a question has come up that we can't agree on,
perhaps because we've read too many books.

Bertolt Brecht, Life of Galileo (Leben des Galilei)

On the other hand, if you're not risk-conscious at all regarding a decision to be taken, most probably you'll take the wrong decision.

'Mathematical Confident'

So this leaves us with the inevitable conclusion that in our eager to take risk-based decisions, a reasoned decision is nothing more than the somehow optimized outcome of a weighted sum of a limited number of subjective perceived risks. 'Perceived' and 'Weighted', thanks to the fact that we're unaware of certain risks, or 'filter', 'manipulate' or 'model' risks in such a way that we can be 'mathematical confident'. In other words, we've become victims of the "My calculator tells me I'm right! - Effect".

Risk Consciousness Fallacy
This way of taking risk based decisions has the 'advantage' that practice will prove it's never quite right. Implying you can gradually 'adjust' and 'improve' or 'optimize' your decision model endlessly.
Endlessly, up to the point where you've included so much new or adjusted risk sources and possible impacts, that the degrees in freedom of being able to take a 'confident' decision have become zero.

Risk & Investment Management Crisis
After a number of crises - in particular the 2008 systemic crisis - we've come to the point that we realize:

• There are much more types of risk than we thought there would be
• Most type of risks are nonlinear instead of linear
• New risks are constantly 'born'
• We'll not ever be able to identify or significantly control every possible kind of risk
• Our current (outdated) investment model can't capture nonlinear risk
• Most (investment) risks depend heavily on political measures and policy
• Investment risks are more artificial and political based and driven, than statistical
• Market Values are 'manipulable' and therefore 'artificial'
• Risk free rates are volatile, unsure and decreasing
• Traditional mathematical calculated 'confidence levels' fall short (model risk)
• As Confidence Levels rise, Confidence Intervals and Value at Risk increase

Fallacy
One of the most basic implicit fallacies in investment modeling, is that mathematical confidence levels based on historical data are seen as 'trusted' confidence levels regarding future projections. Key point is that a confidence level (itself) is a conditional (Bayesian) probability .

Let's illustrate this in short.
A calculated model confidence level (CL) is only valid under the 'condition' that the 'Risk Structure' (e.g. mean, standard deviation, moments, etc.) of our analysed historical data set (H) that is used for modeling, is also valid in the future (F). This implies that our traditional confidence level is in fact a conditional probability : P(confidence level = x% | F=H ).

Example

• The (increasing) Basel III confidence level is set at P( x ∈ VaR-Confidence-Interval | F=H) = 99.9% in accordance with a one year default level of 0.1% (= 1-99,9%).
• Now please estimate roughly the probability P(F=H), that the risk structure of the historical (asset classes and obligations) data set (H) that is used for Basel III calculations, will also be 100% valid in the near future (F).
• Let's assume you rate this probability based on the enormous economic shifts in our economy (optimistic and independent) at P(F=H)=95% for the next year.
• The actual unconditional confidence level now becomes P( x ∈ VaR-Confidence-Interval) = P( x ∈ VaR-Confidence-Interval | F=H) × P(F=H) = 99.9% × 95% = 94.905%

Although a lot of remarks could be made whether the above method is scientifically 100% correct, one thing is sure: traditional risk methods in combination with sky high confidence levels fall short in times of economic shifts (currency wars, economic stagnation, etc). Or in other words:

Unconditional Financial Institutions Confidence Levels will be in line with our own poor economic forecast confidence levels. 

A detailed Societe Generale (SG) report tells us that not only economic forecasts like GDP growth, but also stocks can not be forecasted by analysts.

Over the period 2000-2006 the US average 24-month forecast error is 93% (12-month: 47%). With an average 24-month forecast error of 95% (12-month: 43%), Europe doesn't do any better. Forecasts with this kind of scale of error are totally worthless.

Confidence Level Crisis
Just focusing on sky high risk confidence levels of 99.9% or more is prohibiting financial institutions to take risks that are fundamental to their existence. 'Taking Risk' is part of the core business of a financial institution. Elimination of risk will therefore kill financial institutions on the long run. One way or the other, we have to deal with this Confidence Level Crisis.

The way out

The way for financial institutions to get out of this risk paradox is to recognize, identify and examine nonlinear and systemic risks and to structure not only capital, but also assets and obligations in such a (dynamic) way that they are financial and economic 'crisis proof'. All this without being blinded by a 'one point' theoretical Confidence Level..

Actuaries, econometricians and economists can help by developing nonlinear interactive asset models that demonstrate how (much) returns and risks and strategies are interrelated in a dynamic economic environment of continuing crises.

This way boards, management and investment advisory committees are supported in their continuous decision process to add value to all stakeholders and across all assets, obligations and capital.

Calculating small default probabilities in the order of the Planck Constant (6.626 069 57 x 10^-34 J.s) are useless. Only creating strategies that prevent defaults, make sense.

Let's get more confident! ;-)

Sources/Links
- SG-Report: Mind Matters (Forecasting fails)
- Are Men Overconfident Users?

Europe: Who Pays Who?

Where are we heading with Europe? Let's examine some main topics that illustrate Europe's future direction.

EU Budget Development
The European budget comprises roughly 130,000 Million Euros yearly. The ongoing (2013) budget process in terms of 'net contributions' (= Benefits -Contribution) per country is not transparent. Only the figures until 2011 are available.

Let's take a look a the net contribution development from the start of Europe (2000) until the last available data in 2011. Countries that (net) receive money are 'placed above the x-axis, countries that (net) have to pay money are placed below the x-axis.

Clear is that the amount of money that is transferred from the North&West European countries to the South&East European countries is growing fast from around 15,000 Million Euro in 2000 to around 34,000 Million Euro in 2011.

In a stable Europe the net contributions should decline and vary. However, the opposite is the case!

Who Pays, Who Receives?
It's interesting to look at which countries in Europe are financing other countries.

Take a look at the 2011 transfer of money between all European countries. To create a clear overview, the numbers are rounded in Millions. As a consequence some rows or columns  might not exactly sum up to their total.

To illustrate this table:

• In 2011 Poland received 10,975 Million Euro, of which The Netherlands payed 711 Million Euro of the total of 2,214 Million Euro The Netherlands (net) payed
• Germany payed a net total of 9,003 Million Euros, of which 1,217 Million euro was payed to Greece

It really gets frightening when we analyse the total amount of money transferred between 2000 and 2011:

This table tells us inter alia:

• Over the period 2000-2011 a total amount of 253,119 Million Euro was transferred from North&West to South&East Europe. The end of this imbalanced flow of money is not yest in sight. The future looks dark, due to the current crises in Greece and Cyprus, as well as the worrying situation in Spain and Portugal. 
• Spain has already received 63,563 Million Euro of which 22,115 Million Euro was payed by Germany.
• Germany pay 88,067 Million Euro to support other structural failing European countries, and will continue to do so...... 

Declining Support
On top of the bad financial perspective as presented above, PEW Research recently published, the next survey results:

Only in Germany a small majority still 'believes' in Europe... Other European countries have given up on Europe. Overall, the support for an 'Integral Europe' is declining...

Let's end with the trust European countries have in each other. I leave the trivial conclusions up to the intelligent readers of this blog.. Please don't laugh, while examining the outcomes.

Conclusion
Europe..., how long will it last....???????

 Sources/Links
- Spreadsheets with data used in this blog
- EU Budget 2011
- Folketinget: Net EU Contributions
- PEW Research: The New Sick Man of Europe: the European Union

Willem-Alexander, the New Dutch King

Today - April 30, 2013 - is a special day for The Netherlands.

After 123 years of Dutch queens and a 33-year reign of Queen Beatrix, Willem-Alexander (46) has become the new king in the Netherlands. He's also the youngest monarch in Europe.

A Modern King
Willem-Alexander, a modern King who - together with his wife Maxima and their three lovely daughters - makes his first 'statement' by demonstrating he stands with and for the people that he represents, as his complete family spontaneously appears on stage together with the world's No. 1 DJ Armin van Buuren and the the Dutch Royal Concertgebouw Orchestra.

New Challenges
In his inauguration speech Willem-Alexander stated he's taking the job at a time when many people in the Netherlands feel vulnerable and uncertain. Vulnerable in their work or health. Uncertain about their income or home environment.

Unemployment
And indeed, according to Eurostat unemployment rates in The Netherlands (6.4%) and Europe (10.9%)  are spiking. In Spain even 26.7% of the population is jobless....

Moreover, younger people (under age 25) suffer most from unemployment:

A new generation with good intentions
Willem-Alexander stated that he's concerned about these developments and will contribute to a better world through cooperation, by strengthening the bond of mutual trust between the people and their government, maintain our democracy and serve the public interest.

We need a positive new generation with people like Willem-Alexander.
Let's hope he succeeds! 

Sources 

- Picture: Volkskrant

- Eurostat Unemployment Rates

S&P-500 or Bonds?

On March 28 2013 the S&P 500 hit a new record

1,569.19  6.34(0.41%) Mar 28

Key question is of course will 'L'histoire se répète".....???

Now, take a short look at the (above) S&P 500 last decades development.

Let nature do its work by drowning your brain in the unstoppable growth of debt and considering the fiscal cliffs and endless Quantitative Easing  (QE) programs.

Ask yourself... will new QE-X programs really offer any help....

Without any doubt or any complex investment analyses it's clear that we're heading for a Jungfrau's downfall.

The question is not if, but when exactly and how deep?

S&P 500 

Every year Aswath Damodaran, professor  of Finance at the Stern School of Business at NYU, updates the S&P 500 yearly total return and compares it with the yearly performance of 10Y U.S. Treasury Bonds and Treasury Bills.

Last year's (2012) performance comes down to:

- S&P 500 : 15.83%  ('stocks')
- T. Bills               : 0.05%
- 10Y T. Bonds : 2.97%

Let's take a look at a more general summary of his conclusions: 

Difficult Choice
Most financial institutions (pension funds, insurers, investment funds, banks) are at the crossroad of taking difficult decisions. Investing in 10Y Bonds with an artificial and historical low interest rate of around 2-3% with the risk of depreciation in case of raising interest rates, due to inflation or otherwise. Or going for 'risk' by investing in S&P 500 like funds with relatively high risk.......

In order to get more sight at this 'risk' issue, let's take a look at the 10 and 5 years development:

From this quick investigation it becomes painfully clear that - despite whatever the risk free rate may be - all risk indicators (sharpe, Sortino) point out that the risk on s&P 500 stocks is not adequately rewarded. The M2 (Modigliani risk-adjusted performance) indicator expresses that same fact more intuitively by showing a  10y S&P 500 fictive return of 4.2% if we correct the 10Y average performance of 7.9% for the additional risk level of S&P 500 stocks (against the risk level of 10Y bonds).

Sharpe, wider and in detail
As becomes clear from the next historical sharpe chart, the last decade is not really convincing that an S&P
 500 strategy will pay out......

Take a long Breath...

To confidentially execute a S&P 500 investment strategy it takes a period of 17 years (or more) to avoid an average negative return, as the next charts shows.

In practice this implies that mainly pension funds - with long investment horizons of 15 years and longer - can benefit more or less long-term riskless  from a S&P 500 investment strategy.

However, even from a 17-year cycle perspective it's clear we're still in a  long-term downward trend.

Don't worry, if 'math' shows we're out of options, we can always pray!

Links

-  Damodaran Blog: A Sweet Spot for US Equities: Opportunity and Dangers
- Yahoo S&P 500
- Spreadsheet: historical returns S&P 500 - Bonds
- Spreadsheet: S&P-500 Analysis

Compliance Plus Check

Most often and at a basic level, compliance is perceived and defined as 'regulatory compliance'.

If we comply (act in accordance) with federal or local or local authorities and their requirements, making sure that our company is following all the necessary rules and regulations, we seem done.

Compliance Plus...​

However, the regulatory compliance level is only a start. 

It's simply not enough to be 'Supervisory Compliant'. Compliance is more! Much more.....

Let's find out what Compliance Plus represents...

Compliance, a Competitive Tool​
In practice, compliance can be a distinctive competitive tool​. Being ahead of regulatory compliance, means that a company defines its own compliance level that not only includes regulatory compliance, but also its own professional compliance level, based on its own specific risk structure. 

Compliance, Part of Risk Management
Moreover, one compliance level higher, compliance also embeds the risk of future change of regulations rules and the not-yet-defined compliance rules of future products and investment strategies that are necessary for a sustainable successful development of your company.

As  regulation changes when the economic of financial circumstances change, regulatory compliance is also a substantial part of risk management. That's why regulatory compliance has to be included in our risk models. 

Compliance Check

To check if your company is compliant at a Compliance Plus Level, simply 

Take the 'Compliance Check' Test 

at Symetrics. It takes only two minutes to take this test, as all compliance check boxes are already 'checked' in advance. So if you like 'unticking boxes' instead of 'ticking boxes', here's a splendid opportunity.

AIFMD Fun of Funds

To prevent future crises, a new European law, the Alternative Investment Fund Managers Directive (AIFMD)  came into force on 22 July 2011.

The new directive has to be implemented before 22 July 2013 and will also apply to non-EU fund managers if they ares managing or marketing an AIF to investors in the EU.

It is believed that the directive will reduce the number of non-EU managers operating within the EU.

AIF's assets and risk management

Although the AIFM-Directive has many new demands (appoint independent valuer, custodian, disclosure) we'll focus here on the requirement to ensure an independent evaluation of the AIF's assets and risk management.

AIFMD Risk Management Obligations

• Every AIFM needs to have an adequate documented risk management policy, covering all possible risks faced by the AIFs
• Every AIFM has to set quantitative and qualitative risk limits for each AIF for all possible kind of risks 
• An AIFM's Risk Measurement Procedure should include requirements for: backtesting, stress-testing, scenario analyses and the rules should describe remedial action plans when limits are breached. 

So far so good, peace of a cake, you would think. Unfortunately: NO!

1. In-depth market risk assessment: too complex and not adequate

An adequate in-depth market risk assessment of AIFMs AIFs actually requires a full 'fund of funds' transparency of the portfolio of the (AIF) funds.

The problem is that full 'fund of funds' transparency does not exist yet, nor can it finally be fully obtained. It's simply too complex:

• undefined systemic risks are often beneath the analyse surface
• (re)hedged risks could be part of a fatal unknown or unapparent self-reference hedge cycle
• in-depth 'fund of funds' management is time consuming and presumes that risk profiles of sub-funds are available, when in practice they are often not

To illustrate the desperate, funny and useless efforts that are made to tame the 'fund of funds' issues within the AIFMD, just take a look at the next quote from the AIF Handbook draft 2013 :

Section 5-iii-1, Alias 'Fun' of Funds

"Any proposed investment by a Qualifying Investor AIF into another investment fund must be clearly disclosed.
Disclosure must focus on the implications of this policy regarding increased costs to unitholders (i.e. the fact that fees will arise at two or, in the cases where the underlying fund it itself a fund of funds, three levels – the Qualifying Investor AIF, the underlying fund of funds and the underlying funds in which the underlying fund of funds invests) and the resultant lack of transparency in investments."

I hope you're still with me after all this fund of funds of funds of funds fun..... ;-)

Thus, in-depth market risk assessments in a non transparent market are inadequate and may potentially result in ill-founded or even erroneous conclusions (e.g.' false safety').

Market Risk Assessment

The adequacy of an AIFMD's Market Risk Assessment could be roughly defined as:

MRA-Adequacy = ADTQ x RPQ x RMQ

With: ADTQ= Asset Data Transparency Quality, RPQ= Risk Policy Quality and RMQ = Risk Model Quality.

Just let your colleague rate your ADTQ, RPQ and RMQ on a ten point scale. If the outcome MRA-Adequacy is lower than 800, consider your test as inadequate.

As transparency also includes full sub-cycle  'fund of funds' transparency, often ADTQ will not score high enough for an adequate test outcome.

Example

Suppose an AIF consists of 30% 'fund of funds' with minor risk information regarding the sub-funds.All other scores of the AIF score well (10). In this case the test adequacy score is 700 (= 7 x 10 x 10) . Conclusion: the quality of your risk assessment is insufficient for drawing robust conclusions.

2. Alternative: Strategic Market Risk Assessment

Instead of - come what may - trying to get to the endless bottom of a 'fund to fund' construction, a more strategic risk assessment approach -  as an alternative -could work out much more effective. A strategic market risk assessment that assesses the nature, risk and policy of a AIF and its investments and that implicitly takes into account non-linear risks, the presence of systemic risk, a large number of weighted and not-weighted economic scenarios, stress tests and fat tail risks.

The Secret of the Chef

Many (hedge) funds have only a limited transparent investment policy or an investment policy that  - for whatever reason -is regarded as 'The Secret of the Chef'.

In these kind of funds 'full disclosure' will end in a lot of degrees of freedom in 'risk policy' and corresponding mandates.

It's important to realize that the more degrees of  freedom in 'risk policy' a manager of a fund has, the more risk will emerge in the above formulated alternative assessment.

New alternative market risk models?

Key question is: are there new models that can assess investment strategies and portfolios in a systemic risk environment and on basis of non-linear modeling.

The answer to this question is : Yes, very soon!

Symetrics, a brand new company in the Netherlands is developing an investment decision support and assessment system called SyMath, that is based on nonlinear modeling, grasps systemic risk and includes future crises. SyMath will be on the market mid 2013.

Until then will have to assess AIFMs with pen and pencil... ;-)

Links, Used Sources

- The impact on non-EU fund managers of non-EU funds

- Walkers: AIFMD, Level 2 Measures - The Wait Is Over

- How to deal with leverage?

- Clarity on PII and Capital Requirements under AIFMD (2013)

- AIF Handbook Draft 2013
- BVCA: AIFMD “still damaging” (2011)
- SyMath
- Symetrics

NOT Discriminating is NOT possible

Tomorrow I'll be discussing the borders of solidarity as a panel member at an actuarial congress (VSAE)  for econometricians in The Hague (The Netherlands).

In a Dutch interview preceding the congress, two students asked me:

"The  Court of Justice of the European Union (CJEU) has decided that the use of gender as a risk factor by insurers should not lead to individual differences in premiums and benefits.
What is your opinion?"

My short answer was :

NOT Discriminating is 

NOT Possible

Examples

Let me illustrate this 'quantum quote' with two examples.

Example I: Gender Neutral Car Insurance 

• It's scientifically proven that women are better drivers, have just as much car accidents as men, but cause less damage. That's a fact and that's why car insurance for women is cheaper than for men. 
• As from December 21, 2012, European insurers are not allowed to 'discriminate' anymore by gender, implying equal car insurance premiums for men and women. 
• If insurers calculate this premium as the weighted average of their portfolio, women are obliged to pay (much) more premium than before and also more than actually and actuarially necessary regarding their gender group. 
• Therefore women are de facto discriminated, although the genuine intention was NOT to discriminate!
• Not only women, but also insurers are discriminated as they now will be faced with anti-selection: Relatively more men will choose an insurance cover, as car insurance premiums for men have become less than the premium corresponding with the expected damage for their gender group. Insurers will therefore face a loss on car insurance. 
• Based on solvency legislation, the insurer will (next) be 'forced' to increase the average weighted premium. This - in turn - is at odds with the measures envisaged by the European Court. 
• A similar kind of reasoning applies also for unisex rates for pension and life insurance.
• The upcoming (2014) US health care law will also prohibit “gender rating”. However, gaps persist in most states. There seem to be no signs of insurers that have taken steps to reduce them.

The conclusion must be that discrimination regulation is carried too far.

 'Over-Solidarity' as in this case has nothing to do with real solidarity and is in nobody's interest; it has become 'Anti-solidarity'.

The proposed measures - no matter how well intended - have a opposite effect and should be reconsidered on basis of the question: are the discriminating effects before the new legislation more or less than after?

We've got to stop discrimination due to over-discrimination and anti-discrimination!

Insurance Rating Fallacy: Gender anti-discrimination laws are superseded 

Prohibiting "gender", "marital status" and "age" as rating elements doesn't solve anything.

Modern rating systems based on data mining (Google history), social media (premium quoting on basis of: your smart-phone that captures and shares your drivingstyle with the insurer) and neural networks are "black boxes" that quote insurance premiums in such a way that every client can get individually quoted on bases of his 'profile'.

That 'profile' doesn't have to contain any of the forbidden discriminating elements (nor direct related) to get satisfactory results for clients as well as insurers. Although there are also simple (e.g. Bayesian-Classification) techniques to derive a clients gender from other non-discriminant related variables (e.g. height, weight and foot-size determine gender quite accurately) in an insurers direct or indirect related data base, insurers and their actuaries would end up in an unwanted ethical dilemma by using these direct-related techniques.

Another illustrative and strong example of determining your gender on bases of - at first sight - non-gender-related information is Hacker Factor's "Gender Guesser"  that attempts to determine an author's gender based on the words used. Try  "Gender Guesser" for yourself HERE. Take a part of an email you've written (more than 300 words), copy-paste it to Gender Guesser and notice how gender Guesser will probably determine your gender without any problem in a split of a second!

LET YOUR GENDER BE GUESSED 

These simple techniques show that the developed anti discrimination legislation is superseded and has become irrelevant for insurers and their clients to come anyhow to an adequate and ethical responsible rating policy on basis of neural networks or social media related information, such as information from smartphones that transmit your driving style information to the insurer (why not, if you have nothing to hide?).

Example 2:.Women on Boards: Commission proposes 40% objective

The European Commission has proposed legislation with the aim of attaining a 40% women presence objective in non-executive board-member positions of publicly listed large companies.

Currently, large boards are dominated by men (85% non-executive, 91% executive).

No matter how welcome and needful women are on board level, forcing such a development makes no sense and will have an adverse effect.

From experience I can tell that women who really qualify for board level positions, are very unhappy if they are appointed under the vigor of gender legislation and not on basis of their acknowledged competences.

This is perhaps a sign that women who really qualify feel discriminated by this new proposal. Proposals should better emphasize on stimulating women presence on board level and take away old boys network principles.

Conclusion

Anti discriminating legislation often results in the exact opposite of what is intended. Legislation is often superseded, should be carefully evaluated on its effects and certainly reconsidered if the discriminating effects after applying the new legislation increase.

Used Sources and Links

- E&Y: Gender-neutral insurance

- Gender-rating in the United States Health Insurance Industry (2011)

- Who Are Better Drivers: Men or Women?

- Bayesian Classification: Naive Bayes classifier

- Determine your gender online: "Gender Guesser"

- The Basel II Risk Parameters (incl. neural networks

- Smartphone driving style Insurance premium?

- Age as an insurance rate class variable

- Women on Boards: Commission proposes 40% objective