Areas of Expertise · Areas of expertise - a few examples 1. Solving risk problems – a case study...
Transcript of Areas of Expertise · Areas of expertise - a few examples 1. Solving risk problems – a case study...
Is there an actuarial role in business?
Tel Aviv, 16 June 2014
Areas of Expertise
Tony Hewitt
Chair, Professionalism Awareness Committee
Institute and Faculty of Actuaries
Director, Actuarial Finance MSc Programme
Imperial College Business School
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Acknowledgements
• The areas of expertise are drawn from lectures given by
leading actuaries to trainee actuaries attending the Imperial
Actuarial Finance MSc programme
– Oliver Bettis – Chair, IAA Resource and Environment Working Group
– Brandon Horwitz – Chair-Elect, IFoA Finance & Investment Board
– Neil Cantle – IFoA Risk Management Thought Leadership
• Particular thanks are given to Oliver Bettis for permission to
use many of his lecture slides.
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
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Case Study – Pricing Australian bush fire
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Case Study – Pricing Australian bush fire
• Insuring extreme bush fires, where losses exceed A$100m
• Bush fires are common in Australia, but extreme bush fires
causing >A$100m losses are rare
• Record of bush fires patchy before 1930s
• Big problems normalising for increased population and GDP
growth. Hence only a few useful data points
• Extreme bush fires occur during periods of extreme hot dry
weather – also need high wind to drive fire.
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Australian mean temperature record
6 Australian Government Bureau of Meteorology: http://www.bom.gov.au/
• Australian
temperature has
increased in recent
decades.
• This is an
expected outcome
of global mean
temperature
increase.
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Small shift in mean can give large increase in
probability over high threshold
7
0
0.2
0.4
0.6
0.8
1
1.2
-2 -1 0 1 2 3 4
f1(x)
f2(x)
Tail
• Small increase in
mean temp. may
increase probability
of extreme heat by
several times.
•Risk has
increased but is
hard to estimate
size of the loading
needed for
increased
temperature.
Given the high uncertainty about bush fire risk, is it insurable?
Yes – through diversification and risk transfers.
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
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Global temperature for last 11,000 years
http://www.sciencemag.org/content/339/6124/1198
DOI: 10.1126/science.1228026 A Reconstruction of Regional and Global Temperature for the Past 11,300 Years, Shaun A. Marcott, Jeremy D. Shakun, Peter U. Clark, Alan C. Mix
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What do we know?
• There is a wide scientific consensus that climate change is
happening now, and is caused by human activity.
• We are at risk of pushing our climate system toward changes
with highly damaging impacts.
• CO2 emissions stay in the atmosphere for centuries. The
sooner we act to lower emissions, the lower the risk.
Source: http://whatweknow.aaas.org/get-the-facts/
http://whatweknow.aaas.org/get-the-facts/
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World Bank – Why a 4°C warmer world
must be avoided
4°C warmer world would mean:
• Possible large-scale displacement of populations.
• Risk of crossing thresholds of nonlinear tipping elements in the
Earth system e.g. disintegration of West Antarctic ice sheet.
• Possible nonlinear responses within particular economic
sectors e.g. reduced crop yields.
• Given uncertainty about the full nature and scale of impacts,
there is no certainty that adaptation to a 4°C world is possible.
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Source:
http://climatechange.worldbank.org/sites/default/files/Turn_Down_the_heat_Why_a_4_degre
e_centrigrade_warmer_world_must_be_avoided.pdf
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Contrast: Economic Modelling Output
Chart from Nicholas Stern 2008 http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.1
4 climate change economists’ model outputs.
• All models show smooth change with increasing temp., up to 6°C
• Maximum drop in GDP at 4°C warming is about 6%
• But, World Bank report says adaptation to 4°C may not be possible.
• Stern said “a temperature increase of 5°C would most likely result in
massive movements of population and large-scale conflict.”
% Drop in
global GDP
versus increase
in global mean
temperature °C
4 Economists:
•Hope
•Mendelsohn
•Tol
•Nordhaus
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Can we learn from other risks?
Tobacco
• Link to lung cancer was proved in the 1950s.
• Societal attitudes changed, but slowly.
• More than half a century later, laws are still changing.
Asbestos
• Health hazard was proved from the mid-1960s at latest.
• Asbestos continued to be used beyond 2000.
• “Wilful Blindness” by Margaret Heffernan.
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
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Stranded Carbon Assets
A “Carbon Bubble”?
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• Many fossil fuel
companies are
valued assuming all
resources will be
extracted and
consumed
• Consumption of
proven fossil fuel
reserves in top 100
quoted companies
gives more than safe
emissions.
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The Danger of Stranded Carbon Assets
• If not all fossil fuel reserves can be burnt, are
the unburnable reserves worth anything?
• If they’re not worth anything, how can they
be valued in the share prices?
• If governments act faster on climate change, markets will
revalue share prices downwards
• This “carbon bubble” has not been widely recognised by
investors
See: http://www.smithschool.ox.ac.uk/research/stranded-assets/
And http://www.carbontracker.org/carbonbubble
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Ethical Issues: Serving the public interest
• Climate change raises some deep issues of intergenerational
equity.
Discount Rates
• Normally assets are valued as the sum of future cash flows
discounted to present value.
• But, there are unaccounted costs from carbon emissions,
unless carbon is priced adequately. Such costs fall to future
generations.
• Normal financial discount rate for business projects is arguably
not appropriate for accounting between generations.
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
1
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Research into limits to growth
• The IFoA has identified resource depletion (e.g. high oil price)
and environmental issues (e.g. climate change) as being
important issues for investigation.
• Research was commissioned on limits to economic growth,
reporting in January 2013.
• The IFoA does not assert that growth/discount rates need to be
changed now – just this is an area for investigation.
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Rule of thumb: doubling time
“The greatest shortcoming of the human race is our
inability to understand the exponential function”
– Professor Albert Bartlett, Colorado University
Rule of thumb for doubling time
• Approx. doubling time = 70/(Growth Rate in %)
Reason: 70 ≈ 100*ln(2)
• E.g. 3% p.a. growth means doubling time of 70/3 = 23 years
Source: http://www.albartlett.org
There is a great presentation about exponential growth at this web address.
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Exponential Growth
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0
10
20
30
40
50
60
1750 1800 1850 1900 1950 2000
GD
P, 1990 $
tril
lio
ns
Year, A.D.
World GDP, 1750-2008 AD
Exponential Growth
World GDP growth has
been exponentially
growing.
• In real terms world GDP
has grown at average
rate of c.3% per year in
recent decades =
doubling time 23 years.
• 2012 to 2100 is almost
4 doubling periods.
• If 3% growth continues,
world economy would
grow 14 times as large
in 2100 as it is now.
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Future Growth?
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0
10
20
30
40
50
60
1750 1850 1950
GD
P, 1990 $
tril
lio
ns
Year, A.D.
World GDP, 1750-2008 AD
Green Growth
Growth is the
Solution
End of Growth
Beyond the Limits
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Oil Prices since 1875
2
3
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Limits interact e.g. oil, food prices and civil
unrest
24
Sources: http://www.fao.org/worldfoodsituation/wfs-home/foodpricesindex/en/
http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rbrte&f=m
0
20
40
60
80
100
120
140
50.00
70.00
90.00
110.00
130.00
150.00
170.00
190.00
210.00
230.00
250.00
1990 1995 2000 2005 2010
Oil
Pri
ce, d
olla
rs p
er
bar
rel
Foo
d P
rice
In
de
x
UN FAO Food Price Index and Oil Price
Food Price Index
Oil Price
Social unrest.
Many countries
banned grain
exports
“Arab
Spring”
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Opportunities in a constrained World
• Renewable energy
– £300 billion required between now and 2030 in the UK (Blyth and McCarthy)
• Large scale wind
• Locally distributed generation
• Energy efficiency improvements (e.g. Green Deal)
– $35 trillion required globally (IEA)
• Sustainable transport technologies
– Hybrid and electric vehicles, bus rapid transit
• Sustainable agriculture
• Ecosystem protection
– Ecosystems provide tens of trillions of dollars worth of services to the world economy
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
26
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Making sense of complexity
• Treating businesses as open, complex, adaptive systems
• Adaptive cycles
• Tipping points
• Non-linear behaviour
• Dynamic interaction at different levels
– businesses
– industries
– Society
Source: Neil Cantle presentation to Actuarial Finance students
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Risk modelling
• Cognitive analysis – asking the experts
– Finding the most important causal factors
– Capturing expertise using Bayesian Networks
– Pattern spotting using visual analysis [Dacord software]
– Identifying risks, remote but catastrophic, that are not in the data
– Building models combining data and cognitive analysis
• Creating causal modelling techniques, enabling
– Dynamic scenario modelling
– Reverse stress testing
Source: Neil Cantle presentation to Actuarial Finance students
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Risk DNA – spotting emerging risks
• Evolutionary forces in risk
– Cladistic approach, thinking like an ecologist
– Profiling the evolution of risk
– Replacing less valuable “risk registers”
• Enabling evolving assumptions in modelling projections
• Building models to explain “why” and “how” as well as “what”
Source: Neil Cantle presentation to Actuarial Finance students
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
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Culture, regulation and ethics
• Adherence to rules is necessary, but not sufficient:
– Regulator looking for evidence of firms demanding and demonstrating the right
behaviours from their staff , and
– Being aware of the impact of their actions on the behaviours of customers (including
demonstrating how they allow for consumer biases identified through behavioural
economics, and how the right customer outcome is achieved)
• Said another way by author and teacher Rabbi Lord Jonathan Sacks:
– “The market economy depends on trust. Absent that, and depend instead on contracts,
lawyers, regulations and supervisory authorities, and there will be yet more scandals,
collapses and crashes since the ingenuity of those who seek to sidestep the rules always
exceeds those whose job it is to apply them. The only safe regulatory authority is
conscience, the voice of God within the human heart forbidding us to do what we know is
wrong but think we can get away with.”
Source: Brandon Horwitz presentation to Actuarial Finance students
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Complexity science
6. Culture, regulation and ethics
7. Changes in economics
8. What do actuaries add to business?
32
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Financial crisis raised deep questions on
economics
Adair Turner (ex-chairman of the UK Financial Services
Authority), on the need to “reconstruct” economics*
– “… one oversimplified strand [of economics] dominated in the pre-crisis
years”
– “… do we really need, as Skidelsky argues, to “reconstruct economics”?
My conclusion is that we do.”
Joseph Stiglitz, Nobel prize winning economist
– Models said that financial markets were always efficient.
– Remarkably, standard macro-economic models did not even
incorporate adequate analyses of banks.
.
33
*Source: “Economics After the Crisis”, by Adair Turner, MIT Press 17 April 2012
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Market Efficiency
34
“If the markets were efficient, I’d be a bum on
the street corner with a tin cup.” Warren Buffett
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Neoclassical Economics
• The 3 central assumptions of neo-classical economics are:
1. People have rational preferences (e.g. If prefer A to B and B to C,
then would also prefer A to C).
2. Individuals maximize utility.
3. People act independently on the basis of full and relevant information
(“perfect information”).
• Also, neoclassical economics assumes that the economy is an
equilibrium system.
• Financial Economics is built on a foundation of
neoclassical economics.
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Test 3rd assumption: Independent decisions
Experiment – Free Beer!
• Offer one free beer – choice of four. Take order in front of others.
• Those that chose first liked their beer the best, because those that chose after felt obliged to choose a different beer to the first, to show their individuality.
• Effect disappears if choice made in private.
• Same experiment in Asia gives same result for opposite reason, later choosers felt obliged to choose same beer as first chooser.
• People change their choice for social reasons, and do not maximise their utility.
Behavioural economics undercuts the foundations of neoclassical economics.
36 Source: Dan Ariely “Predictably Irrational”, “The Upside of Irrationality” and “The (Honest) Truth about Dishonesty”
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Institute for New Economic Thinking (INET)
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Areas of expertise - a few examples
1. Solving risk problems – a case study
2. Climate change – a brief overview
3. Stranded carbon assets
4. Limits to economic growth
5. Changes in economics
6. What do actuaries add to business?
38
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Business modelling
39 ‘The Philosophy of Modelling’ by Matthew Edwards and Zaid Hoosain.
http://www.sias.org.uk/diary/view_meeting?id=SIASMeetingJune2012
• Modelling begins and
ends with the world.
• Sense checking of
model output is a key
skill.
• Sense checking may
involve using imagination
to think of scenarios to
test the model output.
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Negative Capability
• Negative capability is the ability to live comfortably in a state of
uncertainty.
• Very important that actuaries are open to different possibilities
and open to change our minds if evidence changes.
“When my information changes, I alter my conclusions.
What do you do, sir?”, John Maynard Keynes
Thanks to Colm Fitzgerald of the Society of Actuaries in Ireland for discovering this concept.
http://en.wikipedia.org/wiki/Negative_capability
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Behavioural finance
• Behavioural biases are universal and impossible to avoid. The
only defence is to know that they exist. Try to focus only on
what the data shows. The more logical we are the better job
we do as actuaries.
• Biases include:
– Anchoring
– Prospect theory
– Framing
– Overconfidence, and many others
“Making Actuaries Less Human – lessons from behavioural finance”. By Nigel Taylor, 18 January 2000
http://www.sias.org.uk/siaspapers/listofpapers/view_paper?id=BehaviouralFinance
See also Daniel Kahneman: “Thinking, Fast and Slow”
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• Anthropology offers insights into financial markets
• “Fools Gold” by Gillian Tett is great explanation of financial crisis.
• Culture theory gives insight into why different groups see the
world differently.
Learning from anthropologists as well as
ecologists and ethicists
42
Source: Financial Times http://www.ft.com/cms/s/0/faea0bda-dcb5-11e1-99f3-00144feab49a.html#axzz26YLl1a00
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What do actuaries add to business?
• Combining quantitative with problem solving skills
• Working to rigorous standards of practice and behaviour
• Driving forward best practice through thought leadership,
research and continuous learning.
• Lessons learnt from collective experience:
– Use models carefully – always sense check results.
– Look for disconfirming information – don’t be too sure.
– Build in negative capability – the ability to live with uncertainty.
– Be aware of cultural influences and biases – focus on what the data is saying. Lose some
humanity!
– The world is changing rapidly – read widely, keep up to date.
– Above all, be aware. The past may not be a good guide to the future.
43
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Further reading
A longer version of this presentation contains more references to
web sites and further reading. Please contact Tony Hewitt on
[email protected] if you would like to receive this longer
version. Topics covered include:
– Climate change
– Complex adaptive systems
– Risk assessment and decision analysis with Bayesian
networks
– Evolution, complexity and the radical remaking of economics
– Ecological economics
– Santa Fe Institute complexity research.
44