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.

http://www.bom.gov.au/


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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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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

http://climatechange.worldbank.org/sites/default/files/Turn_Down_the_heat_Why_a_4_degree_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

http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.1





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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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1

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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

http://www.smithschool.ox.ac.uk/research/stranded-assets/



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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1

8


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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.

http://www.albartlett.org/


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Exponential Growth

21

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

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P, 1990 $

tril

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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

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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”

http://www.fao.org/worldfoodsituation/wfs-home/foodpricesindex/en/



http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rbrte&f=m


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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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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


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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”


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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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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.

.

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*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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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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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

http://www.ft.com/cms/s/0/faea0bda-dcb5-11e1-99f3-00144feab49a.html



























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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.

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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

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