Why We Need Modern Finance, or Guarantees ? Us
Why We Need Modern Finance, or Guarantees R Us
by Mary Rosalyn Hardy
In the last edition of Expanding Horizons, I wrote about concern over the lack of financial economics in the new Society of Actuaries curriculum. In the proposed 2005 education syllabus, actuaries qualifying through the SOA would not study modern finance in any detail in the directly examined curriculum, unless they chose to specialize in finance, investment or risk management.
In this article I will try to explain why I think it is important that this decision is reviewed, and will describe briefly the steps that are currently being taken.1
First, I should explain what I mean by modern finance. In 1973 Fischer Black, Myron Scholes and Robert Merton published their seminal works on the pricing of options. Within a few years, some actuarial pioneers were applying the new theory to embedded options in insurance contracts. It took a lot longer for the profession as a whole to understand the importance of the new paradigm, and it is arguably still not widely accepted. It was a different matter in the world of banking; within a few years, the Black Scholes framework was supporting the pricing of billions of dollars of trades daily. The Black Scholes framework forms the foundation of the new profession of financial risk manager.
One reason for this is that options are really guarantees, and guarantees appear in many forms in all financial services. How is an option a guarantee? Take a regular put option on a stock. The stock has a variable price, say St at t. The put option gives the buyer the right to sell the stock at some future time T at a price of K. The option holder only exercises this option at T if the price ST is less than K. In other words, the option provides a guarantee to the option holder that her stock will deliver a price of at least $K at time T.
One of the beautiful things about the Black Scholes framework, is that it does not simply give a methodology for valuation of guarantees, it also provides the risk management tools. In fact, the valuation is worthless without an understanding of how the value relates to the risk management. The Black Scholes formula tells us exactly how to invest to hedge the guarantee cost, and while the model isn't perfect, it has been proven to be remarkably robust to variations from the original assumptions.
Once we understand that the Black Scholes framework describes a rigorous method for valuing and managing financial guarantees, it becomes more obvious why this is critical for actuaries; guarantees are our business. We guarantee level premiums and benefits, we embed guarantees in variable annuities and equity indexed annuities. We guarantee pension benefits, surrender values. We offer guarantees against adverse movements in interest rates, inflation rates, salary rates, stock prices, demographics, government action.
The guarantees that modern actuaries work with apply to diversifiable risk and non–diversifiable risk, but in our traditional training, only diversifiable risk management is conventionally taught. Diversifiable risk means that we sell lots of independent risks, and the central limit theorem applies such that the more risk we sell, the less the relative variability, so that effective risk management is achieved by selling more contracts. Non–diversifiable risk, on the other hand, does not go away with volume. If we guarantee policyholders a return of 10 percent on their premiums, but we have a 50 percent probability of earning less than 10 percent on all the invested premiums, then if it goes wrong, it goes wrong for the entire cohort of policies, and the more we sell the more we lose. Non–diversifiable risk requires a new framework, and modern finance provides it.
It is not sufficient for a few, specialist actuaries to learn this material. It is fundamental to modern finance, and all actuaries work in the environs of finance. All actuaries are engaged at some level in risk management in their professional activity. Risk management in life insurance begins at product design–so the individual life (8I) stream actuaries need to know the implications of guarantees when they are designing and pricing new products. Pensions actuaries are embroiled in debate about discount rates that revolves around the paradigms of modern finance. And the SOA promotion of actuaries into wider fields in finance is doomed if we cannot even begin to speak the same language as other finance professionals.
It is also not necessary for this material to be kept for a minority of actuaries. It can and has been made accessible through numerous textbooks. In my university, students learn this material in their third or fourth year of school. The students generally regard the course as less challenging than, for example, loss models, so it cannot be argued that the concepts are too difficult for the curriculum. Modern finance is incorporated into the compulsory professional curriculum of actuaries around the world, including the UK, Australia, most continental European countries and South Africa. It is compulsory for actuaries qualifying in the Casualty Actuarial Society.
In my opinion, an understanding of financial risk should be part of the definition of an actuary, which is why modern finance should be part of the pre–ASA curriculum. Even the SOA Web site states "The Society's vision is for actuaries to be recognized as the leading professionals in the modeling and management of financial risk and contingent events." How are we to begin to achieve that recognition if we accept that only a small minority of actuaries need ever learn the theory of financial risk?
The E&R Section Council has twice petitioned the Board of Governors to address this problem, and in the past few months an advisory group, of which I am a member, has been working towards a recommendation to the Board. It seems likely that the advisory group will recommend the reintroduction of modern finance into the syllabus. However, it is not clear that the advice will be accepted, and even if it were, there could be a significant lag before the form and content is agreed upon. Some of the issues under discussion include:
Exactly what material is core and should be studied by all actuaries?
Does the material suit the e–learning approach of the FAP modules, or does it lend itself better to the traditional textbook–examination approach of the first four exams?
Will there be uproar if an exam on financial mathematics and economics is inserted into the curriculum between Course C (current Course 4) and the FAP modules?
Can we introduce some of the more elementary ideas of finance even earlier, in the FM (new Course 2) module?
The advisory group will report to the Board of Governors in February. The decision–making processes of the Society are under review, and the educational curriculum is now the responsibility of the Knowledge Management Action Team. So there are many steps to go before the re–introduction of modern finance into the core curriculum will be decided upon. In my view, it is a matter of such moment, that the future of the profession looks bleak if we get this wrong.
1 Although the E&R Section Council agrees with the broad principle that all actuaries should study some modern financial mathematics, the opinions expressed in this article are mine and have not been approved by the current section council.