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From the Readers
CAPM Can Reflect Catastrophes
Dear Editor:A number of panelists in the "Actuarial Roundtable Discussion" from the May 2002 issue of The Actuarial Review, stated that financial theories do not adequately deal with catastrophe risk. I disagree with that claim. We have financial approaches in our own actuarial literature that have begun to deal with the skewed nature of catastrophes. In our Proceedings paper, "The n-Moment Insurance CAPM" presented at the May 2001 CAS meeting, Tom Kozik and I developed a financial model that captured the effects of skewness and higher moments in the equilibrium premium formula. Further, the skewness premium is significant. Only systematic skewness, which is not diversifiable by investors, is considered relevant. Many of the criticisms with the current approaches discussed by the panelists such as reliance on mean-variance analysis and the inclusion of nonsystematic risk were overcome with this model. The criticism of the limitation of mean-variance analysis for measuring catastrophe risk is not new; Yahuda Kahane pointed out this limitation in his 1979 ASTIN Bulletin article where he recommended the CAPM be used to develop insurance industry risk premiums. It is interesting that we are just now addressing the issue. I hope the next major steps in this area of study for the insurance industry will be performing empirical estimates of our industry's cost of skewness.
Aaron Larson, FCASThe Future of Actuarial Education
Dear Editor:The May 2002 Actuarial Review contains an excellent "Actuarial Roundtable Discussion" on the current state of casualty actuarial science. I would like to make a couple of comments on this discussion.
First, Sholom Feldblum states, "we [actuaries] are not sufficiently aware of the developments in related fields such as economics and finance." In response to a question regarding potential changes to the syllabus, Feldblum goes on to state, "The Modigliani and Miller (M&M) propositions are important ... This material is not on the Exam 8 syllabus, but it is the foundation of financial theory on the capital structure of corporations."
I agree completely with this sentiment. In particular, I believe there are many useful potential applications of the M&M propositions to actuarial work. On the SOA side, Jeremy Gold has used the M&M ideas to analyze the design and investment strategy of cash balance pension plans. Also, Luke Girard has used the M&M propositions (in a recent NAAJ article) to unify thevarious approaches to life insurance valuation. On the P&C side, I have used the M&M propositions to demonstrate the impact of an insurance company's investment strategy on its market value, and to point out several pitfalls in the common application of IRR ratemaking models. I think there are many more applications of M&M still to come.
Second, Feldblum states that "Financial theorists deal with systematic risk; shareholders can diversify their risk. The actuarial view is to look at total risk." Again, I agree. I've made the point in a previous CASNET post that the recent "Risk Premium Project" overemphasizes the similarity between financial and actuarial pricing methods. Feldblum points out the most fundamental difference between these two views: the financial methods recognize shareholder diversification, whereas actuarial methods tend to focus on total volatility of the insurance company's results in isolation.
Lastly, Stephen Philbrick asks the following two questions: (1) "is there a favorite or recommended text on finance?" and (2) "what is important on the cost of holding capital?" Regarding the second question: from a purely financial point of view, there are three significant costs to a P&C insurer of raising and holding capital—double taxation, agency costs, and issue costs (including asymmetric information). In a recent call paper, I described each of these costs in depth, and argued that these costs are typically overestimated in the JRI literature (especially double taxation).
Regarding Philbrick's first question, the Brealey/Myers finance book from the Exam 2 syllabus is still the best MBA-level finance book on the market. There is very little, if any, mathematics in this book, but the authors provide an extremely well chosen list of references at the end of each chapter for those interested in the underlying math. We would be well served to add a few of the most important actual finance papers to the Exam 8 syllabus, including several of the papers referred to by Feldblum in the Roundtable Discussion (namely, Merton Miller's "Debt and Taxes," Stewart Myers' "Determinants of Corporate Borrowing," and the Jensen/Meckling paper on agency theory).
It seems to me from reading the Roundtable Discussion that there are two very different viewpoints on the future of actuarial education. It has been my experience that many practicing actuaries hold a disdainful view toward much of modern finance theory (especially efficient market theory and equilibrium asset pricing theories); I think it's great to see a prominent actuary like Feldblum taking such a pro-finance position.
Trent R. Vaughn, FCASUnification Redux
Dear Editor:The subject of unification is in the air again. I understand Clive Keatinge plans to run for the CAS Board. His vision touches on many important areas, but perhaps the most controversial relates to unification. If I understand correctly, his position is not simply pro-unification, but in favor of studying the unification issues.
I remember the last time the issue was seriously raised. I remember trying to have an open mind about the subject, but feeling generally, albeit not strongly, opposed. As I recalled my main reasons for opposition, I realized one was based on a flawed assumption, and the other based on a fact no longer true.
When I was passing my early exams, the SOA was far larger than the CAS, roughly by a factor of ten. (Despite what people in my office believe, the numbers were not recorded on clay tablets.) I had little contact or involvement with the SOA, so my vague impression was a monolithic organization of ten thousand life actuaries. Unification seemed to provide some benefits, but I was concerned that our smaller society might get lost in the larger organization.
Since then, two changes have occurred. The CAS has grown faster than the SOA, so the relative sizes are much different. More importantly, I've had much more contact with the SOA, primarily as chair of the CAS Committee on Principles, which has been working closely together, for almost forever it seems, with the SOA Committee on Principles. We are working jointly to write a document "Fundamental Principles of Actuarial Science." As part of that exercise, I've come to realize that the differences within various subsets of the SOA are as significant as the differences between life and casualty actuaries. On more than one occasion, we've tried to craft an example of an actuarial issue that would work for both life and casualty. In several instances, the life and casualty people would be happy with the example, but one of the pension people, or health people, or financial people would point out that the example was problematic in their areas.
I looked at the Directory of Actuarial Memberships to get a sense of the relative sizes of practice areas. Caution should be used with these numbers, as I understand that one can select more than one practice area, and not all members are in the list, but the results are still interesting. To the nearest 500, the counts are:
Life 4,500 Retirement 5,000 Health 2,500 Financial 1,000 With CAS membership at approximately 3,400, it became clear to me that the casualty actuaries would not get lost in a much larger organization, but would become one of several important practice areas, and not much smaller than the largest of these practice areas.
I'm in agreement that it is time to revisit the unification issue.
Stephen Philbrick, FCASSilence is Golden
Dear Editor:Casualty actuarial science is an eclectic discipline that has gleaned much from other sciences. Psychoanalysis now offers a paradigm with application to the Casualty Actuarial Society.
A famous case study concerns little Jesse, who did not speak for his first six years on earth. His parents took him to doctors and he passed all the physiological examinations. Psychiatrists administered barrages of evaluations and he passed them all, except for those requiring oral response. Apart from not talking, Jesse led a normal life. Every morning he would have toast with jelly and chocolate milk, then spend a fairly normal day playing with his dog, reading, painting pictures, and so on. One morning, when he was about eight, he got up for breakfast, sat down to eat, and exclaimed: "Mom, you burned the toast!" His mother grabbed him and raced to the psychoanalyst to report that he was now speaking. The psychoanalyst asked Jesse why he chose to speak that morning. Jesse's reply was that: "Until now things were pretty good!"
Not having written a letter to the editor in many years, I would now like to point out that the CAS Yearbook no longer has a spiral binding and no longer opens to lie flat.
Alfred O. Weller, FCASManaging Editor's Note: Al Weller suggests that the Yearbook has changed for the worse, but we respectfully disagree. The old Yearbook used to lay flat, which was nice, granted. But the back cover kept slipping off, which was terribly annoying to some people. Like morning toast that is less burnt now than it used to be, the Yearbook has improved.