MODELING CAVEATS: Risks Associated with the Construction and Use of (Actuarial) Models

Transcription

1 MODELING CAVEATS: Risks Associated with the Construction and Use of (Actuarial) Models Ali Zaker-Shahrak, Ph.D.(Econ.), MAAA, FSA, CFA Senior Life Actuary, California Department of Insurance 2016 American Academy of Actuaries. All rights reserved. May not be reproduced without express permission. PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

2 The opinions expressed in this presentation are my own, and do not necessarily represent the official opinion of my employer, the California Department of Insurance. 2 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

3 Agenda: 1. First: The Good News 2. Next, the Warning: Modeling May Be Accompanied with (Hidden) Dangers and Using Models Involves Taking Risks 3. Some Examples of (Wrong) Models Usage Resulting in Spectacular and Not So Spectacular Failures 4. Many Stakeholders with Varying Interests 5. Modeling Done for Other Purposes and in Other Disciplines 3 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

4 6. What is a Model? 7. Major Components of Modeling Processes 8. Two Issues: Credibility of Internal Company Data and Reasonability of Margins for Provision for Adverse Deviation (PAD) 9. Modeling Mortality Rates and Policyholder Behavior 10. Modeling Stock Market Returns 4 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

5 11. Modeling Interest Rate/Yield Curves: Stochastic Interest Rate Generators 12. Secular Stagnation, Negative, or Very Low Interest Rates, and Insurance Company Operation 13. Ms. Frances Oldham Kelsey and Thalidomide Prescription Drug 14. Flight 1549 and Captain Chesley B. Sully Sullenberger 15. References 5 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

6 First: The Good News It is natural to be a little bit stressed out: This is true for company actuaries: They will be estimating reserves using PBR for the first time; and, It is also true for regulators: They will be reviewing such estimates for the first time. But relax. No need to worry too much: Expect plenty of guidance/advice from the NAIC, AAA, SOA, leading consulting companies and rating agencies regarding acceptable models to use, reasonable assumptions to employ, etc. 6 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

7 You are doing this for the first time. You have deterministic calculation of reserves as points of reference. Rating agencies will be monitoring your reserves. Regulators are also new to PBR, and, moreover, they will anticipate shortcomings in the PBR when done for the first time. Barring spectacular unexpected external developments, models usually work well and produce reasonable results. 7 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

8 Next, the Warning: Modeling May be Accompanied with (Hidden) Dangers and Using Models Involves Taking Risks Sometimes, despite the existence of all the safety checks, a defective model becomes popular and gains widespread acceptance and use. Resulting in (sometimes very severe) adverse financial consequences for the company and (perhaps even) for society. 8 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

9 Some Examples of (Wrong) Models Usage Resulting in Spectacular and Not So Spectacular Failures Long-Term Capital Management (LTCM) Gaussian Copula: The Formula That Killed Wall Street (The near collapse of) American International Group Long-term care insurance premium development Executive Life Insurance Company The Enron scandal 9 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

10 Many Stakeholders with Varying Interests: Insurers: Management, employees, shareholders Policyholders Regulators: Solvency, fairness, politics, bureaucracy General public: Taxpayers 10 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

11 Modeling Done for Other Purposes and in Other Disciplines Modeling done by actuaries for other purposes: Rate development, budgeting, company strategic planning, appraisal, etc. Example: Modeling to forecast trend increase in PMPM claim costs Modeling done by economists Modeling done by engineers 11 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

12 What is a Model? Modeling Defined. Many definitions of model Here is one: (T)he term model refers to a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates. Taken from FRB: Supervisory Letter SR 11-7, on Guidance on Model Risk Management, 12 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

13 Major Components of Modeling Processes The data input Assumptions: Explicit and implicit The engine : The equations or the black box that process input data and assumptions to produce the desired output The output/outcome 13 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

14 Two Issues: Credibility of Internal Company Data and Reasonability of Margins for Provision for Adverse Deviation (PAD) Credibility Issues: Need to decide when the (internal company) data set is not credible, partially credible, or fully credible. When the data is not credible or partially credible, need to decide the external or industry data that will replace the company data or combined with the company data. Reasonability of Margins: How do we decide on the size of reasonable margins for PAD? 14 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

15 Modeling Mortality Rates and Policyholder Behavior Modeling for mortality and policyholder behavior lapse rates/policy loans, etc.: Relatively an easy task, if done separately. Modeling interaction between changes in mortality rates, changes in macro economic conditions, and changes in policyholder behavior: More challenging. Actuaries have lots of expertise and experience in this area. 15 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

16 Modeling Stock Market Returns The need to model stock market returns: Insurers did not have to do such modeling in the past. Guarantees provided regarding (minimal) stock market returns. Need to support reserves with enhanced returns. Investment returns and discount rates for reserve are related but need not be identical. Professionals other than actuaries also have expertise in this area, perhaps even more than actuaries. For example: financial analysts and economists. Transparency regarding who participates in gains and who shares in pain of losses. 16 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

17 Modeling Interest Rates/Yield Curve: Stochastic Interest Generators Perhaps the key element in PBR work. Quite different from modeling mortality and lapse rates. Past history need not be a good indicator of future outcome. The two key assumptions: Ultimate or normal level of interest rates The speed of convergence to normal value Developments in external world political, social, international will be significant determinants of future interest rates: How do you model external developments? 17 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

18 Modeling of Interest Rates/Yield Curve: Forecasting Future Interest Rates and Stochastic Interest Generators (continued from previous page) What are we modeling? Risk free rates, or Spreads of investment grade bonds over risk free rates, or Return on junk bonds, or Interest rates in the U.S. or in Europe or in Japan. (Interest rates in the U.S. will be affected by what happens in the rest of world.) 18 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

19 Secular Stagnation, Negative, or Very Low Interest Rates and Insurance Company Operation The phenomenon of negative or very low (nominal) interest rates. A temporary development or something that may last for a long time? If not a temporary phenomenon, will your company be able to operate in low interest rate environment? What is happening to real interest rates? What is going on with the inflation rate? 19 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

20 Ms. Frances Oldham Kelsey and Thalidomide Prescription Drug Frances Kathleen Oldham Kelsey, CM (July 24, 1914 Aug. 7, 2015) was a Canadian pharmacologist and physician. As a reviewer for the U.S. Food and Drug Administration, she refused to authorize thalidomide for market because she had concerns about the drug's safety. 20 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

21 Kelsey received the President's Award for Distinguished Federal Civilian Service from President John F. Kennedy in PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

22 Flight 1549 and Captain Chesley B. Sully Sullenberger 22 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

23 References Long Term Capital Management: Wikipedia: Lowenstein, Loger; When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House; Shirreff, David, Lessons From the Collapse of Hedge Fund, Long-Term Capital Management, Gaussian Copula: Li, David, On Default Correlation: A Copula Function Approach, Third Draft, April 2000; 23 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

24 David Li s Gaussian Copula was Adopted by Basel 2 - Lee, Susan, Formula From Hell, Forbes, ; Salmon, Felix; Recipe For Disaster: The Formula That Killed Wall Street, Wired Magazine; Salmon, Felix; The Dangerous Gaussian Copula Function, June 21, 2012; American International Group: Kiel, Paul: AIG s Spiral Downward: A Timeline ; Pro Publica; Nov 14, 2008; Alling, Jessica: The Collapse of American International Group: A Timeline ; The Motley Fool, Sept. 18, 2013; 24 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

25 Davidson, Adam: The Big Money: How AIG fell apart ; Long-Term Care Insurance Premium Development: Zaker-Shahrak, Ali: A Suggestion to do a Postmortem Analysis of the Work Done by LTC Pricing Actuaries Over the Last Quarter of Century ; SOA, Long-Term Care News; Dec 2009, Issue 24; Executive Life Insurance Company: Modugno, Victor, Murray Becker, John Gies and Keven Maloney, Insurance Company Failures of the Early 1990s Have we Learned Anything? SOA Spring Meeting, May 25-25, 1999; RECORD, Volume 25, No. 1. Zay, Mary: Banking on Fraud: Drexel, Junk Bonds, and Buyouts, Political Science, 1993; pany&source=bl&ots=rkqhtyxhec&sig=kqaisl2vyssvlng4gei8hcbaq9a&hl=en&sa=x&ved=0ahukewimho2cielmahvuzgmk HcKgAhU4ChDoAQhdMAk#v=onepage&q=The%20collapse%20of%20executive%20life%20insurance%20company&f=false 25 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016

26 The Enron Scandal: Enron: The Real Scandal ; The Economist; Jan 17, 2002; Seabury, Chris: Enron: The Fall of a Wall Street Darling ; Investopedia; Dilallo, Matthew; Enron Scandal: A Devastating Reminder of The Dangers of Debt ; The Motley Fool; 26 PBR Boot Camp: Basic Training and Beyond for PBR Implementation June 6-8, 2016