Articles - Application of Actuarial Science to Systemic Risks

The Casualty Actuarial Society, Canadian Institute of Actuaries, and the Society of Actuaries' Risk Management Section is pleased to make available a research report that examines the circumstances that lead to systemic risk and proposes a new definition. The report was authored by Risklighthouse, LLC.

 This paper examines the circumstances that lead to systemic risk and proposes a new definition: A systemic risk to a financial system is manifest when changes in conditions, internal and/or external, lead to major disruptions beyond the collective tolerance level of the participants in the system, thereby causing the participants to change behavior in a way that inhibits the ongoing functioning of the system.
 Systemic risk differs significantly from individual risk, and needs to be analyzed from a system-wide perspective.A study of systemic risk requires a focus on the system as a whole, by examining the policies, incentives and behaviors that drive people flows, resource flows and money flows, as well as their influence on the activities in various sectors of the system.
 Mark-to-Market (MTM) valuations are meaningful for valuing individual risks at a specific point in time. However, from a system-wide perspective, MTM valuations are pro-cyclical and exhibit self-reinforcing momentum, with booms inviting more speculation and busts creating a downward spiral of price depreciation. When a regime-change of the market occurs, some widely-held beliefs, assumptions and behavioral patterns under the old regime may break down and change unexpectedly. As a result, policy decisions made by relying on MTM alone can be misleading or even damaging for the system.
 Effective management of systemic risk requires the utilization of multiple valuation methodologies and understanding of the relationships between different valuations. This paper proposes using an actuarial valuation method for assets and liabilities based on long-term intrinsic value that is more sustainable than market values at a point in time. Actuaries regularly perform appraisals for long-term assets and liabilities based on long-term average trends, without being unduly influenced by market volatilities. An actuarial valuation approach can equip regulators with counter-cyclical metrics and tools to manage systemic risk.
 For the U.S. housing market, the current housing appraisal methods are based on market values of comparable sales, which is pro-cyclical. Over the past few years (2008-2012), downward pressures caused by massive foreclosures and strategic defaults have been preventing the U.S. housing market from returning to its long-term intrinsic value. This paper advocates using an actuarial appraisal method that references construction costs and controls the rate of appreciation within a reasonable range to derive appraisal values more related to intrinsic values. The paper also proposes a strategy for reviving the U.S. housing market, through voluntary mortgage debt reduction by lenders in exchange for the rights to benefit from the future appreciation of the housing unit.
 It is a widely held view that the majority of insurance companies following traditional insurance business models are not a source of systemic risk. There is an exception to the rule for some non-traditional insurance operations such as AIG Financial Products and mono-line bond insurers. This study concurs with the view that insurance companies by themselves do not generate systemic risk for the whole economy. The genesis of systemic risk requires a collective set of factors and players at work. Major contributors to the recent financial crisis include the U.S. government’s housing policies, which helped create the macro-environment for the housing finance bubble. Some insurance holding companies also contributed to the housing finance bubble by expanding their business activities to insuring mortgage-backed securities (MBS) and credit default swaps (CDS). Among many players in the financial system, the insurance industry shares responsibility for proactively monitoring imbalances in the financial system and refraining from activities that exacerbate such imbalances.
 The paper notes that the government either explicitly or implicitly provides “insurance” or “guarantees” to some sectors of the economy (e.g. government-sponsored enterprises (GSE) and the banking system); this type of insurance, unlike traditional insurance products, can generate systemic risk. Similarly, non-insurance activities by insurance groups can be a source of systemic risk.
 The monetary and fiscal policies of the major world economies are by far the most dominant sources of systemic risk. These policies influence future interest rates and can have profound impacts on all financial institutions, including insurance companies.
 As an example, this paper discusses China’s housing market bubble. Based on the interactions of people flow, resource flow and money flow, an analogy can be made to the late 1980s Japanese real estate boom. If the Japanese boom and bust experience is repeated in China, the burst of China’s real estate bubble can destroy trillions of dollars of market value and pose significant challenges to the Chinese economy and to the countries relying on China’s construction boom.
 The paper identifies the need for innovative methods and approaches for measuring and managing systemic risk. Actuaries have long been modeling complex systems involving changes in conditions and policyholder behavior. Moreover, actuaries are experienced in analyzing the impacts of government policies and regulatory changes on financial systems. Actuarial models of complex systems, when applied in connection with the Actuarial Control Cycle and actuarial appraisal methods, can provide useful indicators for policy makers and businesses in managing systemic risk.
 To view the research report please click here.
 If you have any questions or comments regarding the report, please contact Steve Siegel, Research Actuary at
 The Risk Management Section would like to thank the following individuals for their input and review:
 Edson Edwards
 Glenn Meyers
 Dave Sandberg
 Jesse Schwartz
 Henry Siegel
 Steve Strommen
 Robert Wolf
 Steve Siegel, Research Actuary
 Barbara Scott, Research Administrator
 © 2013 Society of Actuaries, Casualty Actuarial Society, Canadian Institute of Actuaries. Posted with permission

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