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The Actuary The magazine of the Institute & Faculty of Actuaries

Professional arrogance the risks

The power of financial modelling tools, and the technology underpinning them, increases every year. As this power escalates, there is danger that professionals using these models will believe, and convince others to believe, that their results enable management to control risks with a high level of certainty.

Handle assumptions with care
However, embedded in the complexity and sophistication of these models is a host of assumptions. It is often too easy to ‘feel good’ when all the assumptions are set, inadequately challenging or analysing sensitivity of these assumptions. Forgotten often is the reality that the business has to be carefully and adroitly managed to achieve many of the assumptions.
This problem can be observed in examples such as projections of US budget surpluses, the blow-up of the Long Term Capital Management fund, projections of US Social Security and Medicare funds, and the recent demise of General American Life.
The human (versus technical) risks include:
– Unquestioned acceptance of a sophisticated ‘black box’.
– Professional resistance to challenging ‘beautiful technological tools’.
– Inherent presumptions that the future will look like the past and that past models, data, rules, and structures will continue to be valid.
– Building tight systems in various functional areas, with no overarching system to address risks that involve interaction of the pieces, so that critical risks fall between the cracks of the models.
– Failure to differentiate between facts, historically validated assumptions, and professional assertions.
– Choosing time periods for validating assumptions that justify one’s theories.
Often, early success with a risky strategy leads to both the blurring of the actual risk and aggressive expansion of the activity. These ‘bet-the-company’ ventures almost always (eventually) lead to the demise of the company. Many US life insurance company failures of the past decade were attributable to these kinds of management failures.
The unknowable future
One additional interesting illustration is found in an article by John Bogle published in the 2 October 2000 issue of Fortune. Discussing his apprehension about ‘statistical support’ for continued stockmarket increases, he says,
the future is not only unknown but unknowable. Yet with the acceptance of ‘modern portfolio theory,’ the ease of massaging data with the computer, and our existence (at least in the US) in today’s era of remarkable political stability combined with powerful economic growth, investors seem to have developed growing confidence that they can forecast future returns in the stock market. If you fall into that category, I send you this categorical warning: The stock market is not an actuarial table.
What does all of this have to do with actuaries and actuarial analysis? Past surveys rate actuaries very highly in terms of intelligence and integrity. On the other hand, actuaries are sometimes accused of lacking broad perspective and sufficient humility. It is the latter two traits that can get us into trouble.
We actuaries need to make sure that we develop and reconcile two approaches to each effort that we undertake. In addition to doing the necessary, actuarial bottom-up assumption setting and analysis, we need to simultaneously address each assignment from a top-down perspective, validating the reasonableness of our detailed actuarial analysis within its larger, real-life context.

This article first appeared in the Society of Actuaries newsletter, The Actuary, in January 2001, vol 35, no 1.