FINANCIAL ECONOMICS AND ACTUARIAL PRACTICE

North American Actuarial Journal, Jul 2004 by Day, Tony

ABSTRACT

Starting in the United Kingdom and continuing through the U.S. and Canadian actuarial professions, proponents of financial economics have been forcefully promoting a review of traditional actuarial practices and training. In particular, the financial theories first proposed by Modigliani and Miller and subsequently developed by others have been used to highlight serious weaknesses in typical actuarial thinking. In summary, it is claimed that much actuarial advice wrongly specifies value, that guidelines and standards need radical revision, and that traditional actuarial intuition suffers in comparison to newer modes of thought adopted by other professions.

This paper examines concepts from both financial economics and actuarial science as applied to defined benefit schemes using a simple discounted cash-flow framework as a reference point. The general finding is that many standard modes of actuarial thought are, in fact, indefensible when examined with the tools and techniques of financial economics. The call for revision of actuarial training and practices is credible and necessary.

However, the paper also touches upon areas where a heavy-handed application of finance theory could be misguided due to limitations in the simple financial economic models presented. It concludes that financial economics should be carefully integrated into actuarial thought rather than appended to existing actuarial theory or inserted as a wholesale replacement.

1. INTRODUCTION

Financial economics has been applied to traditional actuarial problems for a long time. Sharpe (1976), Black (1980), and Tepper (1981) all present results from applying financial economics to pension funding that should have been of note to the actuarial profession. However, the ideas of financial economics have largely failed to engage actuaries until recently. Starting in the United Kingdom and continuing in the United States and Canadian actuarial professions, proponents of financial economics have been forcefully promoting a review of traditional actuarial practices and training. In particular, the financial theories first proposed by Modigliani and Miller (1958; Miller and Modigliani 1961) and subsequently developed by others have been used to highlight serious weaknesses in typical actuarial thinking. In summary, it is claimed that much actuarial advice wrongly specifies value, that guidelines and standards need radical revision, and that traditional actuarial intuition suffers in comparison to newer modes of thought adopted by other professions. While the focus of debate until now has been defined benefit (DB) pension advice, all areas of actuarial endeavor will eventually be taken to account.

The early responses to these challenges have been swift and far reaching. For example, Exley (2002) in commentary about FRS 17, a U.K. accounting requirement that mandates DB liabilities be valued using a corporate bond discount rate, states that "both the accountants and the actuaries seem truly to have been overtaken by events already. Indeed, FRS 17 now seems out of date before it has even been implemented in full" (p. 2). Hershey (2003) gives FAS 87 a life expectancy of less than three years. Globally, major sections of actuarial education and training have been or are being rewritten with the tenets of financial economics at their core.

A survey of the literature does not find much consensus between the two sides of the debate. Proponents of financial economics seldom praise traditional actuarial methods, and advocates of traditional approaches find little to commend in financial economic theory or practice. But are modern finance theory and actuarial science so incompatible? Has actuarial intuition and judgment been hopelessly out of touch and misplaced? Or should financial economics be resisted as a passing fashion?

This paper attempts to make sense of this schism. It examines concepts from both financial economies and actuarial science, as they apply to DB schemes, using a simple discounted cash-flow framework as a reference point. The general finding is that many standard modes of actuarial thought are, in fact, indefensible when examined with the tools and techniques of financial economics. The call for revision of actuarial training and practices is credible and necessary.

However, the paper also touches upon areas where a heavy-handed application of finance theory may lead to inconsistencies or the creation of spurious models. It concludes that financial economics should be carefully integrated into actuarial thought rather than appended to existing actuarial theory or inserted as a wholesale replacement.

The term "financial economics," as used in this paper, should be distinguished from Modern Portfolio Theory (MPT) and asset pricing models such as the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH), which form a slightly dated subset of financial economic theory. Despite being show cased in actuarial training as well as finance textbooks everywhere, these specifications are not central to modern financial economic arguments. In this sense, financial economics is also referred to in the literature as corporate finance, modern financial economics, (modern) finance theory, neoclassical economics, or postmodern financial economics.