Stochastic Modelling

Using simulations of asset returns have proved to be very useful in a large range of situations. They can give great insight into the asset and liability profile of a financial institution, or even for an individual. 

They do, however, need to be used with caution. Some of the issues that need to be dealt with are:

1. Is the asset model appropriate? Most asset models are mathematically quite  complex, often based on some sophisticated statistical analysis. This complexity can make understanding what the underlying assumptions really are.  Does the model make economic and mathematical sense? Does it break down in some situations?
2. How are tail risks modeled? It seems likely that real life returns are, in fact, quite fat tails to their distribution. Using normal distributions will often underestimate tail risks.
3. How does it work on a multi-year basis? A model with too high a degree of mean reversion can result in excessively low long term variance, understating the long term investment risks. I think this was a key problem with the Wilkie model which was widely used, but was poorly understood.
4. Spurious precision. Running the model can give a result, for example a probability of ruin with a great deal of precision. We know that the distribution of the tails of the model are the least well understood parts of the models as the data is very scant. The tail probabilities are nearly entirely the result of the ultimate choice of model.

Often, the best insights come from following through the particular paths of returns where the  company ends up in trouble and then thinking about what management actions could be taken to mitigate the problems. Useful tweaks to the basic strategy can also be derived.

 

Deferred Annuities - A key part of the retirement planning picture?

It seems self-evident to me that genuine deferred annuities, that is annuities which become payable at quite advanced ages (say 75 to 85), would be very useful tools in retirement planning.

This would allow retirees to guarantee a minimum income level after this age, which would then allow a better managed draw down of capital over their retirement. Currently people either draw down too fast and run out of assets or they are too conservative about using their capital and live an unnecessarily frugal lifestyle in their early retirement years

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Why aren’t deferred annuities available in Australia?

• 1.       Tax – currently the assets backing a deferred annuity are taxed at the 15% superannuation tax rate, rather than the zero rates of pensions and annuities.  This makes the annuity 15% to 20% more expensive to offer than otherwise. 

• 2.       Minimum surrender values – Deferred annuities are being treated as investment products rather than an insurance product and fall under the minimum surrender value requirements of the Life Insurance Act. This means that the deferred annuities can’t really be priced as an insured product at the moment. This makes them expensive. Removing surrender values does make the product riskier from a client point of view, so sales and education processes will need to be well developed in order to minimise the risk of mis-selling.

• 3.       Capital Requirements – The capital requirements for these products are quite stringent. The new capital rules which give benefits for annuities when in the same statutory fund as protection business and also some allowance for illiquidity premiums for the annuities if there is no guaranteed surrender value, may improve this a bit.

• 4.       Mortality improvements – Mortality for over 65 year olds is improving rapidly. This makes pricing these products more difficult. Actuaries have traditionally underestimated mortality improvements, which will make them more cautious in setting future pricing assumptions.

• 5.       A lack of long term fixed interest securities – there are very few really long term fixed interest assets for companies to manage the associated investment risks for providing these policies.

The first two items require the government to change legislation. 

Changing the tax treatment would have minimal revenue implications as none of these products are being sold. The assets that might be used to purchase them would currently be invested in pension products where no tax is payable in any case.

Removing minimum surrender value requirements would be straight forward. As mentioned earlier, some safeguards around sales processes and product disclosure, ensuring that these are treated as insurance products, rather than an investment product.

The government could issue more long dated bonds to allow for better asset liability matching. This would reduce risk and also economic capital requirements by mitigating the reinvestment risk.

The ability of life insurance companies to take a credit for offsetting mortality and longevity risks under the new capital rules may also make these products less capital intensive than they otherwise be.

Deferred annuities should be a key part of the retirement planning menu, but won't be until the required changes are made to the legislative framework.

The Hidden Costs of Complexity

Business complexity has a number of costs that tend not to be visible or properly accounted for in much decision making. This is particularly the case where there are excessive numbers of administration systems.

The complexity I’m referring to often results from a proliferation of legacy products as new products replace them for new customers, but the existing customers remain on the older products. This usually seems to be a sensible strategy at the time as no upgrade or migration program is required and the new product gets on the market earlier. The costs of this strategy can gradually accumulate over time.

Examples of these costs include:

• Interfaces and project costs:  Many other projects have to build interfaces into these old systems, which increases these project costs. This means that the project funding pool supports fewer projects and also each project has to meet a higher threshold to be justified. As project costs tend not to be included in the base level of expenses, this cost is not visible and there is little incentive to manage it.

• Option costs: Due to the increased difficulty and complexity of doing things, actions may be considered that are unable to be implemented in a timely or cost effective manner due to the underlying business complexity. This might mean that market opportunities are not exploited; first mover advantages are foregone and such.

• Training costs: The more systems and products, the more training is needed for staff.

• Lack of flexibility: In customer service, for example, because of knowledge limitations staff rosters are less flexible as personnel are less interchangeable. Higher staffing levels may be required in order to ensure that the appropriate levels of expertise are available to serve customers.

• Frictional costs: Often, the existence of all these systems results in various additional activities being required, which are often small in themselves but, in aggregate, accumulate to be quite large. Examples include additional reconciliations, additional feeds into various databases, maintaining additional documentation.

• Operational risks: Complexity can lead to increased operational risks, both on a day to day basis, but also for major decisions that may be made without fully understanding the impact on a particular group of customers due to an inadequate understanding of the unique contractual terms and conditions impacting on those customers, which may result in later customer compensation requirements.

So when evaluating project business cases a thorough, holistic, analysis of project costs and benefits will lead to better decisions about what projects to initiate and persist with.

Welcome to my Blog

Welcome to my shiny new blog.

I will blog mostly on the Australian wealth management, insurance and financial advice industries although occasionally I’ll discuss other issues.

My background is that I’m an actuary with a broad range of experience across wealth management, life insurance, financial advice and banking in Australia, the UK and Asia.

I am currently a Principal of Professional Financial Solutions, a consulting firm but the views I express here are entirely my own.

When not working or blogging I spend time with my wife and three young children, follow and watch sport, am involved in my church, play some tennis, go to movies, read fiction and military history and play board games.