From James’s Page

Actuary: Fap3-1

Module 3: Risk in Actuarial Problems

Section 1: Module Overview

Back to list of modules

Pre-module quiz factoids

• Consider a very real financial crisis. In the 1980s, there were a series of failures among savings and loan (S&L) institutions in the United States. The S&L crisis could have been avoided by proper risk management. The S&L industry did not properly identify and manage risks.
• The failures among U.S. savings and loan (S&L) institutions in the 1980s were caused by a mismatch between the interest rates the S&L institutions received on their loans and the interest rates they paid on their deposits. Although actuaries could have helped manage the S&L risks, they were not employed as managers in the S&L industry.
• In the early 1980s, the U.S. administration determined that it was necessary to reduce the emerging deficit under the U.S. Social Security Program. A suggested method to reduce costs was to reduce early retirement benefits payable at age 62 from the then current 80% to five percent of “full” retirement benefits then payable at age 65. This was not a good idea because the early retirement reduction would cause most pensioners to delay their retirement to age 65 resulting in limited savings.
• In the early 1980s, the U.S. administration determined that it was necessary to reduce the emerging deficit under the U.S. Social Security Program. The following should have been considered to achieve this goal:
  • Choice 1 Allow members to opt out of the program
  • Choice 2 Delay availability of full benefits under the program
  • Choice 3 Increase contributions under the program
  • Choice 4 Reduce covered earnings under the program
  • Choice 5 Reduce full benefits under the program
• During budget discussions, it was determined that an employer’s health care budget should be reduced by ten percent. All of the following should be considered to address this issue:
  • Choice 1 Allow members flexibility, so that they can elect coverage for only the benefits they value
  • Choice 2 Introduce wellness education
  • Choice 3 Review costs of the other health care providers
  • Choice 4 Reduce some of the benefits
• The recent subprime mortgage crisis in the United States was caused by not properly managing risks. Those underwriting the risks did not manage the credit risk of individuals properly. The credit risk of the securitized mortgage bonds was also not well understood or managed by third party purchasers
• When the economy was healthy and banks had a lot of liquid capital, mortgages were being issued to people with poor credit and a high risk of default. These mortgages are referred to as subprime mortgages. Banks then bundled subprime mortgages for sale to investors. Credit rating agencies considered pooling effects on risk and rated these bundled subprime mortgages as being safer, on the whole, than the individual mortgages in the bundle. When the housing market collapsed in 2006 and many mortgage holders walked away from their obligations and there were many foreclosures, several lenders and investments funds were forced to declare bankruptcy. While the bundling of subprime mortgages may have accelerated the crisis, the main causes were the issuing of risky mortgages, the decline in house values, an increase in interest rates, and prepayment penalties.

Module 3 Intro

• Define the Problem is often the first stage of the Control Cycle to which you will be exposed on any particular project. This is perhaps the most important stage. Only by fully understanding a problem and its related issues can one hope to achieve the most appropriate solution. Successful problem definition is central to developing successful solutions. This is especially important because there seldom is a single, correct answer. Many problems involve balancing conflicting variables to produce a solution that is acceptable to all stakeholders
• The Iceberg Principle: Defining actuarial problems is similar to assessing an iceberg while navigating a ship. On a ship, you initially only see the "tip of the iceberg." As an actuary, you usually only see—or are given—a small piece of an actual problem that is inevitably quite complex. Read The Iceberg Principle (m3s1-01_Iceberg_Principle.pdf) to learn more about this example and how the concept helps actuaries look beyond what is initially obvious.
• Objectives for Module 3:
  • Explain “Define the Problem” within the context of the Control Cycle.
  • Explain the significance of identifying and defining the real problem and its associated risks.
  • Describe risks that actuaries manage within a financial security system.
  • Describe risk management for financial security systems.
  • Identify commonalities among problems in existing areas of actuarial practice.
• Read the following story (m3s1-02_module3story.pdf) about a problem where the risks were not clearly identified, and therefore, the problem was not completely defined, leading to an incomplete solution.