Some day, all this will be risk-neutral

Editor's letter


There is a certain faraway look one sees in investment bankers' eyes when they attend actuarial conferences. The majority of the audience might be talking about fitting to historical data and expected returns, but the banker has his eyes firmly on the market-consistent future.

Sophisticated insurance and pensions practitioners know they must look both ways. Behind them are board members rooted in tradition, who might acknowledge flaws in old approaches, but fret about momentous change in terms of governance and communication. What if the new numbers prompt stakeholders to renegotiate benefits? Is it wise to replace a long-term investment policy with something based on short-term market volatility?

In front of the practitioner are the consequences of allowing gradual but unstoppable trends to disrupt insurance and pension balance sheets, and where traditional reserving merely postpones the day of reckoning. In areas such as interest rates, bankers have plenty of solutions, but practitioners must be wary about what 'market-consistent' means. Is the 'risk-free rate' the swap rate, or the government rate? Should implied or historical volatility be used for embedded options and guarantees?

In areas such as longevity risk, practitioners complain that bankers aren't doing enough to come up with capital markets solutions. In bankers' defence, it can't be said they haven't tried. BNP Paribas, Credit Suisse, JP Morgan and Goldman Sachs have invested their expensive resources in a string of zero-volume longevity products. To see how inventive they have to be, consider JP Morgan's Lifemetrics index, which depends on national statistics typically only updated once a year.

How can such a sleepy index compete for hedge fund managers' attention against the minute-by-minute adrenalin thrill of S&P 500 options or wheat futures? To spice things up, JP Morgan brought in top longevity expert Andrew Cairns, who has developed a sort of actuarial donkey derby where six well-known models of future mortality are pitted against each other. Interested spectators can watch Renshaw-Haberman's cohort approach stumble at the fence of robustness while the sleek Cairns-Blake-Dowd age effect model leads the pack according the Bayesian Information Criterion. Call your JP Morgan broker today to bet on the outcome, seems to be the message.

Eventually, something viable is bound to emerge from this, and that distant look in the bankers' eyes will be replaced by the clamour of the trading floor. Just don't bet on the timing of this event.

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