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Actuaries Should be Risk Managers at Financial Firms

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Actuaries Should be Risk Managers at Financial Firms

I’m an Actuary and a Quant.  I’m not and Actuary, and I’m not a Quant.

I suppose I could do the other two permutations.  I won’t, but I will explain.

I passed all of the exams from the Society of Actuaries to become a Fellow in the Society of Actuaries.  I maintained that credential for around 18 years by paying my dues.  Oddly, once I stopped paying my dues, and thus ceased to be a Fellow, I got more requests to be on committees, and give talks to the Society of Actuaries.  Things that I recommended to the Society 20 years ago are finally getting a serious hearing now.  My main suggestion, that actuaries should have to pass a writing test is at least floating among some thinkers at the Society.

Why a writing test?  The ability to express ideas verbally to those who may not have a strong math background is important, and correlates with other social skills that aid in leadership.  The Society of Actuaries at one time (not sure when) did have an English test, and in that era, actuaries were not merely math nerds, and many of them were leaders in insurance and pensions.

So, I am no longer a Fellow in the Society of Actuaries.  I am still an actuary.  The way I reason and use math to solve investing and other problems stems from the skills that I learned when practicing as an actuary.  As actuaries went, I was a generalist, and would enjoy tackling unusual and multi-disciplinary problems.  The problems I liked best were the toughest ones — the ones where there is no easy answer, some degree of qualitative reasoning must be employed, and new techniques created.

Unlike most actuaries, I know the investment math relatively well, which makes me a Quant [quantitative analyst].  But I am not a Quant, or maybe, I’m a skeptical Quant.  Why?  I don’t believe that Modern Portfolio Theory is right.  In general, higher returns are achieved by taking moderate risk, not low or high risk.  More risk does not mean more return after some point.

Also, markets are more complex than the Quants will generally accept.  Disturbances are not normally distributed.  Variances of stock returns are infinite, but normality is used in order to get tractable results.  Markets sometimes fail to trade in a continuous manner.  There are jumps/falls in prices far greater than a normal distribution would expect.  And that gets borne out by the greater volatility of markets close to open, than open to close.

So I am a skeptical Quant at best, but if someone asks me whether I am an Actuary or a Quant, I will say I am an Actuary.  Why?

The main thing is differences in method.  Actuaries believe in table stability; Quants believe in bicycle stability.  Actuaries look at the cash flows, and make minimal assumptions about markets continuing to operate.  Quants usually assume that market continue to operate.  Actuaries look long-term, and do stress-testing.  Quants look short-term, and do hedging.

This is one reason why few pure insurance companies failed during the crisis, while many banks did.  If assets and liabilities are matched, it is hard to have a run on the company, aside from credit events.

Actuaries think long-term, while Quants think short-term.  In the short-run, listening to the Quants will yield greater profits.  In the long-run, listening to the actuaries will yield greater profits.

There’s one more issue.  Actuaries have an ethics code.  Quants don’t.  (Quants that are CFAs have an ethics code, but most aren’t CFAs.)  Actuaries are supposed to act in the best interests of clients.

In my opinion, Wall Street would be far better of replacing their Quants in risk control positions with Actuaries.  Actuaries have a public policy interest, and would not merely bend to the needs of the company.  They would cut back risk positions far more than the Quants do.

I know this only makes sense to Wall Street if they are willing to adopt a stable model.  Actuaries would help to stabilize things , and a focus on long-term stability would aid Wall Street.

But if forced to choose: I am an actuary, I am not a quant!

By David Merkel, CFA of alephblog


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David Merkel

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