2004 national council on compensation insurance, inc. nobel laureates in economics: the implications...
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2004 National Council on Compensation Insurance, Inc.
Nobel Laureates in Economics:
The Implications of Their Work for Actuarial Analysis
Harry Shuford, Chief Economist
National Council on Compensation Insurance
CASE Annual Meeting
September 23, 2004Atlanta, Georgia
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Today’s Discussion
• Background on the Nobel in Economics
• Areas with Implications for Actuarial Analysis
– Financial Economics
– Asymmetrical Information
– Behavioral Economics/Finance
– Econometrics
• Valuable Insights/Observations – part 1
• Valuable Insights/Observations – part 2
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Today’s Discussion
Background on the Nobel in Economics
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Financial Economics
– Markowitz - 1990 for work in the late 1950s
– Modigliani & Miller – 1990 for work in the 1960s
– Sharpe- 1990 for work in the 1960s
– Scholes and Merton – 1997 for work in the 1970s
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Asymmetrical Information
– Mirrlees – 1996 for work in 1970s
– Akerlof – 2001 for work in mid to late 1960s
– Spence – 2001 for work in early 1970s
– Stiglitz – 2001 for work in mid 1970s
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Behavioral Economics/Finance
– Kahneman – 2002 for work in the 1970s
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Econometrics
– Trygve Haavelmo – 1989 for work in the 1940s
– Engle – 2003
– Granger – 2003
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Financial Economics
– Markowitz - microfinance portfolio theory Mean variance
Efficient frontier recognizing covariance of securities
Quadratic objective function
– Modigliani & Miller – corporate finance Capital structure per se (I.e. debt/equity) no effect on value of the firm
Expected return on stock increases linearly with debt/equity ratio
Stockholders can offset in the market any undesired change in firm’s structure
– Sharpe – market focus - CAPM Systematic vs. Diversifiable risk
Risk premium based on covariance with market return
Market portfolio and lending/borrowing @ risk free rate
– Scholes and Merton – option pricing model Risk is embedded in price of underlying asset
Contingent claim concept applies to insurance
Strike price - /expected share value +/volatility of share price +/time+/risk free rate +
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Asymmetrical Information
– Mirrlees – optimal income taxes Moral hazard
Disincentive to work to avoid taxes
Hide income to avoid taxes
– Akerlof – sellers have more/withhold info re: buyers - market for lemons Adverse selection
Why would I want to buy if he wants to sell?
Medical insurance pricing – esp. elderly
– Spence – better informed incur costs to improve outcomes Signaling
Factory mutuals and fire protection services
Auto warranties -
– Stiglitz – poorly informed extract info from better informed Screening
Insurance deductibles
MGAs and retentions
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Behavioral Economics/Finance
– Kahneman – decision making under uncertainty/irrational
behavior– Expected utility is not entirely convex
– Different response to the same problem depending on how it’s presented
– Loss aversion
– Prospect theory
– Ignore/overlook prior information
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Econometrics
– Trygve Haavelmo – made econometrics probabilistic Statistical inference/hypothesis testing
Simultaneous interactions/identification problem
– Engle – changing volatility over time autoregressive conditional heteroskedasticity (ARCH)
– Granger – time series with common trends cointegration
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Valuable Insights/Observations
– Friedman – policy lags/positive vs normative
– Lucas – rational expectations
– Arrow – theory of insurance
– Simon – satisficing vs. maximizing
– Tobin – Tobin’s Q/risk free asset vs market portfolio
– Heckman – selection bias
– Fogel & North – technology and development
– Samuelson
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Valuable Insights/Observations
– The standard model:
• Self interested rational behavior
• Full information
– Akerlof’s “Market for Lemons” story
• Article rejected twice as being trivial
• Article rejected as undermining standard model
• Article finally accepted
– Today’s models are varied and include:
• The standard model
• Models to explain behavior with incomplete and asymmetrical info
– Behavioral finance – irrational exuberance
– Auctions (Vickery & Smith)
– Measuring “happiness”
– How effective are today’s actuarial methods?
– Are they seasoned or just stale?
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Thanks for Your Interest
Questions and Comments