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