Bring to LightSharing the results of a financial economics concept map August/September 2017
“To successfully integrate financial economics into actuarial practice, an actuary needs to know or be able to ______.”
How would you finish this sentence? How do you think other actuaries in the profession would? How should the Society of Actuaries (SOA)?
In order to develop a foundation of financial economics concepts that the SOA could provide to currently practicing actuaries, actuaries in a range of practice areas were asked to provide a comprehensive list of the “concepts,” if you will, or outcomes that complete the sentence fragment that began this article. The idea was to help set the direction for the SOA with respect to curriculum for candidates and professional development for current actuaries. A large number of thought leaders were invited to participate, and more than 50 individuals provided responses.
In brief, a large number of outcomes about financial economics were collected with the idea being to make sure that we are thinking about it as broadly as necessary. These concepts were then sorted by category and reviewed for duplication or gaps in order to come up with a set that represented the range of possible responses. Different ways of wording similar concepts were reviewed for clarity and completeness. The reviewed set was then ranked by relative importance, difficulty and the current state of performance for actuaries.
There are some who may feel that financial economics is only of particular interest to investments, but in truth, many of the concepts underlie all of the practice areas within the SOA. Because of this, actuaries from all areas of practice and with various levels of experience were invited to participate in order to obtain the broadest set of responses. Practice areas included risk management, retirement, investments, life, health, general insurance and accounting/finance.
The responses were sorted to identify similarities with other responses or outcomes, and then aggregated into broadly defined groups. The groups identified were Asset Pricing Models, Economic Scenario Modeling, Asset Pricing, Foundations of Portfolio Theory, Risk and Capital, Accounting and Modern Corporate Finance, Incentives and Behavior, Basics of Actuarial Practice and Applying Financial Economics. Here are brief descriptions of each, along with some selected responses to the key question in italics.
Asset Pricing Models: Includes option pricing models, as well as familiarity with historic distributions of returns for more traditional asset classes. Understand Black-Scholes option pricing; understand the concepts of real-world and risk-neutral probabilities and scenarios, and when each should be used.
Economic Scenario Modeling: Includes scenario generators, but also covariance of returns and stochastic volatility. Evaluate models in terms of strengths and limitations; employ principal components analysis to reduce the dimensionality of a set of risk factors and explain important sources of variance.
Asset Pricing: Includes the concepts of estimating values and/or pricing traditional fixed-income assets with a term structure and equities using beta along with hedging, embedded options and option strategies. Understand risk premiums, such as credit risk, equity risk premiums and term risk premiums; understand how a financial liability might be valued in terms of replicating financial instruments.
Foundations of Portfolio Theory: Includes most concepts from Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM), as well as Modigliani and Miller’s Capital Structure theories. Understand and use CAPM and factor models for equities; be familiar with alternative asset classes, such as real estate and commodities.
Risk and Capital: Includes looking at risk from several viewpoints, including that of economic capital. Estimate the cost of capital for a project using different methods; understand and explain the impact of liquidity on financial decision-making.
Accounting and Modern Corporate Finance: Includes a range of accounting and finance topics. Understand the financial accounting system currently in use; understand how differences in incentives among stakeholders can affect decisions regarding maximization of shareholder value.
Incentives and Behavior: Includes behavioral finance theory and how actors in a financial and political system act and react. Understand the types of cognitive bias; distinguish between principals and agents and understand why their incentives are not always aligned.
Basics of Actuarial Practice: Includes how financial economics relates to more traditional actuarial areas. Know how financial economics fits into the broader field of economics and political economy; apply advanced principles of financial economics to actuarial practice.
Applying Financial Economics: Includes how we would apply the financial economic concepts identified in various settings and different economic environments. Apply investment insights to asset-liability management; understand the role of financial economics in pricing.
The particular grouping assigned is not of particular importance, as many of the groupings include concepts closely related to those in other groupings. They simply make it a bit easier to think in terms of a manageable set. Potential users of this work, such as SOA curriculum committees, would of course be more concerned with the specific outcomes rather than the groupings.
What about the importance rankings? While opinions may differ, an attempt was made to determine relative importance. For instance, which concepts are foundational and which, while important, are thought of as secondary or possibly supporting concepts? Current performance levels also were ranked, from Unable to Perform through Excellently Able to Perform. For example, the Basics of Actuarial Practice were generally ranked midway as to relative importance, but current performance ability was ranked much lower. The grouping Asset Pricing Models was ranked at about the same level as the Basics of Actuarial Practice for importance, but for current performance ability was ranked much higher. Of course, this would primarily indicate the level of performance of the particular respondents, not the SOA membership as a whole.
And it is true that the current level of performance was generally higher for the more advanced practitioners, while those at the more novice level acknowledged they had work to do in order to improve their skills.
Interestingly, Applying Financial Economics was the grouping where relative importance was much higher than current performance. Is there a need to help actuaries move financial economics from the world of theory or academic interest to the world of day-to-day business decisions, including portfolio management?
In addition, the curriculum level was requested. For example, is this an outcome to be expected of an ASA, an FSA in general, an FSA in a specific track or practice area, or rather something that would be generally helpful in professional development to practicing actuaries, whether in the SOA or any other organization?
When a similar exercise was done for predictive analytics, the steering group used the concept map to guide construction of the components being added to the ASA pathway in 2018, as well as the content of the pilot certificate program in predictive analytics being conducted this year. Similarly, we expect to use this financial economics concept map to continue and extend the improvements that have been made in both pre-qualification and continuing actuarial education.