 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, 2004 Atlanta, Georgia

2  2004 National Council on Compensation Insurance, Inc. 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

3  2004 National Council on Compensation Insurance, Inc. Today’s Discussion Background on the Nobel in Economics

4  2004 National Council on Compensation Insurance, Inc. Financial Economics – Markowitz for work in the late 1950s – Modigliani & Miller – 1990 for work in the 1960s – Sharpe for work in the 1960s – Scholes and Merton – 1997 for work in the 1970s

5  2004 National Council on Compensation Insurance, Inc. 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

6  2004 National Council on Compensation Insurance, Inc. Behavioral Economics/Finance – Kahneman – 2002 for work in the 1970s

7  2004 National Council on Compensation Insurance, Inc. Econometrics – Trygve Haavelmo – 1989 for work in the 1940s – Engle – 2003 – Granger – 2003

8  2004 National Council on Compensation Insurance, Inc. 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 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 +

9  2004 National Council on Compensation Insurance, Inc. 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

10  2004 National Council on Compensation Insurance, Inc. 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

11  2004 National Council on Compensation Insurance, Inc. 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

12  2004 National Council on Compensation Insurance, Inc. 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

13  2004 National Council on Compensation Insurance, Inc. 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?

14  2004 National Council on Compensation Insurance, Inc. Thanks for Your Interest Questions and Comments