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Controlling Our Behavior Article from: The Actuary Magazine February/March 2015 – Volume 12, Issue 1 Controlling Our Behavior 20 | THE ACTUARY | FEBRUARY/MARCH 2015 Controlling Our Behavior FEBRUARY/MARCH 2015 | THE ACTUARY | 21 MANY MANAGERS ARE STRUGGLING WITH THE DAUNTING TASK OF DESIGNING A CONTROL ENVIRONMENT FOR THE ACTUARIAL ASPECTS OF AN INSURANCE COMPANY. BY MARK GRIFFIN ehavioral finance (sometimes Prize for his work in behavioral finance. Other more overconfident one becomes. referred to as behavioral economics) authors in this field include Robert Shiller, – We draw unfounded conclusions B represents a synthesis between Hersh Shefrin and Richard Thaler. In 1995, from small samples. psychology, neurology and anthropology. the Association for Investment Management – Experts see things in a much more It demonstrates consistent economic biases and Research (AIMR) published “Behavioral differentiated form, and they may and blind spots in the behavior of individuals Finance and Decision Theory in Investment overlook other perspectives. and groups. Management.” • Loss aversion: Investors are overly Insurance company managements are Their work and that of others has shown that reluctant to sell their loss-making in the process of building the “control behavioral finance demonstrates a number of positions because that would force environment” for financial reporting decision-making traps: them to admit they had made a envisioned by the Sarbanes-Oxley Act mistake. Instead, they hold on to these of 2002 and the 2013 COSO “Internal • Endowment effect: We value the things positions longer than positions with Control—Integrated Framework.” The risk we have, and the things we have gains. management, actuarial, compliance and invested time in, more than we should. internal audit areas within an insurance ASSUMPTION RESETTING EXAMPLE The confirmation bias suggests that those who Consider the following example. An have the initial assumption as their “anchor” may insurance company enters the simplified issue term insurance market. A mortality table is not take the new information seriously or apply a carefully chosen. A couple of years into the disciplined process to its arrival. new venture, the quarterly financials of the company contain a poor mortality result for company (sometimes referred to as • Anchoring: People don’t make this line of business. In preparing to describe the control functions), together with sufficient adjustments from an initial the results to the board of directors and the finance function, will be critical in “anchor,” and give disproportionate outside investors, the finance department building this environment. This article will weight to the first information they “asks” the actuarial department if this result help the reader understand behavioral receive. In Kahneman’s words, this is is merely noise or evidence that the mortality finance and its relevance in identifying “one of the most reliable and robust assumption is too aggressive. analytics and processes suitable for a results of experimental psychology.” control environment. Three examples In this case, for the actuaries involved in are provided. More broadly, the article • Confirmation bias: We tend to look for setting the assumption, the “endowment” is will help any actuary involved in making evidence that confirms our existing their investment in the actuarial designation, and resetting assumptions to understand view and to disregard findings that their stature within the organization and the behavioral finance and thereby avoid contradict it. This is sometimes referred assumption itself. For everyone within the some common biases. to as the “status quo bias.” organization who was not involved in setting the assumption, the assumption is the first THE PITFALLS • Overconfidence: information they receive and becomes the In 2002, Daniel Kahneman won a Nobel – The more expertise one has, the anchor. The confirmation bias suggests that 22 | THE ACTUARY | FEBRUARY/MARCH 2015 those who have the initial assumption as their behavioral finance, we “anchor” may not take the new information should also recognize seriously or apply a disciplined process to that, as soon as we its arrival. With respect to overconfidence, devote time and attention the simplified issue mortality assumption to making an assumption, was probably either made by, or approved we lose our objectivity with by, the ranking mortality “expert” within the respect to the possible future company. In this situation, the expert status need to reset the assumption. of the decision-maker(s) may cause the Therefore, the company’s company to be too reliant on the initial data process should not rely on the and on the initial assumption drawn from that assumption-making body or data. The prospect of changing the mortality person to raise its hand proactively assumption may trigger loss aversion within and identify an issue. the company, as the resulting reserve increase might be viewed as admitting a mistake. The NERVOUS SYSTEM temptation to hold off on the assumption In the December 2014/January 2015 change and pray silently for future reversion edition of The Actuary, a “nervous may be too strong. system” for managing insurance product assumptions was proposed. Standard In the example, there is a possibility that deviations are calculated to differentiate the company will not react promptly to between variation in insurance product experience that is more than noise. Delayed experience that represents noise and applied, not just recognition increases the magnitude of the variation that indeed is an early warning on to assumptions eventual corrective action and may result in the need to change product assumptions. As such as mortality, the capital markets losing overall confidence an example, variation in experience beyond withdrawals and morbidity, in the company’s financials. one standard deviation would automatically but also to other profitability mandate an assumption review, and drivers such as the distribution of In his best-seller, Emotional Intelligence: Why experience beyond two standard deviations business by age, policy size, etc. The It Can Matter More Than IQ, Daniel Goleman would mandate a revision. nervous system can form an important part describes how initial reactions to unexpected of a model governance policy within a events may be emotional rather than rational. The nervous system can be applied control environment, as described earlier. The emergence of negative experience with consistently within an organization as well The analytics can be made available to, respect to an insurance product may constitute as across life, health, property and casualty, and are easily understood by, the actuarial, such an unexpected event. Even apart from and pension assumptions. It should be risk, finance and internal audit teams. While “control environment” considerations, the opportunity to replace what may be a rather awkward, emotional situation with a consistent Reinsurance process should be welcomed. THE RENEWAL PROCESS WITHIN A REINSURER is subject to the same All actuaries must realize that, having made challenges listed in the direct simplified issue example. Applying consistent a large personal investment in actuarial “review and revise” triggers based on the original assumptions at the point of training, we consciously or subconsciously renewal will ensure a disciplined approach and represent an effective control. feel empowered and entitled to make assumptions. Based on the findings of FEBRUARY/MARCH 2015 | THE ACTUARY | 23 process to review and revise assumptions is AN OUTSIDE VIEW echoed by the Federal Reserve’s “Supervisory The example of the nervous system is a Guidance on Model Risk Management,”1 specific combination of processes and analytics that helps address the decision- Validation also can reveal making biases listed earlier. The second deterioration in model performance example, the outside review, can be thought over time and can set thresholds of as a broad principle. It addresses the same for acceptable levels of error, set of decision-making tendencies as the through analysis of the distribution nervous system. of outcomes around expected or predicted values. … An outsider is not as “endowed with,” or “anchored to,” the original assumption, and The objective of the [back-testing] should be able to look more objectively analysis is to determine whether on the assumption and on new evidence. differences stem from the omission of The overconfidence finding suggests that material factors from the model … or the outside view is necessary and it may be whether they are purely random and best if it comes from someone who is less thus consistent with acceptable model of an expert on the topic, and therefore less performance. bound to traditional approaches. The traps listed earlier obviously all involve Kahneman devotes a chapter to “The Outside behavior. The use of a transparent, consistent View” in his behavioral finance best-seller, the approach is not analytically elegant, it process such as the nervous system removes Thinking Fast and Slow. The value of an is understandable by those without deep the opportunities to fall into these traps. A outside perspective is echoed by others. statistical knowledge. Therefore, it will company using the nervous system doesn’t resonate with senior management, industry need to rely on the parties responsible for The Fed makes explicit reference to outside 2 analysts, investors, auditors, regulators, etc. setting assumptions to raise their hand and
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