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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. Nobel Laureates in Economics: The Implications of Their Work for Actuarial Analysis. Today’s Discussion. Background on the Nobel in Economics

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Nobel Laureates in Economics: The Implications of Their Work for Actuarial Analysis

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  1. Harry Shuford, Chief EconomistNational Council on Compensation InsuranceCASE Annual MeetingSeptember 23, 2004Atlanta, Georgia Nobel Laureates in Economics:The Implications of Their Work for Actuarial Analysis

  2. 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 2

  3. Today’s Discussion Background on the Nobel in Economics 3

  4. 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 4

  5. 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 5

  6. Behavioral Economics/Finance • Kahneman – 2002 for work in the 1970s 6

  7. Econometrics • Trygve Haavelmo – 1989 for work in the 1940s • Engle – 2003 • Granger – 2003 7

  8. 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 + 8

  9. 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 9

  10. 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 10

  11. 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 11

  12. 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 12

  13. 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? 13

  14. Thanks for Your Interest Questions and Comments 14

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