E-LEARNING MODULE
ERM Module
Section 2: Introduction to Enterprise Risk Management
Ask An Actuary: Derivatives
Question
How have derivatives affected the actuarial profession?
We asked leading actuaries to comment and received a
variety of answers. Responses are split between positive
changes, negative changes and changes in professional
membership.
Actuary 1 Response
Derivatives spurred the development of the mathemat-
ics of pricing options in liquid markets. Life insurance
contracts have always had embedded options and actu-
aries now have a mathematical toolkit to examine costs
and risks associated with them.
Along with the analytical tools come tools that can
sometimes be used to engineer (that is, lay off or trans-
form) the embedded options in the portfolio of insur-
ance risks.
Actuary 2 Response
 New valuation methods (e.g., insurance op-
tions, corporate debt).
 New products relying on option based hedging strate-
gies (variable annuity guarantees).
 Innovative hedging and reinsurance techniques.
 Drivers in a changed capital market environment.
 Improved stochastic modeling techniques.
Actuary 3 Response
 Provides more tools to reduce asset-liability manage-
ment risk.
 Allows companies to market products with appealing
guarantees to policyholders without having to increase
the company risk profile.
erm_s2-01_AskActuary1.doc Copyright ©2012 by Society of Actuaries
Actuary 4 Response
Financial derivatives have caught most actuaries trained
before 1995 with a limited skill set. This was made
worse as much of the material covering derivatives
through the late ‘90s was incorrect.
Derivative mathematics can take two forms, similar to
electronics engineering. In electronics, if you learn to
accept the concept of impedance, you can design very
basic circuits. Impedance is an algebraic equation that
happens to be a special transform of a relatively com-
plex differential equation which only an electronics en-
gineer would fully understand.
While the algebraic solutions can be done by bright high
school students, their circuits would not be able to han-
dle complex and extreme events. Only the true expert,
the electronics engineer, would be able to design his/her
circuit to withstand these extremes.
This analogy holds within the actuarial community
(many would argue that this includes Wall Street quants
as well). Most actuaries are taught only the very basic
methods to design and model derivatives. Only a few
would be characterized as expert in the design of op-
tions sold within insurance products.
Those who ignore the derivatives market and the infor-
mation it provides are more likely to miss a major risk.
Derivatives are not perfect, nor are practitioners, but the
additional data interpreted by experts can help a firm
make better decisions.
1
Actuary 5 Response Actuary 7 Response
The pricing theory that came out of derivatives thrust I think that the biggest effect has been on the career
martingale transforms into the spotlight in the name of paths available to people interested and capable in both
Q measures. This produced a new pricing paradigm and math and finance. There are many Wall Street quants
also a new class of risk measures - the distortion meas- who might have become actuaries if there was no need
ures. Although there have been papers in these areas, to apply sophisticated math to derivative valuation.
the effect on actual practice has been depressingly slow. People will have differing opinions about whether that
is a good or bad thing, but it is definitely different than
The value of risk transfer has also been given more at-
it would have been otherwise.
tention as risk management has been more available and
formalized. This has produced new ideas about the
value of reinsurance, for example. A lot of this has come
from financial economists, but there is also an actuarial
connection to the de Finetti Gerber-Shiu approach to
optimum dividends, which is optimum capital. Several
authors have extended this to optimum reinsurance
jointly with optimum capital, e.g., John Major.
Actuary 6 Response
Credit default swaps (CDS) are the poster child for the
downside of derivatives. In my opinion, derivatives en-
abled the "opportunity" to usurp the responsibility of
understanding our risks in favor of engineering them
away by calibrating models to financial market prices.
The problem is that markets prove over and over again
to be bad estimators of the real risks. Markets are great
at looking around at the current price, accepting the
price as correct and proliferating that price in new and
bigger ways, never noticing that everyone got to the
price by accepting previous prices as appropriate.
Market-consistent risk management, centered on deriva-
tive prices, is not only dangerous to a company, it's dan-
gerous to whole industries. If everyone is managing risk
in exactly the same way, then when it blows up everyone
is in the blast.
So, I feel that the development of derivatives has left ac-
tuaries with:
(1) The added responsibility of challenging the prevail-
ing price of any risk.
(2) The added responsibility of considering and manag-
ing a broader presence of counterparty risk.
While my life would be easier without derivatives, all is
not negative.
Derivatives do have a good limited use in capital man-
agement for hedging some targeted tail risk. This allows
companies to accept risk while managing their long-term
success. In a world full of derivatives, stochastic model-
ing to analyze the tail risk becomes much more impor-
tant for actuaries.

erm_s2-01_AskActuary1.doc Copyright ©2012 by Society of Actuaries 2