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The Global Financial Crisis

An Actuarial Perspective

he global financial crisis (GFC) has raised serious questions

about the management and oversight of the financial
services industries, at both the micro level for individual
entities and at the macro level for the system as a whole.

Details of the IAA work in this area are set out in the paper
Dealing with Predictable Irrationality Actuarial Ideas to Strengthen
Global Financial Risk Management which can be downloaded from
www.actuaries.org or www.actuaries.asn.au.

Table 1 below illustrates the extent of the impact of the Global

Financial Crisis to date on the market value of both banks and
insurers internationally.

In recent weeks, presentations and representations on these issues

have been made to:

a) various national regulators of banks, insurers and pension funds;

b) the International Association of Insurance Supervisors;
c) the Joint Forum (an international group of banking, insurance
and securities markets regulators);
d) the Social Insurance, Pension and Provident Fund Conference
Pensions in Crisis held in Cyprus;
e) the UK Board of Actuarial Standards;
f) the US House of Representatives Subcommittee
Table 1: Global Indicies of Market Value of Banks and Insurers
on Capital Markets, Insurance and Government
Sponsored Enterprises; and
g) the Financial Crisis Advisory Group of the IASB /
FASB.

The International Actuarial Association (IAA), representing the global

actuarial profession, has been active in addressing these issues
in recent months, through the work of a taskforce formed for this
purpose which has sought to identify lessons being learned from this
crisis and suggest potential reforms, improvements and solutions
many of which will impact the work of actuaries.

Necessary initiatives, consistent with the declaration of

the G20 on 15 November 2008, include strengthening
transparency and accountability, enhancing sound
regulation, promoting integrity in financial markets,
reinforcing international co-operation and reforming
international financial institutions. While supporting
such initiatives, this will not be enough, in the IAAs
view, to prevent future financial crises without taking
additional measures. Further details are set out below
at both the Macro and Micro levels.

A C T U A RY A U S T R A L I A May 2009

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report

At a Macro or System level

I. Introduction of more dynamic counter-cyclical regulatory
arrangements
Existing prudential capital requirements need to become more
dynamic and counter-cyclical, rather than pro-cyclical. This
would include developing approaches that would see regulators
transparently changing capital requirements for market participants
(not just interest rates) when early warnings appear of market
bubbles emerging. This would allow capital shock-absorbers to
be put in place to gradually deflate market bubbles before they burst
painfully, and create the capacity to allow draw downs of such
capital during periods of market stress, rather than having to enforce
tougher capital requirements at such times.
II. Creation of Country Chief Risk Supervisor role
This role would administer the proposed dynamic counter-cyclical
capital requirements and facilitate greater co-ordination and
co-operation between national jurisdictions. It could possibly be
created as part of each countrys central bank. The functions of this
role would include:
a) developing an agreed risk appetite policy for key market-wide
risk indicators;
b) monitoring, managing and publicly reporting on risk indicators
within that appetite;
c) changing capital requirements for regulated market participants
at its discretion; and
d) facilitating risk identification and communication with appropriate
decision-makers, at both the national and international levels.
Creation of a network of such roles would also provide a framework
to better manage risks and overcome the geographic and industry
silos that allow inconsistencies and gaps which critically weaken
current risk management protocols.
Table 2 opposite shows the progress
of yields on US investment grade bonds
during the crisis, demonstrating the relative
impotence during this crisis of reductions in
official interest rates driven by conventional
monetary policy in stimulating the US
economy. Because the crisis has triggered
a significant increase in credit risk spreads,
even investment grade borrowers have
faced higher total borrowing costs during
the crisis, rather than lower overall borrowing
costs the opposite of the effect sought by
reductions in official interest rates.
Accordingly, the concept of pursuing
dynamic capital requirements as proposed
by the IAA would give central banks and

ACTUARY A U S T R A L I A May 2009

regulators further tools to manage the wider economy in future

rather than just relying on conventional monetary and fiscal policy as
administered by Government. Further, dynamic changes to capital
requirements can, if required, be targeted from time to time to
specific overheated markets rather than applying the relatively blunt
instrument of interest rate policy across the economy.

At a Micro or Individual Regulated Entity level

III. Application of comprehensive risk management
concepts
The risk management framework of any entity providing financial or
insurance guarantees (including banks), should include key concepts
currently applied by leading insurer regulators that use a control
cycle approach to the measurement and management of risk. This
approach includes:
a) incorporating allowance for extreme event outliers;
b) specific financial condition reporting (beyond just accounting);
and
c) an independent sign-off on liability and loan loss provisioning for
regulatory purposes by professionals (such as actuaries) who
are subject to professional codes of conduct and disciplinary
processes.
IV. Improved risk governance
Improved risk governance processes being adopted by all financial
market participants so that risk indicators are more consistently
measured, applied, stress-tested and transparently reported. The
underlying concepts of such governance should be applied by all
financial market participants (consistent with principles outlined in a
recently released IAA paper on enterprise risk management).
Other issues discussed in the paper released by the IAA are
summarised as follows:

Table 2: USD Liquid Investment Grade Bonds

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1. Need for a dynamic risk-sensitive framework to avoid

underpricing of risk

The current financial market crisis demonstrates that a principlesbased, comprehensive and risk-sensitive regulatory framework
is essential to the stability of the financial services industries. The
general absence of appropriate risk-sensitive capital charges for
sub-prime related lending and for collateralised debt obligations
(CDOs) was a major contributor to the current crisis. Both the failure
to identify the real risks and to expose the inadequate capital support
for accepting such risks, led to their under-pricing and to the current
results.

Prudential capital
requirements need to
become more dynamic and
counter-cyclical, rather
than pro-cyclical.

2. Risk modelling and inadequate risk measures

The current crisis has reinforced the conclusion that, although

risk models are useful tools, risk management is much more than
just models. Risk models must be embedded in appropriate risk
governance and entity-wide risk culture. The modelling assumptions
and their results need to be transparent, understood and regularly
debated by management and regulators.

cycle concept familiar to actuaries should be more widely applied to

improve the modelling of financial markets and capital requirements
for financial market participants, particularly where markets may
become illiquid. A feedback loop of this kind improves the capacity
and discipline to take action promptly before a financial disaster
unfolds and is more likely to cope when placed under stress.

3. Risk culture and remuneration incentives

Remuneration and other incentive structures should not distort the

proper evaluation of risks. Accordingly, the IAA supports, in principle,
the concept of increasing the capital requirement for any market
participant with remuneration incentives which focus excessively on
short-term results.
4. Valuation of illiquid liabilities and the use of risk margins in
accounting

A traditional skill of the actuarial profession is the valuation of illiquid

insurance and pension liabilities. Approaches developed and refined
by actuaries over many years using market consistent techniques
to value these illiquid liabilities may be usefully applied to valuing
liabilities and assets for other financial institutions where trading has
ceased to exist in current market conditions.
5. Recognising the different objectives of risk (or prudential)
reporting and general purpose financial reporting

More effective assessment, communication and reporting of the

consequences of uncertainty is needed. For example, proper
understanding of the value of some assets and liabilities can only
be provided through the use of ranges of their potential future value.
More consistent risk measures and stress / sensitivity testing, which
reflect the potential of those values to change in the future is required.
6. Need for a control cycle approach

Risk management is as much about preparing for what has not

happened as it is for understanding and preparing for a repetition
of what has been experienced in the past. All too often, capital
markets activity is based on daily procedures that can lose sight of
the bigger picture involving the longer term, whole market risks, shifts
in fundamental risk parameters, systemic risks and/or unexpected
correlations between events, whether extreme or not. The control

7. Independence and role of the risk function in prudentially

regulated entities

Risk management needs to be viewed as integral to the operation of

the business and should not be seen as just a regulatory requirement.
Given the role of risk management, it is important that risk teams
have the freedom and the capability to take an objective view that
may differ from managements, based on full and unrestricted access
to the same information. This preferably should be built on a culture
of mutual understanding and respect between line management
and the risk function across an entity. Where differing views arise
on material matters, this must be reported to the board and be
transparent to the prudential regulator.
8. International prudential regulation needs to be less silo driven

The current crisis reinforces the case for regulation which is more
internationally co-ordinated, principle-based and risk-sensitive and
less driven by industry (banking, insurance, pension funds, etc) and
geography. The crisis has also reinforced the necessity for effective
and integrated supervision of major international financial groups.

Conclusion
At the time of writing, it is evident that the GFC is not over and
further developments can still be expected. The
actuarial profession will need to remain alert to
these issues and be prepared for the regulatory
reform processes that will evolve from the crisis.

Tony Coleman
Chair, IAA Global Financial Crisis Taskforce
TColeman@lonerganedwards.com.au

A C T U A RY A U S T R A L I A May 2009