401-3929-00L  Financial Risk Management in Social and Pension Insurance

Semester Autumn Semester 2017
Lecturers P. Blum
Periodicity yearly course
Language of instruction English

Abstract Investment returns are an important source of funding for social and pension insurance, and financial risk is an important threat to stability. We study short-term and long-term financial risk and its interplay with other risk factors, and we develop methods for the measurement and management of financial risk and return in an asset/liability context with the goal of assuring sustainable funding.
Objective Understand the basic asset-liability framework: essential principles and properties of social and pension insurance; cash flow matching, duration matching, valuation portfolio and loose coupling; the notion of financial risk; long-term vs. short-term risk; coherent measures of risk.

Understand the conditions for sustainable funding: derivation of required returns; interplay between return levels, contribution levels and other parameters; influence of guaranteed benefits.

Understand the notion of risk-taking capability: capital process as a random walk; measures of long-term risk and relation to capital; short-term solvency vs. long-term stability; effect of embedded options and guarantees; interplay between required return and risk-taking capability.

Be able to study empirical properties of financial assets: the Normal hypothesis and the deviations from it; statistical tools for investigating relevant risk and return properties of financial assets; time aggregation properties; be able to conduct analysis of real data for the most important asset classes.

Understand and be able to carry out portfolio construction: the concept of diversification; limitations to diversification / correlation breakdown / what happened in 2008; the Kuhn-Tucker Theorem and optimization (mean-variance, mean-downside); incorporation of constraints; sensitivity and shortcomings of optimized portfolios.

Understand and interpret the asset-liability interplay: the optimized portfolio in the asset-liability framework; short-term risk vs. long-term risk; the influence of constraints; feasible and non-feasible solutions; practical considerations.

Know about active portfolio management: practical issues when implementing an investment strategy; the notion of active management; efficient markets hypothesis and limitations to it; empirical evidence; the fundamental law of active management; Bayesian concepts and the Black-Litterman framework.

Have an overall view: see the big picture of what asset returns can and cannot contribute to social security; be aware of the most relevant outcomes; know the role of the actuary in the financial risk management process.
Content For pension insurance and other forms of social insurance, investment returns are an important source of funding. In order to earn these returns, substantial financial risks must be taken, and these risks represent an important threat to financial stability, in the long term and in the short term.

Risk and return of financial assets cannot be separated from one another and, hence, asset management and risk management cannot be separated either. Managing financial risk in social and pension insurance is, therefore, the task of reconciling the contradictory dimensions of

1. Required return for a sustainable funding of the institution,
2. Risk-taking capability of the institution,
3. Returns available from financial assets in the market,
4. Risks incurred by investing in these assets.

This task must be accomplished under a number of constraints. Financial risk management in social insurance also means reconciling the long time horizon of the promised insurance benefits with the short time horizon of financial markets and financial risk.

It is not the goal of this lecture to provide the students with any cookbook recipes that can readily be applied without further reflection. The goal is rather to enable the students to develop their own understanding of the problems and possible solutions associated with the management of financial risks in social and pension insurance.

To this end, a rigorous intellectual framework will be developed and a powerful set of mathematical tools from the fields of actuarial mathematics and quantitative risk management will be applied. When analyzing the properties of financial assets, an empirical viewpoint will be taken using statistical tools and considering real-world data.
Lecture notes Extensive handouts will be provided. Moreover, practical examples and data sets in Excel and Octave / Matlab will be made available.
Prerequisites / Notice Solid base knowledge of probability and statistics is indispensable. Specialized concepts from financial and insurance mathematics as well as quantitative risk management will be introduced in the lecture as needed, but some prior knowledge in some of these areas would be an advantage.

This course counts towards the diploma of "Aktuar SAV".

The exams ONLY take place during the official ETH examination period.