Financial Versus Actuarial Models of Risk

There are two basic investment risk models, one based on projected cash flows over a long period of time, discounted at a variety of future interest rate scenarios, and one based on short term correlations of expected market values.  I call the first model the actuarial model, and the second the financial model (pejoratively, the Wall Street model).

Under ordinary conditions, the financial model looks better.  It asks, “Can we make money in the short run versus our capital costs?” The  actuarial model asks, “Can we assure that we will be solvent under a wide number of economic scenarios over the long run, some of which might be quite severe?”

During boom conditions, the financial model wins, while those following an actuarial model are branded fuddy-duddies.  During bust conditions, those following an actuarial model survive, while many following the financial model don’t.

There were many on Wall Street that claimed to be following a WOW “Worst Of the Worst” model.  I remember interviewing the chief risk officer of one of those firms in 2005 — Bear Stearns.  Talked a really good game.  To be fair, so did the risk manager of Goldman Sachs that year.  I assume most of the risk managers of Wall Street had their WOW models — after the crisis with LTCM, they had to look at the correlations on risk assets going to one in a crisis.

My guess is the WOW models were largely ignored, and the more common VAR models followed.  Perhaps Goldman And Morgan Stanley gave more weight to the worst outcomes, but hindsight is 20/20.  They might have survived in spite of themselves.

My point: you’ve got to survive in order to win.  Models that emphasize current profits at the expense of survivability get whacked during large busts.  Even if they survive, the hole that they must crawl out of is deep.

The economy is highly variable, and the financial economy as a derivative of it is even more so.  Companies that think long-term with respect to risk management tend to survive crises; they have limited their risks, and left returns on the table during the boom times.

Survival is a major part of the game.  Look at previously successful financial companies.  It doesn’t matter how well you did in the past if you are down 90, 95, 99% over the last two years.

As such, for those that invest in financial companies, evaluate their survivability.  How likely is it that they will get hit badly?  Are they overleveraged?  Do they need additional financing?

Actuarial models focus on the long run, and analyze survivability.  Why aren’t they used more frequently?  The actuarial models indicate a greater need for capital than VAR models.  More capital left in reserve means a lower return on equity, and a lower stock price in the short run.

High quality management teams for financials place more value on their long-run (actuarial) risk models.  They want to make money over the long term, if they can.  Those that focus on VAR will do better in the short run, until the next big bear market hits.  For value investors, stick with the quality players relying on long-term risk models.  Momentum players are free to play with the VAR users, but keep your stop orders ready.