Jonathan Ford’s article last week (Investors should beware the insurance magic money tree) predictably attracted a lot of comment. A few observers, noting Martin Taylor’s famous comment that the “actuarial convention” by which the composition of an insurer’s assets determines the size of its liabilities was “one of the weirdest emanations of the human mind”, suggested that poor Martin was out of kilter with the rest of the Bank, or the PRA.
Far from it.
Don Kohn is a fellow member of the Financial Policy Committee, and former Vice Chairman of the Board of Governors of the Federal Reserve System. In his view:
While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the value of a very low-risk liability is to use a very low-risk discount rate. 1
That is, not only are economists all agreed on the discounting issue, it’s the only thing they are agreed on!
Let’s add Professor David Miles, former member of the Monetary Policy committee.
If a liability is issued on the expectation or promise that it is risk free, then it must be discounted at the risk free rate, otherwise we descend into nonsense. Suppose we raise £1bn from policyholders with the expectation that their exposure is absolutely safe, and we back this liability with £1bn of assets with the promise of a higher than risk free return. Are we to discount liabilities so that their present value is £800m or even £600m? Can we make £200m or £400m out of nothing? That’s nonsense and a dangerous road to go down’.2
As for economists outside the Bank, we have Josh Rauh:
The field of financial economics is unified in agreeing that the present value of a stream of cash flows is a function of the risk of the cash flows themselves.
Not forgetting professor Jeffrey R. Brown and Federal Reserve economist David W. Wilcox
Finance theory is unambiguous in that the discount rate used to value future pension obligations should reflect the riskiness of the liabilities.
No disagreement, unified, unambiguous, you get it. It’s the actuaries who seem to be out of step, no?
- Donald L. Kohn, “Statement at the National Conference on Public Employee Retirement Systems Annual Conference,” New Orleans, LA, May 20, 2008.
- David Miles, quoted in ‘Taken To The Cleaners’, Dean Buckner, The Cobden Centre, September 17