Text by Vicki Zhang, Assistant Professor (Teaching Stream), University of Toronto
Participant at the panel of economic discourse in the classroom and the media organised by Progressive Economics Forum(PEF) held at the « Canadian Economics Association(CEA) »
Introducing Pluralism in Insurance Finance Education
Nine years after the financial crisis, has anything changed in the universities’ finance programs? There have been talks on introducing heterodox economic theories to economics classrooms, but the same intellectual inquiries have not occurred in specialized undergraduate finance programs. I personally teach insurance and financial mathematics to actuarial science students, and this article will focus on insurance finance undergraduate programs. However, many of the observations could be applied to broader financial education in universities.
Neoclassical Root of Financial Theories
One recurring theme in every day teaching of finance is the repurposing of mathematical techniques drawn from the natural sciences, especially physics, to analyze financial phenomena. This tendency follows a long intellectual lineage. In the 1870s the founding fathers of neoclassical economics saw economics as a direct application of the theory of energy fields to what they considered the equally objective problem of economic activity. In 1900 financial economists started to notice the resemblance between the movement of stock prices (an economic phenomenon) and Brownian motion (a physical phenomenon). Based on such insight, Samuelson and Fama developed the Efficient Market Hypothesis in 1965, and Black and Scholes formulated their option pricing technique. At the end of the Cold War, the financial sector became one of the main employers of physics PhDs, who helped design some of the most complex financial instruments in our history. In 2005 the physics faculty at University of Houston’s even opened a PhD program in finance called Econophysics.
But finance is not physics, even though the financial models being taught in undergraduate curriculum often mathematically resemble those used in physics. There is a crucial epistemological difference between finance and natural science. John Maynard Keynes made a clear distinction between risk and uncertainty. I believe he’ll agree that in physics, one deals with risk, while in finance one deals with uncertainty. In physics there is an underlying objective reality (with its “true” probabilities) that the models were to discover, whereas human behaviors in relations to financial market are unpredictable – their objective or “true” probabilities are not merely unknown, but only unknowable.
There is also the issue of self-referential nature of neoclassical finance. Lavoie, MacKenzie, Millo had all written about this. One example: one may derive an implied volatility based on the current options price and the Black-Scholes formula, and then use the implied volatility and Black-Scholes to price other similar options. The new options, engineered and priced using the theoretical model, may then flow into the market and become part of the manufactured reality of the financial market, and the process goes on indefinitely. The point is that in the financial world the “reality” is never completely empirical, as theoretical models and their predictions of future significantly affect the collective belief by investors and in turn the actual prices in the market.
Structural Challenges of Specialized Finance Programs
I believe it is financial educators’ duty to make students aware of the various theoretical and empirical limitations of the neoclassical financial models, and the reasons of their ostensible success in certain areas. The question is why are we not doing it?
For one, specialized finance programs are usually housed either in business schools that have a strong pro-industry, pro-market culture, or else in departments that have a clear quantitative focus such as mathematics or statistics department. More importantly, many programs are also developed in collaboration with the financial industry and financial professional organizations. The external organizations offer credentialing exams that lead to the designations one needs to work in the financial industry. This makes them the de facto curriculum setters for finance education at universities.
Take the actuarial science and insurance finance program in the US as an example. Society of Actuaries (SOA) is the professional organization that provides the much needed credentials for anyone who wishes to work in the capacity of an actuary in the US. Since graduates from university actuarial science programs – even after post-graduate studies – cannot be recognized as actuaries unless they obtain SOA’s credential, universities are forced to focus their efforts on helping students pass SOA exams. SOA also awards “Center of Actuarial Excellence” (CAE) designation to universities, with a key criterion that the university program covers more than 80% SOA’s curriculum. Courses covering SOA curriculum are mandatory to actuarial major students and constitute a heavy course load, leaving little room for courses not directly related to SOA exams.
Most university programs also have an industry advisory board, consisting of practitioners working for major private insurers and consulting services. They meet with university faculty members every year to examine the curriculum development. In the meetings I have attended, there was a clear goal on the part of the faculty members to demonstrate to the industry practitioners that program graduates will be well suited to work for the private industry. Therefore, private sector objectives and interests are crucial factors in curriculum development.
The following is from a survey I conducted in Fall 2014 with my second-year students:
136 students were surveyed and 85 responded. When asked about their motivation in choosing the major (students can choose up to three answers), the majority students picked financial compensation from the future profession as the top reason. The second most popular answer is “job security”. Based on answers to other questions in the survey as well as my conversations with various students, students appeared to be largely driven by exterior, financial motives, and have little interest in exploring pluralistic views and issues. This poses a significant challenge to education reform.
Can we afford not to teach pluralistic perspectives?
A long-held assumption of specialized finance programs, by educators and students alike, is that such programs are only responsible for cultivating “technicians”, who will then work on specific technical tasks in the financial industry. Therefore the training should focus on technical content, which is largely composed of mathematics and statistics. Technicians do not need to concern themselves with broader societal issues and they are not perceived to have a direct impact on the greater society either. But such a notion is simply a myth.
One only needs to look at today’s insurance and financial industry to see the grave social consequences of not exposing students to alternative perspectives.
After directing one’s energy into math and statistical drilling throughout the entire education career, it is not hard to understand why graduates from insurance finance programs view themselves as mathematical wizards whose job at least partially involves “innovations” through math-based manipulations. in recent years, there have been many financial innovations in the insurance industry. They had produced hybrid products that essentially insures against market systemic risks. Often, the design and reserving practices of those products rely on the assumption that such systemic risks won’t materialize. That assumption was clearly usurped during the financial crisis.
Insurance professionals also used derivatives to manage risks and securitization to transfer risks. Due to their neoclassical training, they have not considered issues such as “fallacy of composition”. They only concerned themselves with reducing risks for their individual firms, and ignored the macroeconomic volatilities brought upon by these instruments. Derivatives and securitization provided a theoretical way to reduce the negative impact of market risks. Sometimes the presence of a derivative hedging program or securitization process became the license for insurers to think and act bigger. Moral hazard abounds.
The neoclassical training emphasizes maximizing gains for individual firms and downplays or even ignores the broader interests of the general public. The narrow mindset coming from this school of thought among the insurance professionals is crucial to understanding the conflict of interests between insurers and the general public, and even between insurers and their own policyholders. Due to the wave of demutualization sweeping the industry from the late 1980s to 2000s, the interests of the owners and policyholders are often at odds. With short-term maximization of shareholders’ value in mind, insurance professionals help design ways – captive reinsurance, insurance securitization – to evade reserve and capital standards, which could put policyholders’ interests in jeopardy.
Another issue is that many insurance regulators nowadays are drawn from the private sector itself. In the meanwhile, Insurance regulation has been shifted from rules-based to “principles-based”, which heavily relies on companies’ internal models. This regulatory shift has encouraged the insurance sector’s solution to financial crisis: investing in bigger and faster computer technology, building more complex financial models and exploring new algorithms for derivative hedging. A foreseeable consequence of this regulatory change is that the industry would be empowered to further use complexity as a shield from close public scrutiny, while regulators suffer from epistemological limitation.
Efforts So Far
Due to the aforementioned restrictions imposed by the industry and professional organizations on the core courses of the program, my pedagogical reform had been piecemeal. However, I was able to utilize the space of freedom I had within each course to initiate changes.
In an introductory financial mathematics course, I designed and implemented projects where students research real life financial products – through reading marketing brochures and meeting with financial advisors – to understand, and personally experience, the transparency issues within the industry. The goal is to shift students’ point of view from future financial sector practitioners to a regular consumer and a member of the general public. In the same course, they are also asked to research how financial knowledge could be repurposed for the greater good – students wrote about community bonds, solar bonds, and other social projects that require the knowledge of finance.
In a third-year corporate finance course, a key learning activity is to have students do their own research in order to challenge and critique the classical financial models and their assumptions that were presented in the leading textbooks.
In a fourth-year seminar course I designed, the graduating class of actuarial science students were introduced to complex social issues surrounding financial/insurance product design and insurance regulation. Students were guided to probe controversial topics such as social function of insurance industry, neoliberal underpinnings of the current regulatory policies and corporate structure, and challenge the narrow scope of solutions proposed by the industry during and after the financial crisis.
Going forward, I see art as a potentially powerful tool in battling the stubborn notion among the students that the existing paradigm in finance is the only possible and true pathway. I am currently working on a course redesign that will bring narrative mathematics and mix media to the lecture hall. In a “narrative mathematics” approach, I created an overarching story which presents itself as a central character’s obstacle course that ties together the numerous mathematical concepts covered in the course. It is similar to a “concept map” pedagogical approach but with a crafted storyline and character building. This narrative is then delivered through a mix of video clips, podcasts, still photos. The mix media platform was chosen to recognize that students have distinctively different learning styles – even more pronounced in a large classroom setting – and instructors need to be conscientious about presenting the materials in ways that accommodate different students (“a choreography of attention”). By presenting the story and challenges of a regular consumer, the hope is once again to shift students’ point of view from a future private sector practitioner to a regular member of the public, so that they may take into account the public interest in their future product design and reserving practices.
It is certainly a lot of work. There is often no suitable textbook with a pluralistic perspective and instructors may need to write their own materials. Those new courses are also very different from existing ones in the program and therefore it may be hard to generate interest or support needed to carry out the design and implementation. However, with some careful consideration, I found that it is possible to generate institutional support when the course incorporates demands from various stakeholders – perhaps there is a need from your department to include certain software training in the curriculum, can it be part of your new course? Perhaps there is a specific skill that your students are eager to put on their resume, can you include that? Perhaps the university has an interest in strengthening financial ethics education, can your course be part of that agenda? Be collegial and accommodating. You may just make happen the much-needed education reform, one step at a time.