Actuaries and Equities (1912-1948)
We saw above how both British and American life offices shifted substantially away from illiquid mortgages and loans and moved further into liquid government and corporate bonds between 1890 and 1920 (the US shift starting some fifteen years earlier). Over the following 30 years, another radical change in actuarial investment thinking occurred: equities emerged as a major asset class for British life offices. In aggregate, British life offices increased their equity allocations from under 2 % in 1920 to 21 % by 1952. This time, British and American life office investment practices diverged. The British offices had more surplus capital and a more flexible with-profit bonus distribution system than their US counterparts. These features allowed the British offices more freedom to tolerate and manage the greater volatility associated with equity investment. The American offices were also under a more prescriptive and restrictive regulatory system that varied somewhat from state to state but which generally curtailed equity investment (Fig. 3.8).
Nineteenth-century actuarial orthodoxy had been unambiguous: equities were an unsuitable asset class for life assurance business. Bailey thought it self-evident that equities were too risky for such liabilities. Other nineteenth- century actuarial papers followed this doctrine. In 1891, Mackenzie wrote that ‘ordinary shares ... should be rigidly excluded’.
Actuaries’ first intellectual embrace of equity investment occurred in the 1920s. This was in part a reaction to the poor performance of the long-term government bonds that life assurers had invested so heavily in during the First World War. The high-inflation post-war environment had resulted in substantial falls in long-term bond prices and consequent losses for life offices. As noted by The Economist: ‘From the beginning of 1916 to the end of 1920,
Fig. 3.8 UK life offices' equity and property allocations and UK inflation (1870-1970) (Dodds (1979))
[bond] depreciation ... has been enormous and unprecedented ... and has wiped out nearly whole of the surpluses which would otherwise have been available for bonuses to policyholders.’
The extraordinary burst of inflation that occurred during and after the First World War was an important factor in motivating actuaries’ reappraisal of equities as a potentially useful asset class for with-profit business. The six years from the start of 1915 to the end of 1920 produced annual CPI increases of 13 %, 18 %, 25 %, 22 %, 10 % and 15 % respectively. Whilst with- profit guarantees were written in nominal money terms, there was a conviction that bonuses should be used to ensure the policy delivered a satisfactory real return (especially for endowment business where the pay-out would be used to secure a pension income). The impact of unexpected inflation shocks on the performance of long-term nominal bonds in the early 1920s helped to support the argument amongst actuaries that equities, as a ‘real’ asset class, could offer some form of inflation risk protection. As the chairman of the Pearl put it in 1928:
The effects of the War in matters of finance have taught us ... that it may be safer to have a proportion of our investments ... in first-class ordinary shares, rather than entirely on a fixed monetary payment such as is given by ... gilt- edged investments.
The increase in long-term bond yields that occurred in the early 1920s generated disturbing falls in the market values of life office asset portfolios. It probably did not have an adverse impact on life offices’ overall economic balance sheets, however, as the assets were unlikely to be substantially, if at all, longer than life office liabilities. In this era, actuaries were reluctant to increase the discount rate used in liability valuation unless absolutely necessary, and so the stated surplus positions in the early 1920s were likely to have been a prudent interpretation of the economic reality. Later in the 1920s, bond yields started to fall again. In the midst of economic depression and a policy of cheap money, consol yields fell from over 4.5 % in 1925 to 3.5 % by the mid-1930s. Whilst this resulted in a recovery in bond prices, it resulted in a new problem: such low rates made it increasingly difficult to for bond investments to sustain historical bonus rates, although the competitive pressure to do so was intense. John Maynard Keynes’s speech at the 1927 annual general meeting of National Mutual captured this sentiment:
Policyholders have become accustomed to bonuses which presume, in most cases . a net rate of interest of not much less than 4.5% after payment of income tax. If an attempt is made to put British Government securities on a basis appreciably below 4 per cent net, it is certain that ... a powerful stimulus will be brought into play to find more profitable outlets for invested funds [emphasis added].
The British with-profit policy was by this time unambiguously positioned as a long-term investment contract. As such it increasingly competed with other investment vehicles such as investment trusts. Investment yields and bonus rates had become increasingly important marketing statistics for with- profit funds both in competing with each other and with other investment offerings. A post-tax consol yield below 3 % put in serious peril not only the ability to make bonus distributions commensurate with a 4.5 % net return, but also the ability to meet the guaranteed liabilities (which had typically been set using a 3 % premium rate). In this context, the 4-5 % dividend yield offered by equities was very alluring.
The First World War had created an unintended concentration of British life offices’ assets in long-term government bonds. The post-war economic environment and its consequent impact on both realised and prospective life assurance investment performance created a context where life assurers and actuaries were ready for another significant change in asset allocation profile. A stream of research, from both within the actuarial profession and outside it, emerged in the 1920s that provided an intellectual basis for the new openness to equity investing. But the seeds of this thinking can be found earlier.
George May, an actuary at the Prudential in the UK, presented a notable paper to the Institute of Actuaries in 1912. May had a highly distinguished career. He was secretary of the Prudential from 1915 to 1931; he also held significant advisory roles with the British government between 1915 and 1941. He was made a Baron in 1935. In his 1912 paper, he did not explicitly advocate investing in equities, but his was the first actuarial paper to present a technical justification for life offices taking on more investment risk. He paved the way for the change in actuarial attitudes to investment that would emerge more explicitly over the following ten to 20 years.
His rationale for increasing investment risk was twofold. First, he argued historical analysis suggested that ‘by careful selection, relatively high yielding investments can be obtained which ... will show a margin considerably greater than is required to cover the risk run’. He didn’t, however, provide any statistical analysis or historical statistics, claiming that ‘I do not feel it desirable to introduce examples into this paper; further, I am sure that it is only by personal investigation that one is in a position to form a reliable judgment’.
The second pillar of his argument for increasing investment in riskier assets was that risk should be measured at the total portfolio level rather than at the individual security level. He pointed out that individually risky assets may diversify so that, at the margin, they do not materially increase the overall portfolio risk. He suggested that Bailey’s already historical investment principles should be extended with a further law: ‘That in order to minimise the result of temporary fluctuations and to secure the safety of the capital in the best way, it is desirable to spread these investments over as large an area as possible’. Actuaries were naturally familiar with the diversification concept in mortality risk. Indeed, it was the fundamental principle of insurance business. But this was the first time the diversification concept had been used to argue that life offices should be more willing to invest in high-yielding securities that are significantly riskier than those that had been typically held by life assurers.
May’s advocacy of the adoption of greater investment risk by life offices anticipated the post-First World War Zeitgeist. This experience highlighted the benefit of diversification (or the risk of a lack of it). Life offices were ready to invest in something else. During the decade of the 1920s, three men in particular had an especially great influence on British actuaries’ thinking on life office equity investment: John Maynard Keynes, the famous British economist; Edgar Lawrence Smith, an American economist and investment manager; and H.E. Raynes, the actuary of the Legal & General Assurance Society.
John Maynard Keynes joined the board of National Mutual, a mediumsized British life office, in 1919 and became its chairman in 1921, holding that position until 1938. He also had a less substantial role on the board of another life office, Provincial Insurance, during this period. In the early days of his involvement with National Mutual, Keynes was not yet the global statesman he would become in his elder years. His revolutionary General Theory of Employment, Interest and Money was still some fifteen years away from publication. He had, however, played a prominent role as an economic advisor at the Treasury during the First World War, and his 1920 book, The Economic Consequences of the Peace, was a bestseller that raised his profile and marked him out as an influential commentator on economics and politics. Although he only ever played a part-time role there, he had a major influence at National Mutual, especially on investment policy, where the office pursued a distinctive strategy. In the actuarial journals of the period, National Mutual was often referred to as ‘Keynes’ office’.
Throughout his adult life, Keynes was an active investor. As well as his role at life offices, he managed money for himself and his friends, was involved in various investment trusts, and he managed the endowment fund of King’s College, Cambridge, where he was a Fellow. Keynes was a man of strong opinions, often flavoured by a strain of iconoclasm, and he always had the courage to back his convictions. This is reflected in his approach to investment. As an investor, Keynes has been described as a ‘scientific gambler’. His investment philosophy was active and aggressive. As might be expected of a man of Keynes’s breadth, his investment views transcended any specific type of asset and he regularly took short-term positions in commodities, currencies, equities and bonds as dictated by his macroeconomic and geopolitical outlook. He had a noticeable preference for investing in liquid securities: illiquid assets could not support the short-term active speculation that was at the heart of
Keynes’s investment style. When applied to life assurance, this was the polar opposite of Bailey’s conception of life offices reaping illiquidity premia from assets that would never be sold.
National Mutual was not one of the largest offices, but this appears to have suited Keynes, providing him with an institution which had a certain critical mass but which could be made more malleable to his vision than the larger offices. His vision was of mutual life assurance as the leading savings vehicle for the middle classes. He strongly advocated the promotion of endowment assurance as a more savings-orientated alternative to whole-of-life assurance. He argued that life offices should pursue an ‘active investment policy’ and he piloted such a policy at National Mutual. He viewed investment as the critical function of a life office. In January 1922, in the first of his chairman’s speeches at the annual meetings of National Mutual, he said:
I venture to say that at the present time life assurance societies must stand or fall mainly with the success or failure of their investment policy. The labours of the great actuaries of the 19 th century have carried actuarial science to a point where great improvements or striking innovations are no longer likely ... But investment, on the other hand, provides both more pitfalls and also more opportunities than formerly.
Most significantly of all, Keynes held a strong view that the investment policy of a life office should feature material allocations to equities. In his speech at National Mutual’s annual meeting of 1928, he explained:
The arguments in favour of holding a certain proportion of ordinary shares are ... to be found in the advantage of spreading the fund between assets such as bonds, expressed in money values, and assets representing real values . the second reason is the fact they are undoubtedly under-valued relatively to bonds after making all due allowance for risk.
National Mutual was a pioneer of life office equity investment. Prior to Keynes’s involvement, National Mutual’s equity allocation stood at 3 %. By 1927, it had increased to 18 %. The other British life offices had not yet followed suit. In 1926, the average equity allocation across the industry stood at only 4 %. But they noticed, and in time, they followed. His heavy emphasis on investment strategy and appetite for investment risk never sat completely comfortably with this generation of the actuarial profession. As late as 1942, F.C. Scott, the managing director of Provincial Insurance wrote to Keynes:
My conception of our responsibility is that our first primary duty is to so invest our funds, which are the security we offer our policyholders for the fulfilment of our contracts, that the public confidence will never be impaired____I am sometimes tempted to think that you would pervert my morals and encourage me in my secret vice to regard ... the investment of our funds, not as incidental to our main business — insurance — but as an equally important contributor to the profits of the Company.
Keynes would indeed pervert his morals, and most of the rest of the actuarial profession. But he was not the only important actor in this scene. Edgar Lawrence Smith was an economist at Columbia University and a Wall Street investment manager. His pioneering short book, Common Stocks as Long Term Investments, was published at the end of 1924. It, perhaps inevitably, resonated with Keynes, who wrote a positive review of the book in the Nation and Athenaeum. The book also registered with the British actuarial profession, and was referred to in the papers and discussions of the profession in the second half of the 1920s and beyond.
Smith’s book was the first significant quantitative comparative analysis of the long-term empirical returns of equities and bonds. Smith considered the returns that had been produced from diversified portfolios of equities and high-quality bonds over various 20-year holding periods between 1866 and 1922. He demonstrated that the long-term returns of equities had consistently exceeded those of high-quality bonds. He also showed that the income received from equities had also tended to exceed that generated by bonds over long-term investment horizons. Neither of these observations would necessarily have been especially surprising to financial practitioners. But a more provocative conclusion of his analysis was that equities would even tend to outperform bonds in periods of low inflation or deflation as well as in inflationary periods. It was generally accepted wisdom that equities were a ‘real’ asset class whilst bonds were ‘money’ assets, and as such equities would outperform in times of unexpectedly high inflation and vice versa. Smith argued that the evidence suggested that over a horizon of 20 years equities would outperform bonds under any economic conditions with a high degree of likelihood.
Smith produced a novel argument for why equities performed so robustly. He argued that the corporate practice of only paying out a small proportion of annual earnings as dividends and reinvesting the remainder facilitated a compound interest effect in future earnings which allowed dividends to be smoothed over time, and hence protected equity values from economic downswings and deflation. Such an argument had much resonance with Keynes and the British actuarial profession of the time, but the idea that dividend policy could play such a pivotal and positive role in equity value creation would be rejected by the financial economists that would emerge a few decades later.
Smith’s data analysis did not include any statistical calculations such as confidence intervals or significance tests. His paper did not overly focus on equity tail risk or the possibility that the 20-year outperformance could only be obtained by enduring an uncomfortably volatile path. However, he did include a short section that considered how long a period of equity underperformance an investor may have to suffer. He considered investing in equities at the start of 86 different years from 1837 to 1922 and found that only four of the 86 investment projections resulted in equities producing a negative return over the first four years. He concluded that there was a 78 % probability of equities delivering a positive return over one year, an 87 % chance over two years, and a 94 % chance over four years. To modern eyes, this may appear to be a stretching use of overlapping data periods and a significant understatement of equity risk (the assumption of a normally distributed log annual return with a mean of 7.5 % and volatility of 18 % implies a probability of around 20 % that equities would produce a negative return over a four-year period, assuming annual returns are independent over time).
Finally, it is important to note that Smith’s advocacy of equities as a longterm investment was primarily targeted at the savings strategies of individual investors. It was expressly not intended for insurance companies where ‘their investments are all made to protect dollar obligations. Their sole concern is so to conduct their affairs that they will always have available more dollars than they will be called upon, under their commitments, to pay out, at the same time deriving a profit above operating expenses. It is natural and right that (they) should concentrate their attention upon promissory obligations payable in a fixed number of dollars.’
But by the 1920s, for better or worse, British with-profits business had moved substantially beyond the provision of fixed monetary amounts in the event of life contingencies. Endowment assurance and large ‘bonus loadings’ in with-profit premium rates had furthered the evolution of life assurance into a long-term investment vehicle where mortality protection was a secondary feature. Perhaps perversely, the high degree of actuarial caution in the setting of with-profits premium rates had created a vacuum that risk-taking filled.
Keynes and Edgar Lawrence Smith were both outsiders to the British actuarial profession. H.E. Raynes, however, as the actuary of the Legal & General Assurance Society, was in its inner sanctum. He presented two influential papers to the Institute of Actuaries in 1928 and 1937 that advocated a greater role for ordinary shares in life office asset allocations. Raynes was doubtless influenced by the practices of Keynes and the writings of Smith (both are referred to either directly in his papers or in the formal discussion of the papers that followed their presentation to the profession). But he was not an immediate convert. As late as mid-1927, Raynes ‘contended that considerations of security excluded ordinary shares as investments for life offices’.
He underwent his Damascene conversion when he attended an International Congress of Actuaries in Canada in 1927. He had discussions with T.B. Macaulay, the actuary of Sun Life of Canada (and father of Frederick Macaulay of bond duration fame), in which Macaulay ‘strongly advocated investment of a proportion of funds in common stocks as a measure to combat the trouble of a depreciation of currency [i.e. inflation]’. This inspired Raynes to develop a piece of empirical analysis of UK equity data that was very similar in spirit to Edgar Lawrence Smith’s US equity work, if less comprehensive. The paper, ‘The Place of Ordinary Stocks and Shares (as distinct from Fixed Interest bearing Securities) in the Investment of Life Assurance Funds’, was presented to the Institute of Actuaries in 1928. A follow-up paper, ‘Equities and Fixed Interest Stocks during Twenty-Five Years’, provided further statistical analysis to the first paper, but no new conclusions, and was published in 1937.
Raynes analysed the investment performances of a diversified portfolio of UK equities and a portfolio of debentures over the fifteen-year period from 1912 to 1927. Like Smith, Raynes found that equities strongly outperformed the bond portfolio, both in terms of capital appreciation and income. He found this was true during periods of rising interest rates and falling interest rates. Raynes concluded that equities had a significant role to play in life office asset allocation for the two distinct reasons that Keynes forwarded in his chairman’s speech of 1928: inflation protection as per T.B. Macaulay’s argument; and for the more fundamental reason that they appeared good value to the long-term investor who could ride out the higher short-term volatility that comes with equity investment.
Given Raynes’s role as a leading life actuary, his paper is surprisingly light on the risk implications of equity investment, and how equity asset allocation might be considered in the context of the fixed liabilities of life assurance contracts. Interestingly, it was a visitor to the actuarial meeting, the eminent economist Ralph Hawtrey, who was prepared to look beyond the quantitative results of a relatively small data sample, suggesting that ‘if [insurance companies] were going to take the risk of investment in ordinary shares, then they ought to have a correspondingly larger capital’.
Perhaps with the benefit of hindsight, in reviewing Raynes’s papers and their accompanying actuarial meeting discussions, a creeping sense of hubris and complacency can be detected emerging in actuarial thinking and attitudes. Early in the 1928 paper Raynes writes:
Whether greater security to the capital of a fund is given by the investment of a proportion in ordinary stocks and shares might be considered by deductive reasoning from the principles of economics, but while no doubt the result of such a process would lead to the same result, a statistical investigation will, I think, prove more convincing to actuaries.
This sentence creates the sense that actuaries thought themselves above the theories and deductions of others such as economists, and instead would use their uniquely endowed capacities of observation to judge what was right. This sense of hubris and complacency can be increasingly identified when considering some of the doctrines of the actuarial profession in the second half of the twentieth century. Arguably, it started when actuaries were seduced by the cult of equities in the 1920s.
Thus, the intellectual groundwork for greater life office equity allocations was laid in the decade of the 1920s by the triumvirate of Keynes, Smith and Raynes. Lewis G. Whyte, a senior Scots actuary, wrote in 1947 that ‘by the time Mr Raynes’ paper ... was submitted to the Institute of Actuaries in 1927, the movement [to invest life office funds in equities] had received a large measure of professional approval’. But equity asset allocations in aggregate across the British life offices remained fairly modest through the 1920s. A few life offices such as National Mutual, Scottish Widows and Equity & Law led the way with larger equity allocations than the rest of the industry. Equity allocations gradually climbed during the 1930s in an environment of enduring low government bond yields. The post-Second World War economic environment then provided equity allocations with a significant further fillip. This was driven by near necessity. The ‘cheap money’ era of Hugh Dalton, the Labour chancellor of the exchequer, drove consol yields down to 3.1 % in 1945, presenting a real threat to life offices’ ability to meet the 3 % (aftertax) return assumption almost universally used in with-profit premium rates at the time. As in the 1850s, low interest rates had prompted life offices to take more investment risk. J.B.H. Pegler, the investment secretary of Clerical Medical presented a paper to the Institute of Actuaries in 1948 that argued that this environment demanded a less risk-averse attitude to investment: ‘if the assets are invested, no matter how safely, to provide a yield less than that assumed in the calculation of premium rates, the ‘soundness’ of the investments is somewhat illusory’.
Pegler proposed investment principles that turned Bailey’s risk-minimising ethos on its head. He suggested: ‘It should be the aim of life office investment policy to invest its funds to earn the maximum expected yield thereon’ whilst, in a nod to George May, ‘Investments should be spread over the widest possible range in order to secure the advantages of favourable, and minimize the disadvantages, of unfavourable, political and economic trends’. These principles were perfectly reasonable long-term investment objectives of an investment strategy, but the disregard for how such a strategy should ensure assets could meet guaranteed liabilities is striking. With the benefit of hindsight, it is hard to resist the thought that actuaries were starting to surrender rigour and prudence under the significant competitive pressures of their marketing departments.
-  Dodds (1979), Table A.3.
-  Mackenzie (1891), p. 205.
-  Office of National Statistics Composite Consumer Price Index.
-  Scott (2002), p. 80.
-  Scott (2002), quoting from Keynes (1983).
-  May (1912).
-  May (1912), p. 135.
-  May (1912), p. 143.
-  May (1912), p. 153.
-  Skidelsky (2003), p. 520.
-  Keynes (1983), p. 118.
-  Keynes (1983), pp. 156, 158.
-  Keynes (1983), p. 80.
-  Assuming a cash rate of 5 %, an equity risk premium of 4 % implies an (arithmetic) expected returnof 9 % and hence a geometric expected return of c. 7.5 %.
-  Smith (1924), p. 12.
-  Raynes (1928), Raynes (1937).
-  G.H. Recknell in Discussion, Raynes (1928), p. 35.
-  Raynes (1928), p. 22.
-  R.G. Hawtrey, in Discussion, Raynes (1928), p. 42.
-  Raynes (1928), p. 22.
-  Whyte (1947), p. 221.
-  Pegler (1948).
-  Pegler (1948), p. 180.