2001 Richard C. Witt Award

Stewart Myers

There was a tie for the Witt award in 2001.  The first recipients of the 2001 Witt Award are Stewart Myers and James Read, Jr. for “Capital Allocation for Insurance Companies,” The Journal of Risk and Insurance, Vol. 68, No. 4. (Dec 2000), pp. 545-580.


James ReadThis study shows how option pricing methods can be used to allocate required capital (surplus) across lines of insurance. The capital allocations depend on the uncertainty about each line’s losses and also on correlations with other lines’ losses and with asset returns. The allocations depend on the marginal contribution of each line to default value–that is, to the present value of the insurance company’s option to default. The authors show that marginal default values add up to the total default value for the company, so that the capital allocations are unique and not arbitrary. They therefore disagree with prior literature arguing that capital should not be allocated to lines of business or should be allocated uniformly. The study presents several examples based on standard option pricing methods. However, the “adding up” result justifying unique capital allocations holds for any joint probability distribution of losses and asset returns. The study concludes with implications for insurance pricing and regulation.

The second recipient of the 2001 Witt Award was Kent Smetters for “The Equivalence Between State Contingent Tax Policy and Options and Forwards: An Application to Investing the Social Security Trust Fund in Equities,” The Journal of Risk and Insurance, Vol. 67, No. 3. (Sep 2000), pp. 351-367.

Kent Smetters

Government guarantees are often priced by appealing to an analogy with option pricing techniques pioneered by Black and Scholes (1973) and Merton (1973). Of course, in reality, the government does not purchase options in the open market. Instead, barring a Ponzi game opportunity, the government must adjust tax revenue or spending in response to shocks in the value of the asset being insured for the government to maintain its intertemporal budget constraint. Nonetheless, this article derives an exact mathematical relationship between fiscal policy and option pricing. Explicitly deriving the option pricing equivalence from first principles proves that the analogy is, in fact, correct and suitable for use by public finance economists and government officials to estimate the cost of government guarantees. Starting from first principles also has the benefit of showing that an additional mathematical term, which multiplies the option price, is necessary to capture the pay-as-you-go nature of most perpetual government guarantees–a term that is missing in the previous work.

The author develops the analysis in the context of a highly relevant example: investing the Social Security trust fund in equities. Advocates of this policy have argued that the higher expected returns would help pre-fund future benefits and, therefore, would require less of a tax increase on future workers. Several government agencies have “scored” hypothetical legislation and have concluded likewise. The results herein show just the opposite. By focusing on expected returns, trust fund investment creates an instant windfall for current workers and is mathematically equivalent to a tax increase on all future workers, relative to a baseline policy of maintaining the current payroll tax rate. National saving is reduced. The author computes President Clinton’s proposal to invest in equities to be equivalent to increasing the future payroll tax by 0.8 percent in perpetuity. A policy recommendation to invest about 40 percent of the trust fund in stocks analyzed recently by the Social Security Administration is equivalent to a 2.1 percent increase in the future payroll tax.

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