Abandon the random, manage the risk

Vall Herard, Americas Head of Barrie & Hibbert – winner of Life & Pensions 2009 & 2010 Best Global Economic Scenario Generator and the global leader in stochastic models to the global insurance market – outlines to FST US the growing need for robust and coherent economic scenarios.

“As the global insurance sector steadily moves towards a more principles-based approach to risk, insurance groups have come to embrace stochastic economic scenarios across a number of applications.”
-Vall Herard

Adoption of economic scenario modelling in the insurance sector

Stochastic economic scenarios have been around for a while in financial services. So the phenomenon is not new, especially when you consider their adoption in banking and capital markets. However, as the global insurance sector steadily moves towards a more principles-based approach to risk, insurance groups have come to embrace stochastic economic scenarios across a number of applications in order to gain a more holistic understanding of risks. For calculating the market-consistent value of liabilities, or for making real-world projections over both short and long-term horizons, a coherent and consistent set of robust scenarios is critical to not only measuring risks, but in being able to manage them.  

Regional variations in how economic scenarios are being adopted

Variations do exist. If you look at Europe and the impending implementation of Solvency II (SII), the primary driver there has been a need to harmonize insurance risk practice across the region and to establish a regime where firms are well capitalized. Recognizing this need and also the limitations of a one-size-fits-all approach, SII incorporates an internal model approach in the calculation of the Solvency Capital Requirement (SRC) that relies on a forward-looking one-year Value-At-Risk (VaR) measure. Economic scenarios play an important role in calculating the one-year VaR measure not only because of the need for a robust simulation of the joint risk drivers of the assets, but also in order to get a consistent value of the liabilities at a forward point in time. 

SII also impacts other parts of the world because of the 'equivalency' issue. Since the goal of SII is to ensure that the SRC is sufficient at the group-wide level, any business unit of an EU insurance group operating outside the EU will have to calculate an 'equivalent' one-year VaR. As a consequence, some non-EU countries have intimated their desire to implement SII type regulation in order to qualify for 'equivalence'.

In the US, where there is some resistance to full SII 'equivalence', the impetus for stochastic economic scenario generation has been a mixture of accounting regulations and industry adoption of best practice risk management. For instance, under FAS 133 and 157, certain VA business has to be valued under a market-consistent approach. The underlying hedging that takes place for many of these products requires the calculation of Greeks, which must also be evaluated under market-consistent frameworks. First the liability Greeks are calculated based on scenarios calibrated to prevailing market prices and then a recalibration is performed in order to calculate the appropriate hedging parameters. 

Statutory capital under C-3 Phase II and AG43, is also driving the need for stochastic economic scenario models, in the US.

So as other parts of the world and the US inch towards the adoption of internal models and more robust risk management frameworks, the need for stochastic economic scenarios will continue to grow.

Identifying good economic scenarios

If the economic scenarios feeding into your risk management processes are flawed, problems will arise, so it's important to carefully assess whether ESG providers have the ability to provide you with a robust and coherent set of scenarios - after all, these are the central component of your risk management framework.  To do this, ask yourself the following four simple questions: (1) Does the company providing the scenarios have deep experience in all types of economic scenario applications? (2) Is that experience coupled with the depth and breadth of a multi-disciplinary team of actuaries, quantitative model researchers and economists capable of creating a globally unrivalled pool of economic scenario expertise? (3) Has the company's scenarios been widely adopted by global insurance groups? (4) Is the company just providing models plucked from academic journals with little or no content?

If the scenario generation is built by a company that can answer yes to 1, 2, 3 and answer no to 4, you have found a good scenario generator provider.

Profile

Vall Herard, Americas Head of Barrie & Hibbert, has more than 16 years experience in business development and risk management in the capital markets. He has extensive knowledge of capital markets across various asset classes, hedge fund strategies, and enterprise risk management.