Risk management using economic scenarios

In the UK, where market-consistent valuation has been required for profit-participating life insurance contracts since 2004, economic scenario generators have been used extensively. Colin Ledlie, CRO and group chief actuary of UK-based Standard Life, says "We've found the use of a market-consistent economic scenario generator to be a flexible and transparent tool for calculating market-consistent values of our with-profits policies. It enables us to put an economic value on features such as policy-holder behaviour and management actions."

Good data is available for market-consistent valuation of widely traded instruments over short to medium-term horizons. For example, equity option-implied volatilities are available to 10-year maturities for most major markets. However, there are other prices where market data is not readily available and where robust economic analysis is required to form an objective view of where a liquid market might be expected to trade. This will lead to some degree of subjectivity in the calibration, which needs to be managed and disclosed.

John Hibbert, founder and director of leading ESG provider Barrie & Hibbert, explains the solution his firm has taken: "We took a decision that the subjective elements of our market-consistent calibrations should be open to public scrutiny. We therefore set up a Technical Advisory Panel comprising experts in audit, investment banking and academic research and also invited participants from three of the largest global insurers. We asked them to review our calibration policy so that the choices made will stand up to independent expert scrutiny. We find it a very good way of engaging the key stakeholders in the calibration process and forming an objective view."

Many insurance companies are also finding that an enterprise risk management (ERM) programme needs, at its core, a method for identifying adverse scenarios and quantifying risk exposures, and have been developing sophisticated internal economic capital models for this purpose. With many of the risks that are faced by insurance companies directly or indirectly linked to movements in key market and economic variables, economic scenario generators are proving useful for identifying sequences of economic events that can lead to problems. But, John Hibbert cautions that careful calibration is as important as developing very sophisticated economic models; "It is easy to get carried away designing ever more complex models, but we have found that careful model calibration is the key driver for insurance economic capital requirements. Therefore we feel it is very important to back up developments in model complexity with a coherent calibration process."

However, the ERM process extends beyond the risk management function. Insurance companies are now taking risk management to the front office so that the principles of ERM are being applied in product design and communication. Andy Frepp, corporate development director at Barrie & Hibbert, says: "Our view is that risk management should start before any products are sold. An economic scenario generator can be used to understand guarantee costs and the risk profile of products. This can help to ensure that the products taken to market are genuinely value-added and that there is effective communication of the product risks to the customer".

Solvency II will require that the senior management of the insurance company have oversight and approval of the key assumptions. Elliot Varnell, head of European insurance at Barrie & Hibbert, adds: "Getting senior management engagement on the complex economic modelling in modern insurance companies is a major challenge posed by Solvency II. We see the ability of the board of directors to approve a consistent set of economic assumptions and then have those filtered down to all areas of the business as key to satisfying the demands of Solvency II."

Contact

Elliot Varnell, Head of European Insurance, Barrie & Hibbert Ltd

T. [phone]

E. [e-mail]

www.barrhibb.com.

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