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Casualty Actuarial Society Experienced Practitioner Pathway Seminar Lecture 6 – Current Issues – Economic Scenario Generators Stephen P. D’Arcy, FCAS,

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Presentation on theme: "Casualty Actuarial Society Experienced Practitioner Pathway Seminar Lecture 6 – Current Issues – Economic Scenario Generators Stephen P. D’Arcy, FCAS,"— Presentation transcript:

1 Casualty Actuarial Society Experienced Practitioner Pathway Seminar Lecture 6 – Current Issues – Economic Scenario Generators Stephen P. D’Arcy, FCAS, MAAA, Ph.D. Robitaille Chair of Risk and Insurance California State University – Fullerton D’Arcy Risk Consulting, Inc.

2 Overview 2EPP Lecture 6: Current Issues - Economic Scenario Generators Key aspect of any economic capital model is the approach used for the Economic Scenario Generator (ESG) What ESGs are available? What are the key differences among the ESGs? How do you select which ESG to use?

3 Economic Scenario Generators Stochastic models that can produce multiple potential financial variables that are consistent with each other Key variables modeled –Interest rates –Credit spreads –Inflation rates –Equity returns and dividend –Real estate returns –Unemployment rates –Foreign exchange rates 3EPP Lecture 6: Current Issues - Economic Scenario Generators

4 Sources of Economic Scenario Generators Internally developed Public access Commercial products – some examples –Barrie & Hibbert ESG –Conning GEMS ® –Ortec Finance Dynamic Scenario Generator –Towers Watson Star ESG 4EPP Lecture 6: Current Issues - Economic Scenario Generators

5 Internal Development Expect to invest multiple man and woman years into project Expertise required –Modeling –Economics and Finance –Common sense –Communication skills Advantages –Geared to specific needs of company –Someone in company truly understands the model –Company owns the model Disadvantages –Development time and initial cost –Need to update continually –Obtaining regulatory and rating agency acceptance 5EPP Lecture 6: Current Issues - Economic Scenario Generators

6 Public Access Models - 1 CAS Public Access DFA Model – Dynamo http://www.pinnacleactuaries.com/Products/dynamo/dynamoDownload.aspx CAS/SOA Financial Scenario Generator http://casact.org/research/econ/ American Academy of Actuaries Interest Rate and Equity Generators http://www.actuary.org/content/economic-scenario-generators#10 6EPP Lecture 6: Current Issues - Economic Scenario Generators

7 CAS/SOA Model Modeled Economic Series InflationReal Interest Rates Real EstateUnemployment Nominal Interest Stock Returns Stock Dividends 7EPP Lecture 6: Current Issues - Economic Scenario Generators

8 Public Access Models - 2 Advantages –Cost –Useful learning tools Disadvantages –Generally not updated –Developed for a specific purpose 8EPP Lecture 6: Current Issues - Economic Scenario Generators

9 Commercial Economic Scenario Generators - Examples Barrie & Hibbert ESG –http://www.barrhibb.com/economic_scenario_generatorhttp://www.barrhibb.com/economic_scenario_generator –Contact: Stephen Urbrock (stephen.urbrock@barrhibb.com)stephen.urbrock@barrhibb.com Conning GEMS ® –http://www.conning.com/risk-and-capital-management/software/gems.htmlhttp://www.conning.com/risk-and-capital-management/software/gems.html –Contact: Chris Suchar, chris.suchar@conning.com Ortec Finance Dynamic Scenario Generator –http://global.ortec-finance.com/Pensions/Solutions/dynamic-scenario- generator.aspxhttp://global.ortec-finance.com/Pensions/Solutions/dynamic-scenario- generator.aspx –Contact: André van Vliet, Andre.vanVliet@ortec-finance.comAndre.vanVliet@ortec-finance.com Towers Watson Star ESG –http://www.towerswatson.com/en/Services/Tools/star-esghttp://www.towerswatson.com/en/Services/Tools/star-esg –Contact: Jon Mossman, jonathan.mossman@towerswatson.com 9EPP Lecture 6: Current Issues - Economic Scenario Generators

10 Legal Disclaimer The CAS does not endorse any of the vendors mentioned in this presentation. The providers of the software products and services that are compared here operate entirely separately from each other and do not share information. 10EPP Lecture 6: Current Issues - Economic Scenario Generators

11 Barrie & Hibbert ESG No single Barrie & Hibbert ESG model –User selects from a range of stochastic models Can provide model of 29 global economies including emerging markets Transparent and open Models taken from academic literature and leading practitioners Models and calibration fully documented and updated quarterly Now part of Moody’s Corporation –Access to Moody’s Data Buffet platform Calibrations at the state and regional level for GDP and unemployment Cover entire fixed income structured finance space 11EPP Lecture 6: Current Issues - Economic Scenario Generators

12 Barrie & Hibbert Basic Single-Economy ESG Structure 12EPP Lecture 6: Current Issues - Economic Scenario Generators Source – Barrie & Hibbert email communication

13 Barrie & Hibbert Interest Rate Models Extended Black-Karasinski Model –Two-factor arbitrage free model –Lognormal – cannot produce negative values –Used for nominal interest rates Libor Market Model Vasicek Model –One-factor model –Normal – can produce negative values –Used for real interest rates 13EPP Lecture 6: Current Issues - Economic Scenario Generators

14 Historical 3-month Nominal Rates and Model Project Distribution – Dec. 2008 14EPP Lecture 6: Current Issues - Economic Scenario Generators Source – Barrie & Hibbert Insurance Economic Scenario Generator Modeling Suite, Page 9

15 Barrie & Hibbert Inflation Model Model nominal and real interest rates Derive inflation rates Mean reverting process with time dependent varying reversion level 15EPP Lecture 6: Current Issues - Economic Scenario Generators

16 Barrie & Hibbert Equity Models Log-normal model – constant volatility Deterministic volatility model Local volatility model Stochastic volatility jump diffusion model Equity mean reversion model 16EPP Lecture 6: Current Issues - Economic Scenario Generators

17 Conning GEMS ® Economic Scenario Generator Open and transparent 16 correlated economies Innovative Academically rigorous Utilizes the most up-to-date research Empirically demonstrable Relationships fully accounted for within and across economies Extensively tested and validated 17EPP Lecture 6: Current Issues - Economic Scenario Generators

18 Conning GEMS ® Economic Scenario Generator Interest Rates Credit Spreads Equity Returns Inflation, GDP, Unemployment Claim Cost Inflation Market Value and Cash Flows Municipal Bond Model Prepayments, etc. Credit Rating Transitions Corporate Security Model Corporate Yield Model 18EPP Lecture 6: Current Issues - Economic Scenario Generators

19 Conning GEMS ® Overview of Primary Models 19EPP Lecture 6: Current Issues - Economic Scenario Generators

20 Conning GEMS ® Projections at Year End 2008 20EPP Lecture 6: Current Issues - Economic Scenario Generators

21 Conning GEMS ® Inflation 4 factor affine model 3 factors from interest rate models 1 factor inflation index Model incorporates extreme scenarios including deflation 21EPP Lecture 6: Current Issues - Economic Scenario Generators

22 Ortec Finance Dynamic Scenario Generator (DSG) Provides consistent scenarios with monthly updates Scenarios include key aspects from literature and empirical data –Term structure of risk and return –Business cycle dynamics –Stochastic volatility –Tail risk (both within and between asset classes) –Non-normal distributions –Term structure dynamics Employs a combination of advanced quantitative techniques to meet its objectives 22EPP Lecture 6: Current Issues - Economic Scenario Generators

23 Ortec Finance DSG – Example Tail correlations Euro and US monthly equity returns 23EPP Lecture 6: Current Issues - Economic Scenario Generators

24 Ortec Finance DSG Frequency Domain Approach 24EPP Lecture 6: Current Issues - Economic Scenario Generators

25 Ortec Finance DSG Software and Calibrations 25EPP Lecture 6: Current Issues - Economic Scenario Generators

26 Ortec Finance DSG - Variable Coverage Currently around 350 variables (excluding client specific) 26EPP Lecture 6: Current Issues - Economic Scenario Generators

27 Ortec Finance DSG Backtest example Dec10 27EPP Lecture 6: Current Issues - Economic Scenario Generators

28 Towers Watson Star ESG Fully coherent and integrated stochastic Monte Carlo generator Models 20 economies Fully transparent and documented Supports regulatory submissions Calibrated based on fitting the models to historical data and then adjusted to reflect the long-term views of the Towers Watson Global Investment Committee Updated quarterly Allows users to rescale economic scenarios to reflect the user’s views or create stochastic stress tests 28EPP Lecture 6: Current Issues - Economic Scenario Generators

29 Towers Watson Star ESG Nominal interest rates The Norman (2009) Real World Extension of the Libor Market Model. This model is also used, with minor adjustments, to model real yields and LIBOR spreads Inflation Linear function of current and past short-term interest rates and inflation Error term is AR(1) with conditional heteroskedasticity to give higher volatility in higher inflation environments Equity returns Geometric Brownian motion with jumps 29EPP Lecture 6: Current Issues - Economic Scenario Generators

30 Towers Watson Star ESG 30EPP Lecture 6: Current Issues - Economic Scenario Generators

31 Towers Watson Star ESG Inflation 31EPP Lecture 6: Current Issues - Economic Scenario Generators

32 Towers Watson Star Equity Returns 32EPP Lecture 6: Current Issues - Economic Scenario Generators

33 Comparing Economic Scenario Generators Reference: Ahlgrim, D’Arcy and Gorvett, 2008, A Comparison of Actuarial Scenario Generators, Variance Vol. 2, pp. 111-134. Compares the CAS/SoA model with the AAA C-3 Phase 2 Risk Based Capital model 33EPP Lecture 6: Current Issues - Economic Scenario Generators

34 Comparative Statistics: Interest Rates 34EPP Lecture 6: Current Issues - Economic Scenario Generators

35 Histogram of 3 Month Nominal Interest Rates Model Values and Actual Data (01/34-01/06) 35EPP Lecture 6: Current Issues - Economic Scenario Generators

36 Funnel of Doubt Graphs 3 Month Nominal Interest Rates (U. S. Treasury Bills) 36EPP Lecture 6: Current Issues - Economic Scenario Generators

37 Histogram of Large Stock Return Model Values and Actual Data (1872-2006) 37EPP Lecture 6: Current Issues - Economic Scenario Generators

38 Comparative Statistics: Equity Returns 38EPP Lecture 6: Current Issues - Economic Scenario Generators

39 Quantification of Model Fit Kolmogorov-Smirnov test Tries to determine if two datasets differ significantly Uses the maximum vertical difference between percentile plots of the data as statistic D Chi-square test Take the squared difference between observed frequency (O) and the expected frequency (E), and then divided by the expected frequency 39EPP Lecture 6: Current Issues - Economic Scenario Generators

40 Kolmogorov-Smirnov Test 40EPP Lecture 6: Current Issues - Economic Scenario Generators

41 Chi-square Test 41EPP Lecture 6: Current Issues - Economic Scenario Generators

42 Conclusions Selecting an ESG is a key component of many ERM quantitative analyses Significant differences in approaches to developing an ESG exist Develop a basic understanding of the approach used Examine output for reasonability –Users often have better understanding of the real world than the modelers Tail values are critical as these will generate greatest financial stress Consider magnitude of extreme values –Should be greater than historical experience – The worst is yet to come –Should have reasonable probabilities in tails Review projections regularly Remember – you are not trying to fit the past, but to project the future 42EPP Lecture 6: Current Issues - Economic Scenario Generators


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