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
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?
EPP Lecture 6: Current Issues - Economic Scenario Generators

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
EPP 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
EPP 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
EPP Lecture 6: Current Issues - Economic Scenario Generators

6. Public Access Models - 1 CAS Public Access DFA Model – Dynamo
CAS/SOA Financial Scenario Generator
American Academy of Actuaries Interest Rate and Equity Generators
EPP Lecture 6: Current Issues - Economic Scenario Generators

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

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

9. Commercial Economic Scenario Generators - Examples
Barrie & Hibbert ESG
Contact: Stephen Urbrock
Conning GEMS®
Contact: Chris Suchar,
Ortec Finance Dynamic Scenario Generator
generator.aspx
Contact: André van Vliet,
Towers Watson Star ESG
Contact: Jon Mossman,
EPP 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.
EPP 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
Moo
EPP Lecture 6: Current Issues - Economic Scenario Generators

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

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
EPP Lecture 6: Current Issues - Economic Scenario Generators

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

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

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

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

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

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

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

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

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

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

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

32. Towers Watson Star Equity Returns
EPP 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
Compares the CAS/SoA model with the AAA C-3 Phase 2 Risk Based Capital model
EPP Lecture 6: Current Issues - Economic Scenario Generators

34. Comparative Statistics: Interest Rates
These statistics are during the first 20 years of projections
EPP Lecture 6: Current Issues - Economic Scenario Generators

35. Histogram of 3 Month Nominal Interest Rates Model Values and Actual Data (01/34-01/06)
Model allows users to reject negative interest rate scenarios
EPP Lecture 6: Current Issues - Economic Scenario Generators

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

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

38. Comparative Statistics: Equity Returns
CAS-SOA model has some extremes. But the “middle” of the distribution seems okay (under both)
EPP 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
EPP Lecture 6: Current Issues - Economic Scenario Generators

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

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