PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

192 MODELING FINANCIAL SCENARIOSexternal economic and financial environment before incorporatingthe impact of these variables on the operations of the insurer.Wilkie’s [44] model proposes inflation as the independentvariable, using a first-order autoregressive model to simulate inflation.Wilkie links the realization of inflation with other variablesusing a cascade approach. Wilkie’s original model [44]includes (1) dividends, (2) dividend yields, and (3) interest rates.Wilkie [45] updates his earlier work by expanding on thestructural form of the processes used to represent key variablesin his “stochastic investment model.” The paper includes severalappendices that fully develop the time-series tools used throughoutthe presentation, including cointegration, simultaneity, vectorautoregression (VAR), autoregressive conditional heteroskedasticity(ARCH), and forecasting. Wilkie [45] also estimates parametersfor each equation of the model by looking at data from1923 through 1994 and performs tests on competing models forfit. As in the 1986 model, Wilkie’s updated model simulates inflationas an autoregressive process that drives all of the othereconomic variables, including dividend yields, long-term interestrates, short-term interest rates, real estate returns, wages, andforeign exchange rates. One shortfall of the Wilkie model is theinconsistent relationships generated among inflation and shorttermvs. long-term interest rates. In addition, the equity returnsare based on an autoregressive process that leads to a distributionof returns that is much more compact than history indicates.Hibbert, Mowbray, and Turnbull [24] describe a model usingmodern financial technology that generates values for theterm structure of interest rates (both real and nominal interestrates), inflation, equity returns, and dividend payouts. They usea two-factor model for both interest rates and inflation, a regimeswitchingmodel for equities, and a one-factor autoregressivedividend yield model. The paper discusses issues related to parameterselection and also illustrates a simulation under alternateparameters, comparing results with the Wilkie model.