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

MODELING FINANCIAL SCENARIOS 233eters and then adjust these parameters as necessary to generatedistributions that they feel may be more suitable for a particularapplication. For example, from the results shown above, a usermay feel that the default parameters for equity returns, whileconsistent with historical experience through 2003, produce veryhigh equity risk premiums that may not be expected to continuein the future. When testing long-term insurer solvency, an actuarymight change the regime-switching parameters to look at theeffects of lower stock returns over the next 50 years.6. CONCLUSIONHistorically, actuaries tended to use deterministic calculationsto value financial products. As technology improved, actuariesbegan to incorporate different assumptions about insurance andeconomic variables that would lead to several distinct scenariosto better measure financial risk. The explosion of computingpower now gives actuaries and other financial analysts tremendoustools for more refined risk analyses. Modern approaches tofinancial modeling begin by specifying the underlying economicand financial environments based on sophisticated mathematicalequations, and then incorporate product-specific features thatare commonly related to those external conditions. This approachyields a much richer understanding of the risks associated withfinancial products.The financial scenario model and its underlying mathematicalstructure presented in this paper provide an integrated frameworkfor sampling from a wide range of future financial scenarios. Themodel produces output values for interest rates, inflation, stockand real estate returns, dividends, and unemployment. The modelcan be incorporated into a variety of insurance applications, includingdynamic financial analysis, cash flow testing, solvencytesting, and operational planning. It is hoped that this work willfacilitate the use of recent advances in economic and financialmodeling in the actuarial profession.