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

302 THE APPLICATION OF FUNDAMENTAL VALUATION PRINCIPLESan insurer and thus should be considered during the financialprojection process. There are two broad approaches to modelingfuture financial projections: scenario testing and stochasticmodeling.Scenario testing is a deterministic approach in which resultsare projected from a specific set of conditions and assumptions.With this static approach, the user defines a scenario that reflectsassumptions about various components of the company.The user is able to define the specific interrelationships of componentsand evaluate the impact of changes in different factorson the financial projections. This approach produces results thatare easy to explain and easy to modify by incorporating one ormore alternative assumptions.Stochastic modeling has become increasingly popular in recentyears for the property/casualty industry via dynamic financialanalysis (DFA). Underlying stochastic models are probabilitydistributions for each of the stochastic variables reflectedin the model. Based on the probability distributions and a randomnumber generator, the stochastic model produces a rangeof outcomes from which probabilities may be determined forthe results. Its flexibility and ability to test the impact of a widerange of variables simultaneously make it an appealing approach.With respect to the implementation of stochastic modeling, however,the probability distributions for the stochastic variables andthe correlations between components are critical to a meaningfulmodel.Over the past 10 to 15 years considerable emphasis has beenplaced on the DFA of financial results for insurance companiesto evaluate capital needs, capital allocation, ceded reinsurancestructures, and the risk associated with specific business initiatives.Since valuation formulas include the present value of futureearnings, stochastic modeling of insurance financial resultswould seem like a natural adjunct to valuation.