Forecasting the Future - Stochastic Simulation and Scenario Testing

The envisioned role of the appointed actuary encompasses the evaluation of the insurance company’s financial condition under a range of likely future conditions. Two types of valuation methods are being developed for this task: stochastic simulation and scenario testing. Stochastic simulation is presently the more heralded method, due to the seminal work of British and Finnish actuaries. This paper, in contrast, presents a full description of scenario testing. It contrasts the underlying assumptions of scenario testing with those of stochastic simulation, and it compares the usefulness of the two evaluation procedures for strategic planning. The paper proceeds to the building of scenarios for both adverse economic conditions, such as a recession, and adverse insurance conditions, such as a severe underwriting cycle downturn. Various illustrative insurers are presented, such as a personal automobile insurance writer and a workers compensation carrier, with different investment portfolios and underwriting characteristics, to show the interrelationships of external (economic and financial) conditions and internal (company) attributes. The paper demonstrates how scenario testing can help transform the valuation actuary from a backroom model-builder into a central member of the company’s management team.