On the Use of Stock Index Returns from Economic Scenario Generators in ERM Modeling

The modeling of insurance company enterprise risks requires correlated forecasts of the future values of various economic variables. These forecasts, especially as they pertain to interest rates, inflation, stock market performance and other economic variables needed for asset modeling, are typically obtained from an economic scenario generator (ESG). With respect to stock market performance, third?party ESGs generally provide forecast returns for various market indexes; the output is not tailored to reflect an insurer’s own equity portfolio composition. For that reason, ESG stock return scenarios cannot be used for insurer ERM modeling without adjustment to reflect the insurer’s own equity portfolio composition and idiosyncratic risk. This paper describes two methods for making the necessary adjustment to the ESG market return scenarios based on the assumption of normally?distributed 1) arithmetic returns, and 2) logarithmic returns.

Keywords CAPM; correlated sampling; economic scenario generator; enterprise risk management; stochastic modeling.