The insurance industry can do more to employ scenario analysis to assess future risks rather than making forecasts strongly rooted in current conditions, according to a new Swiss Re sigma study.
Called "Scenario Analysis in Insurance," the sigma study defines scenario analysis as a process that "facilitates business decisions by taking into account a number of potential developments and possible future events in the business environment."
The study added that scenario analysis is used to analyze the outcome of "highly uncertain events and their impact on an organization's profitability or competitive position."
This approach could help overcome what the study calls "the tyranny of the present," in which forecasts, both optimistic and pessimistic, are based strongly on current conditions. This approach, the study said, "prevents one from envisioning a broader set of possible future outcomes. It also leads to surprises that may result in missed opportunities or unmitigated risks."
Scenario analysis could benefit insurers by providing a mechanism for quantitatively evaluating multiple risks that insurers may face, the study observed.
"The insurance industry, unlike some other industries, tends to focus on unlikely events," Kurt Karl, Swiss Re economist, said in a statement. "They use models provided by regulatory authorities or their own in-house models, which are then 'shocked' with a wide range of scenarios to evaluate tail risk. The better models take into account the benefits of diversifying insurance and asset risks."
In an interview with NU Online, Mr. Karl explained models are not necessarily the answers to assessing risk by themselves, and he pointed to the need for a good scenario team to evaluate model results.
The team, he said, should analyze whether the model output makes sense, and a bright team can brainstorm scenarios outside of the model's structure to take additional possibilities into account.
The study said a state-of-the-art approach would see insurers excelling in the following types of scenario analysis:
o A global model of assets and liabilities that can be stress tested with insurance, economic and financial market shocks.
o A regular program of internal scenario tests related to shocks such as natural catastrophes and pandemics, as well as economic and financial market shocks.
o Models that capture how these shocks affect each major asset class and business line.
Some limitations of scenario analysis, the study noted, are the quality of the model, the quality of the data and the quality of the scenario team.
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