Equity ReturnsInflationReal Interest Rate ProcessMeanEquity Dividend YieldsReal Estate (Property)UnemploymentExcluding Negative Nominal Interest RatesUser Defined ScenariosModeling Financial Scenarios:A Framework for the Actuarial ProfessionKevin C. Ahlgrim*, ASA, MAAA, Ph.D.Illinois State UniversityStephen P. D’Arcy, FCAS, MAAA, Ph.D.University of Illinois at Urbana-ChampaignRichard W. Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.University of Illinois at Urbana-Champaign* Corresponding author.Kevin AhlgrimAssistant ProfessorIllinois State UniversityDepartment of Finance, Insurance, and Law340 College of Business BuildingCampus Box 5480Normal, IL 61790-5480(309) [email protected]: The authors wish to thank the Casualty Actuarial Society and the Society of Actuaries for sponsoring this research, as well as the various members of the committees of both societies who provided detailed reviews and numerous excellent comments.Modeling Financial Scenarios:A Framework for the Actuarial ProfessionABSTRACTThis paper summarizes the research project on Modeling of Economic SeriesCoordinated with Interest Rate Scenarios initiated by the joint request forproposals by the Casualty Actuarial Society and the Society of Actuaries. Theproject involved the construction of a financial scenario model that simulates avariety of economic variables over a 50 year period. The variables projected bythis model include interest rates, inflation, equity returns, dividend yields, realestate returns, and unemployment rates. This paper contains a description of thekey issues involved in modeling these series, a review of the primary literature inthis area, an explanation of parameter selection issues, and an illustration of themodel’s output. The paper is intended to serve as a practical guide tounderstanding the financial scenario model in order to facilitate the use of thismodel for such actuarial applications as Dynamic Financial Analysis,development of solvency margins, cash flow testing, operational planning, andother financial analyses of insurer operations. 1. INTRODUCTIONIn May 2001, the Casualty Actuarial Society (CAS) and the Society of Actuaries (SOA) jointly issued a request for proposals on the research topic “Modeling of Economic Series Coordinated with Interest Rate Scenarios.” There were several specific objectives of the request:- review the previous literature in the area of economic scenario modeling;- determine appropriate data sources and methodologies to enhance economicmodeling efforts relevant to the actuarial profession; and,- produce a working model of economic series, coordinated with interest rates, thatcould be made public and used by actuaries via the CAS / SOA websites toproject future economic scenarios. Categories of economic series to be modeled included interest rates, equity price levels, inflation rates, unemployment rates, and real estate price levels.This topic is of considerable value to the actuarial profession given the interest in and substantial development of dynamic financial analysis (DFA). A key aspect of the DFA process is the ability to probabilistically express future economic and financial environments. Byconsidering a variety of future economic conditions, actuaries can evaluate an insurer’s alternative operating decisions and their potential impact on corporate value. An important consideration in creating multiple scenarios is the recognition of the interdependencies between the various economic and financial series - for example, between equity returns and interest rate movements.In the broader insurance community, a second benefit of this research is for regulatory and rating agency purposes, such as for use in cash flow testing. By testing across a wide range of potential scenarios, an insurer’s cash position and liquidity can be evaluated over a variety of future alternative economic and financial environments.Previous research has suggested the need for sophisticated tools to evaluate the financial condition of insurers. Santomero and Babbel (1997) review the financial risk management practices of both the life and property-liability insurers and finds that significant improvements are necessary. They find that even the most advanced insurers are not doing an effective job managing their financial risks. Research also shows that the potential consequences of the lack of risk measurement cannot be ignored. A study by the Casualty Actuarial Society Financial Analysis Committee (1989) discusses the potential impact of interest rate risk for property-liability insurers. Hodes and Feldblum (1996) also examine the effects of interest rate risk on the assets and liabilities of a property-liability insurer. Staking and Babbel (1995) find that significant work is needed to better understand the interest rate sensitivity of an insurer’s surplus.This paper provides a summary of the development of a scenario generation model, which is now available for public use. Full descriptions of the project, the research methodology,analytical implications, and the model itself – a spreadsheet-based stochastic simulation model – are available on the CAS website at: http://casact.org/research/econ/.This paper is organized as follows. Section two discusses the key issues that were addressed during the model’s development and reviews the literature in each of these important areas. Section three describes the underlying variables of the model, illustrates how each processis simulated, discusses how the default parameters of the process were selected, and provides sources of data for use in selecting the appropriate parameters. Section four briefly explains howto use the financial scenario model and discusses how to incorporate the model into other actuarial applications. Section five illustrates the use of the model, summarizes the outputproduced in one simulation, and includes a number of tabular and graphical displays of the output. Section six concludes the paper.2. ISSUES AND LITERATURE REVIEWThere are many issues involved in building an integrated financial scenario model for actuarial use. This section reviews the literature in the modeling of the term structure and equity returns. In addition, the financial models in the actuarial literature are reviewed.Term Structure ModelingInsurance companies have large