Scenario analysis is rapidly becoming the method of choice to evaluate multiple risks for many insurers, says a new sigma study by Swiss Re. But despite its prevalence, Swiss Re feels carriers could do more to fully exploit these state-of-the-art approaches.

Scenario analysis helps insurers make business decisions by considering a number of potential future developments, allowing them to manage a broad range of often-interrelated risks, according to the Zurich-based reinsurer. It is used most frequently in areas such as strategic planning, risk management and underwriting.

"Events like the financial crisis will accelerate the adoption of these approaches and encourage insurers to use state-of-the-art scenario analysis to evaluate risks," says Kurt Karl, a Swiss Re economist.

A state-of-the-art approach, Karl says, would see insurers excelling in the following types of scenario analysis:

•    A global model of assets and liabilities that can be stress tested with insurance, economic and financial market shocks

•    A regular program of internal scenario tests related to shocks such as natural catastrophes and pandemics, as well as economic and financial market shocks

•    Models that capture how these shocks affect each major asset class and business line

Because insurers face such a vast number of risks, including natural catastrophes, mortality risks and investment volatility, these risks can often interact in complex ways.

In the case of a pandemic, for example, thousands of people may lose their lives, resulting in a sharp increase in life insurance claims. In addition, as people shop, work and travel less to avoid becoming infected, businesses may suffer, causing corporate bond defaults to rise. A related impact on the business landscape is faltering share prices.

Because carriers have to price and manage these risks, they need a deep understanding of the risks and how they interact.

"The insurance industry, unlike some other industries, tends to focus on unlikely events," Karl says. "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 order to illustrate how scenario analysis works, the Swiss Re study suggests how an insurer might evaluate a complex scenario like a pandemic. Medical experts are needed to understand how pandemics spread and to help determine infection, mortality and morbidity rates. Economists are needed to assess the impact on different parts of the economy and capital markets. Underwriters are needed to gauge the costs to various insurance lines.

When the analysis is complete, insurers must then review mitigation strategies: Is additional reinsurance required? Should more restrictive clauses be imposed on, for example, business interruption insurance?

"Insurers must also evaluate how a pandemic would impact asset returns,” Karl says. “One must be prepared to de-risk the asset portfolio quickly, if the risk of a severe pandemic escalates."

But, while Swiss Re feels the use and sophistication of scenario analysis in insurance has improved, it is far from perfect. The industry is not yet fully applying state-of-the-art standards.

"The current financial crisis will definitively advance the use of scenario analysis by insurers," Karl adds. “This sigma aims to improve the understanding and use of scenario analysis and modeling in insurance.”

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