Over the last 20 years, the advances enabled by financial modeling are impressive. Insurers have made improvements in risk management, capital optimization, product development and other important aspects of their business with the help of financial models. The critical importance of financial models has never been more evident.Products today are increasingly complex, and the pressure to manage, measure and report risk continues to grow. As a result, models viewed as highly sophisticated just a few years ago are now inadequate to meet today's needs. However, keeping pace with these demands is becoming increasingly difficult.
It reminds me of the farmer who brings his products to town using his horse and wagon. Over time, the farm becomes more productive, but demand increases as well. The farmer considers his options: Add more horses? Get a bigger wagon?
The farmer should be looking for a truck.
The "horses" of the past-desktop financial modeling systems that are coded, deployed and maintained primarily by actuaries-are struggling to keep up with modeling demands. Rating agencies and regulators are requiring insurance companies to demonstrate a full understanding of their risks across thousands of potential scenarios. Complex insurance products with embedded guarantees necessitate hedging programs to manage these risks. Emerging financial reporting regulations (i.e., principles-based approaches for reserves) appear likely to require stochastic analysis. Economic capital requirements are escalating as well, as internal and external stakeholders are demanding a better understanding of risks, return and value. The load is heavy.
Insurers continue to look for ways to squeeze more out of existing modeling systems. Code optimization is one tactic to increase efficiency and improve run times. "Smart modeling" techniques, such as the use of representative scenarios, are tools that have potential to improve the value provided through existing models. Distributed computing and grid software are becoming common as companies search for ways to multiply computing capacity. With these enhancements, financial models continue to progress, but the legacy desktop technology is limiting, rather than enabling. The horses are tired.
The good news is that as early as 2008, a new generation of "enterprise" financial modeling products will start hitting the market. These products will utilize current technology and are designed specifically for the heavy volumes, granular models and tight timelines demanded today and into the future. Grid computing will become standard, with the focus shifting to allocation and prioritization of computation resources rather than simply accessing additional CPUs. These systems will allow server deployment for true collaborative, centralized modeling. Security, controls, automation and integration will ensure that the volumes of data generated are valid, timely and of high quality. Enhanced analytics will provide actuaries with tools to truly understand these volumes of data. Speed, power, control, automation, integration, collaboration-all at levels well beyond what is available today. Yes, these systems are a bit more than legacy desktop applications hooked up to a grid. These are the trucks.
ORGANIZATIONAL CHANGES REQUIRED
Insurers will need to embrace organizational changes as well. Actuaries will be asked to relinquish some control of the modeling systems and processes to IT departments as these systems become more closely linked with other key enterprise IT components. In many cases, this will involve a major shift in mindset as actuaries have traditionally owned the entire financial modeling realm. IT will take on increased responsibility for development, testing, deployment and integration of modeling systems. Model development will become more centralized and controlled to comply with Sarbanes-Oxley and other governance requirements. Driving is not the same as riding.
The benefits are real. Insurers that embrace this change in technology will continue to reap the rewards of advances in risk management, product development and capital optimization enabled through financial modeling. Required economic and regulatory capital will be reduced. Regulatory compliance will be more easily demonstrated, and audit costs will be smaller. Processes will be more stable, repeatable and automated, resulting in less risk of error and lower staffing costs. The product design and implementation processes will be improved as collaboration, process memory and access to computation resources are all enhanced. The partnership between IT and actuaries will enable each to do what they do best. The technology will be enabling. These are not horses.
It is time to start looking for a truck. Financial models are central to competitive advantage and new solutions are on the horizon. And to those insurers that stick with their horses-their legacy desktop systems-make sure you mount a "slow-moving vehicle" sign on the back of your wagon and stay to the side of the road.
Van Beach is a senior consultant with the Tillinghast Division of New York-based Towers Perrin.
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