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The Actuary The magazine of the Institute & Faculty of Actuaries

Insurers seek outside help on internal model market risk

The firm says the rapid economic meltdown in 2008 and the current European debt crisis highlight the risk of unquestioningly relying on historic data when forecasting future economic conditions.

The research found that almost half of insurance companies surveyed (44%) expect the number of developed market sovereign defaults to significantly increase in the next 50 years, although just over one-quarter (28%) prioritise current market conditions over historic data in their risk assumptions.

Neil Chapman, director at Towers Watson's Risk Consulting and Software business, said: "Solvency II will raise the supervisory bar far beyond current ICA requirements with much greater emphasis being placed on data analysis and expert judgement. What makes this particularly important is that for many insurers market risk is the dominant driver and most manageable lever for capital requirements and real economic outcomes."

Alasdair MacDonald, head of investment strategy at Towers Watson, said: "Historic data is only one pillar for market risk model calibration and assumption setting with good judgment also being essential. The current Eurozone crisis is a good example of the dangers of "naive" data analysis without expert judgment.

"Prior to the current crisis some dismissed data prior to the creation of the Euro as not being relevant. This resulted in calibrations predicting very tight ranges for Eurozone sovereign debt yields. The fallacy of such an assumption is now clear to all."

According to other Towers Watson research, the ratings of developed world sovereign debt are expected to decrease over the next 30 years as the full gravity of the imbalances between developed (debtor) and developing (surplus) countries are recognised and reflected in investors' assessment of their relative creditworthiness.

The firm believes that a key element in raising calibration standards is the wider use of internal models in decision making. This is reflected in supervisory approval criteria that focus on statistical quality, documentation and validation. In meeting these criteria, Towers Watson found that companies face a number of challenges, including: resources with the right skills and experience; achieving operationally independent validation; and meeting uncertain Financial Services Authority timeframes and requirements.

Mr MacDonald continued: "Company actuaries are experts in insurance risk, but not necessarily market risk, and have to date made limited use of the expertise of investment professionals.

"The competitive and regulatory impetus of Solvency II signals a fundamental change in the role of investment diversity and complexity in insurers' portfolios; and with it an irrepressible shift for market risk calibration: from cottage industry to game changing paradigm."