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No surprises: insurers should expand scenario testing to help them understand and manage the expected volatility of future earnings. (Life/Health).

In today's volatile business environment, insurance companies need to increase transparency and minimize unexpected surprises in future earnings. That means they must measure the impact of their strategies, in terms of both value and risk, on the organization's key performance indicators, thereby better guiding management decisions. More and more, senior managers are finding that embedding scenario testing into their strategic planning process is a "must have" in order to achieve these goals.

Why Now?

Insurance companies operate in an environment of increased scrutiny by regulators, rating agencies and investors alike. Key provisions in the recent Sarbanes-Oxley Act put significantly increased responsibilities and legal pressures on the chief executive officers and chief financial officers of public companies. Investors have reacted negatively to recent earnings surprises, and the values of certain insurance companies have dropped as a result.

Fundamental business reasons exist for increasing transparency within a company, where the success or failure of a strategic decision may not become clear until well into the future. The squeezing of profit margins, increasing competition from unconventional sources, changes in technology and distribution create a complex environment where sound and informed decisions are critical.

Stochastic Modeling

Scenario testing uses stochastic financial modeling to express the interaction of financial risks and operational risks and strategies, in terms of the organization's bottom-line financials, by modeling future cash flows over multiple, randomly-generated scenarios. Financial institutions already use detailed financial models. Use has typically been limited, however, to meeting regulatory requirements or to answer certain "yes/no" questions.

To broaden and expand the way scenario testing can be used by senior management, a company needs to develop a financial modeling approach that:

* covers a sufficiently broad array of the financial and operational risks that the company faces;

* runs quickly enough to make it accessible on an "as needed" basis, and

* is analyzed in a way that can be clearly understood by senior management.

The insurance industry has long recognized the advantages of broader uses for scenario testing. Technological advances exist now which allow companies to adapt their existing financial models and make broader use of scenario testing a viable option.

Benefits to Insurers

The U.S. Generally Accepted Accounting Principles reporting environment does not provide adequate transparency to understand insurance company financials, creating the need for additional analytical tools. As a result, companies are punished for growth and may not recognize the cost of losing business until it is too late. GAAP does not frilly recognize the greater risk in different investment strategies and product designs from embedded options and capital market volatility. As a result, riskier strategies are sometimes undertaken that do not result in greater expected returns or the adoption of hedging, or other risk mitigation, strategies.

The appropriate development and analysis of scenario testing can enhance senior management's understanding of the expected volatility of future earnings. Further analysis can be performed to identify the key drivers of earnings volatility, to compare earnings volatility among various strategic alternatives.

Stochastic testing can also be used for the following:

* To determine economic capital, a probabilistic determination of capital gaining favor among many companies for improved and more refined approach to allocation of capital on a risk adjusted basis.

* To develop meaningful risk adjusted return targets, which can be used to assess various strategic options as well as impact goals and incentives.

* To improve the product design and pricing process.

* To develop an analysis that is part of an overall enterprise risk management process.

* To develop materials to be shared with rating agencies and/or regulators.

Continued use of scenario testing solely to meet regulatory requirements is inadequate. Testing should be expanded and additional analytical tools should be developed. This will enable senior management to draw a clear link from company results to the actions that drive those results, providing a clearer line of sight between action and results and between risk and value.

Jack Gibson is Tillingbast-Towers Perrin 's life sector leader for North America. He can be reached at insight@bestreview.com.
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Author:Gibson, Jack
Publication:Best's Review
Geographic Code:1USA
Date:Jan 1, 2003
Words:665
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