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, according to Towers Watson. With regulatory requirements evolving in response and more stringent tests being imposed, the company asserts that insurers face a number of new challenges in measuring market risk. The Towers Watson market risk calibration survey* indicates that just under two-thirds of UK insurers intend to use external independent validation of their market 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."
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.
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 judgement also being essential. The current Eurozone crisis is a good example of the dangers of "naive" data analysis without expert judgement. 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.
Towers Watson 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.
Alasdair MacDonald said: "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."
Other key findings from Towers Watson's market risk calibration survey include:
* Reviewing the use of judgement in the model (26%) and an external review of their market risk model (25%) would benefit their Board the most, followed by an improved granularity of the credit model (21%), and the purchase of an externally calibrated market risk model (11%).
*About the market risk calibration survey Towers Watson asked 60 representatives from a range of insurers operating in the UK, including the life and non-life areas, a number of questions about market risk calibration.
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