Economic Scenario Generators for Insurance

Purpose and Structure

Economic scenario generators (ESGs) produce simulated paths of key economic variables (interest rates, equity returns, credit spreads, inflation) used in actuarial modeling. These scenarios drive cash flow projections for reserve calculations, capital assessments, and strategic planning. ESGs can produce real-world scenarios (calibrated to historical data and reflecting the actuary's view of future economic conditions) or risk-neutral scenarios (calibrated to current market prices for use in fair value calculations). The AAA's interest rate generator, prescribed for certain statutory valuations, is the most widely used ESG in US life insurance.

Key Modeling Considerations

Building or selecting an ESG requires careful attention to several factors. The models must capture important features of economic variables: mean reversion in interest rates, volatility clustering in equity returns, and correlation between asset classes. Calibration targets (historical statistics, market prices, or a combination) determine the scenarios' properties. The number of scenarios must be sufficient for stable results, particularly when computing tail risk measures like CTE 70. Actuaries should validate ESG output by checking distributional properties, comparing with historical data, and testing sensitivity to calibration assumptions. The choice of ESG can significantly impact reserve and capital calculations.