Garbage In - Who polices the information used to run the model
Posted on 02-06-2009 by Craig Turnbull | 0 comments
This is partly about finding the right regulatory balance between prescription and principles. Globally, insurance regulators have so far taken different positions on this spectrum. Some risk factors may be so common and ‘standard’ that a prescriptive approach to the criteria that the model and its calibration must satisfy seems obviously beneficial. As an example, if an insurance company has S&P 500 exposure, the regulator might state that the model should assume that the 99.5th percentile 1-yr fall in the S&P must be at least 40%. This approach can ensure some consistency in capital assessment across firms, and may seem like a no-brainer to most people.
The difficulties though, arise in the detail:
- Who decides what the prescriptive measure is? The regulator? The actuarial profession? The government? How do they do that and will they want to risk getting it wrong? How often should that assumption be updated?
- Are all firms S&P 500 investments really the same, or are some firms taking materially more active risk than others? Are all firms exposed to the same type of behavior in the S&P 500? What if a firm has a hedging strategy that means that they are more exposed to S&P falling 4% than 40%?
As a general rule, greater regulatory prescription usually means greater opportunity to game the system, or to find a regulatory arbitrage. It is worth emphasizing that even in a principle-based system that gives firms considerable freedom to make its own modeling assumptions, strong regulatory oversight is required. The UK ICA system is perhaps a good example of this working in an insurance industry context. However, it has highlighted the need for expert modeling analysts within the regulator that can perform effective scrutiny of firms’ assumptions and modeling methodologies.
Please read our participation policy before submitting a comment.