Economic Scenario Generators and Variable Annuities

Alexey Botvinnik

Variable annuities (VAs) are typically more sophisticated than traditional insurance products, and thus require a more elaborate product management approach. As market risk factors play a critical role in VA products, it is important to account for such risk factors when developing and managing VA products. This is where economic scenario generators (ESGs) come into play, to model future distributions of relevant market risk factors and the resulting profit and loss for the insurance company. The results of such models can be used for pricing, product development, hedging, risk management, etc.

ESGs create scenarios of economic variables that are subsequently processed by the corresponding modelling system. ESG applications are generally based on the Monte Carlo approach, using the law of large numbers and allowing determining expected values by estimation of the mean. The size of a scenario set can be quite large, and is usually a trade-off between the computing power available to the user and the desired degree of convergence for the estimate.

There are two types of ESGs, those for real-world modelling and those for valuation. This chapter will examine both, including which