European insurance legislation aims to enhance consumer protection in a unified EU insurance market. The Solvency II Directive primarily concerns the amount of capital that insurance companies must hold to reduce the risk of insolvency. Admirable in theory, but in practice becoming Directive-ready poses considerable challenges for insurers in valuing complex assets and liabilities. Heriot-Watt mathematicians have helped develop a practical solution to a particularly difficult problem, which is proving a boon to insurers worldwide.
A major challenge for insurers addressing Solvency II is projecting the values of complex liabilities such as variable annuities. These involve many uncertainties such as future interest rates, stock market prices and policyholder behaviour. With no simple pricing formula available, modelling a range of risk scenarios relies on estimating the value of liabilities using ‘Monte Carlo’ simulation.
The original Monte Carlo technique creates ‘simulations within simulations’ to calculate scenarios, thereby taking a long time to compute. Researchers from the Maxwell Institute and Barrie and Hibbert, a leading provider of financial risk models to the financial sector, wondered whether a simpler approach – ‘least squares Monte Carlo’ (LSMC) – could be applied to valuing unit-linked insurance products (LSMC was originally proposed in the US for valuing stock options).
Collaborative research with Barrie and Hibbert (now part of Moody’s Analytics) successfully turned the LSMC approach into a viable solution. A feature of the efficient LSMC solution is that it uses fewer simulations: it could therefore be perceived as a less robust technique. Showing that it is backed by extensive Heriot-Watt research provides important reassurance to clients that the method produces accurate results.
As well as underpinning new Moody’s Analytics products, the research has provided examples and training materials to support the firm’s consultancy. Since Moody’s Analytics clients include over 60 per cent of insurers in the Global Fortune 500, the benefits of the Heriot-Watt research have a very long reach.