Finding Value in Scenario Analysis
I have written recently on the the value of scenario analysis in terms of reducing the risk of or mitigating the impact of extreme events (http://www.cchsword.com/blog/?p=20). As a vendor of a risk management solutions we are constantly faced with the need to convince our customers and prospective customers of their value. In the case of Scenario Analysis, where the solution is seen simply as an aid for assessing a dozen or so scenarios to calculate regulatory capital, this can be a challenge. Of course there is an existing answer to that, based around pillar 2 and the Use Test. Where the scenario modelling and analysis functionality is built into the same system that supports the risk management framework, as it is in Sword, it will be much easier to satisfy the regulators.
From the insurance community however is emerging a different use of scenarios that has a more immediate business value. Scenarios used for assessing regulatory capital concentrate on the tail events in loss distributions, attempting to estimate the frequency and size of extreme events but scenarios can also be used to model the high volume, low value events that fall in the ‘expected losses’ portion of the loss curve. Insurers are used to this type of analysis when looking at insurance risk but are starting to look at their own risks in the same way. Taking an expected loss scenario for which several million euros or more is reserved each year; if the organisation can build scenarios around the actual risks, controls and losses involved, it can examine the impact of further mitigation measures and put indicators in place to monitor the risk and allow early intervention. Unlike with extreme event scenarios, this involves assessing fifty or more different scenarios at many different points across the enterprise, with the total number of scenarios reaching or exceeding one thousand. This level of scenario analysis must be automated but it does raise the possibility of being able to go to senior management and ask for a budget to reduce expected losses immediately. I wouldn’t dare suggest that senior management in our financial insitutions might take a short-term view but human nature is such that this may be an argument that is much easier to win.
Mike MacDonagh