A typical scenario testing dynamic financial analysis generally take the following form :
(i) Â Scenario building – One starts with realistic scenarios, covering a variety of economic, financial, and business conditions, and emphasizing those attributes that have the greatest effect on insurance performance. For e.g, scenarios might be build for a moderate recession and for a prolonged expansion, so that the differential effects of each on company’s performance can be evaluated.
For solvency monitoring, an additional scenario of a severe recession along with an abrupt downturn in financial market may be used. For each scenario, the attributes of inflation, interest rates, GNP growth, unemployment, and factory production are explicitly modeled.
(ii) Â Relationships – The insurance correlations with these economic attributes are formulated. Some of these relationships are obvious, whereas some of them are indirect.
For e.g, prosperous economic times lead to increased business activity. Less experienced workers are hired, overtime hours increase and workers’ compensation claim frequency rise. People purchase more vehicles or goes out more for vacations thereby increasing the business. Recessions usually have the opposite effects.
The ill/injured workers generally are reluctant to give up their disability benefits for fear of being eliminated by workforce reduction. Though there is a decline in workers’ compensation claim frequency, there is a lengthening of the time spent on disability by already ill/injured workers.
(iii) Sensitivity – The magnitude of the insurance correlations are quantified, either by analytical studies, or by business judgement. For e.g, ” 1% drop in unemployment rate leads to a 1.5% of workers compensation claim frequency.
“The claims manager of a large insurance company gets a feel of it. Moreover, conclusions can be drawn from economic studies at the Workers Compensation Research Institute, which has archives of decades old records of workers claim filing behavior, or from Insurance Research Council, which has similar analyses.
The output of dynamic financial analysis is not a specific number, but a future performance of the insurance enterprise, which may be presented as pro-forma financial statements, cash flows of assets and liabilities, or present values of future earnings.