Star ESG Real-World Economic Scenario Generation

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Star ESG Real-World Economic Scenario Generation

Overview of Star ESG

Star ESG is a leading software toolkit providing fi nancial modelling and risk analytics to the insurance, pension and banking communities. Star ESG is used by our clients to manage and report on risk exposures in excess of US$3 trillion, and forms a key component of the advice driving our fi duciary mandates.

Star ESG is a fully coherent and integrated stochastic monte-carlo generator covering a wide array of economic and fi nancial risk metrics including interest rates, credit spreads, equities, property, FX and many alternative series. These metrics are then used to determine the full distribution of returns at one-year and multi-year projections for a wide range of assets (and at both aggregate and/or individual security level detail).

Over 60 clients globally

North America

18

Europe31

Asia Pacifi c

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As you navigate the regulatory seas, Star ESG provides a fully transparent framework ensuring easy adoption, validation and ownership of the calibration, analytics and sensitivities that drive your business. Every line of code is visible, audited and documented – easing the regulatory burden.

Star ESG is supported by a team of 50+ consultants who have academic and commercial experience of working this fi eld. Specialisms range from economics and econometrics, capital and risk, actuarial advisory, asset pricing, trading, risk management and systems engineering.

Star ESG 3

Figure 01. Igloo softwareExample model

Economic Scenario Generation

At a high level, Star ESG is a suite of tools supporting clients with the assessment of economic and fi nancial risk. Technically, these tools provide a coherent and integrated, arbitrage-free, real-world ESG. They use best of breed technical models to simulate the full range of possible outcomes for the economic and fi nancial series driving market risk. Star ESG focuses on economic realism, both in respect of the direct economic items modelled, and how these measures subsequently impact movements in asset series returns. Furthermore, Star ESG incorporates a full suite of asset and portfolio analytics to ensure that series move coherently – and coherence is also captured by an econometric cascade and tail copula framework. A tail copula helps ensure we capture the changes in correlation as market movements become more extreme.

The Star ESG calibration is focused on the full distribution of results, including the tails, average levels and volatilities – and not only at one year but also at multiple year horizons. This ability to model both short-term and long-term risks via the same modelling framework supports the coherent assessment of fi rm-wide risk as advocated by modern enterprise wide risk management (ERM).

Consequently, Star ESG is appropriate for risk management, determination of capital, business planning, hedging strategies, portfolio construction and holistic ERM.

Operational features

The ESG is calibrated quarterly and can be used to project monthly, quarterly or annual scenarios (or indeed any other custom time step). Moreover, users can update the starting values as frequently as daily – always ensuring that full audit trails remain for anything modifi ed.

To date the ESG generates series for the following currencies:

The Star ESG library can be deployed to clients as a toolkit library based on the Towers Watson’s Igloo software platform. This is a high speed parallelised, scalable, stochastic simulation platform capable of running over one million scenarios. Alternatively, clients can purchase pre-generated simulations. In each case, calibrations come complete with comprehensive documentation, training and support. The ESG output simulations can be exported in csv or text fi le format and to databases for feeding to downstream applications – including (among others) Igloo, Remetrica, Simulum and Risk Explorer software platforms.

ARS AUD BRL CAD CHF CNY CZK DKK EUR

GBP INR JPY KRW MEX NOK SEK USD ZAR

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Model Selection Table

GBP USD EUR DKK CAD SEK AUD

Interest Rates

Equity

GDP

Property

Wage In� ation

In� ation

Credit Spreads

FX

IR Based on Spread Over US YC

Dividend Yield

Real Rates

LIBOR Spots

Fed Funds

RPI

Indices Filter

Global_Equity

Hedge_Fund

HFRX_Absolute

HFRX_EqualWeight

HFRX_EquityHedge

HFRX_EquityMN

HFRX_EventDriven

HFRX_Macro

HFRX_RelativeValueArb

HFRX_USConvert

HFRX_USDistrssed

HFRX_USMarketDirectional

HFRX_USMergerArbitrage

HY_Global

HYEM_Sov_Credit

Private_Equity

Property_Equity

ESG control

The Star ESG library provides considerable fl exibility for users to tailor the parameterisation of the ESG to their risk profi le. The model structure and parameters are fully transparent and every line of code is visible. Users can view all model inputs, change the calibration parameters and update the starting yield curves and rates. In addition it is possible to control the ESG output directly using REVO, a tool that allows users to blend their views with the ESG. This works by re-weighting the ESG output simulations, transforming the series towards the target view. It is possible to set coherent targets for multiple economic series and to specify a path of each view. This approach has the benefi t that it is much more simple and intuitive to use than adjusting the ESG calibration parameters directly. REVO has been used to align asset returns with the business plan or fund manager return expectations and is often used for stochastic stress test testing. This can assess the capital impact of extreme ‘what if?’ scenarios such as a rising infl ation and interest rate environments or a period of stagfl ation.

Figure 02. Example inputs

Star ESG 5

Figure 03. Example of results

Correlation Report

Rate in� ation

Wage Inf

Cash Rate

GDP FX FED Rates

Prime Rates

1 Year Spot Rate

4 Year Spot Rate

10 Year Spot Rate

1Y Real Spot Rate

4Y Real Spot Rate

10Y Real Spot Rate

Rate in� ation 100.00% 21.453% 26.560% 3.036% 5.932% 5.932% 28.798% 29.373% 35.185% -39.240% -12.842% -2.015%

Wage Inf 21.453% 100.00% 7.803% 7.919% 6.130% 6.130% 5.395% -0.600% -2.606% -10.339% -12.275% -8.436%

Cash Rate 26.560% 7.803% 100.00% 38.412% 43.812% 43.812% 92.979% 56.663% 31.478% -16.093% 21.548% 10.004%

GDP 3.036% 7.919% 38.412% 100.00% 15.017% 15.017% 41.438% 37.939% 25.104% -16.815% 3.043% 8.445%

FX

FED Rates 5.932% 6.130% 43.812% 15.017% 100.00% 100.00% 43.529% 41.25% 25.349% -3.889% 17.708% 15.430%

Prime Rates 5.932% 6.130% 43.812% 15.017% 100.00% 100.00% 49.529% 41.257% 25.349% -3.889% 17.708% 15.430%

1 Year Spot Rate 28.978% 5.395% 92.979% 41.483% 49.529% 49.529% 100.00% 79.322% 55.836% -7.81% 37.882% 33.252%

4 Year Spot Rate 29.373% -0.500% 56.663% 37.939% 41.257% 41.257% 79.322% 100.00% 89.549% -10.811% 42.899% 56.337%

10 Year Spot Rate 35.185% -2.606% 31.478% 25.104% 25.349% 25.349% 56.836% 89.549% 100.00% -18.130% 29.610% 51.854%

1Y Real Spot Rate -39.240% -10.339% -16.093% -16.815% -3.889% -3.889% -7.817% -10.811% -18.130% 100.00% 67.544% 50.152%

4Y Real Spot Rate -12.842% -12.275% 21.548% 3.043% 17.708% 17.708% 37.882% 42.899% 29.610% 67.544% 100.00% 88.446%

10Y Real Spot Rate -2.015% -8.436% 10.004% 8.445% 15.430% 15.430% 33.252% 55.337% 51.854% 50.152% 88.446% 100.00%

1Y LIBOR Swap Rate 3.434% -3.565% 23.964% -1.112% 10.560% 10.560% 33.417% 33.821% 24.332% 31.476% 40.079% 31.671%

4Y LIBOR Swap Rate 29.825% 0.685% 61.218% 38.638% 33.695% 33.695% 80.780% 92.694% 79.247% -11.326% 37.704% 49.189%

10Y LIBOR Swap Rate 37.536% 1.375% 55.262% 39.718% 27.586% 27.586% 72.596% 88.268% 82.106% -23.390% 25.436% 40.244%

Cred Spread A 4Y 15.512% 8.678% -32.715% -35.194% -24.836% -24.836% -38.101% -50.835% -48.465% 36.298% 4.498% -6.899%

Cred Spread AAA 4Y -14.522% 8.587% -32.735% -33.464% -25.345% -25.345 -37.004% -48.470% -46.071% 35.965% 4.935% -5.520%

Equity Total Return 5.385% 13.567% 16.158% 39.937% 7.110% 7.110% 25.886% 36.671% 30.515% -2.554% 16.012% 27.925%

Equity Dividend Yield -8.065% 6.050% -21.285% 29.109% -20.595% -20.595% -29.076% -39.398% -32.405% 9.763% -15.110% -23.638%

AAA -13.930% 8.618% -32.813% -32.283% -25.471% -25.471% -36.258% -46.814% -44.404% 36.214% 5.585% -4.323%

AA -13.634% 8.297% -32.053% -31.540% -25.693% -25.693% -36.258% -47.070% -44.743% 34.150% 3.926% -5.903%

A -15.217% 8.746% -32.960% -34.663% -24.974% -24.794% -37.875% -50.141% -47.750% 36.603% 4.815% -6.296%

BBB -17.212% 8.539% -32.654% -37.911% -24.567% -24.567% -40.057% -55.182% -52.928% 36.081% 2.710% -10.066%

BB -18.806% 7.320% -30.727% -39.751% -24.405% -24.405% -41.288% -59.696% -57.884% 32.118% -2.263% -16.228%

B -18.712% 6.386% -27.803% -39.369% -23.510% -23.510% -41.327% -62.211% -60.694% 25.822% -7.738% -22.263%

CCC -18.259% 5.627% -19.480% -38.055% -11.547% -11.547% -34.523% -55.679% -54.515% 21.181% -6.016% -21.290%

Property 27.948% 4.031% 53.540% 30.453% 23.019% 23.019% 57.165% 43.473% 30.152% -6.464% 24.539% 22.056%

“The Star library can be deployed to clients as a toolkit run on Towers Watson’s Igloo software platform.”

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7%

6%

5%

4%

3%

2%

1%

0%0 2 4 6 8 10 12 14 16 18 20 22

9%

8%

7%

6%

5%

4%

3%

2%

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Spo

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Term Term

EUR, 31 December 2014USD, 31 December 2014

� 90th percentile � 75th percentile � 50th percentile � 25th percentile � 10th percentile � Mean

Figure 04. Example Projected Spot Rate Yield Curve

Asset modelling

The Star ESG library contains a suite of models for a wide range of asset classes. The assets are valued directly using the yield curves, credit spreads and other economic items feeding directly from the ESG. This preserves coherence between the asset returns and the underlying economic drivers from the ESG so the market risk for the assets and liabilities will be assessed consistently. This is essential for an holistic, fi rm-level framework used for Asset Liability Modelling (ALM) and capital setting. The asset model simulates migrations and defaults for every bond using the stochastic transition matrix generated by the ESG. It is possible to model groups of bonds and individual securities. Rules can be specifi ed for the evolution of the asset portfolio through time. The asset model provides the option to hold bonds to maturity and then reset them, or reset them each quarter or year. At the end of each projection period it is possible to rebalance assets between asset classes and currencies.

To date the asset model includes the following asset classes:

• Government Bonds • Corporate Bonds • Floating Rate Notes • Municipal Bonds • Infl ation-Linked Bonds • MBS and CMO • Equities

• Property • Swaps • Derivatives • Alternative assets, including hedge funds, private equity, commodities.

Supporting regulatory compliance

The Star ESG library supports clients’ regulatory submissions, including Solvency II requirements, to understand, own and use the models. The open architecture, transparent code and documentation allow users to understand each model to a degree that would be impossible in a black box setting. The ability to control the calibration assumptions and blend views using REVO facilitates ownership of the modelling results – an essential prerequisite for developing the trust required to use the model for ALM or for setting business strategy.

Star ESG users are also supported throughout the regulatory process. Star ESG licensees receive documentation corresponding to Solvency II Level 1, Level 2 and Level 3 – detailing models, assumptions, limitations, calibration and validation processes – directly supporting client Solvency II regulatory submissions. In addition the Star ESG team has considerable experience responding to questions and supporting clients in regulatory meetings where helpful.

“The assets are valued directly using the yield curves and credit spreads from the ESG.”

Star ESG 7

Consultancy support

Towers Watson is a leading global consultancy fi rm, providing tailored, value-added investment advice. In addition to providing fi nancial systems such as Star ESG, we provide a full range of investment consulting services to our clients, including advice in the areas of governance, investment risk management, investment strategy, and manager selection and monitoring. We have a global network of over 700 investment consultants. Our professional staff is drawn from a wide variety of backgrounds and disciplines, including actuarial work, fund management, pension scheme management and consulting.

Why choose Star ESG?

Over 60 clients globally, including some of the largest fi nancial services providers, have chosen the Star ESG risk management framework. Star ESG has been chosen as the ESG platform for the following main reasons:

• The technical models generate realistic outputs that can be used to assess risk coherently in an integrated framework, whether for capital setting, business planning or ALM.

• The toolkit transfers control and understanding of the modelling to clients because the code and architecture is transparent. The calibration parameters are all visible and can be changed, while REVO can be used to blend views into the ESG.

• The models and documentation support regulatory submissions, including Solvency II.

• Towers Watson offers a range of consultancy and advisory services to support the tools.

Further information

For further information, please contact:

Sam Worthington +44 20 7227 2058sam.worthington@towerswatson.com

Towers Watson is represented in the UK by Towers Watson Limited and Towers Watson Capital Markets Limited.

The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice.

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Copyright © 2013 Towers Watson. All rights reserved.TW-EU-2013-32294. June 2013.