Computer Simulation in Financial Risk Management: A Guide for Business Planners and Strategists

Much of what goes on in the insurance business in assessing risks and determining premiums to cover such risks is done by actuaries. It is not the intention of this chapter to suggest that computer simulation be used alongside of, or be substituted for, actuarial calculations. Simulation should be considered only for those situations where actuarial calculations fail to provide a solution. This fits the philosophic thought of simulation being the last resort of mathematicians in attempting to obtain a quantitative solution to a problem. This may even avoid piquing the sensitivities of an established profession.

The calculation of risk premiums and adequate reserves to provide for some degree of intended coverage against a potential loss falls under the rubric of financial risk management. The presentation of risk management in providing protection against a potential loss is in terms of self-insurance, not in terms of the purchase of insurance from an independent insurance company. This choice should not be construed as an endorsement of such a course of action, but to simplify the description of insurance as it pertains to financial risk management. There is no confusion over who is benefiting and who is paying for laying off the risk of a situation when, for instance, banks band together to self-insure against potential defaults in a portfolio of loans.

Addressing the subject matter in terms of self-insurance avoids the issue of government regulation of the insurance industry. Other issues that are not addressed are the operating costs of an insurance company and the competitive nature of the insurance business. Insurance companies recoup their operating costs by an "add-on" to the premium rate. This "add-on" and the premium rate affect the competitiveness of an insurance company in its market environment. The derivation of a risk premium in this chapter is strictly from the point of view

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