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DEFINITION OF STOCHASTIC MODELING


A stochastic model is a tool for estimating probability distributions of potential outcomes by allowing for random variation in one or more inputs over time. The random variation is usually based on fluctuations observed in historical data for a selected period using standard time-series techniques. Distributions of potential outcomes are derived from a large number of simulations (stochastic projections) which reflect the random variation in the input(s). Therefore, the valuation of an insurer involves a set of projections, looking at what is expected to happen, and thus coming up with the best estimate for assets and liabilities, and therefore for the company's level of solvency.

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