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Steering Committee
Position Paper 961 (v 4)
General Stress Testing Guidance for Insurance Companies
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Position Paper 96 (v 4) was approved as a FINAL Position Paper by Steering Committee on 24
February 2014.
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Mention here the relevant ICP’s and ORSA text
Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
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Discussion Document 71 v5
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
Comprehensive stress testing programs should consider the insurer’s most material
risks and aim to take into account system-wide interactions and feedback effects
(e.g. second order and macroeconomic effects).
This means that the identified scenarios should not only consider the initial strain, but
also the sequence of effects that can play out over months and years. However, it is
difficult, if not impossible, to think through all the possible ramifications of such an
event. The purpose of assessing a scenario is less about predicting a future event
than it is about getting an insurer to think in advance about certain types of events
and to be prepared if a similar (but not necessarily identical) scenario was to occur. It
is therefore sufficient that the formulation of the scenario captures the essence of the
effects of an initial disruptive event.
Where relevant and material, such risks may include:
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
A reverse stress test starts with a specified outcome that challenges the viability of
the insurer. One example of such an outcome would be that over a short time period,
the insurer incurs a very large loss that challenges its viability. The analysis would
then work backwards (reverse engineered) to identify a scenario or combination of
scenarios that could bring about such a specified outcome. The reverse stress test
induces insurers to consider scenarios beyond normal business settings that would
include events with contagion and systemic implications.
As described earlier in the document, a stress testing program should also determine
what scenarios could challenge the viability of the insurer (reverse stress tests). A
firm’s business model is described as being unviable at the point when crystallising
risks causes the market to lose confidence in the firm. A consequence of this would
be that counterparties and other stakeholders would be unwilling to transact with or
provide capital to the firm and, where relevant, that existing counterparties may seek
to terminate their contracts. Such a point could be reached well before a firm’s
regulatory capital is exhausted.
Specific consideration should be given to important inter-relations between various
risk factors. For a long-term insurer, changes in economic conditions can
significantly affect policyholder behaviour such as lapse rates, utilisation of options
within an insurance contract, and morbidity and recovery rates. For a short-term
insurer, changing economic conditions will not only influence investment income and
company expenses, but can also lead to higher claims and loss reserves, particularly
in times of inflation. The inter-relations of various factors will depend upon the
insurer’s products, its investment policy and its approach to managing its business.
A critical goal for insurers is to identify situations in which the assumed normal
pattern of inter-relationships breaks down due to a change in the business
environment.
4.1.3 Historical scenarios
A historical scenario is based on an observed historical event. A major advantage of
a scenario based on a historical event is that it can be more easily communicated
since the event has actually occurred.
As a further advantage, since such a scenario is based on an observed event, data
with regards to its short-, medium-, and long-term impact might be available. In
particular, the impact of the event on other risk factors, such as interest rates, equity
markets, and inflation can be studied, as can its pre-history, i.e. the history leading
up to the event.
Clearly, the circumstances surrounding the historical event will be different to the
current situation. Therefore, in constructing the scenario, appropriate adjustments
need to be applied. In many scenarios, financial values will have to be adjusted for
inflation to make the values more consistent with current values. Great care has to
be taken when a historical scenario relates to the financial markets. Financial
markets are constantly evolving and an event that had little impact in the past might
have a big impact now or vice versa.
Other examples of factors that require adjustment in historical scenarios include:
Changes in population movement
Medical advances
New technologies
Globalised and more closely linked financial markets
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
Such adjustments cannot realistically consider all differences between the present
situation, and that of the historical scenario. The idea is to use historical events as
best as possible, given the limitations, to assist in dictating scenarios.
4.1.4 Synthetic scenarios
In contrast to historical scenarios, synthetic scenarios describe events which have
not yet been observed and which thus can be more easily tailored to a specific
situation of the insurer. Synthetic scenarios require more assumptions than historical
scenarios. For this reason they are subject to more questioning and can be more
difficult to communicate and discuss both within the company and with third parties.
4.1.5 Formulation of scenarios
A scenario needs to be formulated such that the financial impact on the insurer can
be calculated. The first step in formulating a scenario is to explain it in a concise,
understandable narrative that outlines the initial event and the potential effects
cascading from it. The narrative should explain the key assumptions and
simplification that have been made. It should focus on the qualitative aspects of the
scenario but also include the major quantitative assumptions.
The qualitative formulation describes the effects of the initial event over the duration
of the scenario. If relevant, this also includes a description of the effects not only of
the risk factors, which affect the firm directly (e.g. mortality rates, claims, interest
rates, etc.), but also the effects on other market participants.
The sequence in which events occur can be of major consequence for the financial
impact on the insurer. The qualitative description therefore should not only contain
the sequence of effects but also a time-line. This is particularly relevant for
scenarios, which evolve over months and years or in which the effects of actions that
management would take are to be included in the evaluation of the scenario.
Many risk factors which enter into scenarios exhibit dependencies or relationships.
When formulating a stress scenario, it is important to incorporate dependencies as
they exist in stressful circumstances. Experience has shown that in many situations
dependencies under stressed situations are different from dependencies under
normal situations. In practice, dependencies under stress will usually not have been
observed. It would therefore then be necessary to model them based on informed
judgement.
It should also be noted that the Solvency Capital Requirement (SCR) calculation
under the standard formula of the Solvency Assessment and Management (SAM)
regime is a defined stressed scenario.
4.1.6 Risks not covered in the regulatory capital formula
Certain risks an insurance company faces cannot be appropriately quantified, since
their likelihood of occurring is highly uncertain or there is no underlying scientific
theory. However, they do have quantifiable consequences that can have strong
effects on a firm’s financial condition.
An example of a risk with a highly uncertain probability of occurrence is reputation
risk. The likelihood of financial loss due to loss of reputation depends on the firm’s
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
strategy, the behaviour of its senior management, operational risks etc. However,
while it is difficult, if not impossible, to give a reasonable close estimate of the
probability of this occurring, the financial damage once such a reputational loss
happens can be expressed numerically. Such damage may affect policyholder
behaviour (lapse rates), new business volume, employee turnover or productivity,
relations with suppliers, and regulatory actions. All of these effects will have financial
consequences. In order to consider the effects of such a risk, one must construct a
scenario that describes the situation and its impact on various financial elements of
the insurer’s operations.
pursuing similar risk mitigating strategies. Stress testing should also reflect
constraints on management action and should not place undue reliance on the
timeliness of mitigating actions. Factors such as company history and philosophy,
competitive position and policyholders’ reasonable expectations can have important
effects on the timing of proposed action.
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Solvency Assessment and Management: Steering Committee
Position Paper 96 (v 4) - General Stress Testing Guidance for Insurance Companies
SELECTED REFERENCES
The following list includes some of the works referred to in the paper.
Financial Services Authority (FSA). Policy Statement 09/20 Stress and Scenario
Testing – (December 2009).
International Association of Actuaries (IAA). Paper on Stress Testing and Scenario
Analysis.
International Association of Insurance Supervisors (IAIS). Stress Testing by Insurers
Guidance Paper (October 2003).
Office of Superintendent of Financial Institutions Canada (OSFI). Guideline Stress
Testing (December 2009).
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