After reading this article you will learn about the stress test which is a risk management tool adopted by insurance companies.
Stress Test:
The business of insurance is based on dealing with uncertainty. Therefore, an insurer needs to consider a wide range of possible changes that may affect its current and expected future financial position. Stress test is a necessary risk management tool to ascertain whether it is financially flexible to absorb possible losses that could occur under various scenarios.
All the effects of stress testing, both direct and indirect, should take into account both sides of the balance sheet. It should help the insurer in making decisions as to whether, and what, action is needed to ensure that it is not taking undue risks from its own or the policyholders’ perspective. The insurer should use stress testing for strategic planning and for contingency planning also.
Scope of Coverage:
Stress testing includes both sensitivity testing and scenario testing. Both approaches are undertaken by insurers to provide a better understanding of the vulnerabilities. They are based on the analysis of the impact of unlikely, but not impossible, adverse scenarios. These stresses can be financial, operational, legal, liquidity or any other risk that might have an economic impact on the insurer.
The sensitivity test estimates the impact of one or more changes in a particular risk. On the other hand a scenario test is a more complicated test, to examine simultaneous moves in a number of risk factors linked to explicit changes. The Scenario tests examine the impact of catastrophic events on an insurer’s financial condition.
There are two basic types of scenarios:
i. Historical and
ii. Hypothetical.
Historical scenarios reflect changes in risk factors that occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks that is thought to be plausible, but has not yet occurred. Each type of scenario has its benefits.
Depending on the risks, both approaches could be of value and should be used. An analysis of extreme scenarios is needed to gain a comprehensive view of the risk assumed in order to measure the effects of unusual or extreme movements. There are numerous techniques that can be used including Monte-Carlo simulation approaches.
Insurer should have expertise and technology required to design and performs stress tests. This may involve a specialized risk management skill, actuarial personnel or external consultants. Insurer shall design its stress tests considering its own risk profile and the complexity of its business.
Various considerations are likely to determine the nature and extent of tests required.
They include the insurers:
1. Solvency position
2. Lines of business and distribution systems
3. Current position within the market
4. Current position within the group
5. Investment policy
6. Business plan
7. General economic conditions
The purpose is that the insurer should be able to withstand adverse circumstances that are reasonably foreseeable. Insurance risks may be underwriting risk, catastrophe risk, or the risk of deterioration of technical provisions.
Underwriting Risk:
Insurance risk primarily relates to risk of inappropriate underwriting strategy, inappropriate pooling of risks, adverse selection or inadequate implementation. Unexpected losses may also arise even when an appropriate strategy is properly implemented. Hence the first and foremost factor is, underwriting risk.
The insurer should satisfy itself that it can charge adequate rates, (premium) taking into account the nature of business, terms of the policies, options or guarantees, etc.
Risk can also arise:
(i) Out of rapid growth or decline in underwriting
(ii) Uncertainty in claims experience, and size of large claims
(iii) The length of tail of the claims and latent claims (Disputed long drawn claims)
(iv) Over dependence on certain intermediaries for a disproportionate share of the insurer’s premium income
(v) Possibility of reinsurance rates increasing substantially or becoming unavailable
(vi) Lack of information needed to make a proper assessment of the risk and to decide on premium
(vii) Geographical concentrations
(viii) Low tolerance for variations in expenses, including indirect costs, such as overheads
(ix) Catastrophe risk is a headache to any insurer. The ability of the insurer to withstand catastrophic events, increase in unexpected exposures and claims and manage them successfully is critical.
(x) Possible exhaustion of reinsurance arrangements or unavailability is a serious problem.
Risk of Fall or Deterioration of Technical Provisions:
The issues on provision relate to adequacy of the claims provisions, outstanding claims, incurred but not reported claims and claims handling expense, provisions for unearned premiums and unexpired risks, frequency and size of large claims and disputed claims
Market Risk:
Market risk is concerned primarily with adverse movement in the value of the assets as a consequence of market movements of interest rates, foreign exchange rates, equity prices, etc., more often it is not offset by a corresponding movement in the value of the liabilities.
Group Risk:
The membership of an insurer in a group can be a potential source of strength to the insurer, but it can also pose risks, particularly as a result of difficult market conditions and the insurer may be unable to access additional capital or repatriate funds.
The adverse effect on the insurer of an impaired parent or affiliate within the group, failure or downgrading of one or more big insurers in a market could result in market or reputation risks for other insurers. So also the failure or downgrading of one or other financial institutions, such as banks, could affect an insurer’s operations.
Frequency Stress Testing:
It is normally appropriate to perform stress testing annually, but more frequent stress testing may be appropriate for an insurer with a high risk profile.
Modelling Techniques used in Stress Testing:
Various modelling used are based on static or dynamic modelling and deterministic or stochastic approaches. Static modelling implies that the analysis of the insurer’s financial position is at a fixed point in time, whereas dynamic modelling takes into account developments over a certain time period, and deterministic models examine the financial impact if a certain scenario occurs.
The stochastic models also take into account the probability of various scenarios occurring. Modelling provides an indication of the range and the likelihood of different financial outcomes occurring. Risks are seldom totally independent or totally related. The insurer should examine the correlations among various risks. Despite the advantages and necessity there are Limitations to stress tests. An insurer should take note of it in risk management.