The Use Test – A Simple Suggestion
Many are concerned about what the “Use Test” will be. Will it be a pop quiz or will companies be allowed to study?
Well, I have a suggestion for a simple and, I believe, fairly foolproof test. That would be for top management (not risk management or modeling staff) to be able to hold a conversation about their risk profile each year.
Now the first time that they can demonstrate that would not be the “Use Test”. It would be the second or third time that would constitute the test.
The conversation would be simple. It would involve explaining the risk profile of the firm – why the insurer is taking each of the major risks, what do they expect to get out of that risk exposure and how are they making sure that the potential losses that they experience are not worse than represented by their risk model. This discussion should include recognition of gross risk before offsets as well as net retained risk.
After the first time, the discussion would include an explanation of the reasons for the changes in the risk profile – did the profile change because the world shifted or did it change due to a deliberate decision on the part of management to take more or less or to retain more or less of a risk.
Finally a third part of the discussion would be to identify the experience of the past year in terms of its likelihood as predicted by the model and the degree to which that experience caused the firm to recalibrate its view of each risk.
To pass the test, management would merely need to have a complete story that is largely consistent from year to year.
Those who fail the test would be making large changes to their model calibration and their story from year to year – stretching to make it look like the model information was a part of management decisions.
Some firms who might have passed before the crisis who should have failed were firms who in successive years told the same story of good intentions with no actions in reducing outsized risks.
For firms who are really using their models, there will be no preparation time needed for this test. Their story for this test will be the story of their firm’s financial management.
Ideally, I would suggest that the test be held publicly at an investor call.
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