What kind of Stress Test?

What kind of future were you thinking of when you constructed your stress tests?  Here are six different visions of the stressed future that have been the basis for stress tests.

  • Historical Worst Case – Worst experience in the past 20 – 25 years
  • Normal Variability – Stress falls within expected range for a normal five year period
  • Adverse Environment Variability – Stress falls within expected range for a five year period that includes general deterioration such as recession or major weather/climate deviation
  • Future Realistic Disaster – Worst experience that is reasonably expected in the future (even if it has never happened)
  • Adverse Environment Disaster – Worst experience that is reasonably expected in the future if the future is significantly worse than the past
  • Future Worst Case – Maximum plausible loss that could occur even if you believe that likelihood is extremely remote

Here are a long list of stress scenarios that comes from the exposure draft of the NAIC document for ORSA reviewers:

1. Credit

• Counterparty exposure (loss of specified amount to reinsurer, derivatives party, supplier)
• Equity securities (40%/50% drop, no growth in stocks in 3 years)
• General widening of credit spreads (increase in defaults)
• Other risk assets

2. Market

• 300 basis point pop up in interest rates
• Prolonged low interest rates (10 year treasury of 1%)
• Material drop in GDP & related impacts
• Stock market crash or specific extreme condition (Great Depression)
• Eurozone collapse
• U.S. Treasury collapse
• Foreign currency shocks (e.g. percentages)
• Municipal bond market collapse
• Prolonged multiple market downturn (e.g. 2008/2009 crisis/or 1987 stock market drop-or 50% drop in equities, 150bp of realized credit losses)

3. Pricing/Underwriting

• Significant drop in sales/premiums due to varying reasons
• Impact of 20% reduction in mortality rates on annuities
• Material product demonstrates specific losses (e.g. 1 in 20 year events)
• Severe pandemic (e.g. Avian bird flu based upon World Health Organization mortality assumption)
• California and New Madrid earthquakes, biological, chemical or nuclear terrorist attacks in locations of heaviest coverage (consider a specified level of industry losses)
• Atlantic hurricane (consider a specified level of industry losses previously unseen/may consider specified levels per different lines of coverage) in different areas (far northeast, northeast, southeast, etc.)
• U.S. tornado over major metropolitan area with largest exposure
• Japanese typhoon/earthquake (consider a specified level of industry losses previously unseen)
• Major aviation/marine collision
• Dirty bomb attack
• Drop in rating to BB

4. Reserving

• Specified level of adverse development (e.g. 30%)
• Regulatory policy change requires additional reserves (e.g. 30%)

5. Liquidity • Catastrophe results in material immediate claims of 3X normalized amounts
• Call on any existing debt
• Material spike in lapses (e.g. 3X normal rates)
• Drop in rating to BB

6. Operational

• Loss of systems for 30 days
• Terrorist act
• Cybercrime
• Loss of key personnel
• Specified level of fraud within claims

7. Legal

• Material adverse finding on pending claim
• Worst historical 10 year loss is multiplied at varying levels

8. Strategic

• Product distribution breakup

9. Reputational

• PR crisis
• Drop in rating to BB

These seem to RISKVIEWS to fall into all six of the categories.  Many of these scenarios would fall into the “Normal Volatility” category for some companies and into the worst historical for others.  A few are in the area of “Future Worst Case” – such as the Treasury Collapse.

RISKVIEWS suggests that when doing Stress Testing, you should decide what sort of Stress you are intending.  You may not agree with RISKVIEWS categories, but you should have your own categories.  It might be a big help to the reader of your Stress Test report to know which sort of stress you think that you are testing.  They may or may not agree with you on which category that your Stress Scenario falls into, and that would be a valuable revealing discussion.

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