PD 38

Stress Testing for Insurers

Stuart WasonSenior Director Actuarial Division

OSFI

CIA Annual Meeting, HalifaxJune 26, 2009

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Stress Testing

Agenda:

Lessons learned from financial crises What is stress testing? OSFI expectations Q&A

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Lessons learned from financial crises

Stress testing is a valuable risk management tool

Improved risk management is required

More up-to-date stress testing results are needed

Increasingly, crises are due to systemic inter-connected events

Greater consideration needs to be given to extreme events

Individual insurers can have difficulty identifying industry-wide contagion impacts.

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Lessons learned from financial crises

Insufficient consideration of extreme events

– “It is hard for us without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” August 2007, Joseph Cassano, a former AIG executive

– “Almost no one expected what was coming. It’s not fair to blame us for not predicting the unthinkable.” Daniel Mudd, former chief executive of Fannie Mae

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What is stress testing?

Stress Testing: Generalized process of determining the impact of a change in one or more risk factors on the operations of an insurer.

Scenario Testing: Form of stress testing which uses a hypothetical future state of the world to define the changes in the risk factors affecting the insurer.

Sensitivity Test: Form of stress testing which typically involves an incremental change in a risk factor to determine the impact on an insurer.

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Complexity

Severity

Stress Testing

Single risk/single time period

Many risks/interactions & time periods

Low stress

Severe stress

Scenario testing

DCAT

Sensitivity testing

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OSFI expectations

Strengthened risk management

Robust capital management plan

Scenario types considered

Stress testing used frequently

Earlier DCAT stress testing

DCAT disclosure improved

OSFI stress tests considered

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Strengthened risk management

Stress testing is an important risk management tool

OSFI expects stronger ERM:

– Demonstrate embedding of stress testing in ERM via “use test”

– Stress testing clearly documented & available for review

– Develop & implement stress testing controls

– Notify OSFI expeditiously of material adverse effects from stress testing

– Ability to run stress tests frequently through the year

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Strengthened risk management

OSFI DCAT expectations

– Senior management engagement with DCAT

– Risk management is more than risk identification

– DCAT report experimentation

– Importance of actuarial opinion in DCAT

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Robust capital management plan

Stress testing (including DCAT) is an important part of internal capital management planning

Board sets risk appetite & senior management implements through internal target capital levels

Management should not rely exclusively on complex models

Stress testing should be used to test the vulnerability of assumptions

Management plans should anticipate both severe and more plausible stresses and scenarios

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Scenario types considered Scenarios enable a complete picture of a crisis to

be constructed Some types of scenarios:

– Reverse Scenarios: start with a given loss and make assumptions about a possible event that could give rise to such a loss

– Macro Scenarios: Scenarios that are defined on a global and market wide level Examples: Global downturn of financial markets, Pandemic

– Historical Scenarios: Scenarios that are defined with reference to a past observed event. Example: Influenza pandemic, Tokyo earthquake

– Company Specific Scenarios: Scenarios that are tailor-made for the risk exposure of a specific company

– Narrowly Specified Scenarios: Scenarios that describe a very specific event. It can be easily implemented consistently but might have a very small probability. Examples: A very specific earthquake, defined by location, magnitude etc.

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Stress testing used frequently

Financial conditions can change rapidly - stress tests more than a few months old may not reflect the current economic reality

Prudent ERM practice dictates that insurers review their future financial condition more frequently than once a year

OSFI expects insurers to prepare on a quarterly basis a comprehensive set of “what if” stress tests commencing with Q3 2009 for the largest insurers and Q1 2010 for all other insurers

OSFI should be informed immediately of a significant change in the condition of a company and an updated DCAT report be prepared and filed with the Board and OSFI within 45 days

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Earlier DCAT stress testing

Annual DCAT report expected to be integral part of risk management & strategic planning process

Starting in 2010, OSFI expects that annual stress testing (including the DCAT report), be presented to Board no later than 6 months after year end

For 2009, the reports must be presented no later than 9 months after year end

The reports must be filed with OSFI within 30 days after presentation to Board.

OSFI expects DCAT report to be used to identify risks that must be addressed in planning process -not the other way around

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DCAT disclosure improved

DCAT reports should utilize better practices currently used by some, but not all, insurers, including:– Displaying financial results for each year in the

projection period, not just the beginning and end of period results

– Displaying the results of the adverse scenario both before and after relevant management reaction

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OSFI stress tests considered

Stress testing will be a part of OSFI’s on-going supervisory regime

Stress testing will enable OSFI to,– analyze insurer specific risk exposures– assess the effectiveness of risk management

Stresses or scenarios which impact all companies, can have industry-wide contagion impacts

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OSFI stress tests considered

Consistent application of these macro scenarios across all companies is the best way to identify these systemic impacts

Standardized stresses or scenarios enable OSFI to– analyze market-wide risk exposures in a jurisdiction or

globally

– assess the resilience of each insurer to similar stresses or scenarios.

OSFI will publish list of standardized stress tests, including underlying assumptions, and revise them from time to time

In conducting these tests for OSFI, insurers may wish to consider such scenarios in their own risk management

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In conclusion

Stress testing is an important risk management tool

OSFI is outlining its expectations for stress testing to build on DCAT experience and lessons learned from current crisis

OSFI will continue to work with the industry and the CIA to strengthen risk management

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Questions and Answers

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