0 0 © 2013 Quantitative Risk Management, Inc.

Dynamic Stress

Testing for an

Insurance

Company

Chicago | London | Singapore

1 1 © 2013 Quantitative Risk Management, Inc.

I. Introduction

II. Defining and applying a stress testing framework

III. Advancing stress testing in the organization

IV. Summary

Dynamic Stress Testing

for an Insurance Company

2 2 © 2013 Quantitative Risk Management, Inc.

Insurance products, insurance company balance sheets

and the surrounding economic environment will each

continue to dynamically evolve

Market-sensitive demand for insurance products

Rapidly changing global capital markets

Evolving solvency regulations

Extreme scenarios can be far ranging, both good and bad

Plausible scenarios are those that could happen AND an

organization could reasonably prepare for

Dynamic stress testing must model changes to the

organization (business mix) and the economy (scenarios)

Dynamic Stress Testing Evaluates the Impact of

Extreme Yet Plausible Scenarios Through Time

3 3 © 2013 Quantitative Risk Management, Inc.

What risk exposures does the company have now?

What risks does the company want to run?

What can the company do now to remove unwanted risks?

How can the company prepare for the retained risks?

How can the company prepare to take advantage of

potential opportunities?

Dynamic Stress Testing Can Initiate and Frame

Conversations on Risks and Opportunities

4 4 © 2013 Quantitative Risk Management, Inc.

Stress Testing is Increasingly Recognized by Industry

Stakeholders as a Key Component of ERM

North American CRO Council identifies stress

testing as a component of a strong ERM program NAIC ORSA Guidance Manual March 2013

Section 2: Insurer Assessment of Risk Exposure

“… assessments of risk exposure in both normal

and stressed environments.”

Section 3.B: Prospective Solvency Assessment

“… prospective solvency assessment should also

consider both normal and stressed environments.”

Fed stress tests apply to insurance companies

classified as non-bank SIFI’s

5 5 © 2013 Quantitative Risk Management, Inc.

I. Introduction

II. Defining and applying a stress testing framework

III. Advancing stress testing in the organization

IV. Summary

Dynamic Stress Testing

for an Insurance Company

6 6 © 2013 Quantitative Risk Management, Inc.

Single or multiple factors

Historical or hypothetical

Local or global

Sudden or gradual

Temporary or structural

Deterministic or stochastic

Standalone or cascading

Stress Testing Requires a Feedback Loop

Identification of

stress scenarios

Qualitative analysis of

exposures

Projection and

analysis of

economic impact

Policyholders and

products

Credit counterparties

Equity and alternative

investments

Employees

Processes

Liquidity

Capital

Earnings

Sales

Brand and reputation

7 7 © 2013 Quantitative Risk Management, Inc.

Stress Scenarios Often Reveal Indirect and

Cascading Risks and Opportunities

Cash

surrenders

RMBS cash

flow timing

Rates

Up Collateral

calls

Credits paying a

floating rate Financial sector

credit quality

Derivatives

counterparty

exposures

Short-term

funding costs

Residential

housing credit

Credit asset availability at

longer maturities

Impacts to premium flows in flex-premium

products

New sales of

existing

products

Credited rate changes to drive

retention

Draws on

private equity

commitments

Hedge costs

Product designs

fit for the new

environment

(Re)emergence

of asset

classes

Assumptions driving growth

8 8 © 2013 Quantitative Risk Management, Inc.

Deterministic stress testing may not reveal all ruinous

scenarios

Reverse stress testing starts with a ruinous result and

backs into a corresponding economic scenario

Stochastic economic capital analysis reveals tail scenarios

exceeding the level of capital

The ruinous stochastic scenarios can serve as a basis for

formulation of other deterministic scenarios

Best Practice Leverages Stochastic Analysis

For Reverse Stress Testing

9 9 © 2013 Quantitative Risk Management, Inc.

Proper Stress Testing Is Embedded Within All

Levels of the Organization

Annuity

Business

Units

Life

Insurance

Business

Units

Investment

Portfolios

Business units / Portfolios

ERM /

Capital

Mgmt

Finance /

Corporate

Actuarial

Board of

Directors

Global functions

Executive

Committees

Investment

Portfolio

Mgmt

Express hard-to-quantify risks

Identify gaps in product hedging programs

Discover risks in new product designs

Evaluate pricing of new products

Capital validation and planning

Risk mitigation strategies

Contingency planning

Communication with regulators

Risk appetite and tolerances

Strategic sales planning

Communication with rating agencies

Executive leadership

10 10 © 2013 Quantitative Risk Management, Inc.

Contingency plans should help management navigate

through a variety of stress scenarios

Business continuity plans

Liquidity plans

Capital plans

Stress testing can help define and test the basic elements

of a contingency plan

Triggers for activating a contingency plan

Available set of achievable actions

Potential sequences of actions

Clear responsibilities for decisions

Rigorous Stress Testing Facilitates Formulation

and Evaluation of Contingency Plans

11 11 © 2013 Quantitative Risk Management, Inc.

I. Introduction

II. Defining and applying a stress testing framework

III. Advancing stress testing in the organization

IV. Summary

Dynamic Stress Testing

for an Insurance Company

12 12 © 2013 Quantitative Risk Management, Inc.

Collaborative and comprehensive

Reflect realistic expectations of behavior

Consistent and integrated

Properly sized and nimble

Complementary to other processes

Credible and Sustainable Stress Testing

Processes Incorporate Key Attributes

13 13 © 2013 Quantitative Risk Management, Inc.

A “Hub and Spoke” Approach Enables

Collaboration and Comprehensive Analysis

Investment

Mgmt

ERM /

Stress

Testing

ALM /

Finance

Business

Units

Broad, coordinated involvement

enhances credibility and

applicability of analysis

Business units and Investment

Management offer expertise on

respective markets and products

ALM / Finance can offer global

perspectives on interest rate risk,

and centralized modeling tools

ERM offers specialized stress

testing advice, an unbiased

perspective and complementary

analytical tools

14 14 © 2013 Quantitative Risk Management, Inc.

Covering all parties with options linked to economic states

Policyholders, both current and prospective (new sales)

Investment counterparties

Company management

Competitors

Under a broad range of conditions through time

Using expert judgment for environments with no close precedent

Reflecting sufficient conservatism

Stress Testing Requires Realistic

Behavioral Estimates of Decay and Growth

15 15 © 2013 Quantitative Risk Management, Inc.

Organizations face challenges when following an

“aggregation” approach to stress testing

Questionable consistency of analysis

Limited integration of assets and liabilities

Difficulties with iterative analysis and/or rapidly changing scenarios

Effective stress testing is an extension of a strategic

financial planning process

Models both assets and liabilities

Incorporates existing and new business

Projects financial statements

Integration of risk management with strategic planning

processes is consistent with NAIC ORSA guidance

Stress Test Analysis Needs to be

Consistent and Integrated

16 16 © 2013 Quantitative Risk Management, Inc.

Dynamic modeling assumptions enable quick response to

any scenario

Centralized modeling to any extent possible enables faster

turnaround

Leverage modeling proxies coupled with expert judgment

Replicating portfolios

Response functions

Companies Must Balance Response Time with Analytical

Precision for Nimble Yet Rigorous Stress Testing

17 17 © 2013 Quantitative Risk Management, Inc.

Product development

Identification of product designs potentially fit for stressed environments

Identification of potential for exploitation of gaps in product design

Pricing and profitability analysis

Evaluation of wide ranges of potential policyholder behavior

Evaluation of gaps in hedging programs

Financial planning and forecasting

Evaluation of potential deviation from organization’s planned goals

Investment portfolio management

Determination of constraints in strategic asset allocation analysis

Capital management

Validation of capital estimates

Evaluation of a capital plan

Stress Testing Needs to be Complementary

With Other Key Processes

18 18 © 2013 Quantitative Risk Management, Inc.

I. Introduction

II. Defining and applying a stress testing framework

III. Advancing stress testing in the organization

IV. Summary

Dynamic Stress Testing

for an Insurance Company

19 19 © 2013 Quantitative Risk Management, Inc.

Broadens the perspective on risks and opportunities

Incorporates dynamic behavior, including new business

Needs to be integrated into everyday decisions at all levels

of the firm

Plays a complementary role in a risk management

framework

Needs to be a continuously evolving and sustainable

process

Dynamic Stress Testing

20 20 © 2013 Quantitative Risk Management, Inc.

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