Conducting Solvency II, tests in insurance companies

Autor:María José PéRez-Fructuoso
Cargo:Universidad Carlos III de Madrid

Introduction.What Are Stress Tests?.Designing Stress Tests. Identification Of The Main Risk Factors. a) Insurance risk. b) Market risk.c) Credit risk.d) Operational risk.e) Group risk. f) Systematic risk.Frequency And Time Horizon Of Stress Testing.Applicable Models For Designing Stress And Validation Tests.Conclusions.References.


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The insurance activity is based on the statistical treatment of uncertainty. It therefore behoves all stakeholders to analyse the highest possible number of possible situations or results that might impinge on their current or future financial po sition and jeopardise their solvency and stability.To that end, and following a methodology used by financial institutions, the application of stress tests in risk mana gement might help to ascertain whether or not insurers have the financial wherewithal and operational flexibi lity for assuming losses that might arise from a host of more or less atypical scenarios.

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In recent years, especially after the international financial crises and the appearance of Basel II, supervision authorities and financial institutions have been taking a growing interest in the question of measuring and monitoring vulnerabilities of the financial system, doing so by applying techniques that gauge the effects caused by changes in the main variables affecting this system.These techniques, known as stress tests,were first used in the nineties of last century and have since become widespread in the finance world. Along the same lines the International Association of Insurance Supervisors, (IAIS) drew up a global supervision framework under the name Solvency II (IAIS, 2005) whose aim is to keep insurance markets efficient, fair, firm and stable, thereby guaranteeing the protection of policyholders. Solvency II updates the regulatory requirements for evaluating and supervising the financial situation of insurance companies and their internal mode of operation, taking its cue from the guidance papers drawn up by IAIS (IAIS, 2005). It moots the need for fundamental changes in regulating the solvency regime of Europe’s insurance companies, since the great variety of risks existing today can no longer be dealt with by the simplified standards laid down in the previous project, Solvency I (Pérez-Fructuoso, 2005).

Furthermore, in terms of risk management and assessment, the IAIS document called «Insurance core principles and methodology» (2003) expressly lays it down that the supervisory authority should require insurers to recognise the range of risks that they face and to assess and manage them effectively. It also requires insurers to undertake regular stress testing for a wide range of adverse scenarios to ascertain the adequacy of capital resources in case technical provisions have to be increased.As a result of this rethink, the IAIS’s 2003 document called «Principles on capital adequacy and solvency» lays down a series of fundamental principles solvency» lays down a series of fundamental principles underpinning the solvency regime to ensure the proper regulation and supervision of insurers.Among the principles referred to therein, stress tests are deemed to be especially relevant to the following ones:

* Capital adequacy and solvency regimes have to be risk sensitive and rounded out with integral risk management systems.

* The technical provisions of an insurer have to be adequate, reliable, objective and allow comparison across insurers.

* The insurer’s assets have to be appropriate, sufficiently realisable and objectively assessable.

* Capital requirements are needed to absorb losses that might derive from technical and other risks.

* Capital adequacy and solvency regimes have to address the matching of assets with liabilities, have to define themselves as risk sensitive and should be supported by appropriate disclosure methods.This entails the replacement of traditional solvency methods by modern systems that incorporate all-in management of the risks any insurer faces and ensure supervision thereof by the competent authorities. Here is where stress tests come into their own as well as different levels of control, including control of the required degree of solvency.

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The concept of stress testing takes in a set of mathematical and statistical techniques for quantifying the vulnerability of a financial or insurance institution to any significant change in the economic environment it operates in, with the aim of ascertaining potential losses that might affect the solvency thereof.The complexity of the tests varies in line with the information to hand, the type of market and the depth of the institution’s risk management and administration.This article analyses how stress tests should be conducted as part of all-in insurer risk management and how these tests may help to establish and maintain the minimum capital and solvency requirements laid down by Solvency II.

What Are Stress Tests?

Stress testing is a generic term normally used to describe a set of techniques applied in financial and insurance institutions, the aim of which is to ascertain their potential level of economic and financial vulnerability in the event of certain exceptional but plausible scenarios. Stress tests help insurance companies to manage their risks and maintain enough financial resources to cover them, doing so by identifying and quantifying different complex scenarios based on expected future financial positions.These tests estimate the quantitative impact of adverse exceptional but plausible disturbances on those variables that affect the results and solvency of an insurer or group of insurance companies (IAIS, 2003).

Generally, in the insurance context, the term stress testing includes two types of analysis: sensitivity and scenarios.The objective is to ensure that insurers have sufficient data for a better understanding of the vulnerabilities they face under unlikely but not impossible atypical conditions.These stresses might be financial, operational, legal, liquidity-based or be related to any other risk that might have an adverse economic impact on the insurer. Simple sensitivity tests are used to estimate the impact of one or more moves in a particular risk factor, or in a small number of closely linked risk factors, on a financial or insurance institution’s portfolio or business unit or the future financial condition of the insurer.

Scenario testing, for its part, quantifies the effect of a simultaneous move in diverse risk factors.The scenarios may be based on significant market events occurring in the past or on estimates of the consequences of a an event or possible variations on market conditions that have not yet occurred.The first type are called historical scenarios and the second, hypothetical scenarios (KPMG, 2002).

Historical scenarios reflect the changes in risk factors that have occurred at given moments of history. The simplest way of defining these scenarios is to identify specific periods of time (days or months) that were particularly extreme in terms of volatility or variability of risk factors and then observing their effects on insurers.After weighing up all the consequences of this past shock, the conclusions are then brought to bear on the company’s present situation, measuring or quantifying the effect and consequences both on the individual firm and the whole insurance market under analysis.The main advantage of historical scenarios is that the risk-factor changes brought under the spotlight actually occurred rather then being arbitrarily chosen; this grants them a certain aura of trustworthiness on the premise that history usually repeats itself. Furthermore, this method is very transparent because the past events and consequences under study and brought to bear on the present usually have well-known outcomes.The drawback is precisely the fact that they are based on the assumption that past events will reoccur in the future and ipso facto that the risk factors will always behave the Page 5 same; this is not necessarily so.Another disadvantage of this method is that it is hard to assess new products when by definition they could not possibly have been involved in the past effects and variations under study.

Hypothetical scenarios, on the other hand, are based on a set of shocks that are thought to be plausible but have not yet in fact occurred, thus covering the lacunae of the previous method. It should be borne in mind here, however, that hypothetical scenarios are always based on some hypothesis of historical behaviour.

For example, any estimation of the contagion effects...

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