How Can Insurance SIFIs Overcome the Challenges of the Fed Stress Testing?


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If the banking experience is anything to go by, insurance SIFIs are going to face major challenges in preparing for and implementing the Fed stress testing. This presentation identifies and proposes solutions to these challenges, referencing our experience of working with the banks to address their stress testing needs and putting this in the specific context of an insurance operation.

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How Can Insurance SIFIs Overcome the Challenges of the Fed Stress Testing?

  1. 1. Overcoming the Challenges of Insurance SIFI Fed Stress Testing Originally presented at the 3rd Annual Risk Americas Summit | May 12, 2014
  2. 2. 2Stress Testing & Capital Planning for Insurers – March 2014 Agenda 1. Insurance vs. Banking 2. Stress Testing Pain Points for an Insurer 3. Focus Area 1: Scenario Design 4. Focus Area 2: Speed 5. Q&A
  3. 3. 3Stress Testing & Capital Planning for Insurers – March 2014 Insurance vs. Banking1
  4. 4. 4Stress Testing & Capital Planning for Insurers – March 2014 Insurance vs. Banking There are a number of reasons why the insurance Fed stress testing experience is going to be different to what the banks have been going through: » Financial Accounting – An Insurer’s income statement and balance sheet look very different to a bank’s. » Model Sophistication – An Insurer’s projection models are already quite sophisticated, such that an Insurer must build from existing capabilities. This is different to where many banks stood at the advent of the stress-testing process. » Scenario Design – Current FRB stress scenarios do not mean a lot in an insurance projection model – so development of enhanced or custom scenarios will be needed to properly capture and model insurance risks.
  5. 5. 5Stress Testing & Capital Planning for Insurers – March 2014 Insurance vs. Bank Forecasted Values BANK INSURANCE COMPANY COROLLARY Interest Income -------> Investment income and capital gain on assets - Interest Expense -------> - Policyholder claims + Non-Interest Income -------> + Policyholder premiums - Non-interest Expense -------> - Expenses and commissions = Pre-Provision Net Revenue = Pre-Tax Earnings before changes in reserves - Provisions -------> - Increase in Reserves = Pre-Tax Net Income = Pre-Tax Earnings - Tax -------> - Tax = After-Tax Net Income = Earnings net of tax The financial accounting line items between a bank’s financial statements and those of an insurer are different and need to be treated differently.
  6. 6. 6Stress Testing & Capital Planning for Insurers – March 2014 Stress Testing Pain Points for an Insurer2
  7. 7. 7Stress Testing & Capital Planning for Insurers – March 2014 Stress Testing: Recognized and Anticipated Pain Points Insurers already have the ability to project Income Statement and Balance Sheet items over deterministic and stochastic scenarios using standard actuarial projection systems. But there are pain points specific to stress-testing that these systems alone will not resolve: » Data and Process Management - Fed stress testing necessitates the management of big data volume and creates process management challenges. » Report Aggregation - Consolidation of reports from multiple LoBs with the required audit trails and internal controls. » Scenario Design - Fed stress scenarios will need to be converted into something that is meaningful in the context of an insurance projection and supplemented by custom scenarios. » Documentation - Documenting supporting analysis and judgment required in developing appropriate projection assumptions for type of product issued, new business volumes and management actions. Based on what we have seen the Fed expects of the banks, insurers are going to need to move up a notch their quality of documentation. » Speed - Especially for VA GLB products, excessive model run-time will need to be addressed when projecting reserves.
  8. 8. 8Stress Testing & Capital Planning for Insurers – March 2014 Focus Area 1: Scenario Design3
  9. 9. 9Stress Testing & Capital Planning for Insurers – March 2014 Aspects of Scenario Design There are two key aspects to scenario design » Stress scenario generation – Insurers will need to convert a given Fed stress or company specific “narrative” into a fully articulated scenario set that can be understood by the Insurer’s projection system and appropriately captures all the risk exposures. For example, it is not enough to say the short rate will stay at 1% for the next n years; in order to capture fully interest rate risk a projection of the full yield curve will be required » Development of company-specific stresses that supplement the Fed stresses – In addition to the stresses that the Fed specifies, firms are required to do supplementary stresses that recognize the specific risks to which they are exposed that may not be picked up by the specified Fed stresses
  10. 10. 10Stress Testing & Capital Planning for Insurers – March 2014 Stress Scenario Generation » Need to translate macro/narrative scenarios to scenarios relevant for Insurers – For example, how do you go from a single macro interest rate stress  full yield curve  continuous time stochastic/statistical model needed for insurance product analysis? » What scenarios are in scope? – Interest rates? – Equities? – Mortality risk? – Longevity risk? – Lapse risk? – Cat risk? – Etc. » Relationship across stress scenarios – Are stressed scenarios fully consistent/integrated across risk variables – Flu pandemic  drop in equity markets
  11. 11. 11Stress Testing & Capital Planning for Insurers – March 2014 Development of Scenarios that Supplement the Fed Stresses: Critical to get the Stresses Right for your Line of Business 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 2011 2012 2013 2014 2015 2017 CTE70Reserve Baseline forecast Stronger Near-Term Rebound Slower Near-Term Growth Double-Dip Recession Protracted Slump Below-Trend Long- Term Growth Oil Price Increase, Dollar Crash Inflation Using Moody’s Analytics Economic and Consumer Credit Analytics (“ECCA”) Macro scenarios and financial impact on CTE Reserves for UL line
  12. 12. 12Stress Testing & Capital Planning for Insurers – March 2014 “Narrative” stresses » Japan Scenario (“Narrative 1” or “N1”) – Start: 12/31/1989 – End: 12/31/2012 – Deterministic scenario = 276 months, forward-looking projection = 444 months. » Great Depression Second Dip (“Narrative 2” or “N2”) – Start: 06/30/1936 – End: 12/31/1938 – Deterministic scenario = 30 months, forward-looking projection = 690 months. » Post WWII period of financial repression (“Narrative 3” or “N3”) – Start: 12/31/1945 – End: 12/31/1955 – Deterministic scenario = 120 months, forward-looking projection = 600 months.
  13. 13. 13Stress Testing & Capital Planning for Insurers – March 2014 Focus Area 2: Speed4
  14. 14. 14Stress Testing & Capital Planning for Insurers – March 2014 Bank vs. Insurer Forecasted Variables INSURANCE COMPANY Investment income and capital gain on assets - Policyholder claims + Policyholder premiums - Expenses and commissions = Pre-Tax Earnings before changes in reserves - Increase in Reserves <------- Major Pain Point = Pre-Tax Earnings - Tax = Earnings net of tax
  15. 15. 15Stress Testing & Capital Planning for Insurers – March 2014 Nature of the Stress-testing Beast – Multi-Stochastic Processing
  16. 16. 16Stress Testing & Capital Planning for Insurers – March 2014 Proxy Modeling as a Way to Manage the Beast » Proxy fit – Can be done using “Curve Fitting” or “Least Squares Monte Carlo” – Both approaches in essence are about acknowledging there is a “scenario budget” and trying to make best use of that budget – Curve Fitting - establish key fitting points on the risk spectrum, do accurate calculations at these key points and then fit a function to these key points – Least Squares Monte Carlo (LSMC) – establish what the entire risk spectrum is, do a relatively inaccurate calculation at every single point, then fit a function to every single point. Each fitting value on its own is wrong, but with many points calculated the errors cancel, on average, giving an extremely good resulting fit. » Key benefits of the proxy approach – Can significantly reduce A-L projection runtime – Resulting function enables you to do stresses “at will” – The NAIC is supportive of proxy techniques for projecting capital – providing the resulting functions are properly validated
  17. 17. 17Stress Testing & Capital Planning for Insurers – March 2014 Model Comparison – LSMC enables you to capture a larger risk space
  18. 18. 18Stress Testing & Capital Planning for Insurers – March 2014 LSMC is Accurate and Easy to Validate Comparison of 1-year surplus calculated using the proxy and calculated using 1,000 RN scenarios » The average difference between the validation and the proxy function is $60 million -4000 -3000 -2000 -1000 1000 2000 -4000 -2000 2000 B&HLSMC($m) B&H Validation Scnearios Validation points chosen to test function in different regions, or in regions of high sensitivity
  19. 19. 19Stress Testing & Capital Planning for Insurers – March 2014 Q&A5
  20. 20. 20Stress Testing & Capital Planning for Insurers – March 2014 © 2014 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.