The document discusses dynamic stress testing for an insurance company. It defines dynamic stress testing as evaluating the impact of extreme yet plausible scenarios over time as the insurance products, company balance sheet, and economic environment evolve. It emphasizes that stress testing can initiate important conversations about risks and opportunities and is increasingly recognized in the industry as a key component of enterprise risk management. Finally, it outlines best practices for implementing a credible and sustainable stress testing process.

1. Dynamic Stress
Testing for an
Insurance
Company
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Chicago | London | Singapore
© 2013 Quantitative Risk Management, Inc.

2. Dynamic Stress Testing
for an Insurance Company
I. Introduction
II. Defining and applying a stress testing framework
III. Advancing stress testing in the organization
IV. Summary
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© 2013 Quantitative Risk Management, Inc.

3. Dynamic Stress Testing Evaluates the Impact of
Extreme Yet Plausible Scenarios Through Time
 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)
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© 2013 Quantitative Risk Management, Inc.

4. Dynamic Stress Testing Can Initiate and Frame
Conversations on Risks and Opportunities
 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?
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© 2013 Quantitative Risk Management, Inc.

5. 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
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© 2013 Quantitative Risk Management, Inc.

6. Dynamic Stress Testing
for an Insurance Company
I. Introduction
II. Defining and applying a stress testing framework
III. Advancing stress testing in the organization
IV. Summary
5
© 2013 Quantitative Risk Management, Inc.

7. Stress Testing Requires a Feedback Loop
Qualitative analysis of
exposures
 Policyholders and
products
Projection and
analysis of
economic impact
Identification of
stress scenarios
 Single or multiple factors
 Liquidity
 Historical or hypothetical
 Capital
 Local or global
 Earnings
 Equity and alternative
investments
 Sudden or gradual
 Sales
 Employees
 Temporary or structural
 Brand and reputation
 Processes
 Deterministic or stochastic
 Credit counterparties
 Standalone or cascading
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© 2013 Quantitative Risk Management, Inc.

8. Stress Scenarios Often Reveal Indirect and
Cascading Risks and Opportunities
Product designs
fit for the new
environment
New sales of
existing
products
Credit asset
availability at
longer
maturities
Credits
paying a
floating rate
Financial sector
credit quality
Short-term
funding costs
Cash
surrenders
Rates
Up
Credited rate
changes to drive
retention
Derivatives
counterparty
exposures
Collateral
calls
Draws on
private equity
commitments
RMBS cash
flow timing
Residential
housing credit
(Re)emergence
of asset
classes
Impacts to
premium flows
in flex-premium
products
Hedge costs
Assumptions driving growth
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© 2013 Quantitative Risk Management, Inc.

9. Best Practice Leverages Stochastic Analysis
For Reverse Stress Testing
 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
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© 2013 Quantitative Risk Management, Inc.

10. Proper Stress Testing Is Embedded Within All
Levels of the Organization
Executive leadership
Executive
Committees
 Risk appetite and tolerances
Board of
Directors
 Strategic sales planning
 Communication with rating agencies
Global functions
ERM /
Capital
Mgmt
Finance /
Corporate
Actuarial
 Capital validation and planning
Investment
Portfolio
Mgmt
 Risk mitigation strategies
 Contingency planning
 Communication with regulators
Business units / Portfolios
Annuity
Business
Units
Life
Insurance
Business
Units
Investment
Portfolios
 Express hard-to-quantify risks
 Identify gaps in product hedging programs
 Discover risks in new product designs
 Evaluate pricing of new products
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© 2013 Quantitative Risk Management, Inc.

11. Rigorous Stress Testing Facilitates Formulation
and Evaluation of Contingency Plans
 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
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© 2013 Quantitative Risk Management, Inc.

12. Dynamic Stress Testing
for an Insurance Company
I. Introduction
II. Defining and applying a stress testing framework
III. Advancing stress testing in the organization
IV. Summary
11
© 2013 Quantitative Risk Management, Inc.

13. Credible and Sustainable Stress Testing
Processes Incorporate Key Attributes
 Collaborative and comprehensive
 Reflect realistic expectations of behavior
 Consistent and integrated
 Properly sized and nimble
 Complementary to other processes
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© 2013 Quantitative Risk Management, Inc.

14. A “Hub and Spoke” Approach Enables
Collaboration and Comprehensive Analysis
Investment
Mgmt
Business
Units
ERM /
Stress
Testing
ALM /
Finance
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 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
© 2013 Quantitative Risk Management, Inc.

15. Stress Testing Requires Realistic
Behavioral Estimates of Decay and Growth
 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
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© 2013 Quantitative Risk Management, Inc.

16. Stress Test Analysis Needs to be
Consistent and Integrated
 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
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© 2013 Quantitative Risk Management, Inc.

17. Companies Must Balance Response Time with Analytical
Precision for Nimble Yet Rigorous Stress Testing
 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
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© 2013 Quantitative Risk Management, Inc.

18. Stress Testing Needs to be Complementary
With Other Key Processes
 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
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© 2013 Quantitative Risk Management, Inc.

19. Dynamic Stress Testing
for an Insurance Company
I. Introduction
II. Defining and applying a stress testing framework
III. Advancing stress testing in the organization
IV. Summary
18
© 2013 Quantitative Risk Management, Inc.

20. Dynamic Stress Testing
 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
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© 2013 Quantitative Risk Management, Inc.

21. World Headquarters:
181 West Madison Street, 41st Floor
Chicago, IL 60602
+1 (312) 782 1880
London Office:
13 Austin Friars
London EC2N 2HE
+44 (0)20 7920 9442
Singapore Office:
6 Battery Road, #18-07
Singapore 049909
+65 6536 3402
www.qrm.com
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© 2013 Quantitative Risk Management, Inc.