Insurers and reinsurers are in the business of risk management, and one key question preoccupies their minds: “What’s the worst that can happen?” Jeremy Waite explores this question through the lens of scenario and stress tests, examines the merits of these approaches and highlights the necessary considerations.
Stress tests and scenarios are used by companies and regulators, in order to explore the potential actions, post a “scenario event”.
In insurance, this could be to explore policy limits from plausible events, or to think through correlations that may not otherwise be considered. Lloyds have been considering scenarios for more than 20 years, and typically describe an event and the syndicate would need to consider all the covers that it offers which could be impacted, as well as its own protections.
This became very real to the author following the World Trade Center events, where airline hull losses became 100% correlated with buildings losses, and even whether this was one or two events on the insurance side, and whether one or two on the reinsurance side.
The International Actuarial Association (IAA) has defined a scenario as:
“a possible future environment, either at a point in time or over a period of time. A projection of the effects of a scenario over the time period studied can either address a particular firm, or an entire industry or national economy. To determine the relevant aspects of this situation to consider, one or more events or changes in circumstances may be forecast, possibly through identification or simulation of several risk factors, often over multiple time periods. The effect of these events or changes in circumstances in a scenario can be generated from a shock to the system resulting from a sudden change in a single variable or risk factor. Scenarios can also be complex, involving changes to and interactions among many factors over time, perhaps generated by a set of cascading events. It can be helpful in scenario analysis to provide a narrative (story) behind the scenario, including the risks (events) that generated the scenario.”
Source: Stress Testing and Scenario Analysis, IAA (July 2013)
The IAA has defined a stress test as:
“a projection of the financial condition of a firm or economy under a specific set of severely adverse conditions that may be the result of several risk factors over several time periods with severe consequences that can extend over months or years. Alternatively, it might be just one risk factor and be short in duration. The likelihood of the scenario underlying a stress test has been referred to as extreme but plausible.”
The illustration below makes clear the distinction between stress and scenarios:
Source: Stress Testing and Scenario Analysis, IAA (July 2013), t represents time.
Stress tests and scenarios are a useful alternative method of measuring adverse outcomes in a way that is more easily understood by boards and senior management within a company. These scenarios can consider risk beyond the normal modelled loss and indeed consider things that seem remote.
Stress scenarios are one way to quantify catastrophic loss potential and thereby manage exposure. The Scenario approach has the following advantages:
- Less complex approach – Easily understood by non-technical management, board members and other interested parties;
- The output is “Board-friendly” and can provide significant insight into the effectiveness of a company’s catastrophe risk strategy without unnecessary management time investment;
- Assumptions are explicit and able to be altered at an event level (e.g. vulnerability factors);
- The resultant loss is based on a realistic event, not a reading of an OEP curve at a particular return period (which is contributed to in a probabilistic manner by many events);
Natural Catastrophe Scenarios
In Australia, it would be necessary to consider not just major perils, such as earthquake and cyclone, but also more frequent perils such as flood, cyclone, storm and bushfire. Events occurring overseas could have a substantial impact (direct or indirect) on APRA regulated insurers, and as such may need to be factored into the analysis.
The following highlights some of the key considerations when developing realistic disaster scenarios:
- It is important to ensure that the underlying exposure information is accurate, and reasonable assumptions and adjustments are used in the scenario analysis; and
- Scenarios could include multiple events within a short timeframe (e.g. 2 Earthquakes within 30 days within a similar geographic area), potentially occurring over a reporting or reinsurance treaty year.
- Scenario events do not need to be limited to perils covered by vendor models and other relevant perils could be considered (e.g. Tsunami) if material.
- The event scenarios should be regularly reviewed and updated to ensure they represent material catastrophe risk to the insured.
- Scenarios can be stress tested in that they contain damage assumptions which can be varied in realistic ranges. This is a practical and deterministic way to consider secondary uncertainty.
- It is necessary to consider secondary perils which may have a material impact on the insured. For example, with earthquake, it is important to consider other secondary perils such as liquefaction and fire following. For cyclone, it would be necessary to consider storm surge and precipitation flooding correlated with cyclone events.
Natural peril scenarios typical feature
- A definition or description of the physical event, with a map showing the hazard footprint or area affected (e.g. below we show the Brisbane 1974 flood extent)
- The assumed industry insured loss which could be split by line of business, e.g. Property– Domestic, Commercial Industrial, or include other classes of business if material (e.g. Marine); and
- Other details could be provided (e.g. where applicable, a catalogue of major infrastructure (i.e. ports) that may be affected by the event, and consideration of wider impacts, knock on impacts.
Scenarios are a useful complement in risk assessment and strategic planning, and can highlight the need to avoid, mitigate, reduce or transfer risk.
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