Stress testing insurers during COVID-19

Last year, with key insurance risks rapidly changing due to COVID-19, APRA conducted a series of stress tests on the 21 largest life insurers (LI), comprising 14 direct insurers and seven reinsurers, accounting for 90% of GWP. They also stress tested four active Lenders Mortgage Insurers (LMI), again covering most of the sector by GWP.

APRA based its tests on significantly worse macroeconomic outcomes compared to the Downside Scenario in the RBA’s 2020 Economic Outlook.

ARPA’s stress tests included recurring Stage 3 and Stage 4 COVID-19 restrictions, international border closures, reduced economic activity over three years, falling asset prices, low bond yields, and rising credit spreads.

The stress test for LMI’s included GDP contracting 10%, unemployment rising to 10%, and house prices dropping 30%, driving higher claims. For LI’s, GDP contracted by 15%, and unemployment rose to more than 13%, with significant claims deterioration. The different stress test assumptions for LMI’s and LI’s was a reflection of different timings of the exercises and an evolving view of downside economic risks.

The results showed insurers are well-placed to survive even very severe economic downturns. Despite significant capital losses, both sectors (as a whole) remained above their minimum capital requirements.

The capital impacts of the stress scenarios varied widely among individual insurers, with capital coverage ratio falls reflecting different business models, portfolio composition and levels of reinsurance coverage. The results demonstrated the need to use regular stress tests covering a wide range of scenarios, to test the boundaries of insurer’s capital adequacy.

Some insurers fell below their minimum capital requirements, prior to management actions. The key reasons for falling capital levels during the stress were large investment losses in insurers with lower-rated investments due to rising credit spreads, and higher claims costs due to significant deterioration in disability income insurance claims and credit quality of underlying mortgages.

Insurers across both sectors used three main management actions to rebuild their capital levels; capital injections and raisings, reducing new business volumes, and repricing. Yet few insurers considered the feasibility and second-order impacts of these actions, particularly when other insurers were likely to adopt similar actions under a stressed scenario.

Better practice insurers incorporated thorough assessments of flow-on effects of repricing and reductions on new business volumes, such as increases in selective lapses, changes in reinsurer appetites, and the cost and availability of insurance.

APRA found recovery plans across several LI’s are not yet mature and has urged insurers to better embed these plans into their broader risk management frameworks. Among several LMI’s, recovery plans were not being regularly reviewed and updated as their key risks evolved.

APRA also assessed the internal stress testing capabilities of the 18 largest general insurers (GI). Several insurers had developed and used internal stress test scenarios that were severe enough for them to respond to the stress through management actions but were not sufficiently severe to test the limits of their capital adequacy. For several GI’s, effective testing of recovery options was limited by a lack of severe enough stress scenarios.

Despite previous tests showing the industry needed to better use insights from stress testing, some insurers showed only limited progress in using stress tests as a key part of their risk management frameworks, capital management practices, recovery plans and risk appetite statements. Insurers must continually self-assess their own internal stress testing frameworks, APRA said.

APRA intends to consult with the insurance industry on new guidance for stress testing in future, with the aim of enhancing overall stress-testing capabilities.

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