What Effect Do Pandemics Have On Stress Tests & Operational Resilience?

What Effect Do Pandemics Have On Stress Tests & Operational Resilience?

It is interesting with the world’s current focus on the virus pandemic how it has happened at a point when regulators worldwide are collaborating together on regulatory structures and operational resilience principles.

In the UK in 2019, the PRA (Prudential Regulation Authority, a department of the Bank of England) had conducted the Insurance Stress Test (IST 2019) exercise which has now been followed up in 2020 with recent engagement on Covid-19 stresses. Stress testing continues to be a valuable tool for regulators worldwide in pursuing a forward-looking, proportionate, and judgment-based approach to supervision.

IST 2019 was the third PRA exercise for general insurers and the first one for life insurers since the introduction of the Solvency II regulations in Europe. This exercise incorporated asset and liability shock scenarios as well as a number of exploratory scenarios, including a climate change exercise. The exercise asked the largest regulated life and general insurers to provide information about the impact of a range of stress tests on their business. At a sector level, this exercise was designed to allow the PRA to assess market resilience and to be better prepared in the event similar scenarios were to occur. At a firm level, IST 2019 will inform the view of a firm's risk management systems - it was not used to set any capital requirements.

General insurers were asked also to complete exercises relating to cyber underwriting and commercial liability exposures. These are designed to explore emerging risks so that the regulators together with the industry can improve shared understanding of sector exposures. 

Within the UK we are not alone amongst general insurers, in recognition of the reliance on Bermuda-based reinsurers, and therefore a collaborative initiative was conducted in the first joint exercise with the Bermuda Monetary Authority (BMA) for natural catastrophe scenarios, supporting a joint commitment to supervisory cooperation, in line with the Insurance Core Principles of the International Association of Insurance Supervisors. Results from the joint exercise with the BMA indicate that Bermuda-based reinsurers are resilient to the stresses examined in the exercise and that they also rely heavily on reinsurance, and in particular the capital markets via Insurance-Linked Security structures.

This obviously has serious implications for Insurers and InsurTech businesses. In order to assess the ability of the insurance sector to withstand potential further stresses which might be caused by the Covid-19 pandemic, they have conducted further resilience testing of firms during April. Our analysis used the illustrative scenario outlined in the May 2020 Monetary Policy Report3 and further severe asset and insurance shocks tailored to stress the different risks to which different types of insurance firms are exposed.

So, what does this mean for insurers right now while still within the pandemic? In the UK and Europe, the regulators have seen sense to defer any further stress testing until mid-2021, when they are likely to include cyber and climate factors. However, InsurTech’s and Insurers should not become complacent and keep developing their strategic Operational Resilience programs. Analysis undertaken showed that the UK sector was robust to downside stresses, with the highest uncertainty centered on certain general insurers’ liabilities, particularly those arising from business interruption claims. To ensure that the sector remains robust in this evolving situation, firms will be expected to maintain close monitoring of the additional risks presented by Covid-19, update their risk and capital assessments as the situation evolve and take appropriate management actions where necessary.

For Life Insurers the stress test applied was in addition to the changes in financial markets already seen during Q1 2020, most notably falls in the level of nominal interest rates and equity markets. In addition to asset price falls, spread- widening, and falls in risk-free interest rates, analysis tested a 50% downgrade of assets by one credit quality step (CQS) (i.e. a whole single letter downgrade, such as A to BBB). The PRA focuses on credit downgrades because these affect both the value of credit risky assets life insurers hold and (on the other side of the balance sheet) the level of matching adjustment benefit firms can claim, the net effect of which can have a significant impact on life insurers’ solvency ratios. This 50% downgrade scenario is broadly equivalent to the worst one-year experience in history, felt during the Great Depression in 1932. They could have additionally allowed for defaults explicitly, but historically these have been very low, and it was more practical to allow for this implicitly within the chosen allowance for downgrades, which was higher than that experienced in 1932. The stresses were applied instantaneously to life firms’ balance sheets and did not allow for the management actions that firms would have time to apply in reality, and which would provide some offsetting benefit to their capital positions.

The work provides the regulator with a good relative measure of the risks faced by individual firms, and a means to assess how rigorously each firm and its board are assessing their position against their own risk appetites. The results of this resilience exercise showed that, for the reasons set out above, most firms are sensitive to severe downgrade stress of this kind, but that it would be manageable, particularly given that firms have a range of management actions available to absorb losses which tend to arise over a reasonable timeframe. This work has informed supervisory dialogue with each firm and will continue to be refreshed as the Covid-19 situation develops.

General insurers’ business models typically have lower levels of investment risk than life insurers but have greater sensitivity to liability stresses. Therefore, in addition to stressing assets, for general insurers, they also made non-life insurance specific assumptions and applied further stresses, including:

  • Underwriting losses based on the GDP path and length of lockdown in the MPR scenario;
  • Stresses on revenues and earnings due to premium holidays, lower economic activity, and/or an increase in bad debts; and
  • Further liability stresses, including from business interruption claims.

This exercise showed that the general insurance sector is resilient to these stresses under the assumption that the insurance policies work in line with insurers’ current expectations. However, there are differences between insurers and policyholders as to the interpretation of some business interruption contract wordings in the context of the COVID-19 pandemic. To test this sensitivity, the PRA stressed the assumptions made by firms around the robustness of their policy wordings. This showed that the sector was in aggregate resilient, but the level of uncertainty is high and some more severe scenarios could have a significant impact on the capital positions of a few firms.

It will be interesting to see now how things will develop once the pandemic has passed and the regulator's collaboration starts to work towards reviews in mid-2021.

Peter Smith
FinTech Advisory Board Member at Centre For Financial Professionals. 
Member KPMG Board Leadership Centre. 
Member of The Steering Committee at Future of Finance. 
Member of APPG on AI & FinTech. Member of European AI Alliance. 
Member HM Office for Artificial Intelligence, 
MIT Technology Review Global Panel. 
Member Centre for Study of Financial Innovation