Stress testing in a SII environment

Stress testing in a 

Solvency II 

environment 

NOVEMBER 5, 2020 

Insurance Supervision and Risk Management 

Center of Excellence in Finance 

Bernhard Mayr 

INTERNATIONAL MONETARY FUND 1

Questions 

• Are you familiar with stress testing? 

• Does your authority use stress testing as part of the regular supervisory process? 

• Do you require insurers to run regular stress tests? 


Stress test – motivation and 

definition 


Motivation and definition 

Definition: A method of solvency assessment that measures the financial impact of 

stressing one or more factors which could severely affect the insurer. 

Recital 42 of regulation 1094/2010 (regulation on the establishment of the European 

Insurance and Occupational Pensions Authority) provides a useful example to show 

the integral role of stress testing; embedded in broader economic analysis. 

• In order to safeguard financial stability it is necessary to identify, at an early 

stage, trends, potential risks and vulnerabilities stemming from the microprudential 

level, across borders and across sectors. The Authority should […] 

initiate and coordinate Union-wide stress tests to assess the resilience of 

financial institutions to adverse market developments […]. In order to perform 

its functions properly, the Authority should conduct economic analyses of the 

markets and the impact of potential market developments. 


Motivation 

• Stress tests are a useful bridge to Solvency II 

• They can fulfil the purpose of quantitative impact studies 

• In contrast to Solvency II development the focus now is not on the design of a new 

regime but mainly on the identification of potential hot spots. 

• It helps the industry and authorities to get ready for a new regulatory environment 

• Do they have the resources needed and the right type of resources? 

• Are better systems needed? 

• Do they have the data to do a proper analysis? 


Different forms of stress tests 

By topic: 

• Solvency stress tests 

• Liquidity stress tests 

• Macro stress tests 

By type: 

• Single factor/sensitivity analysis 

• Reverse stress testing 

• Scenario analysis 

• Climate stress tests 

Execution of stress test: 

• Bottom up: the supervisor defines the scenarios and requests the insurer to run the 

stress test. 

• Top-down: Stress tests are run by the supervisor based on regulatory return data or 

specific data requests from insurers. 


Type of stress test 

Stress testing 

Single factor/ 

sensitivity analysis 

Assess effect of a large 

move in one risk factor 

Reverse stress test 

What scenario makes the 

business unviable 

Multi-factor/scenario 

analysis 

Historic or hypothetical 

scenarios, consideration of 

dependencies among risk 

factors 


Specificities of the insurance sector 

Insurance stress tests require 

a solid understanding of the 

sector’s specificities: 

 

 

 

Characteristics of insurance 

business, products, balance 

sheet structure, funding… 

Risks and vulnerabilities, key 

performance indicators 

Regulatory framework, valuation 

and solvency regime 

Key 

indicators 

Insurance 

business 

Regulatory 

framework 

Stress testing tool 


Stress testing as part of a broader 

surveillance approach 


Embedding the stress test in a broader 

assessment framework 

• Stress tests are one element to the assessment of risks to (micro) and from 

(macro) the insurer. 

• Based on pre-defined assumptions, they provide one perspective on potential 

vulnerabilities. The usefulness of its output is a function of how realistic the model 

is and what simplifying assumptions need to be taken (“correlation/dependencies of 

risk factors”). 

• Hence, a stress test should be an integral part of a supervisor’s toolkit and the 

results need to be interpreted in the context of the broader environment. 


Surveillance cycle - example 

Vulnerabilities 

General risk 

monitoring and 

analysis 

Targeted 

assessments 

Follow-up 

assessments 

Policy 

• Endogenous risks 

• Exogenous risks 

• Market 

analysis and 

diagnostics 

• Qualitative 

and 

quantitative 

analysis 

Assessment of 

identified risks (e.g): 

• Stress and 

scenario 

analyses 

(macro and/or 

micro) 

• Network 

analysis 

• Deeper dive, 

where relevant 

• Corrective and 

preventive 

measures, if 

needed 

Feedback to monitoring and analysis 

Feedback to sources of systemic risk, vulnerabilities and trans-mission channels 


Pre-Screening and Diagnostics 

• A good understanding of the local insurance and financial/capital markets is a 

prerequisite for any assessment of insurers’ vulnerabilities to particular risks. 

► It helps in the design and the calibration of the stress tests 

► It provides valuable insights into the potential strengths and weaknesses of the 

local insurance market. 

• When assessing the market as a whole, it is important to look at the distribution 

(low and high percentiles, median and mean) 

• The analysis as part of the regular market monitoring should cover data, such as 

► General assessment of economic, monetary and capital market conditions 

► Solvency and performance and other sector specific measures of insurers 

► Market competition 

► Qualitative information 


Indicators for economic, monetary, and capital 

market conditions (II) 

Data type 

Economic, monetary, and 

capital market conditions 

Socio- demographic 

changes, disasters, etc. 

Household (and/or corporate) 

leverage 

Real estate prices 

Market competition 

Impact on insurers 

Adverse economic conditions generally decrease demand for 

insurance 

Unexpected deterioration in underwriting profitability may erode 

liquidity buffer and impact solvency. Inadequate adjustment to sociodemographic 

changes may in the long run lead to under-reserving / 

under-pricing 

Decreases demand for insurance (to be assessed together with 

surrenders and lapses) 

Declines in real asset values may generate collateral calls on certain 

products and outstanding credit lines (linked to aspect above) 

Important asset on many insurers’ balance sheets 

Intense market competition may encourage insurers to take on 

additional investment or product risk, potentially leading to underpricing 

or under-reserving of the risks (Two important causes for 

insurance failures). It may also indicate higher interlinkages. 


Solvency, performance, and other sector-specific 

measures (I) 

Examples: 

• Solvency coverage ratio (capital / solvency capital requirement): - measures the 

extent to which assets cover commitments for future payments. 

• Combined ratio for non-life insurers to measure underwriting profitability, consists 

of the sum of 

► Loss ratio (claims paid and changes in outstanding claims provisions over gross 

earned premiums) 

► Expense ratio (operating expenses and commissions over gross written 

premiums) 

• Return on excess of assets over liabilities (or return on equity if available), 

return on assets 


Solvency, performance, and other sector-specific 

measures (II) 

• Capital to premium (total capital to net written premiums): - indicates the 

availability of capital in support of the insurance risks taken. This indicator is mainly 

used for non-life business. It is a crude measure as it ignores asset quality. 

• Retention rate (net written premiums to gross written premiums): - measures the 

share of the insurance risk retained by the insurer. 

• Interlinkages (direct and indirect exposures), e.g. 

► Investments in banks and other institutions 

► Derivatives holdings 

• Lapse (or surrender) ratios: Technical provisions (or number) of contracts lapsed 

during a period relative contracts in force at the beginning of the period 


Qualitative information 

Covers all types of data that are qualitative in nature, hard to quantify, or not available. 

These data can often support the findings or, alternatively indirectly highlight otherwise 

hidden prudential risks. 

• Change in product mix 

• Increase in policyholder complaints – e.g. an increase in complaints for late 

settlements could be an indication for a company in financial difficulties (e.g. if it is 

accompanied by increasing surrenders) 

• Increase in fraud cases 

• High staff turnover 

• …. 


How to use these data 

• The data enable a high level monitoring of vulnerabilities in the insurance sector. 

Organising this information in a dashboard will help visualise the strength and 

weaknesses and potential risks ahead. 

• The analysis should be done on a regular basis. 

• Both levels and trends are of interest. 

• Such a dashboard is a stand-alone tool but can serve as a useful input or 

complement to a stress test exercise, by helping identify scenarios and interpreting 

results. At the same type, it provides useful checks on insurers’ own stress test 

assumptions. 

• A useful, publicly available, example for such analysis are the quarterly risk 

dashboards by EIOPA. 


Steps in setting up a stress test 

exercise 


Questions 

• What are the main steps in a stress test? 

• How would you organise your stress test 

• Bottom up? 

• Top down? 

• How do you determine what you want to cover in the stress test? 

• How will the results impact your supervisory process? 


The stress test cycle 

1. Identification of risks and scenarios to be tested; 

including type of stress test 

2. Specification of specific scenarios 

3. Coverage 

• Level of market coverage 

• Type of insurer 

• Type of products 

Preparation 

4. Involvement of insurers 

5. Running the stress test 

6. Analysis of findings and back testing (plausibility checks) 

7. Conclusions and potential follow ups 

Execution, review and 

conclusions 


Identification of stresses (I) 

• Is the stress test for all insurers, for life or non-life, specific products? 

• Is the stress test run at the same time as the banking stress test? 

► If so: 

◆Ensure that there is some coordination with the banking supervisor 

◆The market risk assumptions should be aligned 

• The pre-screening and market diagnostic/monitoring work (described above) may 

have already identified particular risks that require further assessment. 

► High lapses and surrenders → test potential liquidity strain and implications of 

further increase of surrenders on insurers’ solvency. 

► Massive fall in real estate values → Impact on insurers’ balance sheet and 

regulatory position 

► High concentration in the market → assume increased default 


Identification of stresses (II) 

• Regular sensitivity tests for specific risks (change in asset values, changes in 

underwriting risks) 

• Assessment of pre-defined catastrophe scenario (e.g. flooding, earth quakes, 

volcanoes) 

Second round effects 

• Second round (or second-order) effects are feedback effects that involve changes 

in behaviour as a result of a shock, e.g. through changes in portfolios or business 

models. 

• These are not (sufficiently) taken account of in a single period stress test. It is 

therefore useful to combine the stress test with an additional questionnaire asking 

insurers how they would react to a specific shock (i.e. after the shock has occurred 

and not as a mitigant to the shock). 


Specification of specific scenarios (I) 

Stress testing involves changing the value of specific risk factors and determining the 

impact of such changes on the insurer’s business (balance sheet). The impact is 

measured against pre-defined output metrics (e.g. solvency ratios). 

• Capital market events: Although the past is not necessarily a good predictor of the 

future, analysis of past price movements can help identify specific scenarios. The 

time series analysed should ideally be longer than a typical economic cycle. 

• Default of banking counterparty: Specify specific haircuts dependent on the 

seniority of the asset, e.g. 

► 100% loss on equity, 100% loss on subordinated debt, 50% on senior bonds, etc. 

► Historic recovery rates may inform the scenario 


Specification of specific scenarios (II) 

• Catastrophe event: Examples in Europe show that historic scenarios are easiest 

to implement 

• Biometric shocks: 

► Mortality shock: permanent increase in mortality rates 

► Longevity shock: Permanent decline in mortality rates 

► Pandemic: temporary increase in morbidity and mortality rates 

► NB: Insurers’ exposure depends on the products they offer. 


Specification of specific scenarios (III) 

Risk factor Explanation Examples 

Interest rate risk 

Equity risk 

Real estate risk 

FX-risk 

Credit risk and 

counterparty 

default risk 

Economic value change of interest rate sensitive 

assets and liabilities, measured by a shift in the yield 

curve (parallel, flattening, steepening) 

Need to consider different shocks for different types 

of equity. Defined as % loss in market value 

Similar to equity risk. May need to consider, 

differentiation between residential commercial real 

estate 

Negative shocks to net open FX-positions and/or FX 

denominated assets and liabilities 

Market value changes of fixed income instruments, 

increase of counterparty risk 

+/- 200bps parallel shift 

-20% fall in value 

+/- 20% 

Increase of credit spread by 50%, 

downgrade counterparties, failure 

of large counterparty 

For more detailed examples refer to: Jobst, 

Sugimoto, Broszeit (2014), Macroprudential 

insurance stress testing 


Specification of specific scenarios (IV) 

Risk factor Explanation Examples 

Mortality/morbidity/ 

longevity 

Economic loss resulting from increase in risk factor 

25% increase in risk 

Lapse/surrender Economic losses caused by higher surrender rates Mass lapse of 25% 

Natural catastrophe 

Other non-life shock 

Economic losses from natural or man-made 

disasters 

Cost/claim increase 

Historical claims experience 

+10% increase in cost of claims 

and +15% increase in frequency of 

claims 

For more detailed examples refer to: Jobst, 

Sugimoto, Broszeit (2014), Macroprudential 

insurance stress testing 


Specification of specific scenarios (V) 

• The above are examples of specific shocks to consider. There are several others. 

The question is always how to integrate them into the stress test model. Therefore, 

market monitoring of specific risk indicators is an important complement to stress 

testing. 

• To be useful, the stress test scenarios need to be severe but plausible. 

• If all specified scenarios should be tested at once, they should be internally 

consistent (e.g. mortality and longevity assumptions, development of equity and 

bond values). 

• Not all shocks are equally relevant. 

• NB: Stress tests undertaken at the European level cannot take account of national 

idiosyncrasies. 


Mitigating actions 

• The stress test can be complemented by a questionnaire on how the insurer would 

react, assuming the persistence of a specific scenario. 

• Changes can be made to: 

► Capital: e.g. dividend retention, equity issuance 

► Asset side: sale or purchase of specific investment assets 

► Liability side: change in profit sharing, run off or sale of in force business, review 

of guarantee policy, etc. 

• Questionnaire should cover: 

► Likelihood of action 

► Expected impact 

► Timing 


Final output 

The impact of the stress can be assessed by the change in the solvency ratio and 

its components (eligible capital and solvency requirements) 

It shows how robust a company is against the defined shock, the scenario. 

Example of useful output: Technical note of 2018 FSAP in Belgium 


Analysis of findings and back-testing 

• Before drawing any conclusions, the supervisor should assess the results. 

► Do the numbers make sense or are there potential errors, both in terms of input 

and calculations (built-in plausibility in a stress template can reduce the risks of 

errors)? 

► Were the scenario assumptions reasonable? The scenarios should be severe but 

plausible. 

► What risk mitigating actions does the insurers have at its disposal? 

◆How realistic are they under specific circumstances? 

◆Have they been considered/excluded in the scenarios? 


Communication of results 

• Based on experience in several countries, insurance supervisors tend to be more 

restrictive in terms of what information they disclose compared to the banking case. 

• However: Generally, disclosing results is recommendable 

• The disclosure should be combined with clear messaging on the 

► The nature and objective of the exercise; 

► The stresses applied; 

► The insurers included in the exercise; 

► Any (simplifying) assumptions made; 

► Available mitigating actions that have or have not being taken into account; 

► General conclusions. 


Conclusions and potential follow-ups 

• Once all results have been validated, first conclusions can be drawn. This may 

include a more detailed analysis of the respective insurer. 

• Supervisory action (or the development o broader supervisory policies) should not 

be solely based on the stress test outcome but they may provide a solid foundation. 


Important to remember 

A stress test is a useful tool but is only as good as the data that are used and the 

assumptions that go into it. It cannot replace thorough supervision. 

Do not underestimate the value for supervisors of market surveillance and diagnostics. 


Useful background material 


Useful background material 

Data diagnostics 

Kwon W.J., Wolfrom L. (2016): Analytical tools for the insurance market and 

macro-prudential surveillance, in OECD Journal: Financial Market Trends, Vol. 

2016/1 

Insurance stress testing 

• Jobst, A., N. Sugimoto, T. Broszeit (2014), Macroprudential solvency stress 

testing of the insurance sector, IMF WP/14/133. 

• EIOPA website covers useful material on European stress tests, including, stress 

specifications, reporting templates and final reports. 

• Surveying responses to stress by banks and insurers, ESRB Occasional Paper 

No. 15.

Stress testing in a SII environment

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