Stress and scenario testing

Stress and scenario testing (SST) have been a longstanding practice in the insurance sector but recently their importance has grown significantly, driven by the introduction of local regulatory requirements, and increased market awareness of the benefits of stress testing.

In its simplest form SST encourages business leaders to think about what ‘might’ happen, now or in the future, and how it could impact their business. By considering SST in a structured way, it can generate ideas on how to grow the business or how to position it to avoid potential losses (or maximise certain gains). It can help identify new opportunities, or areas where current business models are threatened. 

Ireland is the 5th largest beef exporter in the world and the largest exporter of beef in Europe. A recent suite of publications from the Intergovernmental Panel on Climate Change emphasise the importance of reducing meat consumption if we are to successfully combat climate change. The Irish government and agriculture industry could consider the impacts if beef consumption ceased within say, the next ten years and how this issue could be addressed. If beef consumption were to cease, how would individual farms need to change their business models to adapt to this new world? What tools, knowledge and governmental support would be required to facilitate the change?

Within the US, there are approximately 3.5 million professional truck drivers. Robotic cars and trucks are already in development – Google, Tesla and Uber have, for many years, circulated reports about their own development of driverless vehicles. If robotic trucks become common, what will the 3.5 million drivers do for employment? Will the US government support training programmes so they can gain other jobs? If so, is funding for this being considered now?

Many of us face uncertainty in every aspect of our lives. Business leaders need to acknowledge that uncertainty does not mean they cannot plan, and SST is a powerful tool available to help them do this.

‘Uncertainty’ is the core of the insurance industry – the purpose of insurance is to transfer uncertainty from an individual (be it a person or a firm) to another entity, in exchange for a fee. However, if you’re not used to thinking about uncertainty within the business, the approach below is a useful guide:

• Level 1 – Clear Enough Future - managers can develop a single forecast of the future that is precise enough for strategy development. Although it will be inexact to the degree that all business environments are inherently uncertain, the forecast will be sufficiently narrow to point to a single strategic direction.
• Level 2 – Alternate Futures- the future can be described as one of a few alternate outcomes. In other words, you don’t know what exactly will happen, but what can happen is restricted to a few possible events.
• Level 3 – A Range of Future - like Level 2 – there might be definite bounds on what can happen, but what will happen is within those two bounds and can sit anywhere in between.
• Level 4 - True Ambiguity - multiple dimensions of uncertainty interact to create an environment that is virtually impossible to predict. What does this mean? Well, it means you do not know what’s going to happen.

In reality, for businesses Level 4 situations are quite rare. Businesses do not often face true ambiguity in the short to medium term. Most often a range of identifiable possible outcomes exists; SST provides a structured way to consider these, their impacts and how to deal with them.  However, over the longer term, all businesses face some ambiguity, as it is impossible to predict the impacts of technology, changing consumer trends and changing societal preferences can have. SST is also useful in this case – whilst any scenarios you consider will never play out exactly as you describe, they may give your fellow business leaders food for thought on areas to explore in the present. SST considers how things could evolve in the future – it is then up to business leaders decide what to do about these potential evolutions.

Within the life insurance industry, each company is obliged to carry out an Own Risk and Solvency Assessment (ORSA) process each year. This is a regulatory requirement under the current insurance regulatory regime, which was introduced in 2016. In Ireland, the predecessor of the ORSA was the Financial Condition Report (FCR), which had similar aims. The implication of these regulatory requirements is that life insurers in Ireland have been considering these types of issues for a very long time.

The purpose of the ORSA (and the FCR before it) is to consider the expected evolution of the insurance company’s balance sheet over its business planning horizon (typically five years). Within this projection, the company will consider how its risk profile, capital needs and profitability will evolve.  The ORSA also considers how stresses and scenarios could impact on this projection and hence SST forms the bulk of the output from the ORSA process.

The ORSA considers reverse stress testing, the purpose of which is to identify stresses and scenarios that could lead to the failure of the business.

The ORSA process typically takes several months, with the Board considering the range of stresses and scenarios to be considered and the core central business plan early in the year. The results are assessed with input from a variety of internal departments. The consideration of SST focuses on quantitative impacts, and, as a result, assessing the results depends on the structure of the firm and the resources allocated. Once results are prepared, they are considered by the Board, who then discuss the output and agree on actions to be taken, if necessary. An overall report is then prepared, approved by the Board and submitted to the regulatory authorities (in Ireland, for insurance companies, this is the Central Bank of Ireland).

Below, we considered some of the positives and negatives that we’ve observed within ORSA processes, which might guide businesses when considering SST.

• The Board direct the ORSA process and input is sought from senior management across the firm. This means that SST gets significant visibility at a senior level within the firm and key decision makers are informed as to how potential actions or events could impact the firm.
• The regulatory rules encourage the ORSA output to form part of the decision-making process of the firm. This has fostered a cultural shift in firms, where firms actively consider the ORSA and SST when making key decisions, to ensure that the impacts are fully explored and understood.
• The ORSA and SST illustrates the risk profile of the firm – whilst it may be easy to identify what the key risks to your business are, it takes discipline to formally consider these risks and quantitatively assess their impacts. This assessment enables decision makers to understand what the key risks are,
• Reverse stress testing is a key part of most ORSA processes and is actively encouraged by the regulatory authorities. Reverse stress testing asks a firm to consider the risks, or combination of risks, that could lead to failure of the firm. considering it enables decision makers to better understand what the tipping points may be and identify actions to prevent such points being reached.

The ORSA process tends to focus on downside risks, i.e. risks that cause a loss to the firm, lead to lower profits or less available capital. Many firms are focused on protecting the business and view the ORSA and SST as a crucial tool to do this. However, upside risk should also be considered – there are scenarios where, if the firm has positioned itself appropriately, it can take advantage of changing market trends or consumer preferences, perhaps establishing a first mover advantage.

• The regulatory requirements mean that firms focus on the business planning horizon, for most firms this is a period of 3-5 years and longer-term risks are the exception rather than the rule. There can be excessive focus on short-term, immediate impact risks that materialise over a very short space of time.
• The regulatory focus can also cause some issues:
  • The regulatory requirements can lead to reports that have too much material and are too long, meaning that the key messages can be lost in a haze of filler material.
  • Given the regulatory expectations, the ORSA process can be very long-winded, taking months to complete. It can lose relevance as external environments change and the stresses considered become irrelevant.
  • The exercise can be viewed as a compliance exercise which adds no value to the business – it is completed to avoid any regulatory sanctions, meaning that the potential value that could be added is lost.
  • The regulatory requirements mean that the exercise can be treated as a cyclical “business as usual” process, rather than as an exercise that can enable leaders to form new perspectives on the business.

In my opinion, the SST that adds most insight to business is one which is:

• Timely,
• Gets senior leadership engagement,
• Focuses on key results,
• Considers upside and downside, and
• Considers short-term (level 2-3 uncertainty) and long term (level 4 uncertainty) risks.

Consideration of SST can be a long journey, as it may ultimately lead to consider your business in a new light. Hence, you may use it to continually explore new things. However, the crucial thing really is to just start – that first step is the most important one to take.

In terms of how to approach SST, there’s no defined way. Whilst regulatory rules in the life insurance approach add structure, these structures can cause problems, so don’t think that a life insurers’ approach is necessarily best. The following points give some food for thought and some generic considerations:

• Firstly, if you think it’s important to do, then it is important to do right; fully commit to it! Allocate time and resources to it.
• Be clear on what you want out of the exercise. For example, it could be that you just want to consider some plausible futures and how they may impact your business, rather than making any significant strategic or tactical decisions.
• In advance, ask those involved to give it some thought. In terms of establishing scenarios to explore, the points below may help:
  • Sometimes the easiest place to start is what scares you – the stuff that keeps you awake at night. What would kill our business?
  • Consider what your competitors are doing. Don’t copy them but consider their actions and ask why they are doing it.
  • Consider the risks you take on a day to day basis – you may buy, you may sell, you employ staff, you incur expenses, you pay taxes.
  • Consider the key assumptions that you have about your business – what are they?
  • Consider related industries and look at emerging trends. Do the patterns emerging there indicate any issues that may emerge from your industry?
  • Consider upside – don’t just focus on bad things. What if you grow by 20%, not 5% - how would you handle this?
  • Consider PESTLE – political, economic, social, technological, legal and environmental issues and how they could change over time and the impacts they would have.

SST is a powerful tool that enables business leaders to identify what their key risks are and how potential future evolution could impact on their business. It can generate unique insights to your business. Business leaders don’t always consider changes, but the success or failure of their business will depend on the ability to respond to them. SST gives you a head start in developing your response.

Dave O’Shea is an actuary in KPMG Ireland’s life insurance practice and has been involved in stress and scenario testing for a number of insurance companies.

David O'Shea

KPMG in Ireland
+353 1 410 7979