AIFMD | Capital instruments | Climate Change Adaptation Reporting | H2 2014 stress scenario | Remuneration Code | Run-off | Skilled Person Reviews | Stress testing
For firms to which CRDIV applies, rules and expectations in relation to stress testing, scenario analysis and capital planning can be found in the PRA Rulebook in Chapter 12 of the Internal Capital Adequacy Assessment rules and in SS 6/13. For other firms including insurers relevant rules and additional guidance on stress testing and capital planning can be found in the PRA Handbook in GENPRU 1.2, BIPRU 2.2 and INSPRU 7.1. In line with SS 6/13 and GENPRU 1.2.73B within the PRA Handbook, the Prudential Regulation Authority (PRA) publishes a macroeconomic scenario for the UK which firms may use as a complement to firms’ own scenarios. The scenario should be used by firms as a guide to calibrate their own scenarios for Pillar 2 capital planning stress tests. Note that the scenario is for stress-testing purposes only, and the scenario paths should not be interpreted as a forecast of the macroeconomic outlook for the UK or elsewhere.
The scenario is separate from the concurrent stress-testing that is being undertaken by the Bank of England in response to recommendation six of the Financial Policy Committee’s meeting on 19 March 2013.
Background to supervisory scenarios
As part of PRA efforts to strengthen firms' Pillar 2 stress-testing, the PRA believes that supervisory scenarios will help firms to undertake stress tests using more appropriate scenarios, and will give firms a clearer indication of our expectations of appropriate severity.
In addition, the scenarios are designed to encourage:
- engagement of senior management: firms' awareness of the reputational considerations associated with undertaking stress-testing exercises using recommended scenarios should result in senior management being better engaged in the stress-testing process;
- overcoming 'disaster myopia': during prolonged periods of economic stability, firms tend to underestimate the probability of adverse outcomes and the potential crystallisation of 'tail risks’. One way of addressing this is for supervisors to portray scenarios that represent a 'tail event' allowing firms to set their own stresses accordingly; and
- benchmarking of results and approaches: asking firms to run scenarios that are broadly comparable in terms of severity will allow supervisors to more easily compare and benchmark individual results and firms' approaches to stress-testing.
How the H2 2014 stress scenario should be used
Firms should consider the H2 2014 stress scenario in the context of their business and specific risk drivers, and use the scenario as a starting point with which to build and calibrate their own scenario under Pillar 2.
For most firms, the H2 2014 stress scenario will inform the severity of their scenario, but should not be used as a substitute. The PRA may ask some firms to run the full H2 2014scenario.
The scenario reflects minimum adverse conditions, through which firms should assess their ability to maintain minimum specified capital levels.
The H2 2014 stress scenario is a mechanical update of the ‘UK variant’ stress scenario published by the Bank in April 2014. It seeks to incorporate developments in the macroeconomy over the first half of the year and has been produced in a mechanical way, with a view to achieving broadly the same level of severity. Consideration was given to two approaches in determining the severity of the updated scenario relative to that published in April 2014, taking into account data outturns for H1 2014. These were the severity implied by maintaining the peak or trough levels reached by key variables in the April 2014 scenario, and by applying the same quarter-on-quarter changes as those specified in the April 2014 scenario. Equal weight was attached to each of these approaches in producing the mechanical update. The key variable paths can be found below under Key Resources.
The scenario is founded on the same economic narrative as the UK Variant scenario published in April 2014. A link to this is also included below.
The PRA is aware of the challenges of developing a macroeconomic scenario that is to be used as the scenario by various firms operating under different business models and are exposed to a variety of risks. Therefore, the scenario is intended to help firms calibrate the severity of their own capital planning stress scenarios under Pillar 2, and should not undermine firms’ efforts and responsibility to develop their own scenarios.
Specific points for consideration by insurers
The H2 2014 stress scenario aims to give firms a consistent basis on which to confirm that their planned capital resources are sufficient to remain solvent and adequately capitalised in order to continue to write business throughout the capital-planning horizon (normally three to five years).
Firms should consider the conditions implied by the parameters set out in the H2 2014 stress scenario in order to derive consistent assumptions, on a prudent basis, for key risk factors that would affect their projected capital requirements. Firms should also consider insurance risk aspects (e.g. recession-related claims) arising from the scenario.
Insurers should incorporate these assumptions into their capital-planning processes, and be prepared to show this in discussions with their supervisors. Insurers should also examine the complementary relationship between the one in 200-year required stress for the Pillar 2 ICA and the macroeconomic scenario used for capital-planning purposes. For example, a four-year capital plan might assess how a firm expects to be able to continue to meet its capital requirements (including ICA) over the next few years in the face of a changing economic environment.
A detailed spreadsheet for the H2 2014 stress scenario is available below under Key Resources. (Note that the scenario is for stress-testing purposes only, and the scenario paths should not be interpreted as a forecast of the macroeconomic outlook.)
“Stress testing the UK banking system: key elements of the 2014 stress test” provides context for the variable paths in the scenario.