Stress testing: insurers
Insurance firms use stress and scenario testing to consider the potential impact of certain adverse circumstances on their business. It is an important element in firms’ planning and risk management processes, helping them to identify, analyse and manage risks.
Insurers should develop, implement and action a robust and effective stress testing programme that assesses their ability to meet capital and liquidity requirements in stressed conditions, as a key component of effective risk management. All firms should undertake relevant analysis, commensurate with the nature, scale and complexity of their business.
The Prudential Regulation Authority (PRA) also runs its own stress tests on a periodic basis for a number of insurance firms. It does this regularly for specific high-impact firms and for other firms as the need arises, to assess their ability to meet minimum specified capital levels throughout a stress period.
System-wide stress testing is also undertaken by firms using a common scenario for financial stability purposes. To support its framework, the PRA sets policy for firms' stress testing requirements, sets stress scenarios and monitors test results.
Reverse stress tests
The PRA also expects insurance firms to apply reverse stress testing as part of their own risk and solvency assessment (ORSA) process. Reverse stress tests are stress tests that require a firm to assess scenarios and circumstances that would render its business model unviable, thereby identifying potential business vulnerabilities. This differs from typical stress and scenario testing, which tests for outcomes arising from changes in circumstances. A firm's business model is described as being unviable at the point when crystallising risks cause the market to lose confidence in the firm.
Reverse stress testing is primarily designed to be a risk management tool, encouraging firms to explore more fully the vulnerabilities and fault lines in its business model, including 'tail risks', and to explore potential mitigating actions. The PRA works with counterparts in the EU and internationally on approaches to stress testing.
Supervisory Statement 19/16