Stress Testing of Insurance Companies

Stress testing of insurance company balance sheets and income statements is not as well developed in financial stability analysis as in stress testing of banks. Insurance companies are generally considered to represent a lower level of systemic risk than banks, mainly because of the different character of their liabilities, which often have a longer duration than banks. However, distress in the insurance sector can have important systemic impli­cations, including through ownership relations with the banking sector and its effect on confidence in the financial sector as a whole.

Because insurance companies have a different balance-sheet structure compared to banks, stress tests of their balance sheets present unique challenges. Insurance companies face underwriting risk, catastrophe risk, and risks on technical claims provisions. On the asset side, more or less similar to banks, they also face market risk, credit risk, liquidity risk, operational risk, group risk, and systemic risk in differing degrees to those faced by banks and other financial institutions. Thus, the stress testing of the risks could be based on methods similar to those used for banks. However, on the liability side, different types of shocks and methods of analysis would be needed. For an example, increase in mortality rates or probabilities of certain catastrophic events would increase claims, and those fac­tors would have to be modeled.

The complexity of the contracts underlying insurance company balance sheets can create difficulties in revaluing liabilities and may require detailed data on a contract-by­contract basis to enable an accurate assessment of the effect of changes in risk factors. Stochastic techniques are sometimes used by insurers to assess their resilience to shock. Such techniques are complex and account for the probability of a range of possible outcomes. Alternatively, simple deterministic tests (for example, shifts in loss ratios or in

gauging the effect of specified catastrophic events), can reveal useful information about immunity to shocks. In some jurisdictions, insurance firms are required to report regularly on standardized stress test results to their supervisors. Recent FSAPs have begun to apply stress test scenarios affecting the liability side developments, in addition to the focus on asset values.

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