Supervisory Information Circular – Stress Testing for Insurers

Stress testing is a risk management technique used to evaluate the potential effects on an insurer’s financial condition of a set of specified changes in risk factors corresponding to exceptional but plausible events. Stress testing includes scenario testing and sensitivity testing. Scenario testing uses a hypothetical future state of the world to define changes in risk factors affecting an insurer’s operations. Sensitivity testing involves an incremental change in a risk factor (or a selected number of risk factors). For instance, shifts in assumptions surrounding mortality, morbidity, interest, or inflation rates. Regulators also use stress testing to assess the ability of insurers to withstand external shocks that will adversely affect their book of business. The International Association of Insurance Supervisors (IAIS) defines stress testing as “a method of assessment that measures the financial impact of stressing one or more factors which could severely affect the insurer”, and its Insurance Core Principles (ICPs) require insurers to conduct stress testing to assess the resilience of its total balance sheet against macroeconomic stresses.

Scope and Applicability

The Cayman Islands Monetary Authority’s (the “Authority”) Rule on Risk Management for Insurers (the “Rule on Risk Management”) requires insurers to conduct stress tests and scenario analysis.

Section 5.3.2 of the Rule on Risk Management states: “As appropriate, an insurer must conduct quantitative and qualitative analyses namely stress tests and scenario analysis having regard to the size and complexity of the insurer, and the nature of its risk exposures.”

This Supervisory Circular is applicable to all categories of insurers that are licensed by the Authority to conduct (re)insurance business and provides guidelines to follow in developing and implementing its stress testing activities. These guidelines do not restrict an insurer from conducting additional stress testing other than that recommended by these guidelines if an insurer deems it appropriate.

Appendix A details the effect of shocks in stress testing scenarios.

Appendix B and Appendix C detail examples of the type of scenarios that the Authority expects class A insurers, and class B(iii) and D insurers carrying on reinsurance business to consider respectively.

General Instructions

• Each insurer should design its stress testing framework taking into consideration its own risk profile and the nature of its business. The insurer’s board of directors and senior management should take a leading role in the stress testing process. The board should approve the scenarios and assumptions put forward in the stress test, and the senior management should ensure that when conducting stress tests, all areas of risk to the insurer are considered.
• In performing the stress tests, the Authority requires the insurers to consider- solvency position; lines of business and distribution systems; current position within the market; current position within the insurer’s group; investment policy; business plan; and reinsurance ceded.
• The stress testing process should examine the impact of shocks to different risk categories within the book of business of an insurer (for example, insurance risk; market risk; credit risk; liquidity risk; operational risk; group risk; and system risk). This impact can be considered individually. For instance, the single-factor shock scenario of an increase in interest rate risk can be investigated individually by stressing the interest rate risk category only and assessing the impact on the book of business. Alternatively, impacts can be considered collectively. For instance, the impact of catastrophes on property, personal/ordinary life claims and mortgage payments can be considered collectively in a multi-factor shock scenario. The catastrophe and economic downturn are both multi-factor shock scenarios.
• The Authority requires that a baseline scenario should be the first scenario in the stress testing exercise and should depict the “null” impact on the insurer’s book of business. That is, the baseline scenario will represent the book of business of the insurer with no applied scenarios or sensitivity testing. The impact of each scenario selected (examples in Appendix B and C) can then be compared to the baseline scenario when producing the results of the stress testing.
• The insurers should perform stress testing on a regular basis to assess and identify adverse impact on its book of business. This can be done annually or biennial on a routine basis and whenever there is any material change in the insurer’s book of business.
• The source of the data that each insurer is required to use for the stress testing exercise is the year-end data i.e., the Annual Return Filings data which are submitted to the Authority on an annual basis.

The Authority’s Review and Assessment Process

From time to time the Authority will review and assess the adopted stress testing framework of the insurers. This includes a review of the selected scenarios and sensitivity analyses employed by the insurer during their stress testing exercise. The Authority reserves the right to evaluate and challenge the scope, severity, assumptions and scenarios of stress testing. The results of the stress testing exercise will be reviewed in detail assessing the impact on the insurer’s capital and solvency, including the margin for technical reserve.

Based on the outcome of the stress testing exercise, the Authority may recommend a corrective or remedial action plan for the insurer to undertake to correct any negative implications to the insurer’s book of business. The Authority may also require the insurer to submit stress testing results to the Authority on a more frequent basis.

Appendix A: Effect of Shocks in Stress Testing Scenarios

Table 1 below identifies the shocks that include immediate changes in interest rates, mortgage values, real estate market values, equity market values, claims experience, property insurance claims, levels of technical provisions, defaults by related parties, failure of one or more, reinsurers, adverse expenses and devaluation of government securities.

Appendix B: Examples of the type of scenarios that the Authority expects Class A insurers to consider

Three (3) typical scenarios that may be tested for class A insurers are, economic downturn, catastrophe, and an extended pandemic, that will examine the resilience of the insurer to severe but plausible shocks. For each scenario, the impact of an economic downturn will be considered simultaneous with the defined scenario.

Economic downturn

This scenario investigates the impact of an economic downturn on the insurer. The downturn may be a result of external shocks that leads to unemployment and decline in the stock market. This economic downturn will also result in a decrease in sales and decline in investments as individuals reduce spending. The table below highlights the shocks that will be applied to the stress factors in this scenario.

Catastrophes

These scenarios hypothesize the occurrence of natural catastrophes and the impact they will have on the insurer. The most likely natural catastrophe to occur in the Cayman Islands is a hurricane/windstorm. A hurricane with strong sustained winds will cause damages to buildings, houses and inflect injuries or loss of lives. It can also cause significant impact on the infrastructure of the country damaging the airports, shipping ports, utility plants, utility transmission networks, telecommunications networks, roads, cars etc.

An earthquake is also a likely natural catastrophe to occur in the Cayman Islands. For this catastrophe scenario, the occurrence of an earthquake and subsequent tsunami is considered. A tsunami is a devastating natural catastrophe that can cripple the economy of a country with devastating damages because heights above sea level are minimal. The multi-factor shocks in these scenarios are outlined in the table below.

Extended Pandemic

This scenario explores the possibility of an extended pandemic, like the coronavirus (SARS-CoV-2), in the first instance then coupled with an economic downturn in the second case.

Appendix C: Examples of the type of scenarios that the Authority expects Class B(iii) and Class D insurers carrying on commercial reinsurance business to consider

Three (3) typical scenarios that may be utilized by class B(iii) reinsurers and D reinsurers are- economic downturn, catastrophe, and a mortality/longevity event, that will examine the resilience of the reinsurer to severe but plausible shocks. For each scenario, the impact of an economic downturn will be considered simultaneous with the defined scenario.

Economic downturn

This scenario investigates the impact of a global economic downturn on the reinsurer. The downturn may be a result of external shocks that lead to a decrease in real estate values, unemployment and decline in the stock market. This economic downturn will also result in a decrease in the reinsured book of business due to a decrease in insurance sales and decline in investments as individuals reduce spending.

Catastrophes

These scenarios hypothesize the occurrence of wind disasters (example- hurricanes, tornados and windstorms) and the impact they will have on the reinsurers. The Authority will consider the effect of hurricanes in the United States (“US”) on the Cayman-based reinsurers with US catastrophe exposures. These hurricanes typically follow a path along the coastline of Florida and up the east coast of the US, but there may be hurricanes along the west coast of US as well.

The occurrence of earthquakes in California is also a likely natural catastrophe that will have significant impact on the Cayman-based property and casualty reinsurers. One of the scenarios to be considered is the impact of an earthquake or series of earthquakes in California that will significantly impact the claims and hence the viability of the reinsurers.

Other natural catastrophes that can harm the financial stability of the commercial reinsurers that insures property and casualty risks in the US jurisdiction are tornadoes and winter storms. The National Oceanic and Atmospheric Administration identifies the tornado season in the US to run from March through to July each year. Winter storms (include snow, ice, freezing and flooding) also cause severe damage to US properties annually.

Given the prevalence of these natural catastrophes in the US, it is prudent that the reinsurers perform stress tests on their book of business to identify the vulnerability to increase claims from such events. The multi-factor shocks in these scenarios are outlined in the table below.

Insurance Asset Shock and Longevity Event

This scenario involves the occurrence of an economic downturn simultaneously with an increase in longevity expectations. Reinsurers that underwrite annuity business will consider the effect of longevity on their book of business. The increase in life expectancy across the globe has led actuaries to consider the impact that this will have on the annuity-related products being developed. The Authority requires that the reinsurers incorporate a scenario that accounts for this type of impact.