CIA.FCT-1 Flashcards
What does FCT stand for?
Financial Condition Testing
What are the 2 goals of FCT?
- Identify threats to the insurer’s financial condition
- Take corrective actions to address those threats
Why does an insurer perform stress-testing? (HISC)
- Helps identify and control risk
- Complement other risk management tools such as Best Capital Adequacy Ratio
- Supports capital management
- Improves liquidity management
What are the 5 key elements of FCT? (BACRO)
- Base Scenario: must develop a base scenario
- Adverse Scenario: must analyze the impact of several adverse scenarios
- Corrective action: identification and analysis of corrective management actions to mitigate risks.
- Report: submit recommendations to management and the board of directors (or chief agent)
- Opinion: Appointed Actuary signs an opinion regarding the financial condition of the insurer.
Briefly describe the stress-testing purpose: ‘risk identification & control’.
risk identification:
- identify concentrations & interactions of risks
risk control:
- adjust individual portfolios or overall business strategy
Briefly describe the stress-testing purpose: ‘complementing other tools’.
Can be used to validate & verify findings from other risk modeling techniques
Briefly describe the stress-testing purpose: ‘supporting capital management’.
Understand where the risks are & set required capital to cover them
Briefly describe the stress-testing purpose: ‘improving liquidity management’.
Assess liquidity profile and adequacy of buffers FOR institutional & market-wide stresses.
To perform FCT, it is necessary to understand which 2 key metrics?
• regulatory capital minimum(s)
• insurer’s internal target capital requirements ← determined by ORSA
True or False?
FCT and ORSA are closely related although ORSA is more comprehensive in nature.
True
Identify the ‘preliminary’ step and the ‘extra’ step in addition to ‘BACRO’ when performing FCT.
preliminary step:
- review financial position at year-end for each year in historical period
extra step at the end:
- identify possible regulatory action
Identify the 2 actions performed during the review of operations and financial position (preliminary step).
• review balance sheet, statement of income, and source of earnings for an appropriate number of years
• analyze any trends in these numbers
What is the desired forecast period for FCT?
Generally 3-5 years although there is no minimum (should also be consistent with ORSA)
Which 4 elements should be captured by the forecast period of FCT?
The forecast period should be long enough to capture
[1] risk emergence
[2] financial impacts
[3] ripple effects
[4] corrective action
How do you determine the materiality standard for FCT? (3 elements)
FCT sets the materiality standard with management input and by specifically considering:
- size of insurer
- financial position
- nature of regulatory test
Define the term base scenario.
A set of assumptions on risk factors that are consistent with the business plan over the forecast period (if plan is realistic & consistent).
Define the term adverse scenario.
A scenario that is developed by stress-testing assumptions used in the business plan (look specifically for risk factors that threaten financial condition).
Define the term solvency scenario.
A plausible adverse scenario
An adverse scenario that has a non-trivial probability of occurring.
Define the term going-concern scenario.
An adverse scenario that is more likely and/or less severe than a solvency scenario (could include risks not considered in solvency scenarios).
What is a ripple effect?
An event that occurs when an adverse scenario triggers a change in 1 or more inter-dependent assumptions.
Can include policyholder actions, management’s routine actions, regulatory actions
Example: a ripple effect of an earthquake may be loss of reinsurance
What is a corrective management action?
An action management takes to mitigate adverse ripple effects
What is an integrated scenario for FCT?
A scenario created by combining two or more risks factors to produce a new plausible adverse scenario
Example: combine a low-probability scenario with a higher-probability adverse scenario
Identify 3 considerations in the development of a climate change integrated adverse scenario. (Hint = PLT)
Consider these climate-related risks:
1. Physical risk → frequency and severity of wildfires, floods, wind events, rising sea levels
2. Transition risk → due to economic shift to greener technologies
3. Liability risk → exposure to climate-related litigation
An FCT model should reproduce which 4 key elements of the Financial Statements?
- Balance sheet: assets, liabilities, retained earnings
- Income statement: revenue and expenses
- Regulatory measures of capital adequacy: MCT ratio, BCAR, MSA ratios
- Sources of earnings: detail on sources of premium ans investments
What is the recommended loss distribution percentile for a going-concern scenario?
90th → 95th percentile (if the loss distribution and percentiles are available)
What is the recommended loss distribution percentile for a solvency scenario?
Above 95th percentile (if the loss distribution and percentiles are available)
How does an actuary validate an FCT model on an accounting basis?
statement of income = (cash flows) + (change in balance sheet items)
How does an actuary validate a FCT model in a static environment
Base scenario should show continuity of results from year-to-year (cash, liabilities, surplus,..)
When is a stochastic FCT model appropriate (2)?
- when risk distributions are easily inferred (Ex: cats)
- capital market risks
When is a deterministic FCT model appropriate?
When distributions are NOT easily inferred
Actuary then selects scenarios based on (historical experience, credibility of data)
Briefly describe the stochastic/deterministic combination model.
When RESULTS of a stochastic model are used to DERIVE a deterministic scenario that REPRODUCES the stochastic results.
What are the 2 ways to model ripple effects in a FCT analysis?
AUTOMATICALLY: by computer model
MANUALLY: by actuary based on knowledge of situation
What are the 3 considerations in FCT model segmentation?
MANAGEMENT: segment around management structure
PRODUCT: smallest subdivision - may combine similar products
INVESTMENT: asset categories
How frequently should the FCT be performed?
At least once during each financial year
Why is FCT report so important?
That is part of how an actuary communicates the state of the company to the BoD and includes:
1. Identification of risks to the insurer’s financial condition
2. Identification of ways to mitigate and reduce risk
Who are the 3 audiences for an FCT report?
- BoD: prefers an interpretive summary (versus a detailed statistical report)
- management: receives a more detailed report
- Regulator: focuses on solvency issues
Identify the 3 possible types of opinion included in a FCT report.
- Satisfactory
- Satisfactory subject to appropriate corrective action (if management promises to fix whatever is wrong, then the AA will be nice)
- Not satisfactory
When can an actuary report that the financial condition of an insurer is satisfactory?
The following conditions must hold throughout the forecast period:
[1] under the base scenario insurer meets its internal target capital ratio(s) as determined by the ORSA (ex: MCT > 180%)
[2] under the going-concern scenarios → insurer meets the regulatory minimum capital ratio(s) (ex: MCT > 100%)
[3] under solvency scenarios → must have assets > liabilities
How many adverse scenarios should an FCT report include?
At least 3, including 1 going-concern scenario and 2 solvency scenarios
They should be chosen from multiple risk categories
True or False?
In the assessment of the satisfaction of a FCT analysis, you should always consider all displayed years.
False
Even if the given information displays 5 years of projections, you only have to check the conditions for years that are in the stated forecast period.
Identify the 9 P&C risk categories. (Hint: F-PIP-RIGOR)
- Frequency & Severity
- Policy Liabilities
- Inflation
- Premiums
- Reinsurance & Counter-Party risk
- Investment risk
- Government risk
- Off-Balance-Sheet risk
- Related Company risk
Identify 7 common ripple effects.
- Higher LR (due to higher losses or operating costs)
- Loss of reinsurance
- Post-event inflation
- Forced sale or liquidation
- Mix shift
- Policyholder actions
- Regulatory action
Identify 7 common corrective management actions.
- Tighten U/W guidelines
- Raise rates
- Review reinsurance
- Sell assets
- Review mix of business
- Suspend dividend payments
- Reduce capital transfer to parent or home office
Identify 2 possible causes of a change in frequency and severity.
- Catastrophic events
- Large Claims
- Social inflation (claims inflation resulting from changes in the likelihood of claimants bringing suit, the size of awards, the standard of liability, or the attitudes of claimants towards settlement of their claims.
Identify 2 possible causes of Policy liabilities risk.
- Selection of inadequate LDFs
- Class actions and other mass torts
- Change in mix of business (especially if large claims are paid earlier)
- Actual return on investment supporting the liabilities significantly lower than assumed
Identify 2 causes of Inflation risk.
- A significant, rapid and sustained increase in the general rate of inflation
- A significant temporary increase in the cost of labour and materials following a catastrophe or other major event
- A severe recession in the economy
Identify 2 causes that could result in significant reduction in premium volume (premium risk).
- Entry of a new strong competitor in the market
- Increased competitiveness in the market
- Loss of a key distributor or even an entire distribution channel
- Loss of a key client
- Action by any influential entity that affects the insurer’s reputation or growth negatively
- Non-competitive premium rates
Identify 2 causes that could result in significant increase in premium volume (premium risk).
- Withdrawal or failure of major competitors from a market
- Appointment of a key distributor
- Unexpected new business from a large client
- Any action by any influential entity that affects the insurer’s reputation or growth favourably
- Unexpected success in a new product area, or against previously stronger competition
- Premium rates set too low compared to the competition
Identify 2 causes leading to reinsurance risk.
- Reinsurance insolvency
- An increase in the reinsurance rates or a reduction in reinsurance commission
- Reduction in capacity
- Disputes over policy conditions
Identify 2 causes of a change in investment risk.
- Significant change in the yield curve
- Increase in the default rate on debt securities
- Decrease in the returns and/or value of equities
- Decrease in the returns and/or value of real estate
- Decrease in the returns and/or value of subsidiary
- Significant change in foreign exchange rates
- Decrease in the returns and/or value of other major asset categories
Identify 2 causes of a change in government risk.
- Rate freeze or rollback of rates by gov
- Change to regulations regarding use of rating variables
- Change to legislation that that prescribe levels of insurance coverage
- Increase in taxation rates or rules for corporations
- Nationalization or privatization
- Change to legislation that creates or restricts distribution channels
- Change in regulatory solvency standards
- Political instability
Identify 2 causes of a change in off-balance sheet items risk.
- Structured settlement (credit risk associated with the insolvency of the insurer selling the annuity)
- Contingent liabilities or losses (tax, litigation, etc.)
- Letters of credit and pledged assets (lending institution default risk)
- Capital maintenance agreements
- Derivative instruments (market risk, default/credit risk, management risk and legal risk)
- Pension underfunding
identify 2 causes of a change in related companies risk.
- A reduction in reliance on the parent company for financial support
- An increase in the provision of financial support to the parent
- A high level of dependency on group operation resources
- A rating agency downgrade reflecting difficult financial conditions at the group level.
Identify 2 methods for selecting adverse scenarios.
- Percentiles (if a loss distribution is available)
- Reverse stress-testing
Briefly describe the method of reverse stress-testing in an FCT analysis
Start by considering a specific adverse scenario where the insurer’s surplus becomes negative (surplus = assets - liabilities)
Work backwards to find the risk factors required to produce that scenario
Determine if it’s plausible for risk factors of the insurer’s current financial position to deteriorate to that degree
→ if yes then this adverse scenario may be a solvency scenario
Should the actuary integrate the FCT report with the ORSA report or keep them separate?
Actuary should use judgement
May produce 2 independent reports or 1 integrated report
Identify 4 considerations supporting integration of FCT and ORSA.
- FCT uses internal target capital ratios developed by ORSA
- ORSA is useful in assessing adverse scenarios
- May be more efficient to integrate the reports (both require data collection and similar types of analysis, both may be released at the same time)
- A single integrated report may be better for the end user
Identify 3 challenges regarding integration of FCT and ORSA.
- Oversight: AA is responsible for FCT whereas the board and senior management is responsible for ORSA
- Different methodology: FCT follows a prescribed regulatory basis while ORSA reflects own models and assumptions
- Staff responsible: different for FCT versus ORSA and coordination may be costly
