CIA.FCT-1 Flashcards
Briefly describe the purpose of stress testing [RCCL]
Risk
- Identify and control risks
Complement:
- Provide a complement to other risk management tools & simulate shocks
Capital
- Support capital management
Liquidity
- Improve liquidity management
Describe the stress testing purpose: “risk identification & control”
Stress testing can be used to address institution-wide risks and consider concentrations and interactions between risks in stress environments that might otherwise be overlooked. Knowing the sources of threat will help advise the insurer where it is most vulnerable & aid the development of potential management actions that could be applied
Describe the stress testing purpose: “Complementing other tools”
- Stress tests would complement risk quantification methodologies that are based on complex, quantitative models using historical data and estimated statistical relationships.
Describe the stress testing purpose: “supporting capital management”
- Stress testing would form an integral part of an institution’s internal capital management where rigorous, forward-looking stress testing can identify severe events, including a series of compounding events or changes in market conditions.
Describe the stress testing purpose: “improving liquidity management”
- For assessing the institution’s liquidity profile and the adequacy of liquidity buffers in case of both institution-specific and market-wide stress events
Identify and briefly describe the key elements of FCT (Financial Condition Testing) [BACRO]
- Base Scenario - must develop a base scenario (usually the insurer’s current business plans)
- Adverse scenarios - must develop mutliple adverse scenarios (Ex: COVID, climate change)
- 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
Identify key metrics that must be understood when performing FCT (2)
- Regulatory capital minimum(s)
- Insurer’s internal target capital requirements - determined by ORSA
Identify the “preliminary” step and the “extra” step in addition to “BACRO” when performing FCT
Preliminary step (rev):
- review financial position at year-end for each year in historical period
Extra step at the end (reg):
- Identify possible regulatory action
What is a review of operations and financial position
- 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 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
Generally 3-5 years although there is no minimum (should also be consistent with ORSA)
How do you determine the materiality standard for FCT
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 used to forecast the insurer’s financial position over the forecast period. The assumptions on risk factors should be consistent with the business plan (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 occuring)
- Should fall above the 95th percentile on the loss distribution (if the distribution is available)
- Or possibly as high as the 99th percentile and beyond depending on circumstances
Define the term: going-concern scenario
An adverse scenario that is more likely and/or less severe than a solvency scenario
- Should fall above the 90th percentile on the loss distribution (if distribution is available)
- 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 actions?
An action management takes to mitigate adverse ripple effects
What is an integrated scenario in FCT?
A scenario created by combining two or more risk factors to produce a new plausible adverse scenario
Example: combine a low-probability scenario with a higher-probability adverse scenario
Identify considerations in the development of a climate change integrated adverse scenario
Consider these climate-related risks (PTL):
- Physical risk - frequency and severity of wildfires, floods, wind events, rising sea levels
- Transition risk - due to economic shift to greener technologies
- Liability risk - exposure to climate-related litigation
Identify examples of IFRS17 measurement features to consider for FCT scenarios (3)
IFRS 17 Liabilities:
- generally make no provision for default risk, reinvestment risk or other asset-related risks.
- only include provision for maintenance expenses that are directly attributable to the administration of the contracts
- do not reflect certain benefits such as the impact of discounting arising from deferred tax assets and risk premiums that are deducted in determining discount rates.
Identify key elements that an FCT model should reproduce (4)
- Balance sheet: assets,liabilities,retained earnings…
- Income statement: revenue & expenses
- Regulatory measures of capital adequacy: MCT ratio, and possibly others like BCAR or MSA ratios
- Sources of earnings: detail on sources of premium and investments
What is the recommended loss distribution percentile for a going-concern scenario
90-95th percentile (if the loss distribution and percentiles are available)
What is the recommended loss distribution percentile for a solvency scenario
95-99th percentile (if the loss distribution and percentiles are available)
- Or even beyond the 99th percentile in some cases
How does an actuary validate an FCT model on an accounting basis
Verify: 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)
This can be used to compare two FCT models and determine which is valid
How does an actuary validate a new FCT model or model update
NEW MODEL: run with data at (t-1) & compare to actual data at t (should be close)
MODEL UPDATE: do a retrospective test (compare prior base scenario projection to current data)
How does an actuary validate a FCT model in a changing environment?
ASK: does model properly QUANTIFY changes in results under different assumptions
COMPARE: 2 adverse scenarios (magnitude & direction of change should be consistent with assumptions)
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)
What is a combination stochastic/deterministic model
When results of a stochastic model are used to derive a deterministic scenario that reproduces the stochastic results
How are ripple effects in a FCT analysis modeled? (2)
AUTOMATICALLY: by computer model
MANUALLY: by actuary based on knowledge of situation
What are some considerations in FCT model segmentation? (3)
MANAGEMENT: segment around mgmt structure (LOBs, cost centers)
PRODUCT: is smallest subdivision - may combine similar products
INVESTMENT: segments are based on asset categories
Identify an important IFRS 17 concept to consider when creating an FCT scenario
CSM (Contractual Service Margin) for the GMA and VFA approaches
Identify aspects of IFRS 17 that should be considered when creating FCT scenarios (4)
- The impact of adverse scenarios on onerous groups will not be absorbed by the CSM but will be reflected in earnings immediately.
- Modelling will need to capture the behaviour of groups of contracts rather than individual contracts.
- The need to model and report on groups of reinsurance contracts held separately from the underlying primary insurance contracts
- Modelling of NB and RN will need to capture the determination of whether a groups of contracts is onerous or profitable at inception under the base and adverse scenarios.
What is the purpose of an FCT report?
COMMUNICATION to BoD:
- Identify risks to an insurer’s financial condition
- Identify ways to mitigate and reduce risk
Who are the audiences for an FCT report (3)?
BoD:
- prefers an interpretive summary (vs a detailed statistical report)
OSFI (regulator):
- Focuses on solvency issues
Management:
- Receives a more detailed report
Identify the possible types of opinion that AA could include in their FCT report (3)
- Satisfactory
- Satisfactory subject to appropriate mgmt corrective action
- Not satisfactory
When can AA report that the financial condition of an insurer is satisfactory?
The following conditions must hold throughout the forecast period:
base scenario >= internal target capital ratio as determined by the ORSA
going-concern scenarios >= 100% (e regulatory minimum capital ratio)
solvency scenarios 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 also be chosen from multiple risk categories
Identify the 12 P&C risk categories
[CLIVR ME GO RCT]
Claim Frequency and Severity Risk
Liability for Incurred claims risk
Inflation Risk
Volume and mix of business risk
Reinsurance held risk
Market and Credit Risk
Expense Risk
Government and Political Risk
Off-balance sheet items risk
Related Companies risk
Climated-related risks
Technology and cyber risk
Identify 2 causes, ripple effects and management actions for the following P&C risk: Claim Frequency and Severity Risk
Causes:
- Single catastrophic event
- Single large claim
Ripple effects:
- Forced sale or liquidation of assets
- Rating Agency downgrade
Management actions:
- Implementing rate increases, where possible
- Reviewing reinsurance held coverage, type, or contract terms at renewal
Identify 2 causes, ripple effects and management actions for the following P&C risk: Liability for incurred claims risk
Causes:
- Selection of inadequate loss development factors
- Change in mix of business
Ripple effects:
- Forced sale or liquidation of assets
- Rating agency downgrade
Management actions:
- Implementing rate increases, where possible
- Reviewing reserving and claim settlement guidelines
Identify 2 causes, ripple effects and management actions for the following P&C risk: Inflation Risk
Causes:
- A significant, rapid, and sustained increase in the general rate of inflation
- A severe recession in the economy
Ripple effects:
- A rapid and sustained increase in market interest rates
- Increase in operating expenses
Management actions:
- Implementing rate increases, where possible
- Reviewing reinsurance held coverage, type, or contract terms at renewal
Identify 2 causes, ripple effects and management actions for the following P&C risk: Volume and mix of business risk
Causes:
- Business volume significantly lower than base scenario
- Business volume significantly higher than base scenario
Ripple effects:
- Higher expenses
- Shift in portfolio mix
Management actions:
- Implementing rate increases, where possible (both scenarios)
- Reducing personnel or slowing down hiring (lower)
- Reviewing distribution channels (higher)
Identify 2 causes, ripple effects and management actions for the following P&C risk: Reinsurance held risk
Causes:
- Reinsurer insolvency
- Reduction in capacity
Ripple effects:
- Increase in reinsurance held rates arising from the need to obtain replacement coverage
- Reduced availability of reinsurance held
Management actions:
- Changing reinsurers
- Reducing primary policy limits
Identify 2 causes, ripple effects and management actions for the following P&C risk: Market and Credit Risk
Causes:
- A significant change in the yield curve
- A significant change in foreign exchange rates
Ripple effects:
- Forced sale or liquidation of assets
- Rating agency downgrade
Management actions:
- Selling or reinvesting assets
- Changing the investment strategy
Identify 2 causes and ripple effects for the following P&C risk: Expense Risk
Causes:
- Inflation
- Mergers and acquisitions, or assumptions of new business
Ripple effects:
- Rating agency downgrade
- Litigation impacts
Identify 2 causes, ripple effects and management actions for the following P&C risk: Government and Political risk
Causes:
- A rate freeze or rollback of rates by a government body or regulator on LOBs and jurisdictions in which rates are subject to regulatory approval
- A change to legislation that prescribes levels of insurance coverage, such as automobile accident benefits
Ripple effects:
- Forced sale of liquidation of assets
- Increased litigation costs
Management actions:
- Creating or expanding a separate company or distribution channel
- Reviewing reinsurance held coverage, type, or contract terms at next renewal
Identify 2 causes, ripple effects and management actions for the following P&C risk: Off-balance sheet items risk
Causes:
- Structured settlements (exposed to credit risk from institution selling annuity)
- Letters of credit and pledged assets (lending institution may default on payment)
Ripple effects:
- Forced sale or liquidation of assets
- Significant positive or negative cash flows, affecting the insurer’s liquidity position
Management actions:
- Selling or reinvesting assets
- Changing the reinsurance held strategy
Identify 2 causes, ripple effects and management actions for the following P&C risk: Related Companies Risk
Causes:
- A reduction in reliance on the parent company for financial support
- A rating agency downgrade reflecting difficult financial conditions at the group level
Ripple effects:
- A need to provide for service disruptions
- Regulator action to protect local policyholders
Management actions:
- Implementing rate increases, where possible
- Selling or reinvesting assets
Identify 2 causes, ripple effects and management actions for the following P&C risk: Climate-related risks
Causes:
- Physical risk: increased freq/sev of climate events
- Transition risk: shift towards green initiatives
Ripple effects:
- Increased frequency of catastrophe events
- Increased severity of catastrophe events
Management actions:
- Selling or reinvesting assets
- Finding alternative sources of reinsurance
Identify 2 ripple effects and management actions for the following P&C risk: Technology and cyber risk
Ripple effects:
- Disclosure of data breach, and possible reputational damage and fines as a result
- Decline in new business
Management actions:
- Invest in cybersecurity and IT infrastructure to combat possible risks and exposure to a cyber event and ensure compliance with existing legislation
- Purchasing cyber insurance to mitigate against losses arising from future attacks
Identify 2 more corrective management actions that are applicable only in certain situations
- Suspend dividend payments (possible only if company pays dividends)
- Reduce capital transfers to parent or home office (possible only for subsidiaries or branch offices)
Identify methods for selecting adverse scenarios (2)
- Percentiles (if loss distribution is available)
- Reverse stress-testing
Describe the method of reverse stress-testing in an FCT analysis
- Start by considering a specific adverse scenario where the insurer’s surplus become 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 solvency scenario)
Should the actuary integrate the FCT report with the ORSA report or keep them separate?
- Actuary should use judgment
- May produce 2 independent reports or 1 integrated report
Identify considerations supporting integration of FCT and ORSA (4)
- FCT uses internal target capital ratios developed by ORSA (and these target ratios may develop over the time frame of a projection)
- ORSA is useful in assessing & developing 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 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
Define: social inflation
The increase in costs due to changes in public behaviour, being more likely to submit a claim or more likely to sue, resulting in high costs to the company, and can result in inadequate premiums and loss reserves
List the common ripple effects
[MRS LR RIP]
Mix of business change
Reins loss
Sale/liquidation of assets (forced)
LR (higher)
Regulatory actions
Inflation (post-event)
Policyholder actions
List the common corrective mgmt action
[MR U/W RA]
Mix of business (review geo, limits, etc.)
Review reins
U/W tighten
Raise rates
Asset (sale)
