Stress Testing and Scenario Analysis

Question 1

What can stress testing and scenario analysis be used for?

Answer 1

1. Assess capital and liquidity requirements.
2. Understanding the dynamics of the risk environment and provides a tool for decision making.
3. Challenging the output of VaR or other models.
4. Informing senior management.
5. Providing a tool for decision making.

Question 2

What is stress testing?

Answer 2

Evaluates performance areas based on extreme changes to variables e.g. interest rates or equity indices.

Question 3

What is scenario analysis?

Answer 3

Considers portfolio performance in severe states of the world either hypothetical or historical.

Question 4

What are types of stress tests?

Answer 4

1. Sensitivity Tests
2. Historical events
3. Customised events
4. Multi year stress tests
5. Reverse stress tests

Question 5

What is a sensitivity test?

Answer 5

Small changes in input factors in models. Allows to see if a small change in one factor causes a large change to the model’s outputs.

Question 6

What is a historical event simulation?

Answer 6

Simulating a historical event and seeing how the current portfolio would perform.

Question 7

What are customised events?

Answer 7

Hypothetical events that used to see how portfolios may develop e.g. what might happen if Hurricane Katerina took a different path and hit the east coast of the US - what impact would that have on the insurance models?

These are quite costly and time consuming methods

Question 8

What is a multi-year stress test?

Answer 8

Applying a factor change and seeing what impact this has on the business plan looking 3-5 years ahead.

Question 9

What is a reverse stress test?

Answer 9

Start from the point where the business would be unviable and then build an understanding of what conditions may bring about that end state.