The UK’s PRA recently favoured its general insurance charges with the requirements for a periodic stress test. Those of a nervous disposition should look away now!
Of course, at Awbury, we make a virtue of trying to out-think the unthinkable… so, naturally, we read the document with some interest, to see whether it might further portend the end of (re)insurance as we know it, or perhaps envisage the London Market subsiding into the Thames. Perhaps ironically, one of the scenarios is a severe flood event lasting 6 days across most of southern England and Wales.
We were not too disappointed, because, beyond 9 “standard” scenarios (including the above-mentioned “Great Flood”), none of which would particularly surprise anyone used to Lloyd’s standard loss scenarios, the PRA added 2 more, which are more likely to cause furrowed brows and management angst, as they require evidence of some actual imagination. Specifically, the FCA asked firms to address:
- A “worst case own- 1-in-200 [year] insurance loss stress test (insurer specific)”. In other words a “1-in-200 year net aggregate insurance loss over a one year period.” Regulators seem to be fond of the 0.5% probability over a 1-year horizon. Oh, and it cannot be one of 9 “standard” scenarios.
Most, if not all, large P&C (re)insurance groups will have a team (probably part of their Enterprise Risk Management function) focused on scenario analysis and identifying so-called emerging risks. Therefore, it will be interesting to see what each of the respondents decides is its “worst nightmare” (absent the end of the world!), the extent to which there is correlation across the industry, and whether any potential 1-in-200 year event is enough to cause insolvency. Of course, the banking industry is (in)famous for failing to understand and identify its tail risks properly; whereas, so far, the (re)insurance industry as a whole has managed to survive extreme events.
And the second:
- A “reverse stress test (insurer specific)”
This is interesting, because it requires management to contemplate scenarios and circumstances that would “render its business model nonviable.” Your business can fail; and you have to try to identify circumstances where this might occur. Note that such an outcome could arise well before a business is insolvent, or has exhausted its regulatory capital. You don’t have to be insolvent to be out of business! The market simply no longer wishes to deal with you, because your vaunted, “best-in-class” underwriting team may simply have decided to de-camp for a better offer, or hackers “totaled” your ramshackle IT system and dumped all your data into the public domain. Perhaps you were “Googled” and your cost base cannot cope with the price competition? As has been said before: “only the paranoid survive.”
So, what is your worst nightmare in business terms? Will your sociopathic CRO finally take the business down with him/her? Or will his/her ruthlessness, drive and intellect help think the unthinkable, bamboozle the PRA, and outsmart the competition?
– The Awbury Team