1. What is a stress? What are the regulatory history and roles? What is a Stress test process?
2. Including stress scenario and stochastic models and overlay the scenario in the model.
3. Limitations and thoughts.
STRESS TESTING TERMS
1. Sensitivity – Given an x% change in a KPI results in a y% change in capital.
2. Stress – Severe yet plausible event
3. Scenario – Collected set of stress to make one overall scenario
4. Reverse stress test – A stress scenario constructed to a predetermined outcome.
5. Stochastic Stress – Severely adjust stochastic distributions for use in a stochastic capital model
EXAMPLES AND SCALE AND SCENARIOS
REGULATORY ISSUES - DFAST (Dodd-Frank Act Stress Test)
1. Predefined Economic Scenarios
2. Companies add additional liability stresses to the economic
3. All financial institutions (bank holding companies) with total consolidated assets of $10 billion
4. 3 scenarios: Baseline, Adverse and Severe Adverse.
REGULATORY ISSUES - CCAR (Comprehensive Capital Analysis and Review)
1. Similar to DFAST but includes capital outflows and capital planning actions.
2. Same scenarios as DFAST
3. Applies to institutions above $50 billion in assets
STRESS SCENARIOS PROCESS
1. Step 1 - Development of Stress Scenarios
- Macro Economic Stress
- Asset
- Liabilities
2. Step 2 - Evaluate the financial effects of the scenarios
- Direct Financial (Assets)
- Indirect Financials (Liabilities, inflation) - Other Knock on effects (Regulatory action, capital costs)
3. Step 3 - Communication with Leadership
– Review outcome and results
- Risk appetite and tolerances
4. Step 4 - Identifying and recommending management decisions
– Identify actions and gaps to be mitigated
– Risk transfer / Mitigation
UNDERSTANDING THE DEPENDENCIES OF A SCENARIO
1. Scenario need to be developed in conjunction with the assumed effects of the scenario
2. They also provide an excellent way of capturing very remote probability events (Catastrophe and Severe Financial Stress)
3. Changes from events such as catastrophic events and interest rate changes towards effects such as changes in claims frequency, reserving and equity returns.
Communication and Management Actions
1. Stress and scenario testing can be easier to discuss with management than probabilities and stochastic results.
2. View the results of the stress test in conjunction with management and their overall risk appetite.
3. With proper scenarios it can give management good information for planning actions and deciding what risk options to use going forward.
4. Actions may include Risk Transfer, reinsurance, contingent capital, exposure management, and De-risking the business.
UPCOMING POSTS
1. Integration of scenario with capital modelling.
2. Capital models and Standard Capital Modeling Process
3. Thoughts
