10
Stress testing and scenario analysis
10.1
A stress test is for the purposes of evaluating the impact of different adverse scenarios on the capital position of a firm. For example, simultaneous movements in a number of risk categories affecting all of a firm’s business operations, such as business volumes, investment values and interest rate movements.
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10.2
Depending on the nature, scale and complexity of a firm’s business, carrying out stress tests (including reverse stress tests) and scenario analyses can be an appropriate way for a firm to estimate the financial resources it would need to continue to meet Insurance Company - Overall Resources and Valuation 2.3. Such testing should reflect the potential range of outcomes for the risks being quantified and should take into account an appropriate range of adverse circumstances and events relevant to the firm's business and risk profile. For example, circumstances and events occurring over a protracted period of time or sudden and severe events, such as market shocks or other similar events or a combination of the two.
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10.3
The nature, depth and detail of the analysis will depend, in part, upon the firm’s capital strength and the robustness of its risk prevention and risk mitigation measures.
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10.4
Stress tests and scenario analyses can be used to carry out the capital assessment and, if so, should be documented in line with Insurance Company – Overall Resources and Valuation 2.10.
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10.5
The overall assessment of capital may require the aggregation of results from the stress and scenario testing. The firm should be able to explain its choice of aggregation approach and its understanding of the implications of combining the individual risks. The firm should be satisfied that the resultant capital provides the appropriate degree of confidence, given the variability of the underlying risks and the uncertainty associated with those risks. A useful component of this process is the characterisation and explanation of a range of possible circumstances that could give rise to a loss of this magnitude.
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10.6
If carrying out stress tests and scenario analyses, firms should estimate the financial resources that it would need in order to continue to meet Insurance Company – Overall Resources and Valuation 2.3 and the Capital Resources Requirement (Insurance Company – Capital Resources Requirements 3.1) in the adverse circumstances being considered. It should only include financial resources that could be reasonably relied upon in those circumstances and take account of any legal or other restriction on the use of financial resources.
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10.7
A firm should assess how risks aggregate across business lines or units, any material non-linear or contingent risks and how risk correlations may increase in stressed conditions.
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10.8
A firm should undertake a broad range of stress tests which reflect a variety of perspectives, including sensitivity analysis, scenario analysis and stress testing on an individual portfolio as well as a firm-wide level. Firms are reminded that they should also consider undertaking reverse stress testing.
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