Stress and scenario testing are important risk assessment tools. They also provide useful ways to prepare in advance for adverse scenarios so that management doesn’t have to create everything from first principles when something similar occurs.
But trying to imagine scenarios, particularly very severe scenarios, isn’t straightforward. We don’t have many examples of very extreme events.
Some insurers will dream up scenarios from scratch. It’s also common to refer to prior events and run the current business through those dark days. The Global Financial Crisis is a favourite – how would our business manage under credit spread spikes, drying up of liquidity, equity fall markets, higher lapses, lower sales, higher retrenchment claims, higher individual and corporate defaults, switches of funds out of equities, early withdrawals and surrenders and increased call centre volumes?
Mortality rates are estimated anywhere between 30% and 100% without treatment. Many estimates are towards the top end of this range, 80% to 95%. Treatments are available (mostly antibiotics) and are generally effective. Mortality rate where adequate treatment is administered within 24 hours can be 11%. (Either “just 11%” or “11%!” depending on whether you’re counting up from 0% or down from 95%.)
This reminded me a little of trying to come up with the “right” risk taxonomy or risk management framework. There are so many different ways to draw boundaries, none which is perfect and many which are acceptable and useful.
I’ve been working with a few insurers and reinsurers on credit risk recently. We’ve had plenty of reasons to think about it, what with new regulations (SAM, Basel III) and South African government downgrades. However, sometimes I get the impression that credit risk is viewed as an academic risk, as something that happens to others, micro lenders and maybe banks.
In South Africa, we’ve had incredibly few corporate bond defaults and most market participants don’t even know that the South African government “restructured” some of its debt in 1984 and so has, in fact, defaulted on contractual bond obligations.
In a recent credit risk and capital workshop, I raised the issue of Russia defaulting on Ruble-denominated debt in 1998, a big part of what led to the collapse of LTCM. Again, these events are often figured as “exceptionally unlikely” and not even worth holding capital.
Well, in the news, Argentina is about to default. Again. They have been one of the most regular defaulters on sovereign debt in the last couple of centuries. They’re also an example I often use of “currency pegs” doing precious little to mitigate currency risk except on a day to day basis.
More on that in another post (yes, I’m hoping to post a little more regularly in the coming months.)
A few people have mentioned that they found my “live blogging” or tweeting of the 2013 LAC Seminar in Cape Town and Joburg useful. I used the hastag #LACseminar2013. I’m repeating all of them here in case they’re useful in a slightly more long-lived medium of my blog. I didn’t cover all the sessions – below is all there is and yes, in reverse order for bizarre reasons I’m not going to go into now.
@23floor: Also, envisaged that product specifications, including commission, must be filed with regulator #LACseminar2013 #microinsurance
@23floor: And yes, a range of market conduct, board composition requirements are envisaged for micro insurance #LACseminar2013 #microinsurance
@23floor: Raw (cleaned and anonymize) data *might* be released publically. I would definitely support this. Data should be open #LACseminar2013
A client recently mentioned that they were concerned about the implication that the adoption of Solvency Assessment and Management (SAM) would have on insurance accounting under current IFRS4.
The apparent concern was that measurement of policyholder liabilities for IFRS reporting would change to follow SAM automatically.
Let me start out by saying this is categorically not the case. The adoption of SAM should not change IFRS measurement of insurance liabilities. In this post I’ll cover some of the technical details and common misconceptions of IFRS4 to demonstrate why this conclusion is so clear. Continue reading “The Perfect Storm Part 1 – IFRS reporting under SAM”
The world of financial reporting for insurers has never been this close to the edge.
There is more change brewing now even than when Europe adopted “European Embedded Values” and later “Market Consistent Embedded Values”. The irony is that Embedded Values may well fall away as a result of the latest change.
So what is changing?
Solvency Assessment and Management (SAM) is still planned for 2015 in South Africa. SAM will change the calculation of actuarial reserves, or Technical Provisions as they are now known, for regulatory reporting purposes. Solvency II in Europe is now likely to follow rather than precede SAM by a few year, but with nearly identical implications.
IFRS4, the accounting standard covering insurance contracts, is due for a radical change effective in 2016/2017, although this is years later than originally planned. IFRS4 “Phase 2” as it is referred to throws out most of what we’re used to in terms of profit recognition, financial impact of assumption changes, impacts of asset and liability mismatches and may very well push insurers to value their assets on a different basis.
IFRS9, a new standard replacing IAS39 and covering financial instruments, whether these are assets or liabilities, will poke and prod insurers into different decisions now and possibly before knowing exactly how IFRS4 will pan out.
Finally, although this part is still speculative, Embedded Value reporting may fall away as SAM and Solvency II achieve much of the objections of Embedded Value.
This post is the first in a series covering important aspects if the change in financial reporting standards, covering news of the developments as it emerges as well as the likely implications for financial reporting, product design, ALM, financial reinsurance and others. I’d encourage you to post comments or questions on this or later posts and I’ll try to answer those through the series.
Part 1 – IFRS reporting under SAM
Part 2 – EV in a SAM/Solvency II world
Part 3 – Apocalypse! – SAM as the tax basis
Part 4 – Acquisition accounting under IFRS4 Phase II – a little speculation
The Technical Provisions Task Group and KPMG ran a workshop for industry participation on risk-free rates recently. The idea was to see whether we could improve the extent and quality of industry comment on key, controversial areas of the proposed SAM regime.
Turnout was good, but not great, but the discussion and points raised were all fantastic. Plenty more to do from here onwards, but I thought it might be useful to include the presentations somewhere publicly available.
Some of the concepts that were on the agenda
Swaps vs Bonds, the theory as well as practical implications for insurers, banks and the capital markets
Extrapolation methods and what challenges this creates for practitioners
Identifying and measuring illiquidity premiums, credit spreads and the difference between Expected Default Loss and Credit Risk Premiums
European developments on Matching Adjustments and Countercyclical Premiums. Should we follow their path? Is bottom-up or top-down more practical?
Do we need a methodology for nominal and/or real yield curves?
Non-South African countries – what is the practical answer to requiring multiple yield curves?
Reducing regulatory arbitrage between banks and insurers for credit and market risk on swaps and bonds
Presentations (reproduced with permission from the authors)