Stress Testing in the Era of Covid-19

By Kennedy Kaela

On March 11th 2020, the World Health Organization (WHO) declared the COVID-19 a global pandemic. The spread of the highly contagious disease has not only brought about a global health crisis but also a global economic crisis as Governments and businesses have been prompted to restrict activity in these times prompting a recession of which Zambia is not exempted from. Africa’s second largest copper producer posted a decline in business pulse in April, 2020 with the Purchasing Manager’s Index (PMI) declining further to 37.3 from 44.7 in March signaling a contraction in economic activity.

In response to the above, the Pensions and Insurance Authority (PIA) on 30th April, 2020 issued guidelines to the industry regarding the operations of Reinsurers, Insurers and brokers as the country and the globe navigate through the pandemic. One of the key guidelines was that Insurance companies should conduct and submit stress tests with regards the impact of COVID-19 on their financial position. Insurers will have to determine the impact of this ‘black swan’ event on liquidity, capital adequacy and solvency.

The directive by PIA to insurers is timely and will improve stability of the market and mitigate both micro and macro prudential risks not only in this pandemic era but also prospectively.

Stress testing is a forward-looking technique that aims at measuring the sensitivity of a portfolio, an institution, or even an entire financial system to events that have a small probability of occurrence but have a significant impact if they were to occur. Insurers can incorporate sensitivity (effect of percentage changes in a specific variable on others) and scenario (base case, pessimistic and optimistic scenarios) analysis.

In its simplest form Stress testing encourages business leaders to think about what ‘might’ happen, now or in the future, and how it could impact their business and take precautionary measures. These extreme events can be historical (lessons from the past) or hypothetical (assumptions or simulations).

A typical stress test begins by setting out key macro-financial shocks and their impact on the assets, liabilities, revenues and profitability of insurers. In order to exhaust all relevant risk classifications and to generate stress test outputs for various possible outcomes, more than one scenario and combination of those should be used. Typical scenarios could look as follows:

Economy in recession scenario: Slowing or negative GDP growth rate, low incomes per capital, plummeting equity and real estate prices, increase in credit spreads and higher default rates leading to low premiums, high insurance receivables, low asset quality, high impairments of financial assets etc.

General Insurance underwriting shock scenario – large natural or man-made catastrophe claim which could be combined with a default of a reinsurer causing stress on cash flows and solvency.

Long-term Insurance underwriting shock scenario – a modelling of the impact of high lapse rates and other such things like pandemics. A lapse rate is the rate at which life insurance policies terminate because of failure to pay the premiums.

Banking/financial/sovereign crisis Scenario – What would the impact be on the insurer if credit spreads for financials declined, default of large bank counterparty or stress of all asset classes including sovereign bonds.

Rising Costs Scenario – What would be the impact of inflation in and on claims and rising interest rates.

A combination of these scenarios – stress tests can combine many scenarios.

Insurers should then be able to develop models to trace the impact of such adverse events through their Income statements from topline to bottom-line, balance sheet impact on liabilities and assets, solvency and capital adequacy and impact on cash flow statements (always remember that cash is king!).

Section 36 of the Insurance Act of 1997 prescribes a prudential solvency margin of 10% for Insurers. This means that at all times, an insurer or reinsurer’s assets should exceed its liabilities by a minimum of 10%. It is only prudent that insurance companies hold even a higher solvency margin in order to cushion the impact of adverse events should they crystalize. Companies are required at all times to maintain overall financial resources, including capital and liquidity resources, which are adequate to ensure there is no significant risk of liabilities not being met as they fall due.

It is therefore paramount that insurers embrace frequent stress testing as this is a global best practice. If we are to build a strong, ready and resilient insurance market that works for all, there is need to understand fully the risks we face, quantify these risks and model the impacts of these risks should they crystalize.

For comments or questions, send us an email at pia@102.23.123.62 or follow us on our Facebook page, Pensions and Insurance Authority.

You can also call us on 211-251 401/5 or 0977-335809 or 0965-255136.

For complaints, kindly use the following details:

Pensions-related complaints: Mobile: 0950 136662, Email: pensions@102.23.123.62

Insurance-related complaints: Mobile: 0950-136663, Email: complaints.insurance@102.23.123.62

The author is an Inspector – Prudential Supervision in the Insurance Department at the Pensions and Insurance Authority.