Stress testing in business is a technique used to test the resilience of institutions against possible future scenarios. What should brokers understand about this technique?
The 2008 financial crisis and the 2019-2023 COVID-19 pandemic highlighted the importance of the stress testing side of risk management for all types of businesses. Recent years have seen regulations tighten around the stress testing obligations of financial institutions, including general insurers.
“Stress testing is an integral part of risk management,” said the Australian Prudential Regulation Authority (APRA) in a stress testing assessment report released in 2020.
In the report, APRA said this testing improves understanding of risk, enhances capital management and recovery planning and reduces the likelihood of failure.
Ben Crowther (pictured above), Lockton Australia’s head of risk consulting, explained the key elements of stress testing to Insurance Business:
Crowther said that stress testing in an insurance context requires a comprehensive analysis that looks at the causes and impacts of a risk and also the abilities of risk management to prevent or mitigate it.
“This level of analysis may be different and to some extent more involved than what a typical risk team may do on a daily basis,” he said.
Crowther said this type of analysis of risks often leads to a whole new level of detail being considered by insureds. He said this includes understanding root causes.
“Interestingly, when you start to talk about insurable risks, we start to derive some of the risks from insurance policies that are out there, the limits that are available, sub-limits that are within insurance policies and some particular wordings or exclusions that might sit within policies,” he said.
The Lockton risk head said organisations sometimes take a very top-down view of their business risks.
“But when you start to see how insurers and insurance policies start to categorize risks, organizations start to realize that for one particular risk it's actually a subset and there's a whole bunch of them,” said Crowther.
He said the approach he takes is a method called the “bowtie” analysis.
“We’re obviously looking at the risk event but we actually then want to look at the possible multiple causes and depending on the cause, that might have implications from an insurance point of view,” said Crowther.
The stress testing element, he said, involves looking at risk events and identifying the worst-case scenarios that may happen.
“I found myself yesterday looking at an event and a particular risk and the cover that they've got in place, and we were really trying to test how well the cover would respond to a particular scenario,” said Crowther.
He said, an example could be a natural hazard event impacting a hospital.
“Obviously, from an insurance point of view, the client wants to understand, what's the worst possible thing that could happen and how would our insurance best respond?” Crowther said.
The worst-case scenario, he said, could be a total loss of that facility. In that case, some of the testing would involve finding out if the right valuations are in place so the entire facility can be replaced.
In that situation, said Crowther, an insurer would want to understand how much it's going to cost to remove or clear the debris from the site.
“The second thing is that there would need to be a period of planning and approval before building a new building,” he said. “Then there's obviously the rebuild of the building itself and usually the insurers will reinstate it based on as it currently is.”
He said it’s important to understand any potential issues “that might push out or drive additional costs.”
“If you suffered a total loss, and let's just say there were fatalities involved, is that likely to cause an even longer delay, while there potentially could be investigations or government intervention?” said Crowther.
This means part of the stress test, he said, is built around trying to understand if there are going to be circumstances where you need to start to consider longer periods to reinstate.
He said this is testing resilience and the linkages between insurance covers and “what you're doing as a management team.”
For example, Crowther said he’s had conversations with transportation industry clients around supply chain issues.
“We talked about a situation where one of their ships would crash into a port,” he said. “What are some of the downstream impacts that might happen as a result?”
He said these could include loss of cargo and environmental impacts.
“It all comes back to really testing and putting the organization through processes that it might not necessarily have planned for,” said Crowther. “It’s important for the organization to go through these things and for boards to have comfort that they're a resilient organization.”
A recent McKinsey & Company report summarised some of the main financial and non-financial risks faced by insurers.
The financial risks include shifting interest rates, changing costs and sources of capital, and increasing claims levels.
Non-financial threats include climate events and generative AI (gen AI).
“The industry is taking multiple steps to manage both financial risks and pervasive non-financial risks,” said the authors. “We know this based on our ongoing conversations and work with insurers and on insights gathered in our recent industry benchmark.”
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