In spring 2016, PwC investigated the current state and future direction of stress testing. We surveyed 55 insurers operating in the US about their stress testing framework and the specific stresses that they test. We also engaged in more detailed dialogue with a number of insurers in the US and globally, as well as with some North American insurance regulators.

1. Stress testing in the
insurance industry
A “20/80” opportunity
www.pwc.com/us/insurance

2. Stress testing
Stress testing: A “20/80” opportunity
In spring 2016, PwC investigated the current state and
future direction of stress testing. We surveyed 55 insurers
operating in the US about their stress testing framework and
the specific stresses that they test. We also engaged in more
detailed dialogue with a number of insurers in the US and
globally, as well as with some North American insurance
regulators. Our principal conclusion is that stress testing,
though well established, would benefit significantly from a
modest amount of additional effort. Borrowing terminology
from the Pareto principle 1, we think less than 20 percent
more effort would yield 80 percent more value.
2
1 The Pareto principle, named after economist Vilfredo Pareto, specifies an
unequal relationship between inputs and outputs. It states that, for many
phenomena, 20% of invested input is responsible for 80% of the results. It is
also referred to as the "Pareto rule" or the "80/20 rule" .To learn more:
http://www.investopedia.com/terms/p/paretoprinciple.asp

3. Stress testing
A brief history
3
We see three areas
where only a little more
effort can yield
substantial benefit:
1) a clearer definition of
stress testing, 2) more
thoughtful stress
construction, and
3) a more robust stress
testing platform.
Thanks to the requirements of the Dodd Frank Act of 2010,
we expect that stress testing is the most widely recognized and
understood risk management tool. The basic concept is
relatively simple and most people in business and government
readily accept the notion that if a specified future unfolded –
say a repeat of the last economic crisis – it would be good to
know ahead of time if banks would remain financially viable.
After its initial introduction, stress testing continues to
maintain a high level of attention via the ongoing publication
of results from the Federal Reserve Board’s Comprehensive
Capital Analysis and Review (CCAR) which the media,
financial commentators, and the banks themselves
eagerly anticipate.
It is easy to see how stress testing concepts in the Dodd Frank
Act could apply to insurers. And, indeed the insurance
industry (more specifically, its actuaries) has widely used
stress testing and scenario analysis for decades.
More recently, 2013 was especially noteworthy for insurance
stress testing, with publications on the subject by the North
American CRO Council, the CRO Forum and the International
Actuarial Association. From a regulatory perspective, the
National Association of Insurance Commissioner’s (NAIC’s)
Own Risk and Solvency Assessment (ORSA) calls for a
prospective solvency assessment to ascertain that the insurer
has the necessary available capital to meet current and
projected risk capital requirements under both
normal and stressed environments. In Canada,
the Office of the Superintendent of Financial
Institutions (OSFI) has provided clear direction
on stress testing governance and methodology in
its 2009 publication on Sound Business and
Financial Practices (Guideline E-18). It also is
noteworthy that, in Europe, despite all of the
attention lavished on Solvency II and internal
capital models, the European Insurance and
Occupational Pensions Authority (EIOPA)
launched a Europe-wide stress test for the
insurance sector in May 2016.
Equally as important as the regulatory initiatives
are the business applications and benefits of
stress testing. As we address in more detail
below, survey results show that insurers make
good use of this risk management tool and are
looking to expand its application even further.

4. Stress testing
A little more effort
We see three areas where only a little more effort can yield
substantial benefit: 1) a clearer definition of stress testing,
2) more thoughtful stress construction, and 3) a more robust
stress testing platform.
As a start, it will be useful to clarify what we mean by stress
testing. As we use the term here, we mean a projection of
income statements, balance sheets and – most importantly –
projected available and required capital over a multiyear
business planning timeframe (including new business over
the planning timeframe). Typically the test is done for the
entire enterprise and includes a base case and a number of
stressed future states. This definition of stress testing is
consistent with how both insurance (ORSA Guidance Manual)
and banking (FRB CCAR) regulators use the term. It contrasts
with risk-specific stress testing. Risk-specific stress testing
typically looks at a single risk, often only for the part of the
enterprise susceptible to that risk. And, it frequently assesses
the impact over a range of stochastically determined
scenarios. Distinguishing between stress testing and risk-
specific stress testing needs little effort but can help
companies avoid considerable confusion as they enhance and
apply stress testing capabilities. Only with clear definitions
can an insurer evaluate whether or not it has deployed the
tool effectively. A vague notion of stress testing taking place
somewhere in the organization typically means that there is
unawareness of potential gaps in the enterprise risk
management (ERM) framework.
4
Another area where we believe a little more
attention would pay major benefits is the
development of comprehensive stress scenarios.
When describing future states, insurers have
many factors to consider in order to articulate
the risks that can impact their business. As an
indication of the range of these factors, the
section of our survey that addressed stresses
had 32 questions, many with sub-parts, each
covering a different risk. However, rather than
starting with an effort to combine all of these
risks, stress testing benefits from starting
instead with a narrative that articulates a
potential future and then addresses how that
future would impact the insurer through various
risk factors. For example, a stress narrative
could be based on a prognosis of an ongoing
steady decline in the price of oil and other
commodities, then a postulation of the resulting
impact on economic growth, interest rates,
equity valuation, employment rate, etc. The
narrative then could move to an analysis of the
impact of these factors on the insurer’s risks,
leading to a projection of how the company’s
income statement, balance sheet, available and
required capital would fare if this future,
in fact, unfolded.

5. Stress testing
A little more effort
Lastly, we note that despite the considerable
attention and utilization of stress testing as a
management tool, it appears that, for many
insurers, the infrastructure that produces results
is ad hoc and likely inefficient. Our survey
indicates that only 10% of respondents have built
a bespoke platform for stress testing. 78% of them
use spreadsheets alone or spreadsheets combined
with actuarial/projection software. In terms of
how long it takes to conduct stress tests, 42% of
respondents indicate the process takes between
one and two months. A further 35% report that it
takes more than two months, and sometimes
longer than three months.
While systems infrastructure updates do not
normally result in major improvements from little
effort, many insurers, particularly in the life
sector, have already embarked on a process of
modernization. As they are looking to address
their risk, actuarial, and financial reporting needs
in a comprehensive manner, we recommend that
stress testing capabilities receive high priority.
With a modest amount of extra effort, insurers
should be able to incorporate significant
enhancement to their stress testing platform as
part of this modernization. This in turn will yield
the benefit of more timely, accurate and insightful
stress testing results.
5
As insurers look to
modernize their
risk, actuarial, and
financial reporting
needs in a comprehensive
manner, we recommend
that stress testing
capabilities receive
high priority.

6. Stress testing
A lot more value
Insurers already use their stress testing for many purposes.
Survey results show that respondents currently utilize their
stress testing for an average of almost five different uses.
Additionally, respondents indicated they each had plans to
add almost four new uses in the future. More than half of the
respondents reported using their stress testing work for
strategic planning, calibrating their risk tolerances and limits,
assisting with dividend, share-repurchase and similar capital
planning, and regulatory impact assessments. These are
critical business decisions and further highlight the value
of stress testing.
Furthermore, stress testing usage has had a positive impact at
a significant majority of respondents’ companies. 36%
reported instances where key decisions have been made very
differently compared to the process prior to stress testing. An
additional 29% reported that the results of stress testing has a
measureable influence on decision making, though no specific
decisions were cited.
6

7. Stress testing
More benefits
7
Stress testing is useful
not only for high impact,
low probability events
but also more likely
events that need
immediate attention.
We see a few additional areas where better articulated
stress testing processes and procedures could result in
significant benefits.
• Recognize that stress testing is a separate tool in the risk
manager’s tool kit –Frequently, publications and discussions on
insurance stress testing describe it as something that
supplements other risk management tools. We believe that
relegating stress testing to supplementary status undervalues its
benefits and contribution. It would be more productive to
recognize stress testing for what it truly is: a separate tool with
different strengths and applicability compared to VAR-based
economic capital.
Some risks – for example, liquidity risk –can be addressed only
via a stress test. Adding more required capital does not
effectively address the problem; liquidity risk needs to be
addressed by developing a preplanned course of action, including
accessing prearranged liquid funds. Likewise, reputational risk –
and in particular the reputational impact of a cyber event – is
better addressed via the stress test tool than via the
economic capital route (and the potential addition of
more required capital).
Similarly, for some risks where economic capital
looks like a satisfactory tool, it can give misleading
information. Often pertinent risks only reveal
themselves fully via stress testing. New business is
a good example. Economic capital can include one
or more years of new business, typically by
assuming new business premium, claims, expenses,
etc. are a replica of previous years’ values. But this
fails to provide a platform to study how external
factors could impact the insurer’s fundamental
business model, leading to little or no sales of any
new business that resembles prior years’ business.
Lastly, we note that most other measures,
especially traditional economic capital, concern
themselves primarily with very extreme, “in the
tail” events. Stress testing is useful not only for
high impact, low probability events. More likely
events warrant attention – in fact, they may
warrant more attention because they often
represent more tangible and practical problems
that management needs to address immediately.

8. Stress testing
More benefits
8
Insurers should take
advantage of stress
testing to develop
mitigating action plans.
These should go beyond
sweeping generalizations
like “seek capital injection”
and provide an
opportunity to
more critical thinking
around options.
• Use stress testing to “war game” management action and
prepare in advance for risk crises – In our survey, we asked
insurers if stress testing incorporates management actions. In
other words, as stress events unfold, presumably management
would take some form of corrective action in response, and that
corrective action would impact future financial results. Almost
half said they do not incorporate management actions. We
believe this is a significant oversight.
Stress testing provides a ready platform to prepare in advance for
risk crises. Insurers can use the tool to test different responses
and select the one that yields the most effective resolution. They
then can put in place a contingency plan and pre-event
corrections appropriate to the event.
Here again stress testing can provide a different
perspective than economic capital and similar
measures. Economic capital works well as a tool to
quantify the impact of taking certain types of action
in the present. For example, it can help determine
the reduction in required capital if a particular
reinsurance treaty were implemented. On the other
hand, faced with a multifactor, multiyear stress
event (perhaps including changes in interest rates,
inflation and equity values, with increases in
unemployment and deteriorating buying patterns),
stress testing would be a more effective tool in
judging if and when to reconfigure the asset
portfolio, alter products and prices, and the cost
and manner of reconfiguring staffing models.
It is worth noting that, in our discussions with
regulators about the merits of including the impact
of management actions, their expectations are that,
yes, insurers should include them. They recognize
the benefit that stress testing can provide as an
opportunity for planning ahead. However, they
indicated that it would be appropriate to show the
stressed result both before and after the
application of management action. Showing both
results can help promote thoughtfully developed
post-management action results, not just a broad
assumption that management will take
appropriate actions.

9. Stress testing
More benefits
9
• Take advantage of the board’s and senior management’s broad
business insights to construct more insightful stress narratives –
Our survey shows that most boards receive the results of the stress
test either directly or via the risk committee of the board. However,
only 11% report asking either the board or board risk committee to
approve the stresses the company uses. We believe this represents a
missed opportunity to gain board members’ insights and benefit from
their engagement in the stress testing process. Not all directors will
necessarily have detailed knowledge of the range of potential
outcomes of all of the risks that can impact an insurer or the potential
stochastic distributions of those risks, but directors typically are
experienced and knowledgeable, often with a high level of business
and economic acumen. Utilizing their individual and collective skills
to contribute ideas on the types of stresses that merit study seems
like a good fit for their role and an effective complement to
managements’ efforts.
• Stress testing represents a potential avenue for global capital
consistency – As a final potential benefit, we note again that stress
testing seems to have a role in all major insurance and other financial
services regulatory regimes. At the same time, the global insurance
industry is challenged by the task of agreeing to a capital adequacy
ratio, presumably based on an economic capital VAR-like foundation.
A simpler capital formulation coupled with a robust stress testing
regime may hold more promise for a globally agreeable approach.

10. Stress testing
A bright future
10
Based on survey results and various discussions we had with insurers
and other stakeholders, stress testing is universally accepted as a useful
tool. We suspect that this is a consequence of its being directly related to
the common business practice of preparing a financial plan. Including a
few more future states or stresses and incorporating a measure of
required and available capital in the financial plan are not major steps.
Accordingly, the transition from planning to stress testing should be
easy to accommodate. We note how sharply this contrasts with the
introduction of economic capital, especially in the US insurance
industry. Though its usage is growing, economic capital is not a
uniformly accepted regulatory and business tool even after two decades.
On the other hand, stress testing is already actively and universally used
as a management and regulatory tool. With a little more effort, we
believe it can yield very substantial benefits for all.

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Authors/contacts
Henry Essert
Insurance Risk Management Leader
+1 646 471 4400
henry.essert@pwc.com
Dana Hunt
Director, Life Actuarial Services
+1 515 246 3850
dana.n.hunt@pwc.com
Alistair Macpherson
Director, P&C Actuarial Services
+1 646 471 4607
alistair.macpherson@pwc.com