Stress testing activities on life and general insurers during 2020, following the outbreak of COVID-19, demonstrate that insurers are well-positioned to withstand a very severe economic downturn, while still meeting their commitments to policyholders, says the Australian Prudential Regulation Authority (APRA).
The stress tests were carried out because COVID-19 showed how quickly the key risks insurers face – not only traditional insurance risks, but also emerging, new and non-financial risks – can change.
The stress testing activities have also provided insights into how insurers use stress testing to inform their capital and risk management frameworks, as well as wider business decision-making. The findings of the stress tests reinforce the importance of continued development in stress testing capabilities by insurers, including conducting regular stress tests under a wide range of sufficiently severe scenarios to challenge capital levels as a key part of their decision-making, says APRA.
Details of the 2020 stress tests
In 2020, APRA conducted several stress tests with the 21 largest life insurers (LIs), including 14 direct insurers and seven reinsurers, covering 90% of the sector by gross written premium (GWP) and four active lenders' mortgage insurers (LMIs), covering most of the sector by GWP.
These stress tests used scenarios based on significantly worse macroeconomic outcomes than the Reserve Bank of Australia's August 2020 “Downside Scenario”, and were designed to assess insurers’ resilience to further deteriorations in macroeconomic conditions, and the actions they would take in response, both individually and collectively.
In 2020, APRA also completed its assessment of internal stress testing capabilities of the 18 largest general insurers (Gis) to identify how they could enhance their capital management practices and improve their resilience to adversity. This assessment included 15 direct insurers and three reinsurers (covering 80% of the sector by GWP), focusing on areas of governance, scenario design and usage of stress testing in capital management.
Stress scenarios and assessing capabilities
LIs and LMIs projected the impacts of their respective stress scenarios on their capital levels, both before and after mitigating management actions in response to the stress – such as capital increases and repricing – on capital levels. Insurers also provided information that APRA used to inform assessments of their stress-testing capabilities, including how effectively stress test outcomes are internally challenged, the board’s and senior management’s engagement in stress testing, and how stress tests are used in capital management decisions.
APRA requested similar information from general insurers, which formed the basis of APRA’s assessment of their stress-testing capabilities.
Key results and learnings
The results of APRA’s stress tests of LMIs and LIs indicate they are well-positioned to withstand a very severe economic downturn. Specifically, the results indicate that despite significant losses of capital under a severe economic downturn, both the LMI and LI sectors as a whole remained above their minimum capital requirements, while still meeting their commitments to policyholders. However, the outcomes of the stress test were highly variable across both sectors, with some individual insurers falling below their minimum capital requirements.
The key reasons for insurers’ falling capital levels during the stress tests were:
Large investment losses emerging in insurers with exposures to lower-rated investments, as credit spreads over Australian Government Securities rose sharply; and
Significant deteriorations in disability income insurance claims and credit quality of underlying mortgages insured as economic conditions worsened, leading to significantly higher claims costs.
Management actions
Importantly, however, the stress test results are before any benefits that insurers would derive from management actions to respond to the stress. After deploying management actions to mitigate the stress, capital levels return towards pre-stress levels.
Management actions used in response to the stress were crucial for rebuilding insurers’ capital levels, particularly insurers that breached minimum capital requirements under the severe downturn scenarios.
Capital injections provided by parent owners, the raising of capital, repricing and reductions in new business were the means used by most insurers to mitigate the impact of the stress. While individual actions appeared credible in isolation, few insurers considered the feasibility and second-order impacts of these actions in the context of broader industry-wide stress, particularly when other market participants are likely to be using similar actions to rebuild capital levels.
Better practice insurers considered the impacts of industry-wide stress on the capacity of both the broader market and parent owners to provide capital support, especially when capital sources are likely to be scarce and in high demand. Better practice insurers also incorporated thorough assessments of flow-on effects of repricing and reductions in new business volumes. This included considerations of increases in selective lapses, changes in reinsurers’ appetite to absorb increased levels of risk, and impacts on the cost and availability of insurance.
Insurers’ recovery plans
The impact of the stress scenarios on an insurer’s capital levels highlights the importance of credible recovery options, both to withstand stress that threatens their viability and to rebuild their resilience afterward. The stress tests provided insights into the robustness of insurers’ recovery plans.
In relation to recovery plans, APRA observed the following:
Across several LIs, recovery plans are not yet mature, with further improvements needed to effectively embed recovery plans into insurers’ broader risk management frameworks.
Recovery plans of several LMIs had not undergone a process of regular review, challenge and updating to ensure their ongoing robustness and credibility as their key risks evolve.
For several GIs, the effective testing of key recovery options on the emergence of stress was limited by a lack of severe enough stress scenarios.
APRA is encouraging insurers to consider how recovery plans can be improved in light of APRA’s stress test findings to increase their credibility.
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