4

Stress testing

4.1

Article 259(3) of the Delegated Act, which further specifies Solvency II obligations transposed in Conditions Governing Business 3.1(2)(c), establishes an obligation that a UK Solvency II firm, the Society and managing agents conduct stress testing and scenario analysis with regard to all relevant risks in their risk management system. A non-Directive insurer must conduct stress testing and scenario analysis as part of its risk management system under Non-SII firms – Governance 7.3(5). Based on these requirements, an insurer is expected to conduct liquidity stress tests to identify sources of liquidity strain, and ensure its current liquidity profile continues to conform to its liquidity risk appetite, as approved by the board.

4.2

In conducting stress tests, an insurer is expected to capture all relevant, material risk drivers. The stress tests should analyse separate and combined impacts of a range of severe but plausible liquidity stresses on an insurer’s cash flows over the chosen stress horizons, both cash in-flows (sources) and cash out-flows (uses), as well as the insurer’s overall liquidity position. The details of, and justification for, the methods and assumptions used in stress testing is expected to be included in an insurer’s liquidity risk management policies.

4.3

An insurer is expected to have in place adequate management information systems and data processes to enable it to collect, sort and aggregate data and information related to its liquidity stress testing. Where the insurer plans to meet cash outflows with cash inflows during the relevant time horizon, in line with paragraph 6.3, below, the PRA expects information to be collected at an appropriate frequency and granularity to minimise the risk of cash flow mismatches.

4.4

Consistent with paragraph 2.7 above, the PRA expects stress tests to be conducted on both individual funds, which may be exposed to different sources of liquidity risk, and the portfolio as a whole. It expects insurers to perform separate stress tests on MA portfolios and the non-MA business because of the restriction on selling assets from an MA portfolio to generate liquidity outlined in SS7/18. It expects an insurer to be aware of how an MA portfolio can obtain the necessary liquidity, and how liquidity management for an MA portfolio interacts with liquidity management for the rest of the firm.

4.5

To facilitate its understanding of whether solo entities could rely on the parent for liquidity where such arrangements exist, the insurer is expected to conduct stress tests separately at both the individual entity level and on a group basis.

4.6

The PRA expects insurers to consider varying degrees of stressed conditions in a range of stress scenarios. Each are expected to be severe yet plausible, and consider the potential:

  • impact of idiosyncratic, market-wide and combined scenarios;
  • adverse effects of market disruptions; and
  • actions of counterparties, and other market participants experiencing liquidity stresses that could adversely affect the insurer, for instance by selling similar assets to those that the insurer may rely on for liquidity and affecting market prices, recalling sleeper collateral,18 not posting collateral required, or opening valuation disputes.

Footnotes

  • 18. Sleeper collateral refers to the value of collateral that an insurer is contractually obliged to post to a counterparty, but has not yet posted as it has not yet been called by the counterparty.

4.7

In the case of groups, an insurer is expected to define separate stress scenarios on a group basis in order to encompass group-specific risks.

4.8

Liquidity risk can emerge over a number of timeframes. Hence, liquidity stress tests are expected to span a variety of liquidity events over different time horizons. This includes both fast moving scenarios as well as more sustained scenarios where the insurer’s liquidity position deteriorates slowly. An insurer is expected to use appropriate durations for stress testing, which may include, for example, 7, 30, 90 days or one year, as appropriate in light of its business model, liquidity risk appetite and activities. An insurer with significant activity in capital markets or volatile cash flows that could generate short term liquidity needs would be expected to consider daily time or intra-day horizons. In contrast, insurers writing longer-term business, such as annuities, are expected to consider longer horizons. In its analysis of longer-term stresses, taken as one year and longer, the PRA expects an insurer to consider and be able to justify its appetite for capital erosion.

4.9

The PRA expects an insurer to consider the impact of chosen market stresses on the appropriateness of its assumptions relating to the following elements, as relevant to its business model and activities:

  • estimates of future balance sheet growth and premium income from both new and renewal business;
  • additional margin calls and collateral requirements for derivatives and other transactions, especially in respect of assumed continued diversification of markets in stress;
  • the reliability or availability of committed lines of credit;
  • the continued availability of liquidity, including the appropriateness of haircuts applied to assets held in the liquidity buffer, including in currently highly liquid markets;
  • policyholder behaviour, including surrender rates;
  • correlations between funding markets and the effectiveness of diversification across its chosen sources of funding;
  • access to secured and unsecured funding;
  • currency convertibility; and
  • in the case of groups, the insurer’s ability to access cash pooling arrangements and intra-group loans.

4.10

When designing scenarios, an insurer is expected to also consider the appropriateness of their calibration, considering past liquidity events and other relevant data or experience. Regulatory capital requirements are calibrated over a one-year period, while liquidity stresses tend to occur over significantly shorter time horizons. An insurer is expected to be mindful that converting one-year stresses to shorter time periods for liquidity stresses may not be as simple as linearly scaling them down.

Funding arrangements with third-parties

4.11

An insurer is expected to test its access to committed facilities regularly to ensure their availability for use in stressed conditions. Where practical, the insurer may consider maintaining facilities with a number of diverse providers to ensure that it can still obtain funding, even if a lender fails to honour its commitment. Uncommitted facilities are highly unlikely to be available in stressed situations and therefore are not an appropriate source of liquidity. An insurer is also expected to avoid undue reliance on committed facilities to meet stressed liquidity needs, as other institutions may be under similar stress and such facilities might not be available when required.

4.12

The PRA acknowledges that liquidity carries a cost, for example holding liquid assets directly may reduce investment returns and profitability. Use of third-parties for liquidity may mitigate the opportunity cost of holding liquidity directly, but may introduce explicit commitment fees. The PRA expects insurers to consider the trade-offs between the two.

Stress testing governance

4.13

The frequency of stress testing is expected to be proportionate to the nature, scale and complexity of an insurer’s activities, as well as the size of its liquidity risk exposures. Consistent with Conditions Governing Business 2.4 and Non-Solvency II Firms – Governance 3.4, an insurer, other than a small non-directive insurer, must review its risk management policies annually. In light of these obligations, an insurer, other than a small non-directive insurer, would be expected to conduct a holistic review of the appropriateness of its stress testing approach and stress scenarios on a similar frequency. More frequent reviews may be warranted when there are changes in an insurer’s business or strategy, the nature or scale of its activities or the operational environment that may affect the validity of its approach. A small non-directive insurer would be also expected to review its approach when such changes indicate that its approach may no longer be valid.

4.14

The PRA expects an insurer’s approach to liquidity stress testing, including the stresses and scenarios tested, to be regularly reviewed and approved by the insurer’s senior management and any risk committee of the board to ensure their nature and severity remains appropriate. As required by paragraph 1.53(e) of EIOPA Guideline 18 and Non-Solvency II Firms – Governance 7.3(6), the frequency, approach, methodologies and assumptions should be adequately documented within the insurer’s liquidity risk management policies and processes.