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What Can the Insurance Market Teach Banks About Stress Tests?

In the last eight years the national banks of Iceland, Ireland, and Cyprus have failed. Without government bailouts, the banking crisis of 2008 would also have destroyed major banks in the United Kingdom and United States. Yet in more than 20 years, despite many significant events, every insurance company has been able to pay its claims following a catastrophe. The stress tests used by banks since 1996 to manage their financial stability were clearly ineffective at helping them withstand the 2008 crisis. And many consider the new tests introduced each year in an attempt to prevent future financial crises to be inadequate. In contrast, the insurance industry has been quietly using stress tests with effect since 1992. Why Has the Insurance Industry Succeeded While Banks Continue to Fail? For more than 400 years the insurance industry was effective at absorbing losses from catastrophes. In 1988 everything changed. The Piper Alpha oil platform exploded and Lloyd’s took most of the $1.9 billion loss. The following year Lloyd’s suffered again from Hurricane Hugo, the Loma Prieta earthquake, the Exxon Valdez oil spill, and decades of asbestos claims. Many syndicates collapsed and Lloyd’s itself almost ceased to exist. Three years later, in 1992, Hurricane Andrew slammed into southern Florida causing a record insurance loss of $16 billion. Eleven Florida insurers went under. Since 1992, insurers have continued to endure record insured losses from catastrophic events, including the September 11, 2001 terrorist attacks on the World Trade Center ($40 billion), 2005 Hurricane Katrina ($60 billion—the largest insured loss to date), the 2011 Tohoku earthquake and tsunami ($40 billion), and 2012 Superstorm Sandy ($35 billion). Despite the overall increase in the size of losses, insurers have still been able to pay claims, without a disastrous impact to their business. So what changed after 1992? Following Hurricane Andrew, A.M. Best required all U.S. insurance companies to report their modeled losses. In 1995, Lloyd’s introduced the Realistic Disaster Scenarios (RDS), a series of stress tests that today contains more than 20 different scenarios. The ten-page A.M. Best Supplemental Rating Questionnaire provides detailed requirements for reporting on all major types of loss potential, including cyber risk. These requirements might appear to be a major imposition to insurance companies, restricting their ability to trade efficiently and creating additional costs. But this is not the case. Why Are Stress Tests Working For Insurance Companies? Unlike the banks, stress tests are at the core of how insurance companies operate. Insurers, regulators, and modeling firms collaborate to decide on suitable stress tests. The tests are based on the same risk models that are used by insurers to select and price insurance risks. And above all, the risk models provide a common currency for trading and for regulation. How Does This Compare With the Banking Industry?  In 1996, the Basel Capital Accord allowed banks to run their own stress tests. But the 2008 financial crises proved that self-regulation would not work. So, in 2010, the Frank-Dodd Act was introduced in the U.S., followed by Basel II in Europe in 2012, passing authority to regulators to perform the stress tests on banks. Each year, the regulators introduce new stress tests in an attempt to prevent future crises. These include scenarios such as a 25% decline in house prices, 60% drop in the stock market, and increases in unemployment. Yet, these remain externally mandated requirements, detached from the day-to-day trading in the banks. Some industry participants criticize the tests for being too rigorous, others for not providing a broad enough measure of risk exposure. What Lessons Can the Banking Industry Learn From Insurers? The Bank of England is only a five-minute walk from Lloyd’s but the banking world seems to have a long journey ahead before managing risk is seen as a competitive advantage rather than an unwelcome overhead. The banking industry needs to embrace stress tests as a valuable part of daily commercial decision-making. Externally imposed stress tests cannot continue to be treated as an unwelcome interference in the success of the business. And ultimately, as the insurance industry has shown, collaboration between regulators and practitioners is the key to preventing financial failure.…