Although I work in the insurance practice within KPMG, this article is not intended for participants in the insurance industry. Rather, in this article, I will endeavour to set out how some of the lessons learned in the insurance industry can be applied to other industries, outside of the world of financial services. Some industries are already engaged in the practices described here, so you may find nothing of use. However, if this is the first time that your business has considered the issue of stress and scenario testing, then hopefully this will help you start out on this interesting path.
Stress and Scenario Testing – What is it?
In its simplest form, Stress and Scenario testing (referred to as “SST” in the remainder of this article) encourages business leaders to think about what might happen, either now or at some stage in the future, so as to assess how it might impact their business. By considering SST in a structured way, it can generate ideas on how to grow the business, or how to position it so as to avoid potential losses (or maximise certain gains). It can help you identify new opportunities, or areas where current business models are threatened.
Ireland is the 5th largest beef exporter in the world and the largest exporter of beef in Europe . A recent suite of publications from the Intergovernmental Panel on Climate Change  emphasise the importance of reducing meat consumption if we are to successfully combat climate change. The Irish government and agriculture industry could consider the impacts if beef consumption ceased within say, the next ten years and how this issue could be addressed. If beef consumption were to cease, how would individual farms need to change their business models to adapt to this new world? What tools, knowledge and governmental support would be required to facilitate the change?
Electric cars are becoming increasingly popular, with many mainstream manufacturers now offering fully electric models for sale. If you own or run a filling station, what impact would it have on your business if all drivers in future “re-fuelled” at home and didn’t buy petrol or diesel? How could you maintain your business? Many filling stations make considerable additional revenues from the sundries they sell to punters who stop for fuel – teas, coffees, the infamous breakfast roll…… You might think that you don’t make much revenue from fuel, so wouldn’t be affected – but if people had no reason to visit, would you still have such revenues? If this change were to come, what can you do now to position your business to be sustainable?
Within the US, there are approximately 3.5 million professional truck drivers . Robotic cars and trucks are already in development – a simple Youtube search can generate videos circulated by many of the mainstream truck manufacturers demonstrating their research. Google, Tesla and Uber have, for many years, circulated reports about their own development of driverless vehicles. If robotic trucks become common, what will the 3.5 million drivers do for employment? Will the US government support training programmes so they can gain other jobs? If so, is funding for this being considered now?
The above are illustrative examples of how SST can inform you about how you need to manage your business. The fact is, the world constantly changes. Business leaders don’t always cause these changes, but the success or failure of your business will depend on your ability to respond to them. SST gives you a head start in developing your response.
In the English language, we often refer to the “foreseeable future”. The fact is, the future is not foreseeable. No one has a crystal ball.
We face uncertainty in every aspect of our lives, every moment of every day. Some of the uncertainty is minor – for example, will it rain in Ireland tomorrow? Some of it is more severe – will it rain in Ireland at all 50 years from now, given the potential impacts of climate change? However, as business leaders, we need to acknowledge that uncertainty does not mean we cannot plan, and SST is the most powerful tool available to us to do this.
In their article, “Strategy Under Uncertainty" , Courtney et al. indicated that a useful way to think about uncertainty is to classify it in four ways. In the insurance industry, “uncertainty” is a core part of our business – the whole purpose of insurance is to transfer uncertainty from an individual (be it a person or a firm) to another entity, in exchange for a fee. However, if you’re not used to thinking about uncertainty within your own business, the approach taken by the authors is a useful guide and I have replicated it below:
- Level 1 – Clear Enough Future: In a “Level 1” case, the authors set out that “managers can develop a single forecast of the future that is precise enough for strategy development. Although it will be inexact to the degree that all business environments are inherently uncertain, the forecast will be sufficiently narrow to point to a single strategic direction”.
- Level 2 – Alternate Futures: In this case, the authors set out that “The future can be described as one of a few alternate outcomes”. In other words, you don’t know what exactly will happen, but what can happen is restricted to a few possible events.
- Level 3 – A Range of Futures: In this case, the authors set out that “A range of potential futures can be identified”. This is similar to Level 2 – there might be definite bounds on what can happen, but what will happen is within those two bounds and can sit anywhere in between.
- Level 4 - True Ambiguity: Here, the authors set out that “multiple dimensions of uncertainty interact to create an environment that is virtually impossible to predict”. What does this mean? Well, it means you’ve no idea what’s going to happen.
In reality for businesses, Level 4 situations are quite rare. Even if you consider the ongoing Brexit debate – yes there’s huge uncertainty, but there are only a small number of potential outcomes. At worst, Brexit is a “Level 3”, at best, a “Level 2”. Either way, despite the lack of clear direction from the UK government, businesses can identify what might happen, how it could impact them and how to respond.
The point here, and how it ties back to SST, is that businesses do not often face true ambiguity in the short to medium term. Most often a range of identifiable possible outcomes exists; SST provides a structured way to consider these, their impacts and how to deal with them.
Over the longer term, say, ten years and beyond, all businesses face some ambiguity, as it is impossible to predict the impacts that technology, changing consumer trends and changing societal preferences can have. SST is also useful in this case – whilst any scenarios you consider will never play out exactly as you describe, they may give your fellow business leaders food for thought on areas to explore in the present. SST considers how things could evolve in the future – it is then up to business leaders decide what to do about these potential evolutions.
The Life Insurance Industry – What do we do?
In this article, I focus on the life insurance industry, as my background is in life insurance. However, SST is also important in the non-life insurance industry. It’s also becoming a crucial risk management tool in Banking and other financial services sectors.
Within the life insurance industry, each company is obliged to carry out an Own Risk and Solvency Assessment (“ORSA”) process each year. This is a regulatory requirement under the current insurance regulatory regime, which was introduced in 2016. In Ireland, the predecessor of the ORSA was the Financial Condition Report (“FCR”), which had similar aims. The implication of these regulatory requirements is that life insurers in Ireland have been considering these types of issues for a very long time.
The purpose of the ORSA (and the FCR before it) is to consider the expected evolution of the insurance company’s balance sheet over its business planning horizon (typically five years). Within this projection, the company will consider how its risk profile, capital needs and profitability will evolve. The ORSA also considers how stresses and scenarios could impact on this projection and hence SST forms the bulk of the output from the ORSA process.
The ORSA itself is steered by the Board of the entity, with the Board directing the range of stresses and scenarios to be considered within the process, debating the resulting output and directing and approving the actions that should be taken as a result of that output. The ORSA also typically considers reverse stress testing, the purpose of which is to identify stresses and scenarios that could lead to the failure of the business.
The ORSA process typically takes a number of months, with the Board considering the range of stresses and scenarios to be considered and the core central business plan early in the year. Based on the direction given, the results are then assessed with input from a variety of internal departments. The consideration of SST typically focuses on quantitative impacts, and, as a result, assessing all of the results can take a number of months depending on the structure of the firm and the resources allocated. Once results are prepared, they are considered by the Board, who then discuss the output and agree on actions to be taken, if necessary. An overall report is then prepared, approved by the Board and submitted to the regulatory authorities (in Ireland, for insurance companies, this is the Central Bank of Ireland).
Below, I have considered some of the positives and negatives that we’ve observed within ORSA processes, which might guide you when considering SST within your own business.
- The ORSA is considered at a very senior level in the firm. The Board direct the process and input is sought from senior management across the firm. This means that SST gets significant visibility at a senior level within the firm and key decision makers are informed as to how potential actions or events could impact the firm.
- The regulatory rules encourage the ORSA output to form part of the decision making process of the firm. This has fostered a cultural shift in firms, where firms actively consider the ORSA and SST when making key decisions, so as to ensure that the impacts are fully explored and understood.
- The ORSA and SST illustrates the risk profile of the firm – whilst it may be easy to identify what the key risks to your business are, it takes real discipline to formally consider these risks and quantitatively assess their impacts. This assessment enables decision makers to really understand what the key risks are, what can be lived with and what requires more active management.
- Reverse stress testing is a key part of most ORSA processes and is actively encouraged by the regulatory authorities. Reverse stress testing asks a firm to consider the risks, or combination of risks, that could lead to failure of the firm. Whilst the event may be improbable, actively considering it enables decision makers to better understand what the tipping points may be and identify actions to prevent such points being reached.
- The ORSA process tends to focus on downside risks, i.e. risks that cause a loss to the firm, lead to lower profits or less available capital. Many firms are focused on protecting the business and view the ORSA and SST as a crucial tool to do this. However, upside risk should also be considered – there are scenarios where, if the firm has positioned itself appropriately, it can take advantage of changing market trends or consumer preferences, perhaps establishing a first mover advantage.
- The regulatory requirements mean that firms focus on the business planning horizon, which for most firms is 3-5 years. Whilst some firms do think of longer-term risks, these are the exception rather than the rule. As a result, there can be excessive focus on short-term, immediate impact risks that materialise over a very short space of time. Consideration may not be given to risks that arise over the longer-term.
- The regulatory focus can cause some issues:
- The regulatory requirements can ultimately lead to reports that have too much material and are too long, meaning that the key messages can be lost in a haze of filler material.
- Given the regulatory expectations, the ORSA process can be very long-winded, taking many months to complete. This means it can lose relevance as external environments change and the stresses considered become irrelevant.
- The exercise can be viewed as a compliance exercise which adds no value to the business – it is completed to avoid any regulatory sanctions, meaning that the potential value that could be added is lost.
- The regulatory requirements mean that the exercise can be treated as a cyclical “business as usual” process, rather than as an exercise that can enable leaders to form new perspectives on the business.
In my opinion, the SST that adds most insight to the business is one which is:
- Gets senior leadership engagement,
- Focuses on key results,
- Considers upside and downside, and
- Considers short-term (level 2-3 uncertainty) and long term (level 4 uncertainty) risks.
Stress and Scenario Testing – how to start
“The journey of a thousand miles begins with a single step” . This is true in the case of SST. Consideration of SST can be a long journey, as it may ultimately lead you to consider your business in a new light. Hence, you may use it to continually explore new things. However, the crucial thing really is to just start – that first step is the most important one to take.
In terms of how to approach SST, there’s no defined way. Whilst regulatory rules in the life insurance approach add structure, these structures can cause problems, so don’t think that a life insurers’ approach is necessarily best. The following points give some food for thought and some generic considerations:
- Firstly, if you think it’s important to do, then it is important to do right; fully commit to it! Allocate time and resources to it. Block off a day and try take those involved away from the day-to-day tasks (i.e. distractions!) that they will otherwise engage in.
- Be clear on what you want out of the exercise. For example, it could be that you just want to consider some plausible futures and how they may impact your business, rather than making any significant strategic or tactical decisions.
- In advance, ask those involved to give it some thought. In terms of establishing scenarios to explore, the points below may help:
- Sometimes the easiest place to start is what scares you – the stuff that keeps you awake at night. What would kill our business? Once you start exploring issues like that at a leadership level, you may find that there are some issues which require genuine focus and some which do not.
- Consider what your competitors are doing. Don’t copy them, but consider their actions and ask why they are doing it. Are there things you should be doing? Are there scenarios where their actions would give them a huge benefit versus you?
- Consider the risks you take on a day to day basis – you may buy, you may sell, you employ staff, you incur expenses, you pay taxes. What variation in these items have you seen? How have you dealt with it? What level of variation can you tolerate and manage? What level would create a challenge?
- Consider the key assumptions that you have about your business – what are they? Sometimes our assumptions can become so deeply ingrained in the way that we think, we forget what exactly they are – assumptions. Just because we believe something to be true, does not mean it actually is. They may not actually be based on reality! Consider what your assumptions are, what could prove them to be untrue and what impacts that may have.
- Consider related industries and look at emerging trends. Do the patterns emerging there indicate any issues that may emerge from your industry? E.g. decrease in air travel – does this bode well for the domestic tourism industry?
- Consider upside – don’t just focus on bad things. What would happen if sales exploded? Could you handle it, or would you make commitments to a large volume of customers that you would ultimately be unable to satisfy? Would that destroy your business? What if you grow by 20%, not 5% - how would you handle this?
- Consider PESTLE – political, economic, social, technological, legal and environmental issues and how they could change over time and the impacts they would have. Recall the examples given at the outset of this article.
Stress and scenario testing is a powerful tool that enables business leaders to identify what their key risks are and how potential future evolution could impact on their business. It can generate unique insights to your business. I must also emphasise that the world constantly changes. Business leaders don’t always cause these changes, but the success or failure of your business will depend on your ability to respond to them. SST gives you a head start in developing your response.
Dave O’Shea is an actuary in KPMG Ireland’s life insurance practice and has been involved in stress and scenario testing for a number of insurance companies.
The views of this article do not necessarily reflect the views of the Society of Actuaries in Ireland, the Enterprise Risk Management Committee, or the author’s employer.
 Enterprise Ireland, see: https://www.enterprise-ireland.com/en/Start-a-Business-in-Ireland/Food-…
 American Trucking Association, see https://www.trucking.org/News_and_Information_Reports_Industry_Data.aspx
 Strategy Under Uncertainty, Courtney, Kirkland and Viguerie, Harvard Business Review, November 1997
 Chinese proverb – origin uncertain, attributed to Lao Tzu and Confucius