C - OSFI Stress Testing

Question 1

OSFI STRESS TESTING

4 PURPOSES of stress testing program

Answer 1

(1) RISK IDENTIFICATION and CONTROL
- consider concentrations and interactions between risks in stress environments that could be overlooked-

(2) COMPLEMENTARY RISK PERSPECTIVE to other RM tools
- provide insights about validity of statistical models-

(3) support CAPITAL management
- identify severe events that could adversely impact the company

(4) improve LIQUIDITY management

Question 2

OSFI STRESS TESTING

4 general considerations for stress testing programs

Answer 2

1) ACCOUNT FOR VIEWS FROM EXPERTS ACROSS THE ORGANIZATION
2) DOCUMENTED appropriately in a PROCEDURE governing the stress testing program
3) ROBUST INFRASTRUCTURE, but FLEXIBLE ENOUGH for evolving stress test.
4) Regularly UPDATE STRESS TESTING FRAMEWORK. Effectiveness assessed REGULARLY AND INDEPENDENTLY.

Question 3

OSFI STRESS TESTING

3 relevant risks that may be included in stress testing

Answer 3

1) CREDIT RISK
eg. counterparty, reinsurance

2) MARKET RISK
eg. interest rate, foreign exchange

3) INSURANCE RISK
eg. freq/sev, liquidity, legal, concentration, regulatory, reputation)

Question 4

OSFI STRESS TESTING

4 measures used to evaluate the impact of stress tests

Answer 4

1) A/L values
2) regulatory capital (available and required)
3) economic capital
4) liquidity

Question 5

OSFI STRESS TESTING

3 features of methodology and scenario selection for stress testing

Answer 5

1) cover a range of TYPE OF RISKS and BUSINESS AREAS
eg. credit, market, insurance

2) cover a range of SCENARIOS (incl. NON-HISTORICAL SCENARIOS)
must be imaginative!

3) cover a range of SEVERITIES (incl. events capable of generating the most damages)

Question 6

OSFI STRESS TESTING

Contrast :
STRESS TEST
and
REVERSE STRESS TEST

Answer 6

–stress test–
test outcome arising from changes in circumstances.

• -reverse stress test–
• Find what scenarios could bring to the outcome of business failure
• Determine if the scenario is PLAUSIBLE

Question 7

OSFI STRESS TESTING

When reverse stress test prove to be useful

Answer 7

to uncover HIDDEN RISK and INTERACTIONS among risks

Question 8

OSFI STRESS TESTING

4 specific risks requiring attention in light of experience of financial market turmoil

Answer 8

1) Risk MITIGATION (reinsurance)
2) risk to REPUTATION

3) risk of CONCENTRATION
(in regions,in a single risk factor, in off-balance sheet exposure)

4) COUNTERPARTY CREDIT risk

Question 9

OSFI STRESS TESTING

4 elements OSFI may want to assess in cie’s stress testing programs (as per of the Supervisory Review Process)

Answer 9

1) whether chosen scenarios are consistent with risk appetite
2) whether chosen scenarios are appropriate to portfolio of cie and if they include severe shock factors
3) whether frequency of stress testing is sufficient to support timely management action.
4) assess future capital RESSOURSES and capital REQUIREMENTS under adverse scenarios

Question 10

OSFI STRESS TESTING

2 responsibilities
of BOARD
with STRESS TESTING program

Answer 10

1) ULTIMATELY RESPONSIBLE for overall stress test program

2) be AWARE OF KEY FINDINGS
- —
3) that Sr. Mngmnt has a stress test program that is ENTERPRISE WIDE and “FIT FOR PURPOSE”

4) ensure that policies requiring the use of stress testing as a management tool are in place

Question 11

OSFI STRESS TESTING

2 responsibilities of
SENIOR MANAGEMENT
with STRESS TESTING program

Answer 11

1) its IMPLEMENTATION, MANAGEMENT and OVERSIGHT

2) ensure that cie has PLAN TO DEAL WITH RARE BUT PLAUSIBLE STRESS SCENARIOS
- –
3) able to ARTICULATE RISK APPETITE

4) UNDERSTAND IMPACT OF STRESS EVENTS ON RISK PROFILE
5) identify POTENTIAL STRESS SCENARIOS and IMPLEMENT MITIGATION STRATEGIES
5) Document the use of severe scenarios.

Question 12

OSFI STRESS TESTING

Define Stress testing

Answer 12

RM technique to evaluate the POTENTIAL EFFECT OF FINANCIAL CONDITION of a set of changes in risk factors from EXCEPTIONAL BUT PLAUSIBLE EVENTS

Question 13

OSFI STRESS TESTING

2 types of stress testing

Answer 13

Sensitivity testing

Scenario testing

Question 14

OSFI STRESS TESTING

Contrast
SCENARIO TESTING
and
SENSITIVITY TESTING

Answer 14

• -scenario testing–
• HYPOTHETICAL FUTURE STATE OF THE WORLD
• involves changes in a number of risk factors (as well as ripple effects)
• conducted over the appropriate time horizon
• more complex

–sensitivity testing–
INCREMENTAL CHG IN A RISK FACTOR
-conducted over a SHORTER TIME HORIZON
-needs FEWER RESSOURCES than scenario testing
-simpler technique for assessing the impact of a change in risks when a quick response is needed

Question 15

OSFI STRESS TESTING

How a stress testing program can provide a different risk perspective than other RM tools

Answer 15

• provide insight on validity of other stat models at high confidence intervals (VaR)
• assess robustness of models to changes in financial environment
• detect hidden concentrations and interactions overlooked by other models

Question 16

OSFI STRESS TESTING

2 possible outcomes of failure of imagination when performing stress tests

Answer 16

1) underestimation of likelihood and severity of extreme events
2) false sense of security

Question 17

OSFI STRESS TESTING

2 times when stress testing proves to be especially important

Answer 17

AFTER LONG PERIOD OF CALM FINANCIAL CONDITION
where memory of negative position starts to fade, leading to complacency and underpricing

DURING PERIOD OF EXPANSION
when innovation leads to new products, rapid growth, and no historical experience is available

Question 18

OSFI STRESS TESTING

1 example of Stress Testing for Insurers

Answer 18

DCAT