CIA.FCT-1

Question 1

What does FCT stand for?

Answer 1

Financial Condition Testing

Question 2

What are the 2 goals of FCT?

Answer 2

1. Identify threats to the insurer’s financial condition
2. Take corrective actions to address those threats

Question 3

Why does an insurer perform stress-testing?

([Hint: risk-complement-Cap-Liq])

Answer 3

1. Helps identify and control risk
2. Complement other risk management tools such as Best Capital Adequacy Ratio
3. Supports capital management
4. Improves liquidity management

Question 4

What are the 5 key elements of FCT? (BACRO)

Answer 4

1. Base Scenario: Reflects the insurer’s business plan and current conditions.
2. Adverse Scenario: must analyze the impact of several adverse scenarios .
   A. Solvency Scenarios: Test if assets exceed liabilities (≥95th percentile severity).

B. Going Concern Scenarios: Test regulatory capital adequacy (≥90th percentile severity).

3. Corrective action: identification and analysis of corrective management actions to mitigate risks.
4. Report: submit recommendations to management and the board of directors (or chief agent)
5. Opinion: Appointed Actuary signs an opinion regarding the financial condition of the insurer.

Question 5

Briefly describe the stress-testing purpose: ‘risk identification & control’.

Answer 5

risk identification:
- identify concentrations & interactions of risks
risk control:
- adjust individual portfolios or overall business strategy

Question 6

Briefly describe the stress-testing purpose: ‘complementing other tools’.

Answer 6

Can be used to validate & verify findings from other risk modeling techniques

Question 7

Briefly describe the stress-testing purpose: ‘supporting capital management’.

Answer 7

Understand where the risks are & set required capital to cover them

Question 8

Briefly describe the stress-testing purpose: ‘improving liquidity management’.

Answer 8

Assess liquidity profile and adequacy of liquidity buffers

Question 9

To perform FCT, it is necessary to understand which 2 key metrics?

Answer 9

• regulatory capital minimum(s)
• insurer’s internal target capital requirements ← determined by ORSA

Question 10

True or False?
FCT and ORSA are closely related although ORSA is more comprehensive in nature.

Answer 10

True

Question 11

Identify the ‘preliminary’ step and the ‘extra’ step in addition to ‘BACRO’ when performing FCT.

Answer 11

preliminary step:
- review financial position at year-end for each year in historical period
extra step at the end:
- identify possible regulatory action

Question 12

Identify the 2 actions performed during the review of operations and financial position (preliminary step).

Answer 12

• review balance sheet, statement of income, and source of earnings for an appropriate number of years
• analyze any trends in these numbers

Question 13

What is the desired forecast period for FCT?

Answer 13

• the forecast period should be long enough to capture
  [1] risk emergence
  [2] financial impacts
  [3] ripple effects
  [4] corrective action
  → generally 3-5 years although there is no minimum (should also be consistent with ORSA)

Question 14

How do you determine the materiality standard for FCT? (3 elements)

Answer 14

FCT sets the materiality standard with management input and by specifically considering:
- size of insurer
- financial position
- nature of regulatory test

Question 15

Define the term base scenario.

Answer 15

A set of assumptions on risk factors that are consistent with the business plan over the forecast period (**if plan is realistic & consistent).**

Reflects the insurer’s business plan and internal capital targets.

Question 16

Define the term adverse scenario.

Answer 16

A scenario that is developed by stress-testing assumptions used in the business plan (look specifically for risk factors that threaten financial condition).

Question 17

Define the term solvency scenario.

Answer 17

A plausible adverse scenario

• Test the insurer’s ability to maintain assets > liabilities
• should fall above the 95th percentile on the loss distribution (if distribution is available)

Question 18

Define the term going-concern scenario.

Answer 18

An adverse scenario that is more likely and/or less severe than a solvency scenario (could include risks not considered in solvency scenarios).

• Ensure compliance with regulatory minimum capital ratios (MCT >100%).
• should fall above the 90th percentile on the loss distribution (if distribution is available)
  
  • could include risks not considered in solvency scenarios

Question 19

What is a ripple effect?

Answer 19

• An event that occurs when an adverse scenario triggers a change in 1 or more inter-dependent assumptions.
• Can include policyholder actions, management’s routine actions, regulatory actions

1. Example: a ripple effect of an earthquake may be loss of reinsurance

Question 20

What is a corrective management action?

Answer 20

An action management takes to mitigate adverse ripple effects

Question 21

What is an integrated scenario for FCT?

Answer 21

A scenario created by combining two or more risks factors to produce a new plausible adverse scenario

Example: combine a low-probability scenario with a higher-probability adverse scenario

Question 22

An FCT model should reproduce which 4 key elements of the Financial Statements?

Answer 22

1. Balance sheet: assets, liabilities, retained earnings
2. Income statement: revenue and expenses
3. Regulatory measures of capital adequacy: MCT ratio, BCAR, MSA ratios
4. Sources of earnings: detail on sources of premium ans investments

Question 23

What is the recommended loss distribution percentile for a going-concern scenario?

Answer 23

90th → 95th percentile (if the loss distribution and percentiles are available)

Question 24

What is the recommended loss distribution percentile for a solvency scenario?

Answer 24

95th → 99th percentile (if the loss distribution and percentiles are available)
* or even beyond the 99th percentile in some cases

Question 25

How does an actuary validate an FCT model on an accounting basis?

Answer 25

statement of income = (cash flows) + (change in balance sheet items)

Question 26

How does an actuary validate a FCT model in a static environment

Answer 26

Base scenario should show continuity of results from year-to-year (cash, liabilities, surplus,..)

Question 27

How frequently should the FCT be performed?

Answer 27

At least once during each financial year

Question 28

Why is FCT report so important/purpose of an FCT report?

Answer 28

That is part of how an actuary communicates the state of the company to the BoD and includes: 1. Identification of risks to the insurer's financial condition 2. Identification of ways to mitigate and reduce risk

Question 29

Who are the 3 audiences for an FCT report?

Answer 29

1. BoD: prefers an interpretive summary (versus a detailed statistical report) 2. management: receives a more detailed report 3. Regulator: focuses on solvency issues

Question 30

Identify the 3 possible types of opinion included in a FCT report.

Answer 30

1. Satisfactory 2. Satisfactory subject to appropriate corrective action (if management promises to fix whatever is wrong, then the AA will be nice) 3. Not satisfactory

Question 31

When can an actuary report that the financial condition of an insurer is satisfactory?

Answer 31

The following conditions must hold throughout the forecast period: [1] under the `base scenario` insurer meets its internal target capital ratio(s) as determined by the ORSA (ex: `MCT > 180% - internal target)` [2] under the `going-concern scenarios` → insurer meets the regulatory minimum capital ratio(s) (ex: `MCT > 100%`) [3] under `solvency scenarios` → must have `assets > liabilities`

Question 32

How many adverse scenarios should an FCT report include?

Answer 32

At least 3, including 1 going-concern scenario and 2 solvency scenarios They should be chosen from multiple risk categories

Question 33

True or False? In the assessment of the satisfaction of a FCT analysis, you should always consider all displayed years.

Answer 33

False Even if the given information displays 5 years of projections, you only have to check the conditions for years that are in the stated forecast period.

Question 34

Identify the 12 P&C risk categories | hint : F-PIP-REAGOR-C2

Answer 34

Frequency & Severity - Policy Liabilities Inflation Premiums - Reinsurance Expense risk Asset risk Government risk Off-Balance-Sheet risk Related Company risk - Climate risk Cyber risk

Question 35

Identify 7 common ripple effects.

Answer 35

1. Higher LR (due to higher losses or operating costs) 2. Loss of reinsurance 3. Post-event inflation 4. Forced sale or liquidation 5. Mix shift 6. Policyholder actions 7. Regulatory action

Question 36

Identify 7 common corrective management actions.

Answer 36

1. Tighten U/W guidelines 2. Raise rates 3. Review reinsurance 4. Sell assets 5. Review mix of business 6. Suspend dividend payments 7. Reduce capital transfer to parent or home office

Question 37

Identify 2 possible causes of a change in frequency and severity.

Answer 37

- Catastrophic events - Large Claims - Social inflation (claims inflation resulting from changes in the likelihood of claimants bringing suit, the size of awards, the standard of liability, or the attitudes of claimants towards settlement of their claims.

Question 38

Identify 2 possible causes of Policy liabilities risk.

Answer 38

- Selection of inadequate LDFs - Class actions and other mass torts - Change in mix of business (especially if large claims are paid earlier) - Actual return on investment supporting the liabilities significantly lower than assumed

Question 39

Identify 2 causes that could result in significant reduction in premium volume (premium risk).

Answer 39

- Entry of a new strong competitor in the market - Increased competitiveness in the market - Loss of a key distributor or even an entire distribution channel - Loss of a key client - Action by any influential entity that affects the insurer's reputation or growth negatively - Non-competitive premium rates

Question 40

Identify 2 causes that could result in significant increase in premium volume (premium risk).

Answer 40

- Withdrawal or failure of major competitors from a market - Appointment of a key distributor - Unexpected new business from a large client - Any action by any influential entity that affects the insurer's reputation or growth favourably - Unexpected success in a new product area, or against previously stronger competition - Premium rates set too low compared to the competition

Question 41

Identify 2 causes leading to reinsurance risk.

Answer 41

- Reinsurance insolvency - An increase in the reinsurance rates or a reduction in reinsurance commission - Reduction in capacity - Disputes over policy conditions

Question 42

Identify 2 causes of a change in investment risk.

Answer 42

- Significant change in the yield curve - Increase in the default rate on debt securities - Decrease in the returns and/or value of equities - Decrease in the returns and/or value of real estate - Decrease in the returns and/or value of subsidiary - Significant change in foreign exchange rates - Decrease in the returns and/or value of other major asset categories

Question 43

Identify 2 causes of a change in government risk.

Answer 43

- Rate freeze or rollback of rates by gov - Change to regulations regarding use of rating variables - Change to legislation that that prescribe levels of insurance coverage - Increase in taxation rates or rules for corporations - Nationalization or privatization - Change to legislation that creates or restricts distribution channels - Change in regulatory solvency standards - Political instability

Question 44

Identify 2 causes of a change in off-balance sheet items risk.

Answer 44

- Structured settlement (credit risk associated with the insolvency of the insurer selling the annuity) - Contingent liabilities or losses (tax, litigation, etc.) - Letters of credit and pledged assets (lending institution default risk) - Capital maintenance agreements - Derivative instruments (market risk, default/credit risk, management risk and legal risk) - Pension underfunding

Question 45

Identify 2 methods for selecting adverse scenarios.

Answer 45

1. Percentiles (if a loss distribution is available) 2. Reverse stress-testing

Question 46

Briefly describe the method of` reverse stress-testing` in an FCT analysis

Answer 46

Start by considering a specific adverse scenario where the insurer's surplus becomes negative (surplus = assets - liabilities; `Assets < Liab`) `Work backwards to find the risk factors` required to produce that scenario Determine `if it's plausible` for risk factors of the insurer's current financial position to deteriorate to that degree → if yes` then this adverse scenario` may be a solvency scenario

Question 47

Should the actuary integrate the FCT report with the ORSA report or keep them separate?

Answer 47

Actuary should use judgement May produce 2 independent reports or 1 integrated report

Question 48

Identify 4 considerations supporting integration of FCT and ORSA.

Answer 48

1. FCT uses internal target capital ratios developed by ORSA 2. ORSA is useful in assessing adverse scenarios 3. May be more efficient to integrate the reports (both require data collection and similar types of analysis, both may be released at the same time) 4. A single integrated report may be better for the end user

Question 49

Identify 3 challenges regarding integration of FCT and ORSA.

Answer 49

1. Oversight: AA is responsible for FCT whereas the board and senior management is responsible for ORSA 2. Different methodology: FCT follows a prescribed regulatory basis while ORSA reflects own models and assumptions 3. Staff responsible: different for FCT versus ORSA and coordination may be costly