In this blog, David Chen, a member of the Stress Resilience Working Party, provides insight into some of the observations from the recent market stress event, which were presented at the Life Conference 2022.
My nine-year-old likes Rubik’s Cubes and often challenges me to a game. For beginners, like myself, there’s a simple set of rules. You start with the bottom cross and work through the edges and corners, layer by layer. So long as you remember the algorithm, you’ll get there eventually. For the more advanced players, you can forget about the rules and cut some corners (figuratively speaking, of course), so long as you know what you’re doing. But how the ‘pros’ do it in seconds with a blindfold, that I don’t know.
Managing firms through a stress event shares many commonalities. Like the starting point of a scrambled Rubik’s Cube, the starting point of each crisis is different to the one before. There isn’t a magical set of rules to guide one through. However, there are key performance or risk indicators to return to as the ultimate goals.
The IFoA’s Stress Resilience Working Party has undertaken a case study on the recent market turbulence, how it has had an impact on life insurance firms, and what lessons we have learnt from it. Here’s a starter for ten.
Model risk – actuaries’ favourite topic. Many actuaries tried to use complex statistical jargon to convince me that a 330bps 15yr SONIA movement in 9 months has a limited impact on the interest-rate model calibration. But if the internal model says we’ve just seen, say, a 1-in-2,000-year event, and is unlikely to repeat for the next 20 centuries, I remain to be convinced. Truly, there is the mechanical calibration part, and then follows the expert judgement part. Surely I would expect to see a marked increase in calibrated strength, before being managed down with expert judgement overlay? Of course, there is an eternal debate about SII one-year view versus through-the-cycle calibration, which is a proxy for short-term balance sheet volatility versus long-term expectations.
Then there is a question about body correlation versus tail correlation. During March 2020 and September 2022, we witnessed a breakdown of traditional economic correlations, where rates have gone up with a simultaneous weakening of the pound. Although often seen in the emerging market, it is hard for any actuary to justify in the correlation expert judgement panel for UK economy, as vast amount of data supports otherwise. This goes back to my earlier point: that every stress event is unique, and unfortunately economic histories are notoriously poor for predictive powers in stress.
So what’s missing? We have to admit there are risks that are hard to be modelled quantitatively. Political risk and regulatory risk are two vivid examples. The market doesn’t like surprises. And thanks to technology, information dissemination has become increasingly easier and the world smaller. The market therefore has grown more demanding regarding information clarity. Any unexpected fiscal announcement or regulatory policy uncertainty could easily upset the market and set off chain reactions, as seen both in the Covid-19 era and the more recent LDI gilts sell-off.
I hope I have raised enough questions without providing an answer. In fact, putting my risk manager’s hat on, a slight (potential) mis-calibration of the SCR, or some short-term volatility of the balance sheet, is not end of the world. What really matters in a crisis is the ability to stay resilient. By which I mean robustness of liquidity risk management, adequacy and preparedness of recovery planning, agility of hedging and portfolio management capabilities. These can be achieved via stress and scenario testing. Keep asking the ‘What-if’ question and examine: What are the early warning indicators for each scenario? Are our risk indicators practical, risk sensitive and leading? What are the available management actions and how effective are they? Will they get us back to our ultimate goals?
There are many other interesting areas that we explored in the case study. For example, we’ve moaned for years of the ‘low-for-long’ rates environment, is there now a change of regime? If so, what are the implications? Has our debt-leverage ratio become sub-optimal? What about reinsurance, is it still looking as attractive?
For those who benefited from a rising interest rate and an economic hedging strategy, what are the options for spending the ‘windfall capital’?
And not to forget our customers – are there silver linings behind the cloud? What product innovations could there be, to serve better social purpose, or provide better customer outcome?
We hope to see you at our session ‘Stress event resilience – a case study on the inflation shock of 2022’ at the Life Conference 2022 to hear more from our perspective.
Now back to solving Rubik’s Cubes.
Recordings of all sessions in the Life Conference 2022 can be viewed via the IFoA's Virtual Learning Environment (VLE)
