Considerations for selection of adverse scenarios given the COVID-19 pandemic

By Bruce Langstroth, FCIA, Michael Wang, ACIA, and Valerio Valenti, FCIA, members of the CIA Committee on Risk Management and Capital Requirements

Following the May 12, 2020, article Considerations for financial condition testing in 2020 given the COVID-19 pandemic, members of the Committee on Risk Management and Capital Requirements discuss in this article the considerations for the selection of the adverse scenarios, their potential ripple effects, and corrective management actions given the COVID-19 pandemic.

Considerations for selecting going concern and solvency scenarios

The selection of adverse scenarios is somewhat dependent on the date of the investigation and the extent to which the base scenario reflects the impacts of the pandemic. Consideration should be given to the degree of which the pandemic impacts are incorporated, with examples of varying degrees discussed below. The actuary should ensure that the pandemic assumptions are consistently applied in the base and adverse scenarios. The actuary should ensure that the adverse scenarios are not excessively severe, as a result of layering on adverse assumptions on top of a severe, pandemic-driven base scenario. At the same time, the actuary must ensure the adverse scenarios are not unduly optimistic. 

The selection of scenarios can be somewhat simplified if the pandemic is not reflected in the base scenario. The actuary can examine one or more scenarios that explicitly consider the COVID-19 pandemic, its emerging experience, its related ripple effects, and management actions. For example, the actuary might examine variations of a pandemic scenario, incorporating economic, mortality, and morbidity impacts of varying severities.

If the actuary reflects COVID-19 experience to date, the actuary will need to give careful consideration to the scenario assumptions. The actuary should ensure that the joint likelihood of the pandemic and the scenario assumptions are not excessively severe or unduly optimistic. For example, if the economic impact on March 31, 2020 were incorporated in the base scenario, an adverse scenario might involve only modest recovery or modest worsening as opposed to a more severe economic scenario that might have been selected in the absence of the pandemic.

It is evident that the full effect of the pandemic has yet to emerge. While the world has seen increased mortality at certain ages accompanied by highly volatile markets, there are many possible “second acts” that have yet to be seen. COVID-19 projections could include the following:

  • Rising credit losses due to the shutdown of economies and the resulting recessions.
  • Mental health challenges resulting in increased disability claims.
  • Emerging risks in the post COVID-19 forecast period. For example, the actuary could consider increased cyber risk in their investigation due to working remotely and increased reliance on exchanging data over the internet.
  • Reserve strengthening. The uncertainty of COVID-19 could increase the variability of claim settlements for the property and casualty business (i.e., business interruption insurance class action suits) and thus increase reserve risk in the going concern and solvency scenarios. Reserve strengthening during the COVID-19 pandemic could be more severe on a company’s financial condition than under normal circumstances.

Considerations for ripple effects and corrective management actions

There are actions that management can take to mitigate the impact of the COVID-19 pandemic. For example, at the onset of the pandemic, insurers were quick to withdraw their travel insurance products and to give notice of intent to end coverage of travel medical products. As part of the financial condition testing (FCT) investigation, the actuary should consider those opportunities for management to limit their company’s exposure to loss.

In the FCT report, clear and comprehensive disclosure of how the pandemic was reflected is critically important. The actuary should clearly describe the extent to which the pandemic was reflected in the base and adverse scenarios. Recovery from the economic impacts observed in March and April, if any, should be disclosed. Further, the actuary should describe any subsequent ripple effects and management actions from COVID-19 that have been incorporated, and the extent, if any, to which the selection of adverse scenarios were affected.

The actuary should also consider whether the routine and corrective management actions under normal or prior circumstances are still applicable and appropriate to use in the COVID-19 environment. For example, it might be more difficult to raise capital due to constraints in the capital market. Reinsurance is a traditional capital relief management action and its availability could be materially limited due to the COVID-19 environment. The actuary should give careful consideration and disclose the key assumptions and limitations on these routine and corrective actions in the FCT report and the presentation to senior management and the Board.

Proper understanding and interpretation of the FCT investigation necessitates a clear understanding of how the COVID-19 pandemic was reflected.

This article originally appeared on the CIA COVID-19 Hub.

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