COVID-19: Considerations for modelling stress in future
24 Jun 2020
We are currently experiencing one of the most significant stress events in our lifetime. The new and continually emerging data-sets that are available on the impacts of the COVID-19 pandemic present firms with a valuable opportunity to revise and refine their stress and scenario testing. Despite the wealth of new information, there is significant uncertainty about the medium and long term future which impacts firms’ setting of long-term assumptions and modelling of risks to which they are exposed.
Understanding the interaction between risks is central to determining a firm’s capital requirements. However, there is limited data to set and parameterise dependency structures, and therefore a limited set of data to validate these. Hence there is often a significant reliance on professional judgement. This is important, because it is often the simultaneous accumulation of correlated risk events that hurts rather than the occurrence of a single risk event. The availability of data resulting from COVID-19 provides the opportunity to review and validate assumed interaction of risks so that models can be enhanced to better model the behaviour of risks under ‘normal’ and ‘extreme’ circumstances.
Some things to consider
There are a number of foreseeable future scenarios and we expect that firms are already considering these. For example, have you considered the effects on your firm of a second wave of COVID-19? A mutation of the virus? The creation of a successful vaccine? The effects of a prolonged lock-down, or prolonged social distancing?
We set out some things to consider below:
- Stress severity: We have seen good practice in firms considering the effects of both single stress events and multiple correlated accumulated events. It can be useful to rank risks in terms of severity of impact and then consider the effect of a combination of several risks occurring at the same time. Do recent events provide additional data that may be useful to your firm to refine such an assessment? Do you have plans to discuss and develop the impacts of simultaneous risk events in a workshop with business experts?
- Recalibration: Considering recent events, where would COVID-19 have appeared on your firm’s loss distribution curve? If you reverse engineer the probability of such an impact, does that seem feasible and appropriate? Do you have plans to review your risk distributions and dependency structures in light of recent events?
- Stress design: What benefit can be achieved from critically assessing the design of stresses? Are the risk drivers, and the inter-dependency between risks fully understood? Is your data sufficiently granular to enable the effects over single-period or multi-period to be adequately reflected in the results?
- Solo and group: Have recent events placed even greater focus on the need to understand the impact of stress at solo level, and the wider impacts at group level? Are the interactions between different areas of the group business fully reflected in stress event modelling? Did any exposures emerge that had not previously been fully acknowledged? Or diversification benefits emerge that had not been anticipated? Was the impact on the wider business fully understood – such as the impact on staff pension schemes, debt covenants, and the ability to raise capital by issuing debt?
- Stress on a stress: Firms may wish to take action to protect their business from deterioration from the current position. These actions may be helpfully informed by stress and scenario testing which is also an important validation tool given that it is relatively intuitive and easy to understand. Are the impacts on your existing revised business plans fully understood?
There has probably never been greater uncertainty around assumptions and the risks that these assumptions are intended to portray. Firms will have to give some thought to the disclosures that they make to the market and the implications for their firms of “what happens next?” scenarios.
How we can help
Hymans Robertson has a wealth of experience across all matters relating to risk and capital. We can help you make more efficient use of your valuable capital, support you in understanding your risks and the impact these will have on your balance sheet, and keep up with the ever-changing regulatory environment.
If you would like to discuss any of the areas considered in this paper in more detail, please get in touch.