Robert Raber, director of criteria, AM Best, said stress testing involves subjecting rated entities to various scenarios that could affect their balance sheet strength or enterprise risk management to assess their ability to respond. Raber spoke with AM Best TV at the IASA Xchange conference in Pittsburgh.
Following is an edited transcript of the interview.
Q: You’re going to be presented here on stress testing. Can you tell us exactly what that is?
A: Stress testing is a process through which AM Best subjects the rated entities to various scenarios that could affect their balance sheet strength or their enterprise risk management to see how they would respond to issues such as claims payment ability, liquidity needs, or reputational risk in their respective portion of the industry.
Q: Where is stress testing considered in the ratings process?
A: Stress testing is focused on two of the building blocks. The first one being balance sheet strength assessment. It’s part of the calculation of a BCAR score, and the ability of a company to absorb multiple stress tests is considered in the balance sheet strength assessment. Then it’s also considered in the enterprise risk management building block, where it’s a little more of a qualitative nature, understanding scenario testing, what a company considers could be a scenario that might cause insolvency ultimately, or liquidity issues, or cash crunch concerns.
Q: Is it considered in the Best’s Credit Rating Methodology?
A: It’s a big piece of the Best’s Credit Rating Methodology. As I noted, it’s in those two building blocks, but it also kind of floats into operating performance. A company’s inability to sustain their underwriting performance or their investment performance over time could really stress their capital position and really potentially lead to a weakened position that a catastrophe could ultimately make even worse.
Q: Now, AM Best has something called reverse stress testing. Can you explain that?
A: Reverse stress testing, we ask companies to take a look at what could be something that could drive them to a weak capital position and do a little back testing on their capital position, on their historical results to see, hey, what could have been a factor that could have driven us to this point. It’s a little more of a backwards view, and hindsight is always 20/20 vision, but it’s also a way to make sure that a company is taken into account, for example, the worst-case scenario that they may have been impacted by in the past 10 or 15 or 20 years and apply it to what their current exposures might be so that we have a great understanding of what it is, and it goes to the credibility of management being able to really view what could be an exposure in their book of business.
Q: So, why should companies be considering stress testing?
A: Well, as part of the Best’s Credit Rating Methodology we specifically call out stress testing. We’re kind of expecting it from companies when they’re looking at their capital adequacy ratio. We expect it from management teams to take a holistic view of their organization. We expect it very significantly in the enterprise risk management process as we do calculations on a company’s capital adequacy, as we look at their reputation, as we look at their business profile.
We want to make sure that they’re able to sustain and continue as a strong, ongoing entity, looking into the future, and always keeping in mind that a Best’s Credit Rating is a forward-looking opinion. We want to make sure that a company has that financial and operational strength to re-sustain in case they’re exposed to weather events, terrorism events, or any other event that could cause a strain on their financial position.