OSFI.Stress

Reading: Stress Testing, Guideline E-18

Authour: OSFI (Office of the Superintendent of Financial Institutions Canada)

Forum

BA Quick-Summary: Stress Testing OSFI.Stress is yet another elaboration of the central actuarial theme of risk management. It's a general discussion of stress-testing that applies to any FRFI (Federally Regulated Financial Institution.) Contrast this with the CIA's educational note on FCT (Financial Condition Testing), CIA.FCT-1, that applies only to insurers. (There is overlap between the two, but CIA.FCT-1 is significantly more important.)

Pop Quiz

What is the purpose of stress-testing? (See CIA.FCT-1) [Hint: risk-complement-Cap-Liq]

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• purpose of stress-testing
• roles & responsibilities of Board of Directors versus senior management regarding stress-testing program
• compare scenario-testing versus sensitivity-testing
• definition of stress-testing
• SCENARIO: analyze a given scenario for quality of risk management & stress-testing, and suggest improvements
• rudimentary considerations in a stress-testing program [Hint: RUDI]

Top Questions ← Questions you absolutely need to know!

Questions held out from Fall 2019 exam: #20. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Fall #22)	purpose: - of stress-testing	roles & responsibilities: - BoD v management	purpose: - of stress-testing (details)
E (2017.Fall #24)	purpose: - of stress-testing
E (2017.Spring #22)	SCENARIO: - improve stress-testing	SCENARIO: - improve stress-testing	SCENARIO: - improve stress-testing
E (2016.Fall #20)	defn: - of stress-testing	purpose: - of stress-testing	compare: scenario v sensitivity testing	roles & responsibilities: - BoD v management
E (2014.Fall #26)	see CIA.FCT-1 - (reverses stress-testing)	SCENARIO: - improve stress-testing	roles & responsibilities: - BoD v management
E (2014.Spring #27)	defn: - of stress-testing	considerations: - of stress-testing	see CIA.FCT-1 - (reverses stress-testing)
E (2013.Fall #31)	purpose: - of stress-testing	compare: scenario v sensitivity testing
E (2012.Fall #28)	purpose: - of stress-testing	roles & responsibilities: - BoD v management

In Plain English!

Intro

It might be a good idea to first review CIA.FCT-1 because it's closely related to OSFI.Stress. (The FCT article began by addressing the why and the how for stress-testing.)

OSFI's paper on stress-testing doesn't discuss any specific stress-testing methodology, but it does address a few key issues that were not addressed CIA.FCT-1.

Question: define the term stress-testing

stress testing is a risk management technique...

to evaluate

...effects on financial condition of specified changes...

corresponding to

...exceptional but plausible events.

Recall that stress-testing applies to any type of company whereas FCT applies only to insurance companies.

Note: The role of the BoD (Board of Directors) versus the role of management in the stress-testing program is important to understand:

• As an analyst, your role is to build and maintain the spreadsheets that do the actual calculations.
• When you're promoted to management, you'll do less of the technical work and more of the planning.
• If you're ever on the Board of Directors, your involvement would be very high level, but the BoD has ultimate responsibility for integrity of the stress-testing program.

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Considerations in Stress-Testing Programs

Question: identify 4 rudimentary considerations in stress-testing [Hint: RUDI]

R: RANGE (stress-testing should use a range of perspectives & techniques)

U: UPDATE (the stress-testing framework should be updated regularly)

D: DOCUMENTATION (proper documentation of methodology should be available)

I: INFRASTRUCTURE (the stress-testing infrastructure should be flexible if assumptions or methods change.)

This specific question is rarely asked. A better question is one that describes a company's stress-testing program and asks how it could be improved. An example is:

E (2014.Fall #26)

And it was worth 2.0 points! To answer it properly, you had to use common sense and knowledge of these rudimentary considerations.

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Methods, Focus, OSFI Supervision

There was a good question from (2017.Spring #22) on creating scenarios in a stress-testing program.

• (Note that this is different from RUDI, which lists general considerations in designing the overall program, as opposed to creating specific scenarios.)

Comprehensive	scenarios should cover all important BUSINESS & PRODUCT lines
Non-historical	create NON-HISTORICAL scenarios (events that haven't happened but COULD happen)
Downturn	severe & sustained DOWNTURNS (includes large losses, loss of reputation, legal problems,..)

• The exam didn't specifically ask you to list these considerations. Instead, you were given a description of a company's stress-testing program and asked to comment on various different aspects. The way to solve the problem was to ask yourself whether the above considerations were followed (or not followed.)

A related idea is what OSFI looks for in assessing a stress-testing program. The text lists 9 items, but I think you can get away with memorizing just 4. (This has not appeared on a prior exam, and it seems a little too detailed. Nonetheless, the first, and most basic thing OSFI would look for is:

• Are the scenarios appropriate for institution's risk profile?
• (See the BattleCards for a few more.)

Let's close with a question that has appeared on the exam more than once. (See BattleTable for exam references.)

Question: compare and contrast scenario-testing with sensitivity-testing

scenario-testing:

- significant changes to risk factors

- observe future state including ripple effects & management actions over a longer time horizon

- more complex & comprehensive

sensitivity-testing:

- incremental changes to risk factors

- shock is more immediate & time horizon shorter

- simpler fewer resources required

(The main point is that scenario-testing is more complex and requires more resources than sensitivity-testing.)

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BattleCodes

Memorize:

• defn of stress-testing
• role of Board of Directors & management in stress-testing program
• 4 considerations in designing an overall stress-testing program (RUDI).
• 3 considerations in creating scenarios for a stress-testing program
• how OSFI assesses a stress-testing program (probably not too important)
• scenario-testing versus sensitivity-testing

Conceptual:

• You should think about how OSFI.Stress relates to CIA.FCT-1.
  • Recall that in the BattleCodes for CIA.FCT-1, I asked you to think about how these readings are similar and how they are different.
  • The obvious similarity is that they are both about stress-testing. The obvious difference is that CIA.FCT-1 pertains to insurance companies (since it was written by the Canadian Institute of Actuaries!) and OSFI.Stress applies to any type of company.
  • (This is an open-ended question - something fun to think about the next time you're in a boring meeting!)

Calculational:

• none

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  Forum

POP QUIZ ANSWERS

The purpose of stress-testing is:

risk: risk identification & control (stress-testing helps identify and control risk)

complement: stress-testing complements other risk management tools such as Best's Capital Adequacy Ratio as described in BCAR.Cat (may also involve simulation of shocks like earthquakes)

Cap: stress-testing supports capital management

Liq: stress-testing improves liquidity management