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Stress Testing to Evaluate Insurance Cover


Checklist Description

This checklist outlines ways to ensure that insurance policies provide the kind of robust protection businesses need to protect them against risks, both physical and financial.

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Definition

Stress testing aims to determine how well systems and procedures perform when subjected to a wide range of operational conditions. It is frequently employed to help assess performance during extreme or unexpected conditions. During stress testing, a system is subjected either to sudden extreme demands or to gradually higher loads until the point is reached when at least one element of the system stops delivering the desired level of performance. This evaluation helps companies to understand the kind of market conditions under which key elements of their businesses become vulnerable.

Although retail-focused insurance products have become more standardized in recent years, and are increasingly sold via the internet and call centers as consumers focus on price, the commercial insurance industry has retained a high level of complexity. This is largely driven by a broadening of the spectrum of risks faced by businesses in areas such as environmental protection, human resources, product safety, counterparty agreements, and technology. Given the wider range of risks that businesses face, partly as a result of tighter legislation and regulation, ensuring that the appropriate insurance is in place to provide robust protection against unexpected events has never been more important.

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Advantages

  • A better understanding of the risks—both systemic and non-systemic—facing a business can help in contingency planning.

  • Regular stress testing can help to keep management vigilant in an environment of constantly changing business risks.

  • This type of evaluation can identify multiple, seemingly minor chinks in the armor of a business that cumulatively could have a serious impact.

  • What if? analysis can be useful in highlighting event risks that may not otherwise be immediately apparent.

  • Robust financial protection can insulate businesses from the risk of a catastrophic event that could otherwise threaten the viability of the entity.

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Disadvantages

  • Protracted evaluation over extended periods of time could divert key resources away from core business activities, potentially resulting in the business overlooking valuable opportunities.

  • Extended periods of evaluation run the risk of “paralysis through analysis.” Understanding the shortcomings of available options can be beneficial, but, taken to an extreme, it could be counterproductive.

  • Under some circumstances, stress testing may even run the risk of effectively encouraging risky practices by creating a false sense of control.

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Action Checklist

  • Encourage an environment of openness about the kinds of risk facing the business. Some risks are obvious, but more covert risks are sometimes known only to the managers of individual business units.

  • Involve key business stakeholders in the evaluation of risks and alternative ways to protect against them.

  • Consider how existing policies insure against multiple minor claims as well as more significant/catastrophic single incidents. Examine whether particular exclusion clauses could leave your business exposed to risks that you thought were covered.

  • Do try to quantify in financial terms how falling foul of various risks could affect your business. Only once an actual liability figure is available can you expect an insurance provider to be able to provide a quotation to cover that risk.

  • Be prepared to seek the advice of specialist insurance providers. The field of commercial insurance can be immensely more complex than its consumer equivalent, and risk consultants can help companies to understand and evaluate both risks and potential solutions. Industry-specific experts from specialist risk-management companies can help to devise customized solutions to protect against potential liabilities.

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Dos and Don’ts

Do

  • Remember that emerging risks necessitate regular reviews of the way you protect your business.

  • Involve key stakeholders in the evaluation of both risks and potential solutions.

  • Consider seeking the help of specialist consultants.

Don’t

  • Don’t make the mistake of basing a decision purely on price. Commercial insurance is a highly complex field and insurance solutions are many and varied.

  • Don’t fall into the trap of thinking that insurance can cover absolutely every conceivable risk your business could face.

  • Don’t see the right insurance for your company as simply another expense. Securing the appropriate protection for your business can help you concentrate on doing what you do best.

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Further reading

Book:

  • Overbeck, Ludger, and Gerrit Jan van den Brink. Integrated Stress Testing for Financial Institutions. London: Palgrave Macmillan, 2009.

Article:

  • Hilbers, Paul, and Matthew T. Jones. “What if…?” Finance and Development 41:4 (December 2004): 24–27. Online at: tinyurl.com/3ncffh6 [PDF].

Websites:

  • Risk consultancy and management companies: Willis: www.willis.com; Towers Watson: www.towerswatson.com
  • Society of Actuaries (SOA; includes “Effective stress testing” presentation by Mark Chaplin, SOA Annual Meeting, Oct 2007): www.soa.org

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