18 Feb 2010

Harmonised Stress Tests - Good in Theory

CEIOPS plans to introduce a harmonised stress test for Insurance companies in Europe. While this is a worthwhile project it will create one practical problem: what amount of stress will be applied to the balance sheets of the insurers? Well before the Credit Crunch started in the middle of 2007 we often asked the question: What would happen in the hypothetical case that all asset prices drop 20 per cent? would the banking and financial system in general be able to withstand such a shock - given that the margin of safety on a lot of lending was much less than that! We all know the answer to that question and I think that lessons still have not been learned. The problem is, that only by relying less on debt and debt instruments (in any form) and more on equity will the risk of a financial meltdown be successfully contained. Regulators will be hard-pressed to set the appropriate level of 'stress' in any test - too much and they regulate the insurance industry out of business, too little and the test becomes meaningless.

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