Page 134 - Risk Management in current scenario

Application of Stress Testing

Background

Value at Risk (VaR) is central to economic capital calculation used under
both Basel-11/111 and Solvency-11 regime. This enables banks and
insurance companies to calculate the appropriate level of economic
capital to maintain its solvency position to the desired level of confidence
based on the risks that it present within certain time frame.

VaR is defined as the maximum loss that a financial institution can suffer
in a given time frame and within a certain confidence level. VaR uses
statistical distribution to calculate the losses(capital requirement) within
a given confidence level (say 99.5%) over a required time horizon (a
month or a year). However, such measure often fails to capture the
amount of loss sitting in the tail of the distribution.

VaR is a good measure to quantify loss amount that occurs with relatively
high frequency up to a defined level of probability; however, it is relatively
poor in capturing the amount of loss beyond the defined level of
probability which can be catastrophic in nature for the Company. To assess
such losses, Stress and Scenario testing (SST) is used in banking and
insurance industry. SST is developing into a very strong tool as a part of
risk management in financial sectors, though sensitivity testing have been
used in the actuarial domain for last many years to assess the movement
of results but there is a slight difference between Sensitivity testing and
Stress testing. The differences are covered later in the section.

132 | Risk Management in Current Scenario