How do you measure and report the results of risk scenarios and simulations vs stress testing?

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Risk scenarios and simulations vs stress testing are two methods of assessing the impact of potential events on an organization's objectives and performance. They are often used in the context of enterprise risk management (ERM), which is a holistic approach to identifying, analyzing, and managing risks across an organization. In this article, we will compare and contrast these methods and explain how to measure and report their results.

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Hamed Rezk ,MBA, CIA?, ASMEC?, CCRO, CRMP, GRCP, CCP, CLBB

Regional Chief Risk Officer | Driving Growth for 200+ Companies | Executive Risk Committee Chair | Helping You Excel in…
Vipin Pandey

Leadership Enthusiast | Crafting Content for Emerging Leaders & Professionals | US Insurance | Service Delivery Manager…

1 What are risk scenarios and simulations?

Risk scenarios and simulations are hypothetical situations that explore the possible outcomes of a risk event or a combination of risk events. They usually involve a range of assumptions, variables, and probabilities to capture the uncertainty and complexity of the risk environment. Simulations use mathematical models, algorithms, or software tools to generate and analyze the scenarios. Examples of simulations include Monte Carlo simulation, scenario analysis, and sensitivity analysis.

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Risk scenarios and simulations are tools used to assess potential outcomes of risk events. By creating hypothetical situations with various assumptions and probabilities, organizations can better understand the potential impact of risks. These simulations often involve mathematical models and software to analyze the scenarios, helping organizations prepare for and mitigate potential risks effectively. Examples of simulations include Monte Carlo simulation, scenario analysis, and sensitivity analysis.

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2 What is stress testing?

Stress testing is a method of evaluating the resilience of an organization or a system to extreme but plausible shocks or events. It usually involves applying a single or a set of adverse scenarios to a specific aspect of the organization or system, such as its financial position, liquidity, capital adequacy, or operational performance. The purpose of stress testing is to identify and quantify the vulnerabilities and gaps in the risk management framework and to test the effectiveness of the contingency plans and mitigation strategies.

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Stress testing is a technique used to assess the ability of an organization or system to withstand severe yet realistic shocks or situations. This process typically entails subjecting a particular aspect of the organization or system, like its financial stability, liquidity, capital adequacy, or operational efficiency, to one or more adverse scenarios. The primary goal of stress testing is to pinpoint and measure weaknesses and deficiencies in the risk management structure and evaluate the efficiency of contingency plans and risk mitigation strategies.

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3 How are they different?

Risk scenarios and simulations and stress testing are different in several ways. First, risk scenarios and simulations are more exploratory and flexible, while stress testing is more prescriptive and standardized. Risk scenarios and simulations can cover a wide range of risk factors, events, and interdependencies, while stress testing focuses on a few key risk drivers, events, and impacts. Second, risk scenarios and simulations are more probabilistic and quantitative, while stress testing is more deterministic and qualitative. Risk scenarios and simulations use probability distributions, confidence intervals, and statistical measures to express the likelihood and magnitude of the outcomes, while stress testing uses fixed or extreme values and scenarios to assess the worst-case scenarios. Third, risk scenarios and simulations are more forward-looking and dynamic, while stress testing is more backward-looking and static. Risk scenarios and simulations can incorporate the feedback effects, time lags, and nonlinearities of the risk environment, while stress testing assumes that the risk environment remains unchanged or follows a predetermined path.

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Vipin Pandey

Leadership Enthusiast | Crafting Content for Emerging Leaders & Professionals | US Insurance | Service Delivery Manager | AIC |
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I would recommend : 1. Purpose and Focus: Risk scenarios and simulations aim to explore a broad range of potential outcomes, while stress testing zeroes in on extreme, worst-case conditions. 2. Flexibility vs. Structure: Risk simulations offer flexibility in testing various risk combinations, whereas stress testing follows stricter frameworks for assessing system resilience. 3. Outcome Measurement: Risk simulations provide probabilistic insights with varied outcomes, while stress testing delivers clear, deterministic results based on fixed conditions. 4. Adaptability: Risk simulations adjust dynamically to changing environments, while stress testing often assumes static conditions.

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4 How to measure the results?

When assessing the results of risk scenarios and simulations, as well as stress testing, different metrics and indicators can be used, depending on the purpose and scope of the analysis. Value at risk (VaR) is a measure of the maximum potential loss over a given time horizon and confidence level, while expected shortfall (ES) is the average potential loss beyond the VaR level. Capital adequacy ratio (CAR) is a ratio of capital to risk-weighted assets, liquidity coverage ratio (LCR) is a ratio of high-quality liquid assets to net cash outflows over a 30-day stress period, and net stable funding ratio (NSFR) is a ratio of available stable funding to required stable funding over a one-year horizon. Additionally, key performance indicators (KPIs) are measures of operational efficiency, quality, customer satisfaction, or other strategic objectives.

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5 How to report the results?

When reporting the results of risk scenarios and simulations and stress testing to relevant stakeholders, such as the board, senior management, regulators, investors, or customers, it is important to be clear, concise, and consistent. The report should include the objectives, scope, and assumptions of the analysis; the methodology, data sources, and tools used for the analysis; a summary and interpretation of the results highlighting key findings, insights, and implications; details regarding any limitations, uncertainties, and sensitivities of the analysis; as well as recommendations, actions, and follow-ups based on the results.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Hamed Rezk ,MBA, CIA?, ASMEC?, CCRO, CRMP, GRCP, CCP, CLBB

Regional Chief Risk Officer | Driving Growth for 200+ Companies | Executive Risk Committee Chair | Helping You Excel in Credit, MSMEs, GRC, Training, and Consulting | Lecturer | Open to Networking and Collaboration
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As CRO, I oversee a multi-pronged risk assessment. We use stress testing to push systems under extreme, but plausible, conditions, gauging their breaking points. Risk scenarios delve into specific potential events, analyzing their impact and likelihood. Simulations model complex, interconnected risks, offering a holistic view of potential outcomes. Results are reported in a tiered fashion. Stress tests yield clear thresholds for capital adequacy. Scenarios detail potential losses and mitigation strategies. Simulations provide a narrative of potential crises and recovery plans. This comprehensive approach empowers leadership to make informed risk decisions.

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How do you measure and report the results of risk scenarios and simulations vs stress testing?

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1 What are risk scenarios and simulations?

2 What is stress testing?

3 How are they different?

4 How to measure the results?

5 How to report the results?

6 Here’s what else to consider

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