The Stress Test : Can it cause a financial apocalypse?

The life insurance business is currently going through a lot of changes. The turmoil in stock markets during the last years has made regulators realize that there is a greater need for risk management and solvency supervision in the business. Denmark was one of the first countries in Europe to react to this and in 2001 the Danish FSA implemented a stress test called the Traffic Lights System. This is a tool to measure various risks in different scenarios for financial institutions. The purpose of this thesis is to analyze the effects of imposing a Danish style stress test on the Swedish life insurance market. In order to analyze the various effects of this stress test a theoretical framework consisting of fixed income securities and interest rate theory have been applied, since one of the largest risk a life insurer faces is the interest rate risk. Due to the fact that the Danish stress test is not fully applicable on the Swedish market, the authors created a model based on the Danish test to analyze Swedish life insurers. The model estimates the financial risks a life insurer faces. Analyzing the results based on the model, the authors found that three out of seven life insurers in the sample had solvency problems to various extend. The authors conclude that a great part of financial risks within life insurers can be reduced by reallocating equity holding to bonds and by duration matching between assets and liabilities. The authors also conclude that Swedish life insurers are in better financial shape today than their Danish counterparts were in 2001, which is why less dramatic effect is to be expected on the Swedish financial markets as a result of imposing the stress test