26. Risk identification and classification Flashcards
What categories and example of risks could be used in a risk matrix for a typical project?
Please Never Eat Fried Chicken Past Bedtime
- Political - opposition to project, war, terrorism
- Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate movements
- Financial - sponsor default, incorrect cashflow estimates
- Crime - fraud, theft
- Project - time delays, budget overruns, bad design, poor planning
- Business - competition/lack of demand, operational problems, obsolescence
What techniques can be used to ensure all relevant risks have been identified in an organisation?
- Risk classification, to ensure that all risk types have been considered
- Risk checklists, as used for regulatory purposes (e.g. Solvency II standard formula components)
- Utilise the experience of staff who have joined from similar organisations
- Consultants with knowledge of industry involved
- Organisation should gain input from everyone involved at all levels, senior management, junior management
What is market risk
- Risk related to changes in investment market values or other correlated features such as interest rates/inflation
What is credit risk?
- Risk of failure of third parties to meet their financial obligation
What is liquidity risk?
- Risk that an insurer, although solvent, has insufficient available capital to meet its obligations as they fall due.
- Liquidity risk for insurer is low since they hold cash, bonds and stock market assets
What is business risk?
- Business risk is risk specific to business undertaken
What is operational risk?
Risk of loss arising from inadequate or failed internal processes, people and systems or from external events
What is external risk?
- Arises from external events
- Climate change is principal risk, but impacts other risk categories
What are the subdivisions of market risk?
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- The consequences of change on asset values (due to changes in market values of assets or interest and inflation rates)
- The consequences of a change in investment market values on liability values=> where liabilities are related to investment market values, interest or inflation rates
- The consequences of not matching CASHFLOWS OF A and L
Why would a perfect match not always be possible in practice?
- There may not be a wide enough range of assets available to match liabilities
- Liabilities may be uncertain in amount and timing
- Liabilities may have options=> liabilities values uncertain past option date
- Liabilities may include discretionary benefits
- Cost of maintaining a fully matched portfolio=> Prohibitive
What are examples of credit risk?
- Issuer of corporate bond defaulting on interest or capital payments
- Credit concetration risk => lending is heavily weighted towards individual borrowers, industrial sectors or countries
- Risk associated with a credit linked event=> changes to credit quality (e.g. downgrading of an investment) and variations in credit spreads
- Counterparty risk=> one party to a transaction fails to fulfil their side of the bargain
- General debtors=> Purchaser of goods and services failing to pay for them
What factors should an investor or lender consider when assessing the security of a debt and the borrower?
- Nature of the debt=> secured vs unsecured
- Covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, ability to raise more debt, future prospects of the borrower)
- Market circumstances+ relative negotiating strength between the two parties
- What security is available and whether it can be realised if necessary
What is a credit rating?
- Rating given to a company’s debt
- Given by a credit rating agency
- Indication of the likelihood of default
- Top ratting AAA
What is a liquid asset and what makes up a market liquid?
- Close to cash in nature
- Can be converted into cash quickly
- Amount of cash it would become is almost certain
- Liquid market=> Large market+ lots of ready participants
- Marketable assets=> converted to cash quickly
- How ever the amount of cash received is uncertain
Why are banks exposed to significant liquidity risk?
- Banks borrow short and lend long
- They lend depositor’s funds + funds raised from money markets for potentially long periods
- However, customers may want instant access to thier deposits, creating a need for liquidity
- Risk that more customers than expected demand cash withdrawals
- Banks cannot demand early repayment of loans to finance outflow of deposits
What are 4 business risk to a financial provider?
- Inadequate underwriting standards leading to mispricing of risks
- More claims than expected
- Investment in a business project that fails to be successful
- Greater exposure than planned to a particular risk e.g. High volumes sold
What are examples of operational risk?
- Inadequate or failed internal processes, people or systems
- Dominance of a single individual over the running of a business
- Reliance on a 3rd party to carry out various functions for which the organisation is responsible for
- Failure of recovery plans following an external event
- Conduct risk (miss-selling, interest rate manipulation or money laundering)
How are operational risks likely to be identified and analysed?
- Model=> Model only as good as parameters
- Input from owners of the business
- Senior management
- Other knowlegble individuals
Give 5 examples of external risk
- Natural disaster
- Terrorist attack
- Regulatory, legislative and tax changes
- Pandemic
- Climate change
Explain the term climate risk and how climate related risk can be categorised into physical, transition and liability risks.
Climate risks refers to risks arising from adverse changes in the physical environment and secondary impacts on the economy at a regional or global level
Physical - first-order effects of environmental changes, eg greenhouse gas emissions, pollution and land use. Effects may be chronic or acute.
Transition – economic, political and market changes as a result of efforts to mitigate climate change.
Liability – from injured parties seeking compensation for the impacts of climate change. Impacts may be first-order physical impacts or second-order transition impacts.
List the typical risks faced by insurance companies under the headings:
- market
- credit
- liquidity
- operational
- external
- Market risks: change in interest rates / inflation, market crashes, mismatch of assets and liabilities, currency risk
- Credit risks: reinsurer, broker and asset default
- Liquidity risks: insufficient cash resources to meet liabilities as they fall due
- Operational risks: fraud, mismanagement, systems failure
- External risks: natural disasters, terrorist threats, legislative and tax changes, pandemics, climate change
