26. Risk optimisation and responses Flashcards

1
Q

How can risk management optimise risk-return profile?

A
  • Support business’ selective growth
  • Use risk-adjusted pricing to support profitability
  • Control size and probability of potential losses by setting limits
  • Establish risk management techniques
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2
Q

How does risk management support business’ selective growth

A

o Processes to assess new opportunities
o Capital and resource allocation to activities with high risk-adjusted returns

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3
Q

How does risk management use risk-adjusted pricing to support profitability

A

o Must reflect risk costs and expenses
o NPV and EVA based on book values – not fully reflective

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4
Q

How does risk management control size and probability of potential losses by setting limits

A

o Exposure limits
o Stop loss limits – trigger action if losses reached
o Sensitivity limits – designed to stop potential losses from extreme events being beyond certain bounds

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5
Q

How does risk management establish risk management techniques

A

o Active portfolio management
o Reduce risk e.g. duration matching
o Risk transfer eg insurance

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6
Q

What are the fundamental concepts of portfolio management

A
  • Risk
  • Reward
  • Diversification
    o Reduce overall risk by investing in diff things not perfectly positively correlated
  • Leverage
    o Borrow $ and invest it, so increase potential risk return profile
  • Hedging
    o Entering agreement reducing risk because position taken is negatively correlated with existing position
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7
Q

Give examples of risk-return measures

A
  • Risk adjusted return on capital (RAROC)
  • Sharpe Ratio
  • Others
    o Return adjusted on risk adjusted assets: net income/risk-adjusted assets
    o Risk adjusted return on assets
    o Return on risk adjusted capital
    o Risk adjusted return on risk adjusted assets
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8
Q

How can we optimise risk

A
  • Must align strategy with stakeholder expectations
  • Balance risk and reward
  • As N gets large if we hold equal weightings in assets, proportion related to individual variances&raquo_space; 0 and the proportion relating to covariance&raquo_space; average covariance terms
  • Can use mean variance portfolio theory
    o Investors wish to construct portfolio (efficient portfolio) if assets giving max return given level of risk or min risk given level of return
  • Separation theorem: efficient portfolio of risky assets is separate from person’s individual risk-return preferences.
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9
Q

What is the separation theorem

A

Efficient portfolio of risky assets is separate from person’s individual risk-return preferences.

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10
Q

What are the benefits of active portfolio management

A
  • Unbundles business into components
  • Risk aggregation mechanism
  • Framework to set risk concentration limits and asset allocation targets
  • Influences investment, transfer pricing & capital allocation
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11
Q

Give examples of risk transfer

A
  • Insurance
  • Reinsurance
  • Coinsurance
  • Sharing risk with ph via product design
  • Securitisation
  • Derivatives
  • ART
  • Outsourcing
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12
Q

What are the factors affecting the effectiveness of risk transfer

A
  • Cost
  • Market capacity
  • Counterparty risk
  • Liquidity risk
  • Regulation
  • Other constraints:
    o Contract t&cs limiting risk transfer
    o Transferring org needs to assess if it has expertise to execute risk transfer and monitor effectiveness
    o Volume and type of risk transfer must align with risk appetite/tolerances
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13
Q

How can you reduce risk

A

aka risk mitigation, treatment or management
* Reduce likelihood or
* Reduce loss/impact

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14
Q

Give examples of how you can reduce risk

A
  • Diversification
  • Reduce random fluctuation risk by increasing portfolio size
  • Hedging
  • A-L matching
  • Strong internal controls and governance: operational
  • Robust underwriting and pricing: mortality/insurance
  • Due diligence and tightly worded agreements: counterparty
  • Intelligent remuneration and bonus structures: agency risk
  • Capital / funding: insolvency
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15
Q

Outline how you’d remove risk

A
  • Can remove by avoidance
  • Factors to consider:
    o Cost
    o Impact on likelihood of project reaching objectives
    o Lost opportunities
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16
Q

Outline the circumstances in which you’d retain risk

A
  • Absorbing/ accepting/ tolerate
  • Circumstances:
    o Trivial
    o Risk is component of core business
    o Most economical approach
    o Diversifier or hedge
    o No alternative
17
Q

Briefly describe residual risk

A
  • May arise:
    o Decision to retain
    o Result of risk response action
    o Imperfect hedge, i.e. basis risk
  • Must hold risk capital to mitigate
18
Q

Briefly outline ART

A
  • Non-traditional risk transfer products combining features of both (re)insurance products and financial protection products using capital markets (e.g. derivatives)
19
Q

How can ART be helpful

A

o Improve focus on core business and capital efficiency
o Provide quick, tailored solution- more bespoke may be complex and time-consuming
o Reduce total cost, but initial costs may be higher
o Help get market price for risk
o Simplify admin by reducing # of risk transfer arrangements, but ART may increase operational risks, and changes might need to be made to risk assessment and management