28 - Accepting Risk

Question 1

Explain why a market for risk exists.

Answer 1

Different investors and businesses have different metrics for risk, values obtained from those metrics and different views on risk in the form of risk appetites. Thus, different parties have different perceived prices for certain risks allowing there to be a premium for another company, better equipped to deal with that particular risk, to take it on.

Question 2

When is ‘Risk Efficiency’ achieved through risk transfer?

Answer 2

When there is a good market for risk transfer a system is said to be ‘risk efficient’.

Question 3

How are regulators involved in the process of accepting risk?

Answer 3

1. They set minimum solvency levels to avoid inappropriate risk appetites.
2. They limit the amount of risk that a firm may transfer or accept as transferred risk.

Question 4

What is required by any person giving advice on accepting risk?

Answer 4

A good understanding of the clients risk appetite and the involvement of all stakeholders involved in the process.

Question 5

Give the main factors that risk appetites relate to.

Answer 5

Existing exposure to the risk
• Culture of individual / company
• Size
• Period of time for which company has
operated
• Level of capital available
• Existence of parent cpy
• Level of regulatory control to which it is
exposed
• Institutional structure
• Previous experience of board members

Question 6

Describe the main difficulty individuals face when it comes to accepting risk and why they are more likely to transfer risks.

Answer 6

Accepting risk requires that enough capital is needed to cover the potential losses if the risk event were to occur. Most individuals do not have access to this amount of capital.

Question 7

Give the main factors that define an entity’s risk appetite.

Answer 7

1. Risk profile, their current and future exposure to risk
2. Risk limits, the guidelines to the nature and extent of exposure they are willing to take on.
3. Risk capacity, the total manageable amount of risk a firm can take on. According to risk measures e.g economic capital.

Question 8

Give some common metrics for risk limits that can be given by the board of a company.

Answer 8

1. Solvency level
2. Credit rating
3. Earnings and dividends
4. Economic value
5. A combination of the above

Question 9

How do firms communicate their risk appetites and risk management processes to stakeholders?

Answer 9

The risk tolerance statement.

Question 10

Describe which risks a collective investment scheme allows individuals to transfer.

Answer 10

The risk of making poor investment decisions due to a lack of expertise or time to do enough research.

Question 11

How do financial providers usually internally diversify their risk profiles.

Answer 11

Through product synergies such as a life insurers that sells both annuities and term assurances.

Question 12

What is a key factor to align in order for a financial product to fulfil a clients needs as well as a providers risk mandates?

Answer 12

The providers perception of the beneficiary’s needs and risk appetite needs to align with that of the beneficiary.

Question 13

Describe the usefulness of rating factors.

Answer 13

Risk factors allow providers to determine an appropriate cost for a particular policy by classifying homogenous groups of policies.

Question 14

How do providers assess beneficiaries needs and desires?

Answer 14

Through market research and product trials.

Question 15

Why do providers wish to provide additional features to their products?

Answer 15

To make their products more marketable and competitive.

Question 16

What do providers need to keep in mind when including additional features and options in their contracts?

Answer 16

These additional options introduce new risks and therefore additional costs.

Question 17

Why do general insurers have more risk classification than other insurance industries?

Answer 17

1. They have greater competitive pressures and sell policies closer to their pricing basis, so they have less of a profit cushion for losses.
2. They have and record a lot more data due to frequency of collection.
3. Clients are more willing to give over the kind of data a general insurer requires than information about their health that life insurers or medical insurers require.

Question 18

Define an insurable risk.

Answer 18

1. The policyholder has an interest in the risk.
2. The risk is of a financial and reasonably quantifiable nature
3. The claim amount payable bears some relationship to the financial loss

Question 19

Define desirable characteristics of and insurable risk.

Answer 19

1. Individual risks should be independent.
2. The probability of the event occurring should be relatively small.
3. Large numbers of similar risks should be pooled to reduce variance.
4. There should be a limit on the ultimate liability undertaken.
5. Moral hazard should be eliminated as far as possible since it is hard to price.
6. There should be sufficient existing data/information in order to quantify the risk.

Question 20

How do insurers and reinsurers create a profit by accepting risks?

Answer 20

They make use of pooling of risks. This allows them to reduce the variability in their aggregate claims and so allowing more certainty around the capital required to back a group of risks, which allows them to charge profit over the fair price that individuals are willing to pay to transfer the risk.

Question 21

Give the factors that affect a company’s risk appetite.

Answer 21

1. The size of the company
2. The nature of the company’s business
3. Whether the company is a multinational or other enterprise
4. The level of capital available
5. The culture of the company - past experience, views of the board, views of the shareholders
6. The extent to how new risks differ from existing risks
7. Any regulatory requirements

Question 22

A life insurance company writes only group term insurance business insuring members of a group for whole of life
for a sum assured equal to 5 times the last annual salary drawn. There is neither any exclusion to payment of
benefits nor any initial underwriting of members of the group. Discuss briefly how well the risk taken by the
insurer fits the desirable criteria of risk to be insurable. [10]

Answer 22

Insurable risks criteria:
• Policyholder must have an interest in the risk being insured - Generally assumed unlimited interest on own
death
• The risk must be financial and quantifiable - 5 x Salary
• Claim amounts payable must bear some relationship to the financial loss incurred - Can argue, but not unknown
• Individual events should be independent of one another
- Here the risks taken by insurer may not be independent if group schemes/members are concentrated in a
particular region, location increasing concentration risk
- Further concentration risk may also be there due to having exposure to only one particular group or a
particular industry type covered, for eg. say armed forces
• Probability of risky events should be relatively small
- The probability of death is relatively small
- However, given the cover is whole of life when death is certain, the probability is not small But given the
considerable uncertainty on the timing of death, this is still considered as an insurable event
• Large numbers of similar risks should be pooled
- this depends on the number of lives covered by the insurer, more so, how many similar/different types risks
are covered
- Similar risks mean similar occupation, geographical location, industry etc.
• There should be an ultimate limit to the liability undertaken by the insurer
- though the cover is capped to 5 times the annual salary
- however, the annual salary at time of death is not known at outset so some uncertainty exists on amount
• Moral hazard should be eliminated
- cover is capped at 5 times annual salary 5 times the annual salary, hence moral hazard resulting from having
a disproportionate life cover is reduced
- however, there is no initial underwriting nor any exclusions which increases moral hazard
- moreover, cover continues even after employee leaves employment, which could increase moral hazard,
especially if a scheme is voluntary
• Sufficient data should be available to enable estimation of the extent and likelihood of risks occurring
- this depends on the maturity of the industry as a whole and the availability of local industry data
- mortality experience is known to vary with occupation and hence availability of information based on
occupational classes is essential