28. Accepting risk Flashcards
What is an example of a quantifiable risk appetite statement?
- The organization will not accept risks that would cause its available capital to fall below x% of the regulatory MCR.
What features of the company might influence its risk appetite?
ESPECIAL
- Existing exposure to a particular risk
- Size of company
- Period of time for which it has operated
- Previous experience of board members
- Existence of a parent company or other guarantors
- Culture of company
- Institutional structure
- Attitude towards risk of owners and other capital providers
- Level of available capital
- Level of regulatory control to which it is exposed
How does a market for risk arise?
- Different entities have different appetite for risk=> market in risk
- Enables risk to be transferred=> Entities with small risk A> large risk A • All financial transaction=> transfer of risk for payments
What makes a market for risk transfer “risk efficient”?
- Reasonable size
- Participants with excess risk
- Transfer excess risk
- Other participants with less risk
- Than they are prepared to accept
Give an example of pairs of individuals with different appetites of risk that want to transfer risk?
- Policy holder ceding risk to an insurance company
- Insurance company ceding risk to a reinsurance company
How does investment in a collective scheme result in risk transfer?
- CIS allow individuals to transfer risk of making poor investment decisions due to a lack of expertise or lack of time to perform research
How are risk and product design related?
- Financial products transfer risk between parties
- Price of the product cover cost of risk transferred+ profit margin
- Cost of risk= Risk covered+ business risks
- Good product design techniques=> identify all risk involved+ risk management
- Appropriate premium rating requires to perform risk classification
- Risk new product design  needs + desires of beneficiaries
- Additional options=> introduce new risks
- i. Allowed for in the costing
What factors make a risk insurable?
PAR
- Policyholder must have an interest in the risk (insurance vs wager)
- claim Amount must bear some relationship to the financial loss incurred
- Risk must be financial and reasonably quantifiable
Why do insurance companies aim to pool risk?
- Law of large numbers=> Greater certainty in the future payments on the occurrence of the insured event.
What additional criteria should a risk meet to be insurable?
MUD PIS
- Moral hazard eliminated
- Ultimate limit on the liability undertaken
- Data exists with which to price the risk
- Pooling a large number of similar risks
- Independent risk events
- Small probability of occurrence
What is a subjective approach of assessing risk exposure?
- Estimate probability and severity separately
- Assign a number from the scale 1-5
- The product of probability and severity=> ranked 1-25
- Allows risks to be ranked and prioritised
- Carried out with and without possible risk controls
How can a model be used to assess a risk event?
- Distribution assigned to both Frequency and severity of a risk event
- Define an event
- Use historic events to calculate a probability distribution for that event
- Alternatively – Frequency of the event defined=> determine the loss parameter
- Stochastic vs deterministic model
- Availability of data=> Influence which model is used
- Important when considering rare events
What the different ways of valuing risk?
- Scenario analysis
- Stress testing
- Combined stress and scenario testing
- Reverse stress testing
- Stochastic modelling
What steps should be involved in a scenario analysis to evaluate operational risk?
- Group risks into categories.
- Plausible adverse scenario of risk events for each group of risks
- Calculate the consequences/costs of the risk event occurring for each scenario. Involving input from senior staff.
- Calculate the total costs of all risks represented by the scenario
What categories may operational risk be divided into for the purpose of scenarios analysis?
- Fraud
- Loss of key personnel
- Mis-selling of financial products
- Calculation error in the computer system
- Loss of business premises
- Loss of company e-mail access
What is stress testing?
- Deterministic method of modelling extreme risk events
- Commonly used to model extreme market events
- Market risk=> subjecting a portfolio to extreme market movements
- Radically changing underlying assumptions+ characteristics
- Increasing correlations between asset classes and volatilities â– Two types of tests=> designed to:
- o Identify weak areas=> investigate effect of localised stress situation
- Different combinations of correlations + volatilities o Impact of major market turmoil=> all parameters
- Ensure consistency between correlations while they are stressed
What factors need to be built into a model to stress scenario the fall in equity value of unit linked investment bonds?
- The model would need to allow for the impact of the sustained reduction in equity market values on:
- Income received from fund management charges
- Persistency of existing bonds
- New business volumes
- Regulatory capital requirements
- Value of shareholders’ interests
- Probability of any gurantee biting
- Other economic conditions=>interest rates, inflation + investment returns on other assets
What is reverse stress testing?
- Construction of a severe stress scenario
- Only just allows the company to continue
- To fulfil its strategic business plan
- Financial or non-financial
- MUST BE PLAUSIBLE
How can a stochastic model be used to evaluate a particular risk?
- Variable gives rise to risk= RV with probability distributions
- Model=dynamic- with full interactions and correlations between variables
- Model run to determine amount of capital to avoid ruin
- With a given probability
How can the scope of a stochastic model be limited making it more practical to run?
- Restrict the time Horizon that the model projects
- Limit the number of variables that the model models stochastically
- Carry out a number of runs with a single different stochastic variable
- Followed by a single deterministic run using all the worst-case scenarios together
Why can the phrase 1 in 200-year event be misleading, in relation to risk and setting riskbased capital requirements?
- Misleading to non-experts
- If the risk event has just occurred=> will occur again in 200 years
- Rare events in practise such as stock market crashes are occurring more frequently than the assumed probability indicates
- 1 in 200-year combined event combining individual 1 in 200 year events
How does the overall capital requirement relate to the individual capital requirements of a group of risks?
- Fully dependent=> Overall cap = sum of individual cap
- Fully independent=> Overall cap< sum of individual cap
- Partially dependent=> Overall cap requirement< sum of individual cap
- The difference is the diversification benefit
What are examples of likely correlations between risks?
- Inflation risk = expense risk
- Equity markets  inflation rates
- Equity market falls= higher withdrawal rates on unit linked savings products
- Operational risks other risks
- Longevity risk mortality risk
What methods exist for aggregating partially dependent risks?
- Stochastic model
- Correlation matrices
- Copulas
What is a copula and how can it be used to model risk?
- F(Marginal CDF)= Joint CDFs
- Method of calculating joint probabilities of risk
- P(RBonds>L,REquity<M)= Joint probability
- Different copulas are used to describe different degrees of dependence between RV
- Including dependence in the tails of the distributions
- USEFUL for modelling tail risk=> Capital requirements for extreme events
How can liability risk be measured?
- Analysis of experience- A/E
- NB consistent classification and measurement of the risk event+ exposure to risk
What is value at risk?
- Maximum possible loss
- On a portfolio
- Over a given time period
- With a given degree of confidence
- Absolute amount or relative to a benchmark
What are the disadvantages of using VaR as a measure of risk?
- Calculated assuming a normal distribution of returns. NOT TRUE IN PRACTISE
- VaR can be used with a different distribution. Data is sparse particulalarly in the tails=> difficult to fit accurately
VaR does not quantify the size of the tail=> loss might be past confidence level 19) What is tail VaR or TVaR?
- E[shortfall | shortfall] below a certain level
What is a risk portfolio and what might it contain?
- Means of categorising the various risks to the company
- Against each risk=> likely severity + probability
- Product=> idea of relative importance of the various risks
- Extended to explain how each risk was dealt with
- Details for mitigated risks=> revised assessment of risk remaining â– Retained risks=> Details of control, risk owner, need for management.
Why is regular risk reporting important within a business?
- FRAUD CRIME
- Financing
- Rating agencies
- Attractive investors
- Understand better
- Determine appropriate control systems
- Changes over time
- Regulator
- Interactions
- Monitor effectiveness of controls
- Emerging risk identification
Why is it necessary to have a coherent system of risk reporting across the entire enterprise?
- Each unit given risk exposure allocation
- Benefits of diversification rely on each business unit taking on exposure allocated
- Necessary each unit report on exposure they are taking on
- NOT done in a consistent way= more capital required
What are the two modelling steps of the determining the amount of capital to hold?
- A model used to determine risk event at the required level of probability
- Stochastic model used to determine this
- Second model=> determine the consequences/ costs of the risk event determined â– Deterministic model likely to be used
What are the issues when assessing risk-based capital requirements?
