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Actuarial Risk Management > 29 - Risk Measurement and Reporting > Flashcards

29 - Risk Measurement and Reporting Flashcards

1
Q

How are risks quantified?

A

By assessing their frequency and severity.

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2
Q

Why is it difficult to model low frequency events?

A

There is a lack of data.

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3
Q

How is operational risk usually quantified?

A
  1. Broad-brush addition to other risks

2. Scenario analysis

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4
Q

In which circumstance is scenario analysis the most useful?

A

When it is difficult to fit full probability distributions to risk events.

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5
Q

What steps are involved in scenario analysis?

A
  1. Grouping risks into broad categories
  2. Development of a plausible adverse scenario
  3. Calculation of the consequences of the risk event occurring for each scenario.
  4. Total costs calculated are taken as the financial cost of all risks represented by the chosen scenario.
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6
Q

Give a drawback of a scenario testing approach.

A

The approach focuses on severity and neglects the probability of the scenario occurring.
Selection of the scenarios is subjective and non-exhaustive

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7
Q

Define: Stress Testing

A

Involves testing for weaknesses in a portfolio by subjecting it to extreme market movements or credit or liquidity risk events.

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8
Q

Give two types of stress tests.

A
  1. To identify ‘weak areas’ in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities
  2. To gauge the impact of major market turmoil affecting all model parameters while ensuring consistency between correlations while they are ‘stressed’
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9
Q

Describe a ‘reverse stress test’

A

The construction of a severe stress scenario that just allows the firm to be able to continue to meet its business plan. The scenario may be extreme but it should be plausible.

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10
Q

Give the limitations usually applied to stochastic modelling with regards to stress testing.

A
  1. restricting the duration or time horizon of the model
  2. Limit the number of variables modelled stochastically and use a deterministic approach for the other variables.
    3, Carry out a number of runs with a different single stochastic variable and then a single deterministic run using all the worst case scenarios together.
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11
Q

How is risk aggregation, to allow for correlations and inter-actions, usually performed?

A
  1. Stochastic modelling - although impractical
  2. Simple formulae if risk events are fully dependent or fully independent.
  3. Correlation matrices
  4. Copulas
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12
Q

Give the main advantage and main disadvantage of risk aggregation.

A

Pro: combining risks may result in a lower total risk through diversification
Con: The time to run adequate models may be too long and this may restrict the number of scenarios that can be modelled.

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13
Q

Give a measure of the risk taken for a passive portfolio.

A

Historic tracking error and forward-looking tracking error.

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14
Q

How are liability risks measured?

A

By carrying out analysis of actual vs expected experience

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15
Q

Give examples of deterministic approaches to measuring risks.

A
  1. Notional approach
  2. Factor sensitivity approach
  3. Scenario sensitivity
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16
Q

Give the stochastic risk measures.

A
  1. Deviation, such as standard deviation and tracking error
  2. VaR
  3. Probability of ruin
  4. TVaR
17
Q

Explain VaR

A

VaR represents the maximum potential loss on a portfolio over a given future period with a given degree of confidence.

18
Q

Explain TVaR

A

The expected loss given that a loss over the specific VaR has occured.

19
Q

How is the ratio between VaR and TVaR usefull.

A

The ratio can give an indication of the skewness of a distribution and a fatter tail.

20
Q

Give the methods used to calulate VaR and TVaR.

A
  1. Empirical
  2. Parametric
  3. Stochastic
21
Q

Give the advantages and disadvantages of the notional approach to risk measurement.

A

Pros:
1. Simple to implement and interpret across a diverse range of organisations
Cons:
1. Potential undesirable use of a ‘catch all’ weighting for possibly heterogenous undefined asset classes.
2. Possible distortions to the market caused by an increased demand for asset classes with high weightings.
3. No allowance for concentration of risk, the risk weighting for an asset class is the same irrespective of whether the investment in that asset class consists of a single security or a variety of different securities.
4. The probability of the changes considered is not quantified.

22
Q

Give the advantages and disadvantages of the factor sensitivity approach to risk measurement.

A

Pros:
1. Increased understanding of the drivers of risk.
Cons:
1. Not assessing a wider range of risks, by focusing on a single risk factor.
2. Being difficult to aggregate over different risk factors.
3. The probability of the changes considered is not quantified.

23
Q

Give the advantages of using VaR as a risk measurement.

A
  1. The simplicity of its expression
  2. Intelligibility of measurement, being money
  3. Its applicability to all types of risk
  4. Its applicability over all sources of risk - facilitating easy comparisons between products and across businesses its inherent allowance for the way in which different risks interact to cause losses.
  5. The ease of its translation into a risk benchmark.
24
Q

Give the disadvantages of VaR as a risk measure.

A
  1. It gives no indication of the distribution of losses greater than the VaR.
  2. It can under-estimate asymmetric and fat-tail risks as it does not quantify the size of the ‘tail’.
  3. It can be very sensitive to the choices of data, parameters and assumptions
  4. VaR is not always sub-additive (Aggregated)
  5. If used in regulation it may encourage ‘herding’, thereby creating systematic risk.
25
Q

Give the ways in which a risk can be dealt with.

A

PIRATE

Partially transfer
Ignore
Reduce - diversify or control
Accept
Transfer
Evade (avoid)
26
Q

How are retained risks dealt with?

A
  1. Control measures
  2. Reassessment of value and impact after controls
  3. Risk ownership
  4. Board committee/senior manager with oversight of the risk.
  5. Identification of concentrations of risk and related actions.
27
Q

Describe the steps involved in risk reporting.

A
  1. Identifying new risks
  2. Quantifying the impact of individual risks
  3. Determining appropriate control systems for specific risks
  4. Monitoring the effectiveness of existing control systems
  5. Assessing changes to risks faced
  6. Assessing the interaction between risks
  7. Assisting with pricing, reserving and determining capital requirements
28
Q

Give the external stakeholders that benefit from risk reporting and how.

A
  1. Shareholders and potential shareholders - understanding the attractiveness of the business investment
  2. Credit rating agencies - to help with determining an appropriate rating
  3. Regulators - TO identify areas which could require greater scrutiny.
29
Q

Give the main issues facing financial product providers with regards to risk reporting.

A
  1. Should the ruin probability be expressed over a single year or the whole run-off of the business.
  2. A stochastic model with more than two stochastic variables is impractical, so it may be better to use a correlation matrix. However, this introduces subjectivity.
  3. Interactions between risks need to be dealt with.
  4. Some risks are highly subjective, such as operational risks.
  5. Using past data to estimate future consequences needs to be undertaken with caution.
30
Q

Give the approaches used to measure investment risk

A
  1. Retrospective tracking error
  2. Forward-looking tracking error
  3. Liability risks or analysis of experience
  4. Value at Risk
31
Q

Describe the main contents and use of a risk register

A
  1. Provides a means by which to categorise the risks to which the business is exposed.
  2. Record, a possibly subjective, rating of the impact and probability of risks to give an indication of the importance of each risk to the business.
  3. Record how risks may be dealt with
  4. To assess the effectiveness of control measures by being conducted with and without.
  5. Can help identify concentrations of risk
32
Q

Give the ways in which production and updating of a risk register can help a company

A
  1. Obtain better understanding of the risks faced by the business
  2. Asses how risks are changing over time
  3. Identify new risks facing the business
  4. Determine appropriate control systems and their effectiveness
33
Q

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using summing the individual capital requirements

A

Pros:
1. Simple and quick to apply
2. No assumptions are needed - objective
3. Appropriate if risks are fully dependent
Cons:
1. Risks are normally only partially dependent - inappropriate
2. This approach can overstate capital requirements
3. This can result in inefficient use of capital, opportunity cost and and increased cost of capital.

34
Q

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using a correlation matrix

A

Pros:
1. Simple to apply
2. A common and well understood method
3. Allows for partial dependency of risks
Cons:
1. Populating the matrix is subjective
2. There may be underlying assumptions that may not hold in practice - that correlations between risks do not vary
3. In particular, correlations may change during extreme market conditions

35
Q

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using stochastic modelling

A

Pros:
1. Can allow for partial dependency between risks
2. Provides a distribution of outcomes
3. Allows automatically for programmed correlations between events under each simulation and these can vary according to the simulated conditions.
Cons:
1. Can be impractical due to the long run-time period
2. Requires expertise and resources to build the model
3. Calibration and programming of the correlation rules can be particularly complex.

36
Q

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using a copula

A

Pros:
1. Allows for partial dependency between risks
2. Different forms of copula are available to suit different degrees of dependence
3. It is a sophisticated way of allowing for dependence in the tails of the distributions
4. It helps with minimising tail risk and optimising portfolios
Cons:
1. Expertise is required, mathematically complex
2. The choice of cupula and its calibration can be difficult
3. It can be difficult to explain to end users of the outputs,

Actuarial Risk Management (26 decks)

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