C25 Risk Identification and Classification Flashcards
Explain why identifying all the risks in an organisation is a difficult task
Identifying all the risks in an organisation is a difficult task and requires good knowledge of:
- the circumstances of the organisation concerned
- the features of the business environment in which it operates
- the general business and regulatory environment.
Not all risks are immediately obvious.
Techniques that can be used to ensure that all relevant risks have been identified.
There are some techniques available to ensure that all relevant risks have been identified:
- use risk classification to ensure that all types of risk have been considered
- use techniques from project management
- use risk checklists, for example as used for regulatory purposes
- use the experience of staff who have joined from similar organisations, and of consultants with broad experience of the industry concerned.
Describe the steps necessary to achieve an effective identification and analysis of the risks facing a
project
Identification and Analysis of Project Risks
- Conduct a preliminary risk analysis to check the project’s risk level. If risks are too high, the project should not proceed.
- Organize a brainstorming session with project experts and strategic thinkers
- Aim to identify both likely and unlikely project risks, including upsides and downsides
- Discuss risks and their interdependencies
- Provide initial evaluations of each risk based on occurrence frequency and potential consequences
- Generate basic options for mitigating risks
- Briefly discuss the mitigation options. - Perform a desktop analysis to enhance brainstorming results
- Identify additional risks and mitigation options by researching similar past projects.
- Seek expert opinions knowledgeable about the project and its financing plans. - Document all identified risks in a risk register or matrix, including cross-references to show interdependencies among risks.
Explain why a clear understanding of the business undertaken by a provider and its organisational structure in important for risk management
A clear understanding of the business undertaken by a provider and the organisational structure is
- a prerequisite to assessing the significance of each risk and
- how the outcome of that risk translates into a financial impact on the balance sheet and cashflow
requirements.
The main effort in the analysis can then be directed to those key risks.
Define Market risk and three types in which it can be divided
Market risks are the risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates
The risk can be divided into:
the consequences of changes on asset values (this is the most obvious implication)
the consequence of investment market value changes on liabilities
the consequences of a provider not matching asset and liability cashflows.
Two examples of asset value changes
Asset value changes can result from:
- Changes in the market values of equities and property: These risks can be systematic if they occur across the whole market under consideration, or may be specific to particular markets and can therefore be diversified by holding a range of assets and asset classes.
- Changes in interest and inflation rates: These primarily affect the value of fixed-interest and index-linked securities, although there is usually some effect on equities and property too.
Describe how market risk can arise through the impact of investment markets on liability value
Liability Value Changes
1. Changes in liability values can occur due to promises made to stakeholders, policyholders, or benefit scheme members that are directly linked to investment market values or interest rates.
Impact of Interest or Inflation Rates
- A change in interest or inflation rates can influence the provisions a provider must set for future liabilities.
- For instance, a decrease in interest rates can lower the discount rate used for assessing liabilities.
- This reduction can lead to an increase in provisions needed by a benefit scheme to meet its liabilities.
How can market risk be completely eliminated
Market risk could be completely diversified away by choosing a asset portfolio that match liabilities in nature, term and currency.
List six reasons why choosing assets to perfectly match liabilities may be impossible
In practice a perfect match may be impossible because:
1. there may not be a wide enough range of assets available …
2. In particular it is unusual to find assets of long enough duration
3. liabilities may be uncertain in amount and timing
4. liabilities may include options and hence have uncertain cashflows after the option date
5. liabilities may include discretionary benefits
6. the cost of maintaining a fully-matched portfolio is likely to be prohibitive.
Hence even a well-matched portfolio is likely to retain some element of risk.
Define credit risk and give four examples
Credit risk is the risk of failure of third parties to meet their obligations.
1. The issuer of a corporate bond defaulting on the interest or capital payments.
2. The term ‘credit risk’ is sometimes also used to describe the risk associated with any kind of credit-linked event. This could include changes to credit quality (up or down) or variations in credit spreads in the market as well as the default events described above.
3. Counterparty risk, where one party to a transaction fails to meet their side of the bargain. An example of counterparty risk is settlement risk, which arises when a party pays away cash or delivers assets before the counterparty is known to have performed their part of the deal.
4. General debtors – the purchaser of goods and services fails to pay for them.
Discuss the aim of requiring security for lending
List four factors that will influence the choice of security taken for a loan
If a borrower can provide security, providing finance to that borrower will be more attractive to a lender. However, the existence of security is not an excuse for otherwise bad lending.
The decision as to what security is taken is dependent on:
1. the nature of the transaction underlying the borrowing
2. the covenant of the borrower
3. market circumstances and the comparative negotiating strength of lender and borrower
4. what security is available.
It must be within the ability of the lender to realise the security if necessary in a cost-effective manner.
What is meant by the term credit rating and what is its relevance to companies?
A credit rating is given to a company’s debt by a credit-rating agency as an indication of creditworthiness, ie the likelihood of default / credit loss.
A company may act to improve its credit rating and these actions may affect the market for that company’s and other companies’ shares.
What is liquidity risk in the context of an individual or company (rather than a market)
Liquidity risk is the risk that the individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due.
Describe exposure to liquidity risk of the following:
Insurance companies and benefit schemes
Insurance companies and benefit schemes typically have low exposure to liquidity risk.
A significant portion of their assets is held in:
- Cash deposits
- Bond market assets
- Stock market assets
Cash Raising Capability
- These assets can often be easily sold in the market.
- Selling assets helps raise cash when needed.
Describe exposure to liquidity risk of the following:
Banks
Liquidity Risk in Banks
- Banks face significant liquidity risk.
- They lend depositors’ funds and money market funds to other organizations.
- Loans are typically for longer periods than the duration for which they hold the funds.
Retail Banking and Liquidity
- Retail banks provide instant access to customer deposits.
- They must maintain enough liquid resources to handle many withdrawal requests.
- To encourage saving, banks offer better returns on fixed-term deposits.
- Fixed-term deposits restrict access to funds until maturity.
Customer Withdrawals
- Liquidity risk increases when more customers than expected withdraw deposits.
Describe exposure to liquidity risk of the following:
Collective investment schemes and insurance funds
Collective investment schemes and insurance funds must protect against client requests for access to funds.
- Clients may request access when properties cannot be sold.
- Funds can defer withdrawals by up to six months to allow for property sales.
Hedge Funds and Illiquid Assets
- Hedge funds that invest in illiquid assets often have lock-in periods.
- Lock-in periods help reduce liquidity risk.
Direct Investment in Property
- Schemes, trusts, or funds directly invested in property are particularly vulnerable as property is not a liquid asset.
Describe (Financial) Market liquidity risk
Liquidity Risk in Financial Markets
- Liquidity risk occurs when a market cannot handle the volume of asset trades without impacting the price negatively.
- Larger markets are generally more liquid due to a higher number of participants trading simultaneously.
Market Sensitivity Factors
- The market is influenced by changes in interest rates and the economic outlook.
- Asset prices can fluctuate greatly, increasing the risk of loss for asset holders needing to sell quickly at lower prices.
Define business risk and the sub-categories
Business risks are risks that are specific to the business undertaken.
Business risk differs from operational risk in that the latter are non-financial events that have financial consequences.
The business risks of financial product providers can be further divided into the following subcategories:
underwriting risk – arising in relation to the underwriting approach taken
insurance risk – arising from the uncertainties relating to claim rates and amounts
financing risk – arising in relation to the financing of projects or other activities
exposure risk – arising in relation to the amount of business sold or retained, or to its concentration or lack of diversification.
Give seven examples of business risks
- underwriting risk : a life or general insurer not having adequate underwriting standards, and thus taking on risks at an inadequate price.
- Insurance risk : an insurer suffering more claims than anticipated.
- Financing risk: a provider of finance, such as a bank, investing in a business or project that fails to be successful
- Exposure risk: a reinsurer having greater exposure than planned to a particular risk event – for example through writing whole account protection covers as well as primary reinsurance of the risk
- a music production company promoting a CD that fails to sell
- a competitor launching a new product in the week before your similar product launch
- an umbrella manufacturer whose sales suffer in a drought. It might be argued that a drought, as an external event, is an external risk. However,
the profits of the company will be so closely correlated with the amount of rainfall that the risk is key to the company’s business.
Define Operational risk and give four examples
Operational risk refers to the risk of loss resulting from
1. inadequate or failed internal processes, people and systems or from external events.
2. the dominance of a single individual over the running of a business, sometimes called dominance risk
3. reliance on third parties to carry out various functions for which the organisation is responsible, eg if administration or investment work is outsourced
4. the failure of plans to recover from an external event.
Operational risks can be controlled or mitigated
Give some examples of inadequate or failed internal processes, people or systems that may be a source of operational risk to an insurance company.
Examples of inadequate or failed internal processes, people or systems:
mismanagement, for example due to:
– inappropriate actions of the board of directors / staff
– failure (or lack)
-of management systems and controls
– administrative0 complexity
data errors, for example inadequate, inaccurate or incomplete data
inadequate risk control measures
fraud.
Discuss the identification and analysis of operational risk
- Computer models can analyse and price operational risk.
- The quality of the models depends on the parameters used.
- Requires input from: Owners, Senior management and Individuals with detailed knowledge of business operations
Describe External risk
External risk is a form of non-financial risk but is separate to operational risk.
- External risk arises from external events, such as storm, fire, flood, or terrorist attack. In general these are systematic risks. Only for the largest entities is it economically efficient to diversify these by carrying out the same operation on different sites.
- Regulatory, legislative and tax changes are some other examples of external risk.
