Ch 26: Risk Identification And Classifiaction

Question 1

Type of exam Questions

Answer 1

Identifying risk and apply their catergories

Question 2

Risk Identification

Answer 2

Recognise risk that can threaten an organisation’s business plan

Question 3

Two reasons we identify risk

Answer 3

1. Risk Control: Find control process to reduce either likelihood of the risk event happening or impact of risk.
2. Risk Exploitations: to gain competitive advantage over other provider. taking on risk can be a source of profit.

Question 4

who is involved

Answer 4

Everyone.
The mangers are not able to redaily identify the risk on operations level.
The supervises and employees are more able to do so.

1. Internal staff : all levels and new staff
2. External experts: They can help with the more difficult to identify risk
3. External stakeholders: customers can reports risks with using product or visiting the premises

Question 5

What you need to identfiy risk

Answer 5

Have good knowledge of:
1. Circumstance of the organisation : e.g small , large, new, old
2. The features of the business enviroment in which it operates: e.g annuity, insurance,
3. the general business and regulatory environment:

Question 6

Techniques used to identify risks:

Answer 6

• Risk classification (to ensure full coverage)
• Risk checklists e.g., as used for setting regulatory capital requirements like Solvency II will have lists of risks that are relevant to the business
• Experience of staff joining from similar organisations, consultants, experts
• Project management risk identification techniques
• high-level preliminary analysis: pick up on projects that have high risk profile and are not worth further ano

Question 7

Project management risk identification techniques:

Answer 7

• High-level preliminary analysis
• Brainstorming of project experts and senior people
  — Identify project risks and upsides and downsides
  — Discuss risks and interdependency
  — Broad initial evaluation on each risk
  — Mitigation options
• Desktop analysis
  — Identify further risks and mitigation options
• Risk register / risk matrix
  — Stage of project and causes of risk
  — Cross-references to other risks where there is interdependency

Question 8

Risk classification

Answer 8

Allocating identified risks into higher level categories, in order to aid the other stages of the risk management control cycle
* Need to understand significance of each risk and financial impacts of outcome
* Some sources of risk will span several categories - climate change, pandemics

Question 9

RISK CATEGORIES

Answer 9

• Market risk
• Credit risk
• Liquidity risk
• Business risk
• Operational risk
• External risk

COMBEL

Question 10

Market risk

Answer 10

Risks related to changes in investment market
values or other features correlated with
investment markets, such as interest and inflation
rates

Question 11

Sources of market risk

Answer 11

• Changes in asset values
• Investment market value changes on liabilities
• Liability amount (e.g unit-linked benefits) /
  liability value (change in interest rate/ inflation)
• Mismatching assets and liabilities
• Capital risk - risk that the amount of available
  capital falls below the level required to support
  other risks

Question 12

Why a perfect match might be impossible:

Answer 12

• may not be wide enough range of assets
  available - unusual to find assets of long
  enough duration
• Liabilities may be uncertain in amount and
  timing
• Liabilities may include options which have
  uncertain CF’s after the option date
• Liabilities might include discretionary benefits
• Cost of maintaining a fully-matched portfolio is
  likely to be prohibitive

Question 13

Describe the effect of an increase in short-term
interest rates on:
1. Fixed interest bonds
2. Index-linked bonds
3. Equities
4. Property

Answer 13

• Fixed interest bonds: will almost certainly cause
  prices of short-term bonds to fall. Values of
  long-term bonds could go up or down depending
  on investor’s views of future inflation
• Index-linked bonds: If interpreted as sign of
  lower expected future inflation, demand for I-L
  bonds & their values might fall
• Equities: might depress economic growth & so
  equity values might fall
• Property: should lead to lower valuation of
  future rents & therefore lower capital values of
  property

Question 14

Consequences of mismatching:

Answer 14

• Greater exposure to market risk - assets and
  liabilities will not move in line with each other
• Higher liquidity risk
• Reinvestment risk - risk of having to invest
  asset proceeds on unknown future terms

Question 15

Credit risk

Answer 15

Risk of failure of third parties to meet their
obligations

Question 16

examples

Answer 16

• Borrowers defaulting on interest and capital
  payments
• Credit concentration risk - lending heavily
  weighted towards individual borrowers,
  industrial sectors / countries
• Credit spread changes and credit-linked
  events
• Counterparties to a transaction failing to
  meet their obligations
• Settlement risk - pays cash / delivers asset
  before counterparty completed part of deal
• Debtors failing to pay for purchased goods /
  services

Question 17

Define credit spread in relation to a corporate bond:

Answer 17

Credit spread is the difference in yield between the
corporate bond and an otherwise equivalent
government bond. This can change due to perceived
changes in credit quality of the issuers

Question 18

Security

Answer 18

• Security may be required from borrower as a way
  of reducing credit risk when lending money
• Credit ratings are an indication of creditworthiness,
  i.e., the likelihood of default

Question 19

Decision as to what security is taken is dependent on:

Answer 19

• Nature of the transaction underlying the borrowing
• Covenant of the borrower - overall creditworthiness
• Market circumstances and comparative negotiating
  strength
• What security is available

Question 20

Liquidity risk

Answer 20

Risk that the individual / company,
although solvent, does not have
available sufficient financial resources
to enable it to meet its obligations as
they fall due
* Or can secure such resources only at
excessive cost

Question 21

Managing liquidity risk:

Answer 21

• Maintain degree of liquidity
• Convert less liquid assets to cash /
  borrow additional funds
• Risk issues arise as a result of a
  sudden surge in liability withdrawals

Question 22

Liquidity risk for different organisations

Answer 22

• Non-financial institutions - if assets (stock and work in
  progress) cannot be realised
• Insurance companies and benefit schemes
• Little exposure - assets in cash deposits / bond and
  stock market
• Insurers - claim costs higher than expected
• Benefit schemes - bulk transfer out of schemes
• Banks
• Since they ‘borrow short & lend long”
• Significant risk - behavioural aspects
• Liquidity coverage ratio will require banks to hold
  sufficient high quality liquid assets to withstand a
  liquidity stress event specified by regulators
• Collective investment schemes and insurance funds
• Invest in real property - possible to defer withdrawals
• Invest in illiquid assets - lock-in periods to mitigate risk
• More surrenders / more sell units than expected

Question 23

Market liquidity risk

Answer 23

• Market does not have capacity to handle
  that volume of transacted asset without
  a potential adverse price impact
• Liquidity - how quickly asset can be
  converted into cash at a predictable
  price
• Marketability - how easy it is to trade an
  asset

Question 24

Example of an asset that is:
1. highly liquid but not marketable
2. marketable but not liquid

Answer 24

a.) highly liquid but not marketable
7-day fixed-term deposit at a bank is highly liquid - will
become cash within a week but such assets cannot be
traded - unmarketable
b.) marketable but not liquid
Long-term government bond - marketable because there
are many market participants willing to trade at any time
but not liquid since the market value is quite volatile

Question 25

Business risk

Answer 25

• Risks that are specific to the business
  undertaken
• Differ from operational risk in that
  operational risks are non-financial
  events that have financial
  consequences

Question 26

Examples: Business risk

Answer 26

• Underwriting risk - poor underwriting standards
• Insurance risk
• Poor claims experience
• Uncertainties relating to claim rates and
  amounts
• Financing risk - providing of finance that turns out
  to be unsuccessful
• Exposure risk
• Exposure to risk greater than expected
• Lower sales volume - competitor actions
• Amount of business sold / retained
• Concentration / lack of diversification

Question 27

Operational risk can arise from:

Answer 27

• Inadequate internal processes, people, or systems
• Mismanagement - inappropriate actions, failure /
  lack of systems and controls, administrative
  complexity
• Data errors - inadequate, inaccurate, or
  incomplete
• Inadequate risk control measures
• Fraud
• Conduct risk
• Poor conduct towards customers / the market
• Mis-selling, interest rate manipulation and money
  laundering
• Dominance risk - dominance of single individual
• Reliance on third parties - outsourcers
• Failure of plans to recover from an external event

Question 28

Operational risk

Answer 28

• Risk of loss resulting from inadequate /
  failed internal processes, people and
  systems or from external events
• Can be controlled / mitigated

Question 29

external risk

Answer 29

• Risk arises from external events such
  as storm, fire, flood / terrorist attack
• Systematic risks - cannot be diversified
• E.g Regulatory, legislative and tax
  changes

Question 30

climate change

Answer 30

• Risks arising from adverse changes in physical environment and secondary impacts on the economy at
  a regional or global level
• Physical - arising from first-order effects of environmental changes e.g extreme weather
• Transition - arising from economic, political and market changes as a result of efforts to mitigate
  climate change e.g changes in government policy
• Liability - relating to compensation claims due to impacts of climate change