Ch 29: Risk measurement and reporting Flashcards
Subjective Assessment of risk
4
- Extend Risk identification process to estimate frequency and severity
- The probability and severity of each risk event are both estimated (separately) using a simple point scale. eg 1-25
- The product of the probability and severity assessments gives a score on a scale. This provides an assessment of each risk event and allows them to be ranked and prioritized.
- The assessment would be carried out with and without possible risk controls.
Outline how a model could be used to assess a risk
4
- Distributions need to be assigned to both the probability and severity of the risk event (unless the latter is a fixed amount rather than a RV, such as for a without profit term assurance policy).
- To quantify the risk simply, the company could define an event and then use historical data to determine a probability distribution for that event. Alternatively, the frequency of the event could be defined and this could be used to determine the loss parameter.
- A decision needs to be made as to whether a STOCHASTIC or DETERMINISTIC model is appropriate.
- The availability of data to parameterize the model may influence the decision as to which model (if any) is used. This is particularly important when considering RARE EVENTS.
Assessment of operational risk
2
- Difficult to quantify as many events are rare and independent
Usually use Broad Brush approach:
* No detailed analysis - use a % of average income
* Solvency 2 has a standard formula based on premiums and reserves
Outline 4 steps that should be involved in a scenario analysis to evaluate operational risk
- Group risks into broad categories. This should involve input from a wider range of senior individuals in the organization.
- Develop a plausible adverse scenario of risk events for each group of risks, which is REPRESENTATIVE of ALL the risks in the group.
- Calculate the consequences/costs of the risk event occurring for each scenario, again involving senior staff.
- Calculate the total costs of all risks represented by the scenario.
Suggest 6 categories into which operational risks might be divided for the purpose of scenario 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
State 5 ways of evaluating risks
- Scenario analysis
- Stress testing
- Combined stress and scenario testing
- Reverse stress testing
- Stochastic modelling
Scenario analysis
2,4,1
- Assess the financial impact of a plausible set of adverse events
- Used when distribution cannot be fit to the event, too many subjective parameters
Steps:
1. Group Risk exposures
2. Develop plausible adverse scenario
3. Set assumptions for model using the scenario and calculate cost of consequences for each group
4. Calculate total cost across all groups
- Limited to quantifying severity and not frequency and a stoch model must be used for probability.
Stress testing?
3
- Projection of financial conditions under specific adverse events over time.
- Deterministic modle used to model extreme market movements (extreme assumptions used)
- In relation to market risk it involves subjecting a portfolio to extreme market movements by radically changing the underlying assumptions and characteristics - including changing asset class correlations and volatilities, which are often observed to increase during extreme market events.
Outline two types of stress test
2
Two types of tests are designed to:
1. Identify ‘weak areas’ in the portfolio and investigate the effects of localized stress situations by looking at the effect of different combinations of correlations and volatiltiies.
- Gauge the impact of major market turmoil affecting all model parameters while ensuring consistency between correlations while they are stressed.
Explain what is meant by reverse stress testing
4
- Severe stress scenario that just allows company to continue operations as required by regulation (eg Low SCR).
- Aim is to identify the scenario which would just be enough to continue operations
- The scenario might be financial or non-financial
- Although it might be an extreme scenario, it must be PLAUSIBLE!!!
Describe how a stochastic model could be used to evaluate a particular risk
4
- The variables that gives rise to the risk are treated as RVs with probability distributions.
- The model must be DYNAMIC, with full interactions/correlations between variables.
- The model can be run to determine the amount of capital that is needs to (just) void ruin with a given probability
- Long run time. Limit scope of model/ # stochastic variables
Outline 3 approaches to limiting the ideal scope of a stochastic model in order to make the model more practical
- Restrict the time horizon that the model projects
- Limit the number of variables that are modelled stochastically and model the other variables deterministically with scenario testing.
- Carry out a number of runs each with a different single stochastic variable, followed by a single deterministic run using all the worst case scenarios together.
Capital Requirements
3
- Regulatory capital requirements are set in respect of a 1 in 200 year event ocurring within 12 months
- Effect of multiple risks may be less than the individual sum fo risks due to diversification/neg corr
- Stoch modelling used to determine capital req for all risks and provides a dbn so RC can be calc @prob level
How does correlation between risks affect RC?
3
- Risks are fully dependent: The overall capital requirement is the sum of the individual capital requirement corr = 1
- Risks are independent: uncorrelated risks so RC is less than the sum of individual risks RC corr=0
- Risks are partially dependent: Positive/ negative correction so RC is less than indiv sum, Lower correlation higher diversification benefit and lower the RC
List 3 methods of aggregating partially dependent risks
1.Stochastic model :
* Output a dbn that can be used
2.Correlation matrix:
* Directly aggregate across individual risk factors
* Specifiy corr bet risk factors to account for diversification and use sqrt(sum(cij) (ri) (rj))
3.Copulas:
* Have info of indiv risks on isolation (approx dbn)
* Use copula to calc joint prob of risk