CH27 - Accepting risk Flashcards
Risk appetite may be related to (2)
- Existing exposure to the risk
2. The culture of the individual / company
Risk efficient market
The fact that different stakeholders have different appetites for risk enables risks to be transferred between different entities in exchange for a monetary payment.
Where there is a good market for risk transfer, the system is said to be risk efficient.
Almost all financial transactions can be simplified to a transfer of risk from one entity to another in exchange for a payment of money.
Insurable risk (3) + (6)
A risk is insurable if:
- the policyholder has an interest in the risk
- the risk is of a financial and reasonably quantifiable nature
- the claim amount payable bears some relationship to the financial loss
The following criteria are also desirable for a risk to be insurable:
(as the law of large numbers means that these will help the insurer reduce the volatility of the risk profile they hold)
1. individual risks should be independent
2. the probability of the event occuring should be relatively small
(death is certain but the considerable uncertainty over timing still gives rise to an insurable event)
3. large numbers of similar risks should be pooled to reduce variance
4. there should be a limit on ultimate liability undertaken
5. moral hazard should be eliminated as far as possible because these are difficult to quantify
6. there should be sufficient existing data / information in order to quantify risk
However, the desire to write business means that an insurer may be found to provide cover when these ideal criteria are not met.
Pooling risk
Insurers and reinsurers take on risks in return for a premium because in doing so they can combine or pool many risks together. (which means that there is greater certainty in the future payments they are likely to have to make on the occurence of an insured event)
This means that the law of large numbers takes effect, which implies that actual results are increasingly likely to be close to expected results, which results in greater certainty (lower volatility) for the insurer.
Risk appetite of different stakeholders
Different stakeholders will have different appetites for risk and even within a particular class of stakeholder there will be different appetites.
Corporate entities also have different appetites for risk. Frequently the risk appetite is described in public documents, such as the company’s annual report.
Features of a company that may influence its risk appetite (8)
- size
- period of time for which it has operated
- level of capital available
- existence of a parent company / other guarantors
- level of regulatory control to which it is exposed
- institutional structure (e.g mutual or proprietary)
- previous experience of the board members
- attitude to risk of owners and other providers of capital
Capital requirements of risk
A person or company that retains any risk needs to have sufficient capital to cope with the consequences of the risk event occuring. For individuals, this is almost never the case.
To avoid financial product providers adopting an innapropriate risk appetite, regulatory authorities may impose minimum levels of retained solvency capital derived from a risk assessment of the business.
Cost of risk and product design
Each risk covered by a product design has a cost.
The cost of risk depends not only on the features of the financial product being designed, but also on the features and other business of the product provider.
Good product design techniques will list all the risks involved in the product and will consider how each is controlled, transferred, or accepted and costed.
Factors by which a general insurer could classify risks under a personal motor insurance policy (9)
- Gender of the insured driver
- Age of the insured driver
- Postcode of the area in which the vehicle is kept
- Type of vehicle
- Age of vehicle
- Number and type of previous accidents / claims
- Use of the vehicle - social, domestic or pleasure
- Existence of driving convictions
- Anticipated mileage…
The factors used in setting premiums are known as rating factors.
Explain why there is typically a greater degree of risk classification for general insurance risks compared to life insurance risks (3)
- General insurance is highly competitive and largely sold on price. Market pressures have led to greater classification in order for general insurance companies to protect themselves against adverse selection from the policyholder.
- General insurers typically have a greater volume of data to work with than life insurers, making greater risk classification more possible and meaningful.
- Policyholders are likely to be more willing to provide the data required by general insurers, e.g. in relation to number of miles driven, type of car etc when purchasing motor insurance, as opposed to data required by life insurers relating to their state of health.
Appreciation of benefits by recipient
There is a risk that the designer’s perception of the needs and desires is not consistent with the views of the potential beneficiaries. If the beneficiaries do not appreciate the benefits, it is unlikely that thet will purchase the product, or take up the relevant scheme options.
The risk can be mitigated by small scale product trails, market research, focus groups and similar activities.
Risk taken as an opportunity
In financial services, risk is a tradable commodity. Insurance is one of the processes whereby risk is assessed and priced. If the price at which one party is happy to accept a risk is less than the perceived cost of the ris to a second party, the opportunity exists for a risk transfer to the mutual satisfaction of both parties. This is a fundamental rationale for both insurance and reinsurance.
Main issues facing providers of financial benefits in completing the assessment are (5)
- should the ruin probability be expressed over a single year or the whole run-off of business?
- a stochastic model with more than two stochastic variables is impractical, so it may be better to use a correlation matrix instead
- interactions between risks need to be dealt with
- some risks, particularly operational, are highly subjective
- using past data to estimate future consequences needs to be undertaken with caution, particularly for low frequency events.
