Ch28: Accepting Risk

Question 1

Risk profile

Answer 1

• Complete set of risk
  exposures
• Current / emerging

Question 2

Risk limits

Answer 2

• Defined by company -
  set of acceptable risks
  to be adhered to
• Maximum risk

Question 3

Risk capacity

Answer 3

• ‘Maximum’ volume of risk that
  an organisation can take
• According to some risk
  measures, e.g., economic
  capital

Question 4

Risk appetite may be related to:

Answer 4

• Existing exposure to the risk
• Culture of individual / company
• Size
• Period of time for which company has
  operated
• Level of capital available
• Existence of parent cpy
• Level of regulatory control to which it is
  exposed
• Institutional structure
• Previous experience of board members

Question 5

Risk appetite statement:

Answer 5

Set / approved at board level
* Need not be complex
* Short, clear set of statements relating to risk
measures / objectives
- Solvency level
- Credit rating
- Earnings and ability to pay dividends
- Economic value
* Subjective / quantitatively
* Deterministic statement / probabilistic statements
* Could use a combination of metrics
* Different metrics for different stakeholders -
shareholders vs policyholders / regulator

Question 6

Risk tolerance and risk limits:

Answer 6

Translate the risk appetite statement into more
detailed risk tolerance and limits
* Typically done enterprise-wide
* Holistic approach
- Take advantage of synergies
- Avoid undesired risk concentration
* Similar to risk appetite - risk tolerance statements
can be
- Both quantitative and qualitative / subjective
- Often stated as a set of acceptable limits for
different risk categories, considering links between
categories
* Typically, probabilistic statements - difficult to keep
track of, measure and not always easy to use in
practice

Question 7

Risk metrics:

Answer 7

Indicator that aims to express the degree
of risk
- % equity in portfolio
- Exposure to a risk
- Level of duration mismatch between
assets and liabilities
* Measure whether company is operating
within its risk tolerance limits
* Used in order to get quick and early
indication of changes in risk profile that
may lead to breach of risk tolerance
* Quantitative / qualitative indicators of level
of risk in a specific part of the organisation

Question 8

Capital requirements:

Answer 8

Companies need capital buffers to cope with impact of risk events
* Prescribed by regulators - Solvency II / SAM
* Avoid inappropriate risk appetite - minimum levels of solvency capital

Question 9

Markets for risk:

Answer 9

Exits if price < perceived cost of risk
* Different stakeholders have different appetites
for risk - risk transferred between entities for
monetary payment
* Where there is good market for risk transfer,
system is said to be efficient

Question 10

Insurance companies / banks:

Answer 10

Larger
* By pooling the risks - stable returns and make
profit from premiums
* Multiple sources of funding
* Volumes of diverse client base in order to
spread out its risks
* Better systems and techniques to measure the
risks

Question 11

Financial products as risk transfer mechanism

Answer 11

• All risks should be identified during the product
  design process
• Consider mitigation techniques - possibly hedge
  risks across different product types
• Components considered in a pricing assessment of
  a product:
• cost of funding incurred in order to raise the
  funds to lend
• risk premium for prob of default & loss
• margin for costs & required profitability
• Cost of risk depends on features of financial
  product and other business of provider
• Appropriate cost - risks should be classified into
  subgroups, each of which represents a
  homogeneous body of risk with a particular set of
  rating factors
• Additional options
• May make product more attractive
• May introduce new risks and additional costs
• Risk that product design will not meet
  beneficiaries’ needs and desires
• Can be mitigated by small scale product trials,
  market research and focus groups
  Greater risk classification in general insurance:
• Highly competitive and largely sold on price
• Protect against adverse selection from
  policyholder
• Greater volume of data to work with - more
  possible and meaningful
• Policyholders likely to be more willing to provide
  data required

Question 12

Risk classification

Answer 12

Classify risks into homogeneous and credible
risk sub-groups
* Enables cpy to charge premium rates that
fairly reflect relative risk of each sub-group
* Will reduce likelihood of anti-selection
* Use rating factors to divide risks into
homogenous sub-groups

Question 13

Rating factors used by general insurer to
classify risk under personal motor insurance
policy

Answer 13

Gender & age of driver
* Occupation of driver
* Postcode of area where vehicle is kept
* Type of vehicle
* Size of engine
* Age of vehicle
* Number & type of previous accidents/ claims
* Use of the vehicle
* Existence of driving conviction
* Anticipated annual mileage

Question 14

Reasons for typically greater risk classification
in general insurance than life insurance

Answer 14

GI highly competitive and largely sold on
price – market pressures
* GI have greater volume of data to work with
making risk classification more possible and
meaningful
* Policyholders will be more willing to provide
data required by GI than LI

Question 15

Insurable risks criteria:

Answer 15

• Policyholder must have an interest in the risk being
  insured to distinguish between insurance & a wager
• Risk is of financial and reasonably quantifiable nature
• Claim amounts payable must bear some relationship to
  the financial loss incurred

Question 16

Principle of pooling risks

Answer 16

• Insurers & reinsurers take on risks in return for a
  premium because they can pool risks together, which
  means there is greater certainty in the future
  payments they are likely to make on the occurance of
  an insured event
• Greater certainty and less volatility
• Through the assessment and control of risk, actuaries
  create opportunities for insurance companies to make
  profit by accepting risk

Question 17

Criteria for pooled risks to be insurable:

Answer 17

Individual risks should be independent
* Probability of risk event occurring should
be relatively small
* Large numbers of similar risks should be
pooled to reduce variance and achieve
more certainty
* There should be limit on ultimate liability
undertaken by insurer
* Moral hazard should be eliminated as far
as possible
* There should be sufficient existing data /
information in order to quantify risk -
Extent and likelihood of occurrence

Question 18

Bankalot is a small commercial bank in a developing country. Bankalot has received a letter from the banking
regulator, noting that Bankalot’s risk appetite statement appears to be outdated. Bankalot has appointed you to
assist them with improving their risk appetite statement.
i. Discuss potential features of Bankalot that may influence its risk appetite. [6]

Answer 18

Existing exposure to risk may influence appetite for new exposures
* Corporate culture may be geared to be more risk seeking than other banks
* Size of the company – small company may want to take more risk to grow
* Period of time over which it has operated – longer period will provide experience that may influence decision on
risk appetite
* Available capital – more capital will allow more risk to be taken
* Existence of parent company or other guarantors – may be possible to have a larger risk appetite if there are
guarantees from a large parent
* Regulatory environment – might place limits in the risk appetite the bank may have
* Corporate structure, e.g. mutual or proprietary – a mutual company might have a lower risk appetite based on
more difficult capital raising
* Past experience of board members – board members with good / bad experiences with a high risk appetite may
be more / less confident with a higher risk appetite
* Attitude to risk of risk owners, or providers of capital – risk averse owners will require a lower risk appetite

Question 19

Bankalot is a small commercial bank in a developing country. Bankalot has received a letter from the banking
regulator, noting that Bankalot’s risk appetite statement appears to be outdated. Bankalot has appointed you to
assist them with improving their risk appetite statement.
ii.) Give examples of quantitative risk appetite statements, stated in terms of each of a. the solvency level, and b. the
credit rating, respectively. [2]

Answer 19

a.) The solvency level (measured as the available capital / required capital) of Bankalot should stay above a threshold
Y, at a 99.5% level of confidence, over a period of 5 years
b.) The probability that the company’s credit rating is reduced by one notch, over the next three years, is less than 1%.

Question 20

iii.) Explain how the risk appetite of Bankalot will likely differ from the typical risk appetites of a development bank
and a community bank, respectively? [3]

Answer 20

• It is likely that development banks may have high levels of risk limits … considering that risky development is
  integral to their business model.
• Community banks are likely to have a low appetite for risk, … seeing that these are organisations that are
  aimed towards mutual benefit, as well as … safekeeping of money
• In comparison, a commercial bank needs to optimise value for shareholders … … as well as customers and
  other stakeholders, … implying that its risk appetite is likely to be in-between that of community banks and
  development banks.

Question 21

A life insurance company writes only group term insurance business insuring members of a group for whole of life
for a sum assured equal to 5 times the last annual salary drawn. There is neither any exclusion to payment of
benefits nor any initial underwriting of members of the group. Discuss briefly how well the risk taken by the
insurer fits the desirable criteria of risk to be insurable. [10]

Answer 21

Insurable risks criteria:
* Policyholder must have an interest in the risk being insured - Generally assumed unlimited interest on own
death
* The risk must be financial and quantifiable - 5 x Salary
* Claim amounts payable must bear some relationship to the financial loss incurred - Can argue, but not unknown
* Individual events should be independent of one another
- Here the risks taken by insurer may not be independent if group schemes/members are concentrated in a
particular region, location increasing concentration risk
- Further concentration risk may also be there due to having exposure to only one particular group or a
particular industry type covered, for eg. say armed forces
* Probability of risky events should be relatively small
- The probability of death is relatively small
- However, given the cover is whole of life when death is certain, the probability is not small But given the
considerable uncertainty on the timing of death, this is still considered as an insurable event
* Large numbers of similar risks should be pooled
- this depends on the number of lives covered by the insurer, more so, how many similar/different types risks
are covered
- Similar risks mean similar occupation, geographical location, industry etc.
* There should be an ultimate limit to the liability undertaken by the insurer
- though the cover is capped to 5 times the annual salary
- however, the annual salary at time of death is not known at outset so some uncertainty exists on amount
* Moral hazard should be eliminated
- cover is capped at 5 times annual salary 5 times the annual salary, hence moral hazard resulting from having
a disproportionate life cover is reduced
- however, there is no initial underwriting nor any exclusions which increases moral hazard
- moreover, cover continues even after employee leaves employment, which could increase moral hazard,
especially if a scheme is voluntary
* Sufficient data should be available to enable estimation of the extent and likelihood of risks occurring
- this depends on the maturity of the industry as a whole and the availability of local industry data
- mortality experience is known to vary with occupation and hence availability of information based on
occupational classes is essential