Chapter 1

Question 1

Functions and areas of risk management (selection):

Answer 1

• Assistance in risk identification
• Implementing programs for loss prevention or loss limitation
• Instruction sessions regarding risk management activities
• Surveillance of compliance with legal guidelines
• Development of different ways for risk financing, e.g., derivatives or contingent capital
• Claims handling

Question 2

Risk identification

Answer 2

Process of systematic detection of risks before and after their realization

Question 3

Risk measurement

Answer 3

modeling of risks based on models of probability theory

Not always easy because of conditional probabilities (goat example)

Question 4

Risk valuation

Answer 4

transformation of risks into values

Question 5

Risk valuation: Concept of expected utility by Bernoulli

Answer 5

• Transformation of earning quantities (here: gain G) into utility quantities
• Rational decision: alternative (action) with the highest expected utility should be carried out

Question 6

Concept of “relative” valuation

Answer 6

• The cash flows of a particular financial instrument (derivative) to be valued are replicated by means of available securities
• The price of the duplication portfolio must equal the price of the derivative, otherwise the capital market is not arbitrage-free
• Under these circumstances, individual risk preferences are irrelevant for pricing!

Question 7

where can u see evidence of the fact that risk-preferences exists?

Answer 7

• Existence of positive interest rates
• Insurance: premium > expected loss
• Gambling: premium > expected payback to participants

Question 8

Difference between normative and behavioral economics

Answer 8

Models in normative economics prescribe how a rational agent should act in a risky situation. On the other hand, behavioral economics describes how an agent acts in reality, focusing on empirically observable risk measurement and risk valuation by individuals. Normative economics deals with the question of “how should we act in risky situations?”, while behavioral economics tries to answer the question of “how do people behave in reality?”

Question 9

Name and briefly explain the two basic risk management procedures regarding “risk valuation”. Under which one do individual preferences not influence the valuation? Why?

Answer 9

The two basic risk management procedures for risk valuation are the “absolute” and “relative” valuations. In the case of absolute risk valuation, the gains (G) from a risky situation are transformed into utility quantities (U(G))
and the rational agent chooses the alternative with the highest expected utility. In the case of relative valuation, the cash flows of a financial instrument are replicated by means of available securities. In order for the capital market to be in equilibrium, the price of the financial instrument must equal the price of the duplication portfolio. The relative valuation does not take into account individual preferences, because the price of the financial instrument is only determined by the price of the duplication portfolio.

Question 10

Certainty, uncertainty, risk DEFINITIONS

Answer 10

• Certainty: the decision maker knows for sure what (future) outcome will occur
• Uncertainty: the decision maker expects at least two possible states of which only one can occur
• Uncertainty (in the narrower sense): it is not possible to forecast the occurrence probability for a certain state
• Risk (incl. chance): the decision maker can allocate (objective or subjective) occurrence probabilities to all possible states

Question 11

What are the three risk levels?

Answer 11

RANDOM RISK: it exists even if you have full knowledge of the characteristics of the randomness
DIAGNOSTIC RISK: when the model chosen does not well describe the data set
PREDICTION RISK: risk that parameter values estimated from historical data will not be the same in the future (mortality risks an change)

Question 12

What are the central risk types in the insurance business?

Answer 12

• Market risk: relevant for area of asset management (return volatility risk)
• Underwriting risk: premiums
• Credit risk
• Operational risk
• Mortality risk

Question 13

Legal requirements for the risk management of insurance companies:

Answer 13

• Minimum and target (solvency) capital requirements: Solvency II, SST, CH
• Investment regulation (in particular: investment limits for certainasset classes)
• Swiss Quality Assessment SQA

Question 14

Risk transfer

Answer 14

exchange of a stochastic cash flow for a deterministic value