Chapter 22 - Risk optimisation and risk responses

Question 1

Five concepts to consider when optimising a portfolio

Answer 1

Risk - std deviations of returns

Reward - expected return

Diversification - reducing overall return

Leverage - borrow money and invest it, increasing potential risk & return

Hedging - reduce risk by taking position that is negatively correlated with organisations existing position

Question 2

Sharpe ratio

Answer 2

SR = ( Rp - rt) / volatility

used to compare investment managers

Question 3

Risk responses

Answer 3

Avoidance

Acceptance

Transfer

Management

Question 4

Risk-return measures

Answer 4

RAROC Risk adjusted return on capital

RORAA Return on risk-adjusted assets
(net income) / (risk-adjusted assets)

RAROA Risk-adjsuted return on assets
(risk-adjusted return) / assets

RORAC Return on risk-adjusted capital
(net income) / (economic capital or VaR)

RARORA Risk-adj return on risk-adjusted assets
(risk-adj return) / (risk-adj assets)

(risk-adjusted return) / (economic capital)

Question 5

Benefits of portfolio management in ERM

Answer 5

Encourages unbundling of business into component projects

Provides mechanism for aggregating risk cross organisation

Provides framework for risk concentration limits and asset allocation targets Influences investments, transfer pricing and capital allocation decisions

Question 6

Good risk responses should be…

Answer 6

A FAMES

Flexible
Active
Match risk
Economical
Simple
Avoid secondary risk from response

Question 7

Risk transfer options

Answer 7

Insurance/reinsurance

Co-insurance

Sharing risk via policy design

Securitisation (packaging risk into marketable product)

Purchasing derivative

Alternative risk transfer

Question 8

Risk transfer limitations

Answer 8

Cost

Counterparty risk

Regulatory restrictions

Capacity of market to accept

Question 9

Risk management (reduction) options

Answer 9

DRC IS HUMID

D Diversification

R Remuneration systems for agency risk

C Contract wording for counter parties

I Internal controls

S Solvency risk capital increased

H Hedging

U Underwriting practices

M Matching of Assets and Liabilities

I Increase portfolio size

D Due diligence on counter party

Question 10

Unconventional vechicles to cover conventional risks

Answer 10

FC RIMMERS

F Finite insurance (over multiyear to smooth)

C Captives (subsidiaries solely to insure parent)

R Rent-a-captives (shared captives)

I Integrated risk and multitrigger policies (cover baskets of risks)

M Multitrigger policies (insurance triggered if number of simultaneous risks)

M Multiyear, multiline policies

E Earnings protection

R Risk-retention groups (group of companies for self-insurance)

S Self-insured retentions

Question 11

Pros and cons of ART (Alternative Risk Transfer)

Answer 11

Improved organisational focus (transfer risks away)

Customisation and timing (of capital requirements)

Cost reduction (may be tax incentive) and simplified administration

Earnings stability

Marking-to-market (market price for risks)

Higher initial costs

Complex - time and costs tod evelop solution

To gain benefit, may need to change how risk is managed and assessed

Staff education needed

Question 12

Vechicles based on instruments from capital markets

Answer 12

WISCCC

W Weather derivatives

I Insurance-linked bonds (Interest/princpal forfeited if event occurs)

S Securitisation

C Credit Default Swaps (seller makes payment in event of def)

C Cat-E-Puts (allows equity to be sodl at certain price when cat)

C Contingent surplus notes (access to capital in certain event)