Chapter 26: Risk Identification and Classification Flashcards
Risk identification
Risk identification is the recognition of the risks that can threaten an organisation’s business plan
For each risk identified it is necessary to determine any risk control processes than can be put in place which will reduce either the likelihood of the risk event occurring or the impact of the risk event should it occur
It is also important to identify opportunities to exploit risks and gain a competitive advantage over other providers. Taking on risk is a potential source of profit if the risk is priced correctly
Identifying all the risks in an organisation is a difficult task and requires good knowledge of
- the circumstances of the organisation concerned
- the features of the business environment in which it operates
- the general business and regulatory environment
Techniques available to ensure that all relevant risks have been identified
- Use risk classification
- Use techniques from project management (q3)
- Use risk checklists, as used for regulatory purposes
- Use the experience of staff who have joined from similar organisations, and of consultants with broad experience of the industry concerned
Outline 5 methods of identifying the risks associated with a project
- High level preliminary risk analysis to confirm that the project does not have such a high-risk profile that it is not worth analysing further
- Brainstorming with project experts and senior internal and external people to:
- identify likely and unlikely project risks, and their
upsides and downsides
- discuss these risks and their interdependency
- broadly evaluate the frequency and severity of each risk
- generate and discuss initial mitigation options - Desktop analysis to supplement brainstorming, which involves looking at similar projects undertaken by the sponsor and others in the past.
- Consult with experts who are familiar with the details of the project and outline the plans for financing it.
- Set out a risk register or risk matrix setting out risks and their interdependencies
Suggest 7 categories of risks that could be used in a risk matrix for a typical project
- Political - opposition to project, war, terrorism, etc
- Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate movements
- Financial - sponsor default, incorrect cashflow estimates
- Crime - fraud, theft
- Project - time delays, budget overruns, bad design
- Business - competition/lack of demand, operational problems
Market risk
The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation
Examples:
- Change in interest rates / inflation
- Market crashes
- Mismatch of assets and liabilities
- Currency risk
Outline 3 subdivisions of market risk
- The consequences of changes in asset values (due to changes in the market value of assets or changes in interest and inflation rates)
- The consequences of a change in investment market values on liability values, where liabilities are directly related to investment market values, interest rates or inflation rates.
- The consequences of not matching assets and liability cashflows
Do Question on bottom page 9
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Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.
Give reasons why a perfect match may not be possible in practice.
- There may not be a wide enough range of assets available; in particular it may may not be possible to find assets in sufficiently long duration.
- Liabilities may be uncertain in amount and timing
- Liabilities may include options and hence have uncertain cashflows after the option date.
- Liabilities may include discretionary benefits
- The cost of maintaining a full-matched portfolio is likely to be prohibitive.
Credit Risk
The risk of failure of third parties to meet their obligations
Credit Spread and why credit spreads may change over time
Credit spread is the difference in yield between a particular corporate bond and an otherwise equivalent government bond
Reasons for change:
- Perceived changes in quality of the issuers
- Market may alter its view on the premium for illiquidity that is placed on corporate bonds in general
- Perceived security of a type of bond may change
What is a credit rating?
A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default / credit-loss (creditworthiness)
Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower
- The nature of the debt
- The covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, prior ranking debt)
- Market circumstances and the relative negotiating strength of borrower and lender.
- What security is available and whether it can be realized if necessary
Liquidity Risk
The risk that the individual or company, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due.
The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets
Define the term liquid asset.
A liquid asset is one that either:
- is close to cash in nature, or
- can be converted to cash quickly and the amount of cash it would become is almost certain
What makes a market liquid
A liquid market is likely to be a large market with lots of ready participants.
(A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain)
