Chapter 27-Accepting risk Flashcards
- Describe possible risk appetites of different stakeholders and the relevance to the actuary of a client’s risk appetite.
Different stakeholders will have different appetites for risk and even within a particular class of stakeholder there will be different appetites for risk.
For example, one individual may have a speculative attitude to market risk, while another might be highly cautious. The speculative individual will prefer investing in emerging markets or highly geared funds, while the cautious individual would avoid any equity investment at all.
Corporate entities also have different appetites for risk. Frequently the risk appetite is described in public documents, such as the company’s annual report.
Although the published statements of risk appetite may be unquantified, most organisations, and particularly those in the financial sector, should quantify their risk appetite so that it is a measurable item that can be included in monthly or quarterly management information packs.
For a provider of schemes providing benefits on future contingent events, a quantifiable risk appetite might be that the organisation will not accept risks that would cause its available capital to fall below x% of the regulatory minimum capital requirement (where x might be 150 or 200, for example).
Risk appetite may be linked to other features of the individual or company, such as their existing exposure to a particular risk, but it may also be a feature of the culture of the company or the type of individual.
In advising clients, it is important that the actuary has a good understanding of the client’s risk appetite in all the relevant areas.
- Describe, with examples, the capital requirements associated with the retention of risk by a person or company.
A person or company that retains any risks needs to have sufficient capital to cope with the consequences of the risk event occurring. For individuals, this is almost never the case.
For example, individuals who do not insure the contents of their houses against flood normally do not insure either because they cannot afford the premium or because they have a risk preference not to insure low likelihood events. The choice to go without insurance is not because they are in a situation where they have sufficient capital to pay to repair and refurnish their house after a flood.
Companies also have risk appetite and this can result in inadequate available and working capital being held for the risks retained.
To avoid financial product providers adopting an inappropriate risk appetite, regulatory authorities may impose minimum levels of retained solvency capital derived from a risk assessment of the business.
In Europe and other territories that have adopted regulatory regimes based on Solvency II, insurance companies are required to hold sufficient capital as calculated by an internal model or standard formula based on the company’s exposure to the main risks affecting insurance business.
- Describe how entities with different risk appetites enable there to be a market in risk.
The fact that different entities have different appetites for risk enables a market for risk. Risk can then be transferred between entities with a small appetite to those with a larger appetite. Almost all financial transactions can be simplified to a transfer of risk from one entity to another in exchange for a payment of money.
For example, an individual is likely to have an appetite for theft of contents from their home that is lower than the value of the contents that might be stolen. The individual consequently pays a premium to an insurance company to transfer the risk to the insurance company. The insurance company has a greater appetite for the theft risk both because it is larger, and also because by pooling the risks the company can still have stable returns and make a profit from the premiums it charges.
Where there is a good market for risk transfer, the system is said to be risk efficient. Individuals and companies with an excess of risk can transfer the excess to others who have less risk than they are prepared to accept. If the market is of adequate size, normal economic factors will result in an efficient market.
- Explain, including insurance products as examples, how financial products operate as a risk transfer mechanism.
A financial product is a means by which one party transfers risk to another party, normally making a cash payment to the party taking on the risk. The prime examples are pure insurance products: term life assurance cover, motor vehicle insurance and property damage insurance. The payment made not only needs to cover the cost of the risk being transferred, but also needs to enable the party taking on the risks to make a profit.
- Explain how investment in a collective investment scheme results in risk transfer.
It is more difficult to see why investment in a collective investment scheme results in risk transfer. It can be argued that the investor does not want to take the risk of poor performance because of a lack of knowledge of certain investment markets. The investor buys a service,
investment expertise, because they cannot do the job as well themselves, and any poorly done job increases the risk of failure.
It is also possible that the person transferring the risk may be able to do the job just as well themselves, but there are other activities they would rather spend their time doing, either because they are more profitable, or just because they are more enjoyable. Quality of life has a value.
- Explain, using an example, how the cost of risk in relation to a financial product depends on more than just on the features of that product.
However, it is important to note that 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.
For example, an insurance company with a large book of immediate annuity business may be able to offer competitive terms for without-profit whole life assurances, such as products designed to cover funeral costs or inheritance tax liabilities. While there is no perfect match for the annuities, writing the new assurance products will reduce longevity risk across the company and it may be able to include negligible or zero cost of mortality risk on the new contract.
- State how good product design should deal with risk.
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.
- Outline the additional risk that arises as a result of a financial product or scheme being designed by someone other than the beneficiaries.
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 they will purchase the product, or take up the relevant scheme options.
- Outline how this risk can be mitigated.
This risk can be mitigated by small scale product trials, market research, focus groups and similar activities.
- Discuss the extent to which products should include additional options and complexity.
It is a common feature of product design that various groups consulted in the design process believe that the product will be that much more marketable or will look better than a competitor’s product if this or that additional option was included. It is important to realise that all such options introduce new risks, and that each additional risk needs to be paid for.
Reverting to the underlying risk analysis behind the product will enable the designers to determine an appropriate design for a mass-market product and to decide on the extent to which additional risks can be covered.
In markets aimed at high net worth individuals, including additional options and complexity may be viewed as being part of providing a superior product and worth the additional costs.
- What condition on the price of a risk is necessary for insurance or reinsurance to take place?
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 risk 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.
- State the three criteria necessary for a risk to be insurable.
For a risk to be insurable:
* the policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager
* a risk must be of a financial and reasonably quantifiable nature
* the amount payable in the event of a claim must bear some relationship to the financial loss incurred.
- Outline six further criteria that an insurable risk should ideally satisfy.
Ideally risk events need to meet the following six additional criteria if they are 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:
* Individual risk events should be independent of each other - so that there is a spread of risk and the law of large numbers can apply
* The probability of the event should be relatively small - otherwise the cost of cover could be unaffordable.
* Large numbers of potentially similar risks should be pooled - so that the law of large numbers can apply so that actual experience is likely to be in line with expected experience, hence uncertainty is reduced.
* There should be an ultimate limit on the liability undertaken by the insurer - an insurer will have only a finite amount of capital with which to absorb risk.
* Moral hazards should be eliminated as far as possible because these are difficult to quantify.
* There should be sufficient existing statistical data / information to enable the insurer to estimate the extent of the risk and its likelihood of occurrence.
- On which lives are individuals normally deemed to have an unlimited insurable interest?
In most countries, individuals are deemed to have an unlimited insurable interest in their own lives and that of any spouse.
- Describe the principle of pooling of risks for insurance purposes.
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 make on the occurrence of an insured event.
