Chapter 28 - Accepting risk Flashcards
Define the following terms:
Risk appetite
Risk profile
Risk limits
Risk capacity
Statement about the maximum amount and types of risk an individual or organisation is prepared to take on in order to meet their objectives.
Complete description of the risk exposures of an organisation, including risks that might occur in the future.
A set of guidelines that set limits on acceptable actions (i.e. that align with the strategy and risk appetite) that might be taken currently or in the near future.
Volume of risk an organisation can take as measured by some consistent measure, e.g. economic capital.
List factors that would influence a company’s risk appetite.
Existing exposure to a particular risk/risks
Nature of the company
Size of company
Reputation of company (i.e. well-known vs less-known)
Level of capital available
Existence of a parent company/other guarantors
Level of regulation
Organisational structure (i.e. mutual or proprietary)
Previous experience of board members
Attitude to risk of owners and other capital providers
What are some good measures that can be used to express a company’s risk appetite.
Solvency level
Credit rating
Earnings or dividend cover (earnings/dividends)
Economic value
Discuss how the risk appetite is translated into action
Risk management policy, including risk appetite statement, is developed.
Identify material risks to which company is exposed
Develop risk tolerance statement
- Describes level of risk company is willing to bear, both at a business and enterprise level
- Includes company’s attitude towards quantifiable and non-quantifiable risk
As well as the above, the risk tolerance statement should take the following into account specifically:
Risk limits
- These risk tolerance limits translate risk tolerance levels into concrete, operational limits for each category of risk.
- Can be set at multiple “levels” of the organisation and should guide managers as to maximum level of risk their units can take
Application to projects
- Risk appetite, tolerances and limits should be appropriate so as not to hinder new opportunities for the company
Risk metrics
- These a quantitative and qualitative indicators of the level of risk in an organisation
- Chosen metrics should be unambiguous and easy to report
- Thresholds should be identified for each metric to act as triggers and identify potential issues.
Capital requirements of risk
- Level of risk appetite should not hinder company through excessive capital requirements
- Regulators may impose minimum risk requirements and hence levels of solvency capital
Markets for risk
- This arises because different entities have different appetites for risk
- Risk can be transferred between entities
- Can take advantage of “mispricing” of risk, i.e. if your company values risk highly but another is willing to take on all or some risk “cheaply” (compared to your valuation), then you may stand to profit.
Explain, simply, how risks present financial opportunities.
In financial services, risk is a tradeable commodity. If the price at which one party is happy to accept a risk is less than the perceived cost of the risk to another party, the opportunity exists for risk transfer to the mutual satisfaction of both parties.
A combination of synergistic risk mitigation strategies and tactical risk exposures can also lead to opportunities.
What are the essential criteria for a risk to be an insurable risk.
Insurable interest - to avoid gambles and speculation, as well as moral hazard (as much as possible)
Risk must be of a financial and reasonably quantifiable nature
Amount payable in event of a claim must bear some relationship to the financial loss incurred - too large benefits will lead to moral hazard and fraud, while too small will discourage sales
List other desirable criteria for insurable risks.
Risk events should be largely independent
Probability of event occurring should be reasonably small.
Large numbers of similar risks can be pooled to reduce variance and achieve more certainty of claims
There should be an ultimate limit on the liability undertaken by the insurer
Moral hazard should be eliminated as far as possible
There should be sufficient existing statistical data/information to be able to estimate the price of the risk (i.e. amount x probability of occurrence)
Briefly explain the concept of pooling of risks.
Pooling of a large number of risks increases the certainty of the future payments, due to the law of large numbers. This allows for more accurate and appropriate pricing of risk.
