Chapter 28: Accepting risk

Question 1

Define risk appetite

Answer 1

• Maximum level of risk someone will take on to meet their objectives
• All stakeholders have different risk appetites
• Different groups of stakeholders, also have different risk appetites, e.g., different age groups
• Companies may disclose their risk appetite in their financial statements, this is likely to be a quantifiable amount in the finance industry

Question 2

Define risk profile

Answer 2

A complete description of risks faced by an organisation, along with any future emerging risks

Question 3

Define risk limit

Answer 3

Guidelines that set out limits on the risks that can be taken, if each BU is within their risk limit, the risk tolerance is said to be permitted

Question 4

Define risk capacity

Answer 4

The volume of risks an organisation can take on, measured by some consistent measure, e..g, economic capital

Question 5

Four ways in which a board of directors can express their risk appetite

Answer 5

1. Solvency levels
2. Credit ratings
3. Earnings and ability to pay dividends
4. Economic value

Question 6

What is meant by a market for risk (5)

Answer 6

• Risk arises due to different individuals having different risk appetites
• Risk can be transferred from those with a lower risk appetite to those with a greater risk appetite (policyholder to the insurer)
• Insurers then pool a large number of similar risks to increase claim certainty
• They aim to exploit risk as an opportunity to make a profit
• The market is said to be risk efficient if there are many parties willing to accept the risk

Question 7

What are the three criteria for a risk to be insurable

Answer 7

• Policyholder must have an insurable interest in the risk being insured (protection not wager)
• Risk must be of a financial and reasonably quantifiable nature
• The amount payable in the event of a claim needs to bear some relationship to the financial loss incurred (not gain from risk event but recover)

Question 8

What are the six criteria that ideally be satisfied to be insurable?

MUDPIS

Answer 8

M - Moral hazards should be eliminated as far as possible
U - Ultimate limit should be placed on the liability, the liability is quantifiable
D - Data sufficient to quantify the extent and likelihood of a risk occurring, to price it
P- Pooling of similar risks, reduce the variability of claim payments
I - Independent risk events, to avoid concentration of risks
S - Small probability of occurring

Question 9

Why can a market for risk arise even if the criteria for insurability are not met

Answer 9

Premiums can be charged to make a profit and is acceptable for the policyholders