Chapter 28 - Accepting Risk

Question 1

Risk Tolerance’s & Limits

Answer 1

A statement of risk tolerances needs to cover the company’s attitude to all risks, both quantifiable and non-quantifiable.
- Quantifiable categories of risks might have risk tolerance expressed in probabilistic terms ‒ for example, the board will tolerate a probability of no more than 0.5% that losses attributable to market risk should exceed $100 million over the next 12 months. There should be similar statements related to each category of risk, and a full set of statements might be made for each combination of category of risk and business unit.
- Non-quantifiable risks also require a clear statement of what is acceptable or not acceptable

These statements of risk tolerance must be expressed in a way that can be easily understood and implemented by all staff within the organisation. In many cases this might manifest itself through statements of risk limits

Question 2

Risk Limits

Answer 2

Risk metrics will consist of quantitative and qualitative indicators of the level of risk in a specific part of the organisation. At each level of a risk appetite statement, the organisation may utilise a number of risk metrics.Risk metrics can be found at a supporting level below the detail included in risk tolerance and limit statements

Question 3

Capital Requirements for risk

Answer 3

• Retaining risk need sufficient capital to cope with the consequences of the risk event occurring
• Companies who have a risk seeking appetite can then decide to hold 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 (of which South Africa is one) 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.
• South Africa’s regime based on Solvency II principles is called SAM – Solvency Assessment and Management.
• In Europe, banks have equivalent capital requirements to those that apply to insurers under Solvency II.

Question 4

Risk Classification

Answer 4

• A company selling financial products will want to classify its risks into broadly homogeneous and credible risk sub-groups.
• Allows company to charge premium rates that fairly reflect the relative risk of each sub-group
• This will reduce the likelihood of anti-selection by policyholders where a higher proportion of the policies are taken up within the risk sub-groups that are relatively under-priced
• Careful underwriting is the mechanism by which insurers will group risks into broadly homogeneous risk sub-groups.

The underwriting process can determine:
- which policies receive standard terms
- which policies should have special terms applied – and what those special terms should be

The insurer will classify risks into broadly homogeneous risk sub-groups using rating factors, where a rating factor is measurable in an objective way and relates to the likelihood and/or severity of the risk

Good rating factors should define the risk clearly, and not be too closely correlated with other rating factors . An insurance company may not always be able to use the rating factors it wants to when determining the premium for a particular risk, and may need to use a proxy which is correlated with the ideal rating factor

Homogeneous data for each risk sub-group may not always be possible in practice as the insurer may not have sufficient credible data for each sub-group. In this situation, the insurer could choose to group together sub-groups with broadly similar levels of risk and accept that there is some heterogeneity. Alternatively, the insurer could look to augment the data it has with other external data

Question 5

Risk as an Opportunity

Answer 5

For a risk to be insurable:
- 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

Desirable criteria include:
- Individual risk events should be independent of each other
-The probability of the event should be relatively small
- Large numbers of potentially similar risks should be pooled in order to reduce the variance and hence achieve more certainty.
- There should be an ultimate limit on the liability undertaken by the insurer
- 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