Chapter 28 - Accepting Risk Flashcards
Define risk appetite
• Risk appetite can be broadly defined as being a statement of the maximum amount and types of risk that an individual or organisation is prepared to take on, in order to meet their objectives
What is a company’s risk appetite influenced by?
• A company’s risk appetite is influenced by its ability and willingness to tolerate risk (ability and willingness are correlated)
Elaborate on a company’s ability to tolerate risk
• The ability to tolerate risk depends on:
o Size of risk relative to the entity - small = more able to take on risk
o Capital – more capital available, greater buffer and can take on more risk
o Guarantors
o Regulation
o Structure (mutual or proprietary)
o Published documents - especially important in a proprietary – want to attract s/hs. e.g. governance report, s/h’s report
Elaborate on a company’s willingness to take on risk
• The willingness to tolerate risk depends on:
o Attitude/culture of organisation and leadership
o Past experience of board members and management
E.g. got burned previously when took on a similar risk so don’t want to take on that risk again
Define risk: profile, limit, capacity
- Risk profile: complete description of risk exposures including future risks that may affect current business
- Risk limits: group of guidelines that set limits on acceptable actions that might be taken today. Regarded as a component of risk capacity
- Risk capacity: measure of amount of risk an entity can take on measured by some consistent measure e.g. economic capital
What metrics can the board use to express its risk appetite?
• The board’s expression of its risk appetite may be expressed in probabilistic terms and with reference to one or more of the company’s:
o Solvency level e.g. solvency level X should stay above threshold Y with 99.5% probability over the next 3 years
o Credit rating – prob. that company’s credit rating reduced from AAA to A, or worse over next 12 months should be no more that 1%
o Earnings and ability to pay dividends – earnings volatility over the next year should be no more than Y%
o Economic value – company is prepared to lose RY with prob. if no more than 0.5% over next 12 months and RZ with prob. of 0.1% over next 5 years
Differentiate between risk appetite and risk tolerance
- As previously stated, the board usually sets the risk appetite and policy
- The risk appetite is high-level and looks at setting risk targets across the organization as a whole
- The risk managers need to translate this risk appetite into the risk tolerance of a company
- The risk tolerance (RT) of a company is a more detailed set of statements, quantitative or statistical in nature, that describes the level(s) of risk that the insurer is willing to bear
- The RT levels apply across whole organisation and are connected to strategy of company
What should the risk tolerance statement cover?
• Statement of risk tolerances should cover company’s overall attitude to all risks:
o Quantifiable (expressed in probabilistic terms) – e.g. prob. of no more than 0.5% losses caused by market risk exceed R100m over next year
o Similar statements should be related to each category of risk as well as each category of risk per business unit
o Qualitative – clear statement as to what is acceptable or not e.g. individuals with criminal record cannot be in internal audit
How do risk limits relate to risk tolerance?
• Risk limits
o Translate tolerance levels into operational limits for each category of risk, taking into account any links between categories of risk
o Enable all staff to understand and implement risk tolerance levels
o Can be set at multiple levels within organisation
o Gives guidance to managers about maximum level of risk that their BUs or teams may take
How can risk tolerance/limits be measured?
• RA and RT statements probabilistic relating to financial and non-financial events – difficult and time consuming to measure and not easy to use in making business decisions
• Risk metrics:
o Are proxies for risk limits
o Used to measure whether company is operating within risk tolerance limits
o Consist of qualitative and quantitative indicators of level of risk in specific part of organisation
o E.g. board sets limit on level of market risk. Risk management function will conduct analysis to identify key drivers of market risk i.e. equity risk and interest rate risk. RMF could monitor % of equity in portfolio and level of duration mismatch between assets and liabilities to get early indication of changes in risk profile that may lead to breach of risk tolerance
o IT systems downtime and staff turnover rates may be used as an indicator of level of operational risk to which organisation is exposed
o Quantitative/qualitative thresholds act as triggers to identify problem areas so appropriate action can be taken
How does risk appetite create a market for risk?
- Different entities have different appetites for risk, which enables a market for risk i.e. risk can be transferred between entities with a small appetite to those with a larger appetite.
- An example of this market for risk is an individual purchasing life/general insurance from insurer
Why would companies have a greater risk appetite than individuals?
o They are larger
o By pooling risks, company can have stable returns and make profit from premiums
Why would larger banks have greater credit risk appetite than smaller banks?
o They have multiple sources of funding to give out loans
o They have volumes of a diverse client base in order to spread out risks
o They have better systems and techniques to measure risks before giving out loans
How can risk be seen as an opportunity?
• If the price at which one party is happy to accept a risk is less than the perceived cost of risk to a second party, the opportunity exists for a risk transfer to the mutual satisfaction of both parties
Differentiate between the 2 methods of provisioning for a financial outgo
o Pooling – when Prob(pay-out) is really low e.g. term assurance (risk products)
o Saving – when Prob(pay-out) is high e.g. retirement savings (savings products
