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3. Exam 3.1 > Chapter 39: Sources of Risk > Flashcards

Chapter 39: Sources of Risk Flashcards

1
Q

6 Major types of risk faced by a financial organisations

A 
C - credit risk
O - operational risk
M - market risk
B - business risk
L - liquidity risk
E - external risk
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2
Q

4 Financial risks

A
  • Market
  • Credit
  • Business
  • Liquidity
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3
Q

2 Non-financial risks

A
  • external

- operational

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4
Q

Systematic risk

A

Risk that affects an entire financial market or system and cannot be diversified away.

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5
Q

Diversifiable risk

A

arises from an individual component of a financial market or system and can be diversified away.

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6
Q

Credit risk

A

Credit risk is the risk of failure of 3rd parties to repay debts.

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7
Q

the principles of good lending relate to (4)

A
  • character and ability of the borrower
  • purpose of the loan
  • amount of the lown
  • ability of the borrower to repay
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8
Q

Marketability

A

The ease with which an asset can be converted into cash.

The amount of cash received is unimportant.

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9
Q

Liquidity

A

A measure of how quickly the asset can be converted into cash at a predictable price.

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10
Q

Liquidity risk

A

the risk that the individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at excessive cost.

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11
Q

Market risk

A

Risks related to changes in investment market values or other features correlated with investment markets.

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12
Q

3 Types of market risk

A
  • consequences of changes in asset values
  • consequences of investment market value changes on liabilities
  • consequences of mismatching assets & liabilities
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13
Q

Operational risk

A

Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

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14
Q

Operational risk can arise from (4)

A
  • inadequate internal processes, people or systems
  • dominance of a single individual (dominance risk)
  • reliance on 3rd parties
  • the failure of plans to recover from an external event.
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15
Q

External risk

A

Arise from external events such as storm, fire, flood or terrorist attack.

However the failure to arrange mitigation against such risks is an operational risk.

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16
Q

Counterparty risk

A

Where one party to a transaction fails to meet their side of the bargain.

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17
Q

Security

A

Security is a way of enhancing the lender’s position.

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18
Q

The decision as to what security is taken is dependent on (5)

A
  • what security is AVAILABLE.
  • the NATURE of the transaction underlying the borrowing
  • the COVENANT of the borrower
  • MARKET CIRCUMSTANCES
  • the comparative NEGOTIATING STRENGTH of lender and borrower

The lender must be able to realise the security if necessary in a cost-effective manner.

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19
Q

Credit rating

A

Given to a company’s debt by a credit-rating agency as an indication of creditworthiness, ie the likelihood of default/credit loss.

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20
Q

Asset value changes can result from (2)

A
  • changes in the market values of equities and property.

- Changes in interest and inflation rates.

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21
Q

In practice a perfect Asset / Liability match may be impossible because (4)

A
  • may not be a wide enough range of assets available (in particular it is unusual to find assets of long enough duration)
  • liabilities may inclued options and hence have uncertain cashflows after the option date
  • liabilities may include discretionary benefits.
  • cost of maintaining a fully-matched portfolio is likely to be prohibitive.
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22
Q

2 Consequences of mismatching

A
  • higher liquidity risk

- reinvestment risk - the risk of having to invest asset proceeds on unknown terms.

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23
Q

7 areas of risks for insurance companies

A
  • claims
  • withdrawals
  • expenses
  • mix of business
  • options and guarantees offered
  • reinsurance.
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24
Q

Withdrawal risk

A

An insurance company may be at risk of policyholders withdrawing at a time when asset share is negative as the company will make a loss on these policies.
There is also chance of selective withdrawals (better than average experience)

25
Q

Expense risks

A

Expense risks include the risk of higher than expected levels of expense inflation, mismatching between the timing and level of expense outgo and charge income and inadequate spreading of fixed expenses.

26
Q

Volume of business risks

A
27
Q

3 Components of Credit risk

A
  • Asset Default
  • Counterparty risk
  • Debtors
28
Q

4 Areas of BUSINESS RISK

A
  • Underwriting
  • Insurance
  • Finance
  • Exposure
29
Q

2 areas of Operational risk

A
  • Business continuity

- Third party administration

30
Q

“Canons of Lending”:

Character and ability to pay

A
  • Is the borrower known, competent and trustworthy?
  • Who introduced them?
  • Can references be obtained?
  • Do key personnel have the required depth and spread of skills and experience? (lending to a company)
31
Q

“Canons of Lending”:

Purpose of the loan

A
  • To what use will the monies be put?
  • Is the borrower in a sector where there are concerns?
  • Will the lending be subject to country, currency, environmental, resource, technological or other inherent risk?
  • Is the project acceptable on ethical and moral grounds?
  • Are there controls to ensure that the monies are correctly applied?
32
Q

“Canons of Lending”:

Amount of the loan

A
  • Is the amount to be borrowed reasonable, taking into consideration the stated purpose and the adequacy of any contribution of the borrower?
  • Who stands to lose most if the project fails?
33
Q

“Canons of Lending”:

Repayment

A
  • Can the borrower service and repay the debt when due?
  • How certain is the source of repayment?
  • What margin of safety has been built into the projections and assumptions?
34
Q

Reinsurance risks (4)

A
  • inadequate appreciation of the scale of the risks assumed by the insurance company and hence of its reinsurance needs
  • doubts as to the availability and cost of the desired reinsurance
  • reinsurance that is poor value for money
  • failure to comprehend the coverage / limits of a reinsurance arrangement.
35
Q

Credit-linked event

A

An occurrence that is of interest because it will be associated with a change in value of the associated bond. E.g.

  • bankruptcy
  • a rating downgrade or upgrade
  • failure to pay
36
Q

“Due diligence” investigation

A

involves a thorough assessment of the financial “health” of the borrower.

It will typically include consideration of the factors outlined as the principles of good lending.

37
Q

Main claim risks for a

LIFE insurance company

A
  • mortality
  • longevity
  • morbidity (critical illness rates, long term care rates)
  • medical advances
  • loose policy wordings
  • accumulations of risk and catastrophes
  • anti-selection and moral hazard
38
Q

Main claim risks for a

GENERAL insurance company

A
  • claim FREQUENCY
  • claim AMOUNT
  • claim INFLATION (also court-award inflation)
  • claim VOLATILITY
  • claim DELAYS
  • claims HANDLING
  • loose policy wordings
  • accumulations of risk and catastrophes
  • anti-selection and moral hazard
39
Q

Claim frequency (general insurance) might be influenced by (4):

A
  • types of policy / cover
  • characteristics of policyholders and their attitude to claiming
  • economic conditions
  • crime rates
40
Q

6 Examples of inadequate or failed internal processes, people or systems

A

Mismanagement:

  • – inappropriate actions of the board of directors / staff
  • – failure of the appropriate management systems and controls
  • – administrative complexity
  • data errors
  • inadequate risk control measures
  • fraud
41
Q

“covenant” of the borrower

A

The overall creditworthiness of the borrower

42
Q

Why do insurance companies and benefit schemes normally have little exposure to liquidity risk?

A

a large proportion of their assets are in cash deposits or bond and stock market assets, which can be readily sold.

43
Q

When might a general insurer face liquidity risk

A

If claim costs are higher than expected, e.g. a catastrophe

44
Q

When might a benefit scheme face liquidity risk

A

In the event of a bulk transfer out of the scheme.

45
Q

Why do banks face significant liquidity risk?

A

They lend depositors’ funds and funds raised from money markets to other organisations,
and generally do so for LONGER PERIODS than they offer to the providers of the funds.

46
Q

When do banks face liquidity risk?

A

If more customers than expected demand cash (withdraw deposits)

47
Q

Liquidity risk for collective investment schemes

A

Collective investment schemes invested in property need to protect themselves if clients request access to the funds when the underlying properties cannot be sold.

Such funds have the power to defer withdrawals by up to 6 months if necessary.

48
Q

Market liquidity risk

A

Where a market DOESN’T HAVE THE CAPACITY to handle
… (at least, without a potential adverse impact on the price),
… the volume of an asset to be bought or sold
… at the time when the deal is required.

(a.k.a. marketability)

49
Q

2 Characteristics of a highly liquid asset

A
  1. It will QUICKLY BECOME CASH
    - – because of the terms of the asset itself
    - – or there is a high degree of certainty that the asset could be sold quickly if required.
  2. The amount of cash it will become is (almost) certain.
50
Q

Why might liability value changes arise?

A

Because PROMISES to stakeholders, policyholders or benefit scheme members ARE DIRECTLY RELATED TO INVESTMENT MARKET VALUES or interest rates.

Alternatively,
a change in interest or inflation rates might affect the level of provisions a provider needs to establish for future liabilities.

51
Q

Why might the provider intentionally take an unmatched position (assets vs liabilities)?

A

The existence of additional capital
… gives the freedom to intentionally take an unmatched position
… in the hope of achieving an additional return.

The capital will be used to cover the cost of the risk taken.

52
Q

Business risk

A

Risks that are specific to the business undertaken.

53
Q

4 Examples of business risk to financial product providers.

A
  • underwriting risk
  • insurance risk
  • financing risk
  • exposure risk
54
Q

Underwriting risk

A

Risk of loss due to a life or general insurer not having adequate underwriting standards,
and thus
TAKING ON RISKS AT AN INADEQUATE PRICE

55
Q

Insurance risk

A

Risk of losses from an insurer SUFFERING MORE CLAIMS THAN ANTICIPATED

56
Q

Financing risk

A

Risk that a provider of finance, such as a bank,

invests in a business or project that fails to be successful.

57
Q

Exposure risk

A

Risk of an insurer having greater exposure than planned to a particular risk event.

58
Q

Option and guarantee risks

A
  • Risk that the options become valuable to policyholders (and so are exercised), or guarantees bite. Meaning that the cost of cover is higher than expected.
  • Solvency issues, due to the additional capital requirement from offering options and guarantees.
59
Q

“Court award” inflation

A

The risk of many judicial decisions in favour of the policyholder.
Precedents will be set involving new types of claim eligible for compensation and how much the settlements for them are.
This will immediately increase the average amount at which all future claims are settled.

3. Exam 3.1 (56 decks)

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