Chapter 39: Sources of Risk Flashcards
4 Financial risks
- credit
- liquidity
- market
- business
2 Non-financial risks
- operational
- external
What is credit risk
The risk of failure of 3rd parties to repay debts.
E.g.:
- issuer of a corporate bond defaulting on the interest/capital payments
- settlement risk, with one side of the transaction failing to meet their side of the bargain.
- purchasers of goods and services failing to pay for them
If good lending principles are adopted (Canons of lending), then credit risk can be reduced.
What are the 5 Canons of lending?
- Character and ability of the borrower
- Purpose of the loan
- Amount of the loan
- Ability of the borrower to repay
- Risk vs. reward
What questions would you ask of the borrower under the Canons of lending:
Character and ability of the borrower
- Is the borrower known, competent and trustworthy?
- Who introduced him?
- Can references be obtained?
- Do the key staff have the required depth and breadth of experience?
What questions would you ask of the borrower under the Canons of lending:
Purpose of the loan
to what USE will the monies be put?
is the borrower in a SECTOR where there are CONCERNS, or where the total EXPOSURE is already sufficient?
would the lending be subject to risks such as
- country,
- currency,
- environmental,
- resource,
- technological,
- ethical or
- moral risks?
are there CONTROLS to ensure that the monies will be spent as the borrower says it will be?
What questions would you ask of the borrower under the Canons of lending:
Amount of the loan
- Is the amount to be borrower reasonable, taking into consideration the stated purpose?
- Is the borrower contributing any funds?
- Who stands to lose if the project fails?
What questions would you ask of the borrower under the Canons of lending:
Repayment
- 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 assumptions?
What questions would you ask of the borrower under the Canons of lending:
Risk vs Reward
- Has a proper due diligence exercise been carried out?
- Has the borrower signed it?
- Can each statement be verified?
- Are there any remaining doubts?
- Does the return adequately compensate for the risks?
Another issue linked to credit risk is whether there is any security backing the loan.
The decision as to what security is taken, depends on what 4 factors?
- the nature of the transaction underlying the borrowing
- the covenant of the borrower
- market circumstances, and the relative negotiating strength of the buyer and seller
- what security is available?
What is liquidity risk?
Liquidity risk is the risk that an individual or company, although solvent, does not have the financial resources available to meet its obligations as they fall due.
Examples of liquidity risk
- A bank would face liquidity risk if there is a loss of market confidence, resulting in more customers than expected, withdrawing their deposits.
- A general insurance company would face liquidity risk if widespread flooding would result in many property claims.
- A pension fund would face liquidity risk if there is a bulk transfer out of the scheme.
Market liquidity risk
In the context of financial markets, market liquidity risk is where a market does not have the capacity to handle the volume of an asset to be bought or sold at the time when the deal is required (at least, without an adverse impact on the price).
Market risk
The risk of changes in investment market values or other features correlated with investment markets.
Examples of market risk
- the consequences of volatile asset values if asset and liabilities are mismatched
- the consequences of a change in investment values of liability values, e.g. unit-linked liabilities.
- A change in interest of inflation rates, which might affect the level of provisions a provider needs to establish for future liabilities.
Business risk
Risk specific to the business undertaken.
Examples of business risk
- Underwriting risk: inadequate underwriting standards, and mispricing of risks.
- Insurance risk: More claims than anticipated.
- Financing risk: Investment in a business or project that fails to be successful.
- Exposure risk: Greater exposure than planned to a particular risk event.
Operational risk
The risk of loss due to fraud or mismanagement in the organisation.
Examples of operational risk
- the risk of inadequate or failed internal processes, people or systems
- Dominance risk: the dominance of a single individual over the running of a business.
- reliance on 3rd parties to carry out various functions for which the organisation is responsible.
- the failure of plans to recover from an external event.
External risk
Arises from external events.
Examples of external risks
- natural disasters, eg storm, fire or flood
- war or terrorist attack
- legal or tax changes
Risks to a life insurance company
CREDIT RISK
- — reinsurance
- — broker
- — asset default
LIQUIDITY RISKS
—- a lack of sufficient financial resources to meet claims as they fall due
MARKET RISKS
- — mismatch of assets and liabilities
- — volatility of asset values
- — lack of liquidity
BUSINESS RISKS
For unit-linked contracts:
- risk of MISMATCH between expenses and charges
For with-profit contracts:
- policyholder expecations
OPERATIONAL RISKS
- fraud
- mismanagement
- external failure
EXTERNAL RISKS
- legislative changes
- tax changes
Business risks faced by a life insurer
adverse experience relating to
- mortality,
- longevity,
- morbidity,
- withdrawals,
- expenses,
- investment returns,
- inflation,
- new business volumes,
- new business mix,
- average premium size,
- anti-selection,
- moral hazard,
- loose policy wording,
- lack of data
What could happen if new business volumes were greater than expected?
Writing new business requires capital.
If too much new business was written, then the company would incur greater than expected new business strain.
What could happen if new business volumes were less than expected?
The company may not cover its fixed expenses.
Risks to a general insurance company
CREDIT RISKS:
- reinsurer
- broker
- asset default
LIQUIDITY RISKS:
- a lack of financial resources to meet claims as they fall due
MARKET RISKS:
- mismatch of assets and liabilities
- volatility of asset values
- lack of liquidity
- currency risk
BUSINESS RISKS
OPERATIONAL RISKS
- fraud
- mismanagement
- systems failure
EXTERNAL RISKS
- natural disasters
- terrorist threats
- legislative changes
- tax changes
Business risks faced by an insurer
- adverse experience relating to claim amounts and frequencies
- claim inflation
- claim volatility
- claim delays
- accumulations
- catastrophes
- latent claims
- court awards
- expenses
- expense inflation
- investment returns
- renewals
- lapses
- new business volumes
- new business mix
- average premium size
- anti-selection
- moral hazard
- loose policy wording
- lack of data
- changes in the characteristics of policyholders
- difficulty in finding appropriate reinsurance
Systematic risk
Risk that affects an entire financial market or system and not just specific participants.
It is not possible to avoid systematic risk through diversification.
Diversifiable risk
Arises from an individual component of a financial market or system.
