Chapter 43: The Risk Management Process (2)

Question 1

Risk Measures:

- Asset risks

Answer 1

Active risk measures include historic tracking error and forward-looking tracking error.

Question 2

Risk Measures:

- Liability risks

Answer 2

These are commonly measured by carrying out an analysis of actual vs expected experience.

Question 3

Risk Measures:

- Value at Risk

Answer 3

Value at Risk represents the maximum potential loss on a portfolio over a given future time period with a given degree of confidence.

Question 4

Risk Measures:

- Expected Shortfall

Answer 4

The expected shortfall is the expectation of losses below a certain level. If the specified level is a percentile point on the distribution then this is called the Tail VaR.
The Tail VaR could also be defined as the expected shortfall, conditional on there being a shortfall.

Question 5

3 Steps of scenario analysis

Answer 5

• grouping of risks into broad categories
• development of adverse scenario for each risk group
• calculation of consequences of risk event occurring for each scenario
• total costs calculated are taken as the financial cost of all risks represented by the chosen scenario.

Question 6

Stress testing

Answer 6

Involves testing for weaknesses in a portfolio by subjecting it to extreme market movements.

Question 7

2 Types of stress test

Answer 7

• to identify “weak areas” in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities.
• to gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are “stressed”

Question 8

The Stochastic model is often limited by one of the following approaches: (3)

Answer 8

• restrict the duration (or time horizon) of the model
• limit the number of variables modelled stochastically, use a deterministic approach for the other variables
• carry out a number of runs with a different single stochastic variable and then single deterministic run using all the worst case scenarios together.

Question 9

Reporting on risk

Answer 9

It is usual to report on risk by quantifying the capital requirements to protect against ruin at a particular ruin probability.

Question 10

5 Main issues facing providers of financial benefits in completing the assessment

Answer 10

• Should the ruin probability be expressed over a single year or whole run-off of business?
• A stochastic model with more than 2 stochastic variables is impractical, so it may be better to use a correlation matrix instead.
• Interactions between risks should be dealt with.
• Some risks, particularly operational, are highly subjective
• Using past data to estimate future consequences needs to be undertaken with caution.

Question 11

3 Ways in which to deal with low probability, high impact risks (Catastrophes)

Answer 11

• They can only be diversified in a limited way
• can be passed to an insurer or reinsurer, usually by some form of catastrophe insurance or whole account aggregate excess of loss cover (commonly called “stop loss” cover)
• can be mitigated by management control procedures, such as disaster recovery planning.

Question 12

Risk portfolio

Answer 12

The risk portfolio categorises the various risks to which the business is exposed.

Against each risk would be a recorded quantification of:

• – impact
• – probability

Question 13

The risk portfolio can be extended to indicate how the risk as been dealt with: (4)

Answer 13

• retained (and how much capital is needed to support it)
• transferred
• mitigated (and a revised assessment of the remaining risk)
• diversified (and a revised assessment of the remaining combination of risks)

Question 14

The most common way of measuring liability risks

Answer 14

The analysis of actual vs expected experience

Question 15

Analysis of experience

Answer 15

The ratio of the actual occurrences of an event to the expected occurrences when the risk was accepted.

Question 16

Value at Risk

Answer 16

Generalises the likelihood of underperforming by providing a statistical measure of downside risk.

Question 17

Issues with value at risk

Answer 17

Portfolios exposed to credit risk, systematic bias or derivatives may exhibit non-normal distributions.

The usefulness of VaR in these situations depends on modelling skewed or fat-tailed distributions of returns, either in the form of statistical distributions or via Monte Carlo simulations.

Question 18

Scenario analysis

Answer 18

A means of evaluating risk where a full mathematical model is inappropriate.

(frequently used when evaluating operational risks)

Question 19

Possible stress testing for a commercial bank (3)

Answer 19

A commercial bank is exposed to substantial amounts of credit risk and market risk (particularly with regards to interest rates).

Useful stress tests might include:

• testing how the asset and liability values respond to a 3% increase in short- and long-term interest rates
• testing the impact off a worsening of the credit rating of all borrowers
• testing the impact of a widening of credit spreads on assets held.

Question 20

Possible stress testing for a life insurance company (2)

Answer 20

Life insurance companies are exposed to market risk, risk relative to liabilities and credit risk.
There are many other tests worthy of carrying out (eg for liquidity risk) but two examples are:
- testing solvency in the event of a fall in asset prices (eg 20% equities, 10% bonds and some allowance for currency depreciation)
- testing solvency in the event of a widening of credit spreads on assets held.

Question 21

5 main issues facing providers in completing a capital assessment

Answer 21

• Should the ruin probability be expressed over a single year or over the whole run-off of the business?
• A means of assessing the correlation between the risks assessed needs to be developed.
• Interactions between risks may mean that the effect of multiple risk events is greater or less than the sum of the individual risks. A practical techniques must be developed to address this.
• Some risks are highly subjective in their assessment.
• Using past data to estimate future consequences of rare events needs to be undertaken with caution.

Question 22

Explain why the effect of multiple risks may be less than the sum of individual risks.

Answer 22

due to the impact of diversification or negative correlation.

Question 23

Outline 10 steps involved in stochastic modelling

Answer 23

• specify the purpose of the investigation, including a time horizon, measurable criteria and a probability confidence limit
• collect, group and modify data
• choose a suitable density function for each of the variables to be modelled stochastically
• specify correlation between variables
• ascribe values to the variables that are not being modelled stochastically
• construct a model based on the expected cashflows
• check that the goodness of fit is acceptable. This can be done by running a past year and comparing the model with the actual results.
• attempt to fit a different model if the first model does not fit well.
• run the model many times, each time using a random sample from the chosen density function(s)
• produce a summary of the results that shows the distribution of the modelled results after many simulations have been run