Chapter 7: Definitions of Risk

Question 1

Market risk

Answer 1

Risk inherent from exposure to capital markets.

This can relate directly to the financial instruments held on the assets side (equities, bonds, etc) and also to the effect of these changes on the valuation of the liabilities.

Question 2

2 Economic risks

Answer 2

Price and Salary inflation.

Question 3

Interest rate risk

Answer 3

Risk arising from unanticipated changes in interest rates of various terms.
This can be changes in the overall level of interest rates, or in the shape of the yield curve.

Question 4

Foreign Exchange risk

Answer 4

The risk present when cash flows received are in a currency different from the cash flows due.

Question 5

Credit risk

Answer 5

Default risk.

Question 6

2 Major credit risks affecting banks

Answer 6

• credit risks relating to the large number of loans to individuals and small businesses.
• Counter-party risk for derivative trades

Question 7

Counter-party risk for derivative trades

Answer 7

The risk that the opposite side to a derivative transaction will be unable to make a payment if it suffers a loss on that transaction.

Question 8

Main credit risk faced by insurers

Answer 8

Risk of reinsurer failure.

Question 9

Main credit risk faced by pension schemes

Answer 9

Risk of sponsor insolvency.

Question 10

Why is credit risk considered to be very similar to non-life insurance risk

Answer 10

There is both

• incidence (the probability of default),
• and intensity (the recovery rate)

Question 11

3 Ways in which illiquidity can manifest itself

Answer 11

• high trading costs
• a necessity to accept a substantially reduced price for a quick sale
• the inability to sell at all in a short time scale

Question 12

Funding liquidity risk

Answer 12

The risk that a firm cannot meet expected and unexpected current and future cash flows and collateral needs.
And hence, that the firm is unable to raise additional finance when required.

Question 13

My might some illiquidity be desirable

Answer 13

if an institution can cope with a lack of marketability in a proportion of its assets, then it might be able to benefit from any premium payable for that illiquidity.

Question 14

3 Common problems with illiquid assets

Answer 14

They might have other issues such as:

• higher transaction costs
• greater heterogeneity
  (e. g. real estate and private equity)
• they are less likely to be eligible to count fully towards the regulatory capital of a bank / insurer.

Question 15

3 Ways in which assets can provide liquidity

Answer 15

through

• SALE for cash
• use as COLLATERAL
• through maturity or periodic PAYMENTS (dividends or coupons)

Question 16

Systemic risk

Answer 16

The risk of failure of a financial system.
This occurs when many firms are similarly affected by a particular external risk either directly or through relationships with each other and more broadly.

Question 17

Contagion risk

Answer 17

The risk that failure in one firm, sector or market will result in further failures.

Question 18

4 Broad types of systemic risk

Answer 18

• financial infrustructure
• liquidity
• common market positions
• exposure to a common counter-party

Question 19

Systemic risk relating to financial infrustructure

Answer 19

arises if a commonly used system fails.

This is particularly true if it relates to payment or settlement of financial transactions - such a failure can paralyse the entire financial system.

Question 20

When might liquidity risk become a systemic risk

Answer 20

If a run on banks occurs, or if short-term money market become less liquid.
Both result in a reduced ability for banks to raise the capital they need to remain solvent.

Question 21

Feedback risk

Answer 21

The risk that a change in price will result in further change sin the same direction.

Question 22

Mortality risk

Answer 22

The risk that a portfolio will suffer from mortality being heavier than expected.

Question 23

Longevity risk

Answer 23

The risk that a portfolio will suffer from mortality being lighter than expected.

Question 24

4 types of mortality / longevity risk (Int. Actuarial Ass.)

Answer 24

• level
• volatility
• catastrophe
• trend

Question 25

Mortality / longevity risk:

Level risk

Answer 25

The risk that the underlying mortality of a particular population differs from that assumed.

Question 26

Mortality / longevity risk:

Volatility risk

Answer 26

The risk that the mortality experience will differ from that assumed due to there being a finite number of lives in the population considered.

Question 27

Mortality / longevity risk:

Catastrophe risk

Answer 27

The risk of large losses due to some significant event increasing mortality rates beyond simple random volatility.
E.g. natural disasters.

Question 28

Mortality / longevity risk:

Trend risk

Answer 28

The risk that mortality rates will improve over time at a rate different to that assumed.

Question 29

Underwriting risk

Answer 29

The risk that the average level of claims
(as measured by insidence and intensity)
is different from that assumed.

Question 30

Non-life insurance

Volatility risk

Answer 30

Risk that remains even if risks are correctly underwritten, and reflects uncertainty in the incidence and intesnity of claims resulting from the fact that only a finite number of policies exist.

Question 31

Operational risks

Answer 31

A group of risks which impact on the way in which a firm carries on business.

Question 32

Business continuity risk

Answer 32

The risk that an external event will affect the physical ability of a firm to carry on business at its normal place of work.

Question 33

Regulatory risk

Answer 33

The risk that an organisation will be

• negatively impacted by a CHANGE in legislation or regulation,
• or will FALL FOUL of legislation or regulations that are already in place.

Question 34

Technology risk

Answer 34

The risk of a failure in technology, including

• unintended loss or
• • disclosure of confidential information,
• data corruption
• and computer system failure.

Or losses due to undiscovered errors in software used in an organisation. Such errors might result in losses from mispricing, or in incorrect payments being made.

Question 35

Crime risk

Answer 35

Result from the dishonest behaviour of individuals in relation to a firm.
This includes the theft of money or intellectual property by an employee (fraud) and the unauthorised access of system by an outside party with the same aims (hacking).

Question 36

People risk

Answer 36

A term reserved for non-criminal actions that can adversely affect an enterprise.

Question 37

People risk:

Employment risk

Answer 37

The risk that the wrong people are employed.
It is impartant that the people employed have the skills an organisation needs to run its business.

Once employees have been recruited, it is important that the right ones are promoted.
Similarly, it is important that the right employees are retained.

Question 38

Risks associated with losing employees

Answer 38

Losing employees can result in a

• loss of valuable intellectual capital
• and can damage the morale of remaining employees.

It can also be expensive:

• recruitment costs,
• time
• and money,

and every time a new recruit is taken on, there is the risk that the employee is not right for the role or the organisation.

Question 39

People risk:

Adverse selection

Answer 39

The risk that the demand for insurance is possitevly correlated with the risk of loss.

Question 40

Why does adverse selection arise

Answer 40

it arises as a result of asymmetry of information and the inability to differentiate risks when pricing.

Question 41

Moral hazard

Answer 41

The risk that policyholder behaviour will depend on the level of their exposure to a particular risk.

Question 42

Agency risk

Answer 42

The risk that one party appointed to act on behalf of another will instead act on its own behalf.

E.g. Company managers acting for themselves rather than the shareholders whose interests they are supposed to protect.
E.g. In banks, bonus systems might create perverse incentives for traders - eg if good results can give unlimited bonus potential, but the downside from poor results is limited, this can create an incentive for traders to take on too much risk.

Question 43

Legal risk

Answer 43

The risk arising from poorly drafted legal documents within an organisation.

Question 44

Process risk

Answer 44

The risk inherent in the processes used by firms.

Question 45

Model risk

Answer 45

The risk that financial models used to assess risk, to determine trades, or otherwise to help make financial decisions are flawed.
The flaws may be in the structure of a model, which may be overly simplistic or otherwise unrealistic, or it can be in the choice of parameters used for an otherwise sound model.

It may also relate to the incorrect translation of a model from theory into code.
Also occurs if models are put to uses other than those for which they were intended.

Question 46

Reputational risk

Answer 46

The risk that arises from other operational risks that result in a loss of confidence in an organisation due to reputational damage.

Question 47

Project risk

Answer 47

An umbrella term covering all of the various operational risks in the context of a particular project.

Question 48

The most basic Strategic risk

Answer 48

The risk that no coherent strategy for future development exists.

Question 49

Residual risks

Answer 49

Those risks that remain once any action has been taken to treat the risks.