Chp 39-43

Question 1

1) Descriptions and examples of a) Credit risk

Answer 1

a) Credit risk – failure of third parties to repay debts
i) Examples - issuer of corporate bond defaulting in interest or capital payments, change in credit rating of a corporation, counterparty risk where one party to a transaction fails to meet their side of the bargain, purchaser of goods and services fails to pay

Question 2

1) Descriptions and examples of b) Market risk

Answer 2

b) Market risk – risks related to changes in investment market values or other features correlated with investment markets such as interest and inflation rates, this can be divided into consequences of changes on asset values/consequence of investment market value changes on liabilities/consequences of provider not matching asset and liability cashflows

Question 3

1) Descriptions and examples of c) Liquidity risk

Answer 3

c) Liquidity risk – measure of how long it will take for an asset to become cash (marketability risk is how easy it is to convert an asset into cash, the amount of cash received is unimportant)

Question 4

1) Descriptions and examples of d) Business risk

Answer 4

d) Business risk – specific to businesses undertaken, differs from operational risk in that latter are non-financial risks events that have financial consequences
i) Examples – inadequate underwriting standards, more claims than anticipated, investing in project that fails to be successful, reinsurer having greater exposure than planned to particular risk, competitor launching a new product in the week before your similar product launch

Question 5

1) Descriptions and examples of e) Operational risk

Answer 5

e) Operational risk – risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, e.g. dominance of single individual over running of business, reliance on third parties to carry out various functions

Question 6

1) Descriptions and examples of f) External risk

Answer 6

f) External risk – arises from external events such as storm, fire, flood, or terrorist attack

Question 7

5) Risks and uncertainties in benefit schemes (split these DB&DC) a) Benefit risks

Answer 7

higher than expected, or payments required at inopportune time, benefit although sufficient not meeting member’s needs

Question 8

5) Risks and uncertainties in benefit schemes (split these DB&DC) b) Contribution risks

Answer 8

where member defaults on contributions, or contribution level insufficient to provide defined level of benefits

Question 9

5) Risks and uncertainties in benefit schemes (split these DB&DC) c) Investment risks

Answer 9

lower investment return than anticipated, tax, regulation, investment not matching to the liabilities, reinvestment risk

Question 10

5) Risks and uncertainties in benefit schemes (split these DB&DC) d) Sponsor management risks

Answer 10

d) Sponsor management risks – fraud/misappropriation, incorrect benefit payments
e) Inappropriate advice risks

Question 11

5) Risks and uncertainties in benefit schemes (split these DB&DC) e) Inappropriate advice risks

Answer 11

e) Inappropriate advice risks
i) Incompetence or insufficient experience of advisor
ii) Lack of integrity of adviser, perhaps due to sales-related payments
iii) Use of unsuitable model or parameters
iv) Errors in the data relating to the beneficiaries
v) State-encouraged but inappropriate actions
vi) Overcomplicated products

Question 12

5) Risks and uncertainties in benefit schemes (split these DB&DC) f) Operational risks

Answer 12

f) Operational risks – incorrect benefit payments, administrative costs especially as results of compliance with changes in legislation

Question 13

6) Criteria for a risk to be insurable

Answer 13

Large numbers of potentially similar risks should be pooled in order to reduce the variance and hence achieve more certainty
Amount payable by insurance policy in event of claim must bear some relationship to financial loss incurred
Moral hazards should be eliminated as far as possible
Policyholder must have interest in the risk being insured

There should be ultimate limit on liability undertaken by insurer
Individual risk events should be independent of each other
Probability of event should be relatively small

There should be sufficient existing statistical data/information to enable insurer to estimate extent of risk and its likelihood of occurrence
Risk must be of a financial and reasonably quantifiable in nature

Question 14

7) Stages of the risk management process a) Identify risks

Answer 14

those that threat income and assets of organisation, incorporate both financial and non-financial, evaluate all strategies while considering all relevant political/social/regulatory/competitive constraints

Question 15

7) Stages of the risk management process b) Measure and assess the impact of each risks

Answer 15

probability of risk occurring and its likely severity, exploit hedges and portfolio effects among risks

Question 16

7) Stages of the risk management process c) Financing the risks

Answer 16

determine likely cost of risk and ensure adequate financial resources are available

Question 17

7) Stages of the risk management process d) Adoption of control measures

Answer 17

limit financial consequences of risk, severity of effects of risk that does occur, reducing consequences of risk that does occur

Question 18

7) Stages of the risk management process e) Monitoring the risk portfolio

Answer 18

regular review and reassessment of all risks previously identified, identify new risks or previously omitted risks

Question 19

8) Distinction between systemic and diversifiable risks and how this classification can depend on the context

Answer 19

a) Systemic risk – risk that affects entire financial market or system, not possible to avoid through diversification
b) Diversifiable risk – risks specific to individual organisation, possible to avoid through diversification

Question 20

9) Key aims of risk management

Answer 20

Better management and allocation of capital
Avoid surprises
Identify opportunities arising from risk arbitrage
Natural synergies (identify opportunities)

Stability and quality of business (improve)
Exploit risk opportunity (improve growth and returns)
Confidence (business)

Question 21

11) How risks with low likelihood but high impact might be managed

Answer 21

a) Diversified away in a limited way – e.g. production of major product line on two sites
b) Can be passes to insurer or reinsurer – e.g. catastrophe insurance or stop loss cover
c) Can be mitigated by management control procedures such as disaster recovery planning

Question 22

12) Descriptions of scenario analysis in evaluating risks

Answer 22

a) Scenario analysis
i) Group risk exposure into broad categories
ii) For each group of risks, plausible adverse scenario is developed
iii) For each scenario, consequences of risk event occurring for each risk group are calculated
iv) Total costs calculated are taken as financial cost of all risks represented by the chosen scenario

Question 23

12) Descriptions of stress testing in evaluating risks

Answer 23

b) Stress testing – risks incurred by extreme market events
i) Subject business to extreme market moves by radically changing underlying assumptions
ii) Identify weak areas in portfolio and gauge impact of major market turmoil

Question 24

12) Descriptions of stochastic models in evaluating risks

Answer 24

c) Stochastic modelling
i) Extension to stress testing
ii) Full set of dynamic interactions between variables need to be specified
iii) Model can then determine capital necessary to avoid ruin at any desired probability level