Mod 03: Risk taxonomy

Question 1

Define risk taxonomy
(ActEd 39)

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Answer 1

Risk taxonomy
A risk taxonomy is a full list, description and categorisation of all risks that an organisation might face.

(ActEd 40)

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Question 2

Distinguish between risk and uncertainty
(ActEd 41)

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Answer 2

Risk vs uncertainty
The words risk and uncertainty are often used interchangeably in everyday language. However, we may distinguish between them as follows:

Risk
A situation where the actual outcome may be different to the expected outcome
Outcomes known or can be estimated
Risk can often be modelled
Risk can often be managed
Often a choice as to whether to face a risk

Uncertainty
A situation where there is a lack of certainty or knowledge over outcomes
Outcomes are unknown
Uncertainty cannot be modelled
Uncertainty cannot be managed
May not be choice as to whether to face uncertainty

(ActEd 42)

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Question 3

Outline Lam’s seven risk concepts
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Answer 3

Lam’s seven risk concepts

1) exposure – maximum loss if event occurs
2) volatility – variability of possible outcomes
3) probability – likelihood of event
4) severity – likely loss if event occurs, < exposure
5) time horizon – of exposure to risk, or to recover
6) correlation – degree to which risks behave similarly in response to common events
7) capital – money set aside to cover unexpected losses, support business strategy and develop new products / write new business

(ActEd 44)

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Question 4

Outline the risks that may be included in a basic risk taxonomy for an insurance company

(ActEd 45)

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Answer 4

Risks in a basic risk taxonomy
A common, basic risk taxonomy is made up of five risk types:
1) market risk – risks arising from changes in market values
2) liquidity risk – risks associated with funding or cashflow requirements
3) credit (or default or counterparty) risk – the risk of failure of a third party to meet contractual obligations in a timely way
4) operational risk – the risk of loss resulting from deficient internal processes, people or systems or loss due to external events
5) underwriting / insurance risk – the risk of accepting risks which turn out to be inappropriate or pricing accepted risks inappropriately.

Market, liquidity and credit risks are commonly described grouped under the umbrella category of financial risks.

(ActEd 46)

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Question 5

Define market risk
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Answer 5

Market risk
The risks arising from changes in investment market values or other features correlated with investment markets, such as interest and inflation rates. This would include the consequence of investment market value changes on liabilities and may also include the consequence of mismatching asset and liability cashflows.

The term ‘market risk’ may also be used to refer to the risk of lower sales or profit margins resulting from changes in market conditions, where ‘market’ is interpreted as the market into which the products or services of that entity are sold.

(ActEd 48)

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Question 6

Describe types of market risk associated with changes in values of assets and/or liabilities

(ActEd 49)

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Answer 6

Market risk

Type

Trading risk
Asset / liability mismatch
Liquidity risk

Cause
Trading risk
 changes in prices (equity, commodity) or rates (interest, exchange)
 basis risk

Asset / liability mismatch
 unmatched interest rate sensitivity of assets and liabilities
 foreign exchange risk
 basis risk

Liquidity risk
 inability to fund obligations without sizeable losses
 insufficient market capacity leading to adverse impact on market price when deal required

Characterisation: Mismatch risk takes longer to close out than for interest rate trading risk and can be hedged more frequently than the other two types of risk.

(ActEd 50)

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Question 7

Describe economic risk
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Answer 7

Economic risk
The risks arising from the impact of macroeconomic factors on an organisation and/or its customers. Examples are inflation risks and changes in demand.

(ActEd 52)

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Question 8

Define interest rate risk
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Answer 8

Interest rate risk
Interest rate risk refers to risks arising from changes in interest rates, which could include impact on customer behaviour as well as the financial impact.
It can be considered a subset of market risk, and can also be a component of economic risk.
(ActEd 54)

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Question 9

Describe foreign exchange risk
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Answer 9

Foreign exchange risk

Foreign exchange risk is risk arising due to exposure to movement in foreign exchange rates.

Foreign exchange (FX) risk can also be considered a subset of market risk, and a component of economic risk.

Under market risk, foreign exchange rate movements can affect:

1. foreign revenues and expenses as expressed in the home currency (transaction exposure)
2. prices of exported goods thereby affecting foreign sales (economic exposure)
3. consolidated accounts (translation exposure)
   (ActEd 56)

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Question 10

Describe basis risk
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Answer 10

Basis risk
The risk arising from differences in the movements of two comparable indices so that offsetting investments in a hedging strategy will not experience exactly offsetting movements.

For example, hedging a well-diversified portfolio using a FTSE futures contract exposes the investor to basis risk as the value of the portfolio will not move exactly in line with the index future contract.

(ActEd 58)

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Question 11

Describe credit / counterparty risk
(ActEd 59)

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Answer 11

Credit / counterparty risk
The risk of loss due to contractual obligations not being met (in terms of quantity, quality or timing) either in part or in full, whether due to inability of, or decision by, the counterparty.

Credit risk has two components:
 the probability of default
 the loss (or recovery) on default.

Many people (including Sweeting) consider the risk of changes in value of an asset due to changes in the credit spread (reflecting a change in actual or perceived creditworthiness) as a market risk.

(ActEd 60)

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Question 12

Define liquidity risk
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Answer 12

Liquidity risk
Liquidity risk can refer to:
1. the risk of money markets not being able to supply funding to businesses when required (funding liquidity risk)
2. or more broadly to the management of short term cashflow requirements
3. or an insufficient capacity in the market to handle asset transactions at the time when the deal is required and without a material impact on price (market liquidity risk).
(ActEd 62)

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Question 13

Define insurance risk and underwriting risk
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Answer 13

Insurance risk and underwriting risk

Typically, insurance risk relates to deviations in the timing, frequency and severity of insured events from those expected at underwriting. Underwriting risk, on the other hand, relates to the possible errors in the selection, approval or pricing of insurance risks. This is sometimes referred to (eg by Lam) as actuarial risk.

Insurance risk might be broken into various components such as:
1. demographic risks, eg mortality, morbidity, % married
2. non-life insurance risks, eg property, casualty
3. other risks, eg persistency and expense
Similarly, demographic and non-life insurance risks can be sub-divided into:
1. level (or underwriting) risks – underlying claims incidence (and intensity) is not as expected
2. reserving risk, eg volatility, catastrophe, trend or cycle.
(ActEd 64)

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Question 14

Define operational risk
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Answer 14

Operational risk
Operational risk is the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events.
The Basel definition, adds: ‘This definition includes legal risk, but excludes strategic and reputational risk.’

Possible components of operational risk include:
1. strategic risk
2. crime risk
3. regulatory (or compliance) risk
4. project risk.
5. process risk, people risk, systems / technology / cyber risks event risk
(ActEd 66)

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Question 15

Describe legal risk
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Answer 15

Legal risk
Legal risk is risk arising from the understanding of and adherence to legislation, including changes in accepted interpretation.
Adherence also encompasses the need to be able to demonstrate compliance.
Three specific legal risks are:

1. impact of new legislation or changes in legislation
2. problems arising from important contracts’ provisions
3. risks of adverse court judgements.

(ActEd 68)

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Question 16

Outline political risk
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Answer 16

Political risk
Political risk encompasses a wide range of risks, including those related to political decisions (both social and fiscal) or indecision, changes in government, or events related to political instability including terrorism and wars.
Political risks might arise at various levels:
1. micro level – affecting specific firms, sectors, regions etc
2. macro (national) level – eg nationalisation of an industry
3. macro (international) level – eg conflicting actions of different governments on an organisation operating across many countries, perhaps involving a complex system of tariffs and quotas.

(ActEd 70)

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Question 17

Define agency risk
(ActEd 71)

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Answer 17

Agency risk
Agency risk is the risk resulting from the misalignment of interests between different stakeholders.
The term is sometimes used to refer to the specific risk that the management of an organisation will not act in the best interests of other stakeholders.

(ActEd 72)

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Question 18

Define reputational risk
(ActEd 73)

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Answer 18

Reputational risk
Reputational risk is the risk that events or circumstances could have an adverse impact on an organisation’s reputation or brand value.

(ActEd 74)

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Question 19

Define strategic risk
(ActEd 75)

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Answer 19

Strategic risk
Strategic risk relates to the achievement of an organisation’s overall strategic business plans and objectives.
Strategic risk covers all those operational risks that might prevent an organisation meeting its objectives.
(ActEd 76)

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Question 20

Describe moral hazard risk
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Answer 20

Moral hazard risk
Moral hazard refers to the action of a party who behaves differently to that if they were fully exposed to the consequences of that action. The party behaves inappropriately or less carefully than they would otherwise, leaving the organisation to bear some of the consequences of the action.
For example, a bank may perform fewer credit checks if it is securitising the loan portfolio.
Moral hazard is related to information asymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.
Moral hazard may be categorised as a people (operational) risk.
(ActEd 78)

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Question 21

Describe conduct risk
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Answer 21

Conduct risk
The phrase conduct risk is sometimes used to encompass those risks that relate directly to the relationship between a company and its customers.
It can therefore encompass elements such as:
1. operational failures (eg poor control of distribution and/or servicing)
2. information asymmetries
3. keeping pace with regulatory requirements and customer needs
4. market conditions
5. product development activities
6. strategic objectives.

(ActEd 80)

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Question 22

Describe environmental risk
(ActEd 81)

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Answer 22

Environmental risk

Environmental risk covers risks relating to the natural environment and human interactions with it. Drivers range from natural disasters and climate change to pollution and the impact of declining natural resources.

Environmental risk relates to:
1. resources, eg regulation on use, depletion and associated increased costs
2. pollution, eg consequences of non-control, emissions quotas.

The consequences associated with non-control of pollution include fines, reputational damage, business interruption, and the effects of global warming.

A particular concern is the longer-term impact on economic growth.
(ActEd 82)

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Question 23

Describe social risk
(ActEd 83)

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Answer 23

Social risk
Social risk arises due to uncertainty over the future characteristics of a population, such as:
1. age profile
2. educational and health standards
3. economic wealth
4. attitudes and lifestyles.
(ActEd 84)

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Question 24

Describe the various types of risk that might be described as market risks
(ActEd 85)

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Answer 24

Risks that may be classified as market risks
Market risk: just relating to stock market prices, or broader, eg to include interest rate risk? Interest rate risk may be both a market risk and an economic risk.
Market risk may also refer to the risk of lower sales due to conditions changing in the market into which products or services are sold.
Value changes of corporate bonds due to changes in the credit spread, normally deemed to be market risk, may be categorised as a credit risk.
(ActEd 86)

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Question 25

Describe other examples of inconsistent classifications
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Answer 25

Risks that may be alternatively classified
Business risk may be used to encompass all risks to which businesses are exposed or may be used to refer to that subset of risks which are specific to the type of business undertaken, such as insurance risks for insurance companies.

Demographic risk may be regarded as a component of insurance risk, an operational risk (employees) or a market risk (target market).

Government may act (political risk) to devalue the currency (economic risk).

Agency risk may be classified as an operational (people) risk.

Reputational and strategic risks may (Sweeting) or may not (Basel II) be regarded as operational risks.

Insurance and underwriting risks may be used synonymously.

Crime risks might alternatively be categorised according to the nature of the crime.

(ActEd 88)

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Question 26

Describe systematic risk, systemic risk and non-systematic (or specific) risks
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Answer 26

Systematic risk, systemic risk and specific risks

Systematic risk is risk that is not diversifiable, or which cannot be fully diversified because it affects a large number of quantities of interest.

Systemic risk can be used to mean the same thing but is often used more specifically to refer to the risk of problems spreading between entities following a trigger event. In SP9, this spreading of problems from one organisation to another is also called contagion risk.

Non-systematic (or specific) risks are risk factors that are uncorrelated with or possibly independent from other sources of risk. Such risks are largely diversifiable.

Examples: Industry-specific risks are systematic as the limited number of sectors prevents complete diversification. Returns on individual shares comprise: a systematic market return, a systematic industry return, and a non-systematic individual company return (or alpha).

(ActEd 90)

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Question 27

Describe contagion risk
(ActEd 91)

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Answer 27

Contagion risk
Financial contagion refers to situations where financial losses in one company or sector or country lead to losses in another. Market wide contagion risks can destabilise whole sectors, particularly financial institutions, eg:

1. there may be issues of reputation and confidence whereby events can quickly escalate out of control, eg run on a bank (Northern Rock)
   2.the default of one organisation can cause its creditors and suppliers to experience financial difficulties resulting in a chain reaction
2. imperfect information about the scale and location of losses can cause financial market participants to reduce the amount of credit available in the system, in turn increasing the likelihood of further (bank) failure, eg Eurozone crisis

4.many investors may use the same flawed logic, eg Quant Fund crisis
(ActEd 92)

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Question 28

Describe risk concentration
(ActEd 93)

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Answer 28

Risk concentration
Concentration of risk can be described as ‘putting all your eggs in one basket’; that is, relying upon the success of one course of action which, if it fails, leave no alternative.

Concentration of risk may be the result of not being able to diversify (and therefore reduce) risk. Alternatively, it might reflect a deliberate decision, for example based on high expected returns for a specific asset or product. However, it might simply reflect poor risk management.

(ActEd 94)

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