Mod 26: Risk optimisation and risk responses Flashcards
Outline how risk management can optimise the risk / return profile of an organisation
How risk management can optimise risk / return
1. supporting selective growth of the business −eg processes for assessing new business opportunities and allocation of capital and other resources
2. supporting profitability through risk-adjusted pricing −eg pricing to reflect the cost of risk (capital)
3. using limit setting to control the size and probability of potential losses −
eg basic exposure limits, stop loss limits, sensitivity limits
4. employing techniques to manage existing risks −
eg active portfolio management, duration matching, transferring risks to a third party, eg using insurance or derivatives
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State:
1. the objective of risk portfolio management
2. five fundamental concepts of portfolio management ©
Fundamental concepts of portfolio management
The objective of risk portfolio management is to optimise the balance between risk and return – where optimality is judged by reference to risk appetite.
1. Risk – typically expressed as the standard deviation of returns
2. Reward – usually expressed as the expected return on investment 3.Diversification – reducing overall risk by investing in many different projects or assets whose returns are not perfectly positively correlated
4.Leverage – borrowing money and investing it, thereby increasing the potential risk and return profile of the overall portfolio
5. Hedging – entering into an agreement that reduces risk, usually because the position taken is negatively correlated with the organisation’s existing position
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Describe the following two risk-return measures:
RAROC
Sharpe ratio ©
Risk-return measures
1. RAROC
risk adjusted return capital
can be calculated for an institution or for separate activities. The ratio is based on actual or expected return / capital.
2. The Sharpe ratio (SR) measures out-performance (in excess of the risk-free rate of return) per unit of risk taken (volatility). It is often used to compare investment managers who have taken differing levels of risk.
State and define key concepts in mean-variance (or modern) portfolio theory and how it applies to ERM
Portfolio theory can be extended to any portfolio of risks (eg an organisation’s projects).
Portfolios that give the highest return for a given level of risk, or the lowest risk for a given level of return, are said to sit on the efficient frontier. To identify which of the set of efficient portfolios an investor will choose we need to know the investor’s risk appetite, or equivalently the investor’s utility function.
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Explain briefly what is meant by the separation theorem
Separation theorem
The fact that the optimal combination of risky assets for an investor can be determined without any knowledge of their preferences towards risk and return (or their liabilities) is often known as the separation theorem
Outline arguments as to why active portfolio management is useful in ERM
Why active portfolio management is useful in ERM
Although there is little evidence that active portfolio management results in higher sustainable risk-adjusted returns, when managing an organisation’s portfolio of risk there is no appropriate (project) index to track and so passive management is not an option.
Applying portfolio theory principles is an attempt to determine a mix of projects that maximises return for a given level of risk, which:
1. encourages ‘unbundling’ of a business into its component projects
2. provides a mechanism for aggregating risks across the organisation
3. provides a framework in which risk concentration limits and asset allocation targets can be set
4. influences decisions regarding investment, transfer pricing and capital allocation.
List the four main types of risk responses ©
Risk responses
1. avoidance (risk removal / rejection)
2. acceptance (risk retention)
3.transfer (risk transfer)
4. management (risk reduction without transfer
State key steps in a process to develop risk responses
Steps in a process to develop risk responses
1. conduct research about possible responses and their costs
2. determine a response for each risk
3. set a deadline for implementing each response
4. assign a risk manager responsible for response implementation
5. consider whether secondary risks might emerge and what the residual risks are
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List the features of a good risk response
Features of a good risk response
1. economical – the response should cost no more than the reduction in risk
2. well matched to the risk – to avoid introducing basis risk
3. simple – to avoid making mistakes in executing the response
4. active – the response should not ideally simply inform, but also instigate action
5. flexible and dynamic – reacting to changing circumstances ©
State different ways in which risks can be transferred (ie reassigned or deflected)
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Different ways risks can be transferred
1. to another part of the same organisation
2. to another party via, eg:
a. insurance − − − − − − − −
b. reinsurance
c. co-insurance
d. sharing the risk with a policyholder via product design (eg excess or co-payment)
e. securitisation – packaging risk into a marketable investment
f. purchase of some forms of derivative
g. alternative risk transfer (ART) products – combine features of derivatives and insurance
h.outsourcing
i. policy excess or co-payment
Outline the factors that should be considered when selecting whether to transfer risk and between risk transfer options
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Considerations when transferring risk
1. cost effectiveness – the cost over and above the expected loss represents the reward that the counterparty requires in order to accept that risk, and potentially also to contribute to their own profit
2. loss of upside potential – or the additional cost of preserving some or all of the upside
3. capacity of the ‘market’ to which risk is being transferred 4.counterparty risk
5. liquidity risk, eg reinsurer settlement delay, margin calls on derivatives
6. regulatory restrictions, eg maximum permissible amounts to transfer, extent of impact on solvency capital requirements
7.internal restrictions, eg limiting contract terms and conditions, expertise, risk appetite
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State different ways in which the likelihood and/or impact of risks can be reduced without transfer (ie managed or mitigated
Different ways risks can be reduced without transfer
1. taking on uncorrelated (or negatively correlated) risks
2. increasing the size of a portfolio reduces random fluctuation risk
3. hedging (negative correlation)
4. greater matching of assets and liabilities can reduce actuarial risk 5. implementation of strong internal controls and governance
6. robust underwriting practices, analysis using appropriate homogenous groupings and taking into account both past and likely future trends
7. robust due diligence practices, and tightly worded agreements
8. increased capital or funding
Although such methods generally avoid the introduction of additional counterparty risk, there will be costs and reduced potential for upside.
State the factors that should be considered when contemplating risk removal, eg writing fewer ‘high risk’ products, or investing a lower proportion in ‘high risk’ assets
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Factors to consider when contemplating risk removal
- the cost of removing the risk
- the impact of removing the risk on the likelihood of the project meeting its original objective
- whether any opportunities will be lost as a result of removing the risk ©
State reasons that an organisation may choose to retain (ie absorb, accept or tolerate) a risk
Reasons an organisation may choose to retain a risk
1. If the risk is trivial
2. if the taking of that particular risk is a component of its core business
3. if it appears to be the most economical approach, ie if the cost of treatment is greater than the exposure to that risk
4. if it acts as a diversifier (or hedge) to another risk that is retained
5. if there is no alternative – there may be no-one to transfer the risk to (at an acceptable cost), or the risk may uninsurable
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Describe the main sources of residual risks ©
Sources of residual risks
1. decision made to retain them (eg an insurance excess)
2. result of a risk response action, ie secondary risks (eg counterparty risk)
3. result of an imperfect hedge – ie basis risk ©
