Module 25: Assessment of other risks Flashcards

1
Q

Why are quantitative techniques not usually practical when assessing liquidity risk?

A

Due to lack of historical data on liquidity crises and the uniqueness of every organisation’s exposure to liquidity risk, quantitative techniques are usually not practical.

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2
Q

The main methods of assessing liquidity risk: (2)

A
  • scenario analysis - examining when and why expected cash outflows might exceed inflows, considering both short- and long-term scenarios
  • stress testing - examining the effect on liquidity of an extreme event or change in a key assumption
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3
Q

(Assessing liquidity risk)

Cash inflows include: (3)

A
  • reasonably predictable revenues / income generated by assets
  • proceeds from the sale of assets - may be highly uncertain (eg on forced sales)
  • drawings upon sources of liquidity, eg raising capital
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4
Q

2 measures of liquidity risk under Basel III

A
  • Liquidity Coverage Ratio (LCR) - designed to ensure that banks can survive a one-month stress scenario.

• Net Stable Funding Ratio (NSFR) - designed to consider funding over a one-year time horizon.

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5
Q

Demographic risk can be broken down into:

A

• level risk (or underwriting risk)
the risk that claims incidence and intensity is not as expected over the short-term, eg due to poor underwriting.

• reserving risk, which includes:

  • – volatility risk, due to stochastic uncertainty in the experience of sub-populations
  • – catastrophe risk - assumed to be downside only
  • – trend risk (or cycle risk), due to exposure to potential longer-term changes in claims incidence and intensity.
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6
Q

How might level risk be assessed?

A

Level risk may be assessed by combining both experience rating (determining the initial or central mortality rate) and risk rating (eg using GLMs)

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7
Q

How can volatility risk be modelled?

A

Probabilistically or stochastically assuming some underlying statistical process.
As volatility risk varies by age, models are generally fitted by Poisson maximum likelihood estimation.

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8
Q

High can catastrophe risk be modelled?

A

Catastrophe risk may be modelled by scenario analysis (considering sudden temporary increases in mortality) and capturing more complex dependencies using copulas.

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9
Q

Non-life demographic risk can be broken down into: (2)

A
  • level risk

- reserving risk

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10
Q

Modelling non-life insurance risks involves some different complexities than demographic risks, including: (3)

A
  • the intensity of claims also needs to be modelled - having greater uncertainty
  • the possibility of more than one claim per policy
  • the potential for each policy to move through (many) different states over its lifetime
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11
Q

Define liquidity risk

A

Refers to a company not having sufficient short-term or cash-type assets to fund its short-term obligations.

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12
Q

Funding liquidity risk

A

The risk of money markets not being able to supply funding to a business when required.

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13
Q

Market liquidity risk

A

The lack of capacity in the market to handle asset transactions at the time when the deal is required (without a material impact on price).

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14
Q

Outline why prediction cash outflows is particularly problematic for banks

A

Much of a bank’s liabilities will be in the form of deposits from customers who may withdraw their money with little or no notice.

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15
Q

Liquidity analysis:

Describe 7 specific scenarios that should be considered

A
  1. rising interest rates - eg a bank may find depositors transfer funds elsewhere in search of higher returns.
  2. ratings downgrade - eg a bank may find depositors transfer funds to a more secure institutions.
  3. large operational loss - resulting in a sudden reduction in cash-like assets.
  4. large single insurance claim or a large set of claims from associated events - resulting in a sudden reduction of cash assets.
  5. loss of control over a key distribution channel - resulting in a loss of expected revenues
  6. impaired capital markets - equity investors or bondholders may be unable or be unwilling to provide fresh capital when required
  7. sudden termination of a large reinsurance contract - leaving an insurer exposed to large cash outflows, but without expected inflows from the reinsurance contract.
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16
Q

Define level risk

A

The risk that the particular underlying population’s claims incidence and intensity is not as expected over the immediate (short-term) future, eg due to shortcomings in the underwriting process.

17
Q

Define Volatility risk

A

Uncertainty with regard to the actual future immediate (short-term) mortality experience.

This arises due to only having a finite pool of policies.

As a consequence, it is not possible to measure precisely the past underlying rates of the underlying population and, going forward, the experience of sub-populations will exhibit statistical variations from that of the underlying population.

18
Q

Define catastrophe risk

A

An extreme form of volatility risk, eg the occurrence of a natural disaster resulting in a large number of deaths.

19
Q

Define trend risk

A

The risk of future (longer-term) changes in claims incidence and intensity.

20
Q

2 Distinct ways to determine the current underlying level of mortality

A
  1. experience rating
  2. risk rating

They may be combined by using credibility weightings.

21
Q

Experience rating

A

Involves examining the number of deaths in a portfolio of lives to determine the initial mortality rate or central mortality rate.

22
Q

Risk rating

A

Involves modelling the mortality rate (the response variable) of each homogeneous group as a function of the shared characteristics of the members (called covariates).

The model might take the form of a generalised linear model.

23
Q

Discuss 2 characteristics of the data upon which both experience and risk rating methods rely

A

Both rating methods rely on the data being:

  • divided into homogeneous groups (eg male/female, employee type). There is a trade-off between the number of groups and ensuring the sample size in each is sufficiently large.
  • collected over a period which is sufficiently long to generate adequate data, but not so long that the mortality rates could have varied greatly.
24
Q

How might volatility risk be modelled

A

Either probabilistically or stochastically, assuming some underlying statistical process,

eg a binomial or Poisson distribution.

25
Q

3 Stages of the Poisson Maximum Likelihood Estimation process

A
  1. Calculate the expected number of deaths at each age (a function of the parameters)
    using the model to be fitted,
    and set this equal to the mean of a Poisson distribution.
  2. Calculate the probability of the observed number of deaths at each age, based on the Poisson distribution derived above.
  3. The fitted parameters are then obtained by maximising the likelihood function, ie the product of the probabilities (for all ages) that were determined in the preceding step.
26
Q

Discuss how trend or cycle risk for non-life insurance differs from demographic risks

A

More likely to correspond with the economic cycle (than for demographic risk), and so is best assessed using scenario analysis.

However, generally, non-life insurance risks have a shorter period of exposure than life insurance risks so longer term changes in risk factors are less important than a correct assessment of the risk factors themselves.