Module 26: Risk optimisation and risk responses Flashcards
1
Q
Risk management can optimise the risk / return profile of the organisation, with respect to its risk appetite, by: (4)
A
- supporting selective growth of the business
- supporting profitability through risk-adjusted pricing
- using limit setting to control the size and probability of potential losses
- employing techniques to manage existing risk
2
Q
5 fundamental concepts in risk portfolio management
A
- risk
- reward
- diversification
- leverage
- hedging
3
Q
2 Measures of return that reflect the risk taken to achieve the return
A
- RAROC - can be based on actual or expected return and capital
- the Sharpe ratio - a measure of out-performance compared to the riskiness of the portfolio
4
Q
Mean variance portfolio theory (MVPT): (3)
A
- can be extended to any portfolio of risks, eg an organisation’s projects
- states that optimal combinations of risky assets can be determined without any knowledge of the investor’s preferences towards risk and return (the separation theorem)
- states that the investors’ choice from the set of efficient portfolios will be determined by their risk appetite or, equivalently, their utility function.
5
Q
Applying MVPT principles: (4)
A
- encourages companies to “unbundle” the business into component projects
- provides a mechanism for aggregating risks across the business
- provides a framework in which risk concentration limits and asset allocation targets can be set
- influence investment, transfer pricing and capital allocation decisions.
6
Q
4 Key types of risk response
A
- rejection (avoidance / removal)
- acceptance (retention)
- transfer
- management (treatment / reduction without transfer)
7
Q
Good risk responses are: (6)
A
- economical
the cost of implementation should not exceed the reduction in risk. - well matched to the risk
to avoid introducing basis risk - simple
to avoid making mistakes in executing the response - active
the response should not simply inform, but also investigate action - flexible and dynamic
reacting to changing circumstances
8
Q
Risk can be transferred to: (2)
A
- to another part of the same organisation
- to another party, eg
— insurance,
— sharing with the policyholder,
— ART,
— outsourcing
9
Q
5 Considerations when transferring risk include:
A
- cost
- loss of upside potential
- counterparty risk
- regulatory restrictions
- market capacity
10
Q
Risks can be reduced without transfer by: (8)
A
- taking on uncorrelated (or negatively correlated) risks
- increasing the size of a portfolio
- greater matching of assets and liabilities
- implementation of strong internal controls and governance
- robust underwriting practices, analysis using appropriate homogeneous groupings and taking into account both past and likely future trends
- robust due diligence practices, and tightly worded agreements
- remuneration and bonus systems that align agents’ interests
- increased capital or funding
11
Q
Risks may be accepted by an organisation if they are: (3)
A
- a core component of its core business
- it appears to be the most economical approach
- there is no alternative
12
Q
Residual risks result from: (4)
A
- decisions to retain risks
- secondary risks
- imperfect hedges
- an inability to transfer or fully mitigate risks
13
Q
ART
A
ART products are non-traditional risk transfer products which often combine features of both (re)insurance products and financial risk protection products utilising the capital markets (eg derivatives).
14
Q
What are the benefits of ART?
A
D - Diversification E - Exploiting risk as an opportunity S - Solvency management C - Cheaper cover possibly A - Available cover, when reinsurance isn't R - Results smoother T - Tax advantages E - Effective risk management S - Security is greater
- improve the focus on the core business, and capital efficiency
- provide a quick and potentially more tailored solution, although more complex and bespoke arrangements can take time to develop
- reduce total costs, although they may involve higher initial costs
- stabilise earnings
- help establish a market price for risk
- simplify administration by reducing the number of risk transfer arrangements, although the use of ART could potentially increase operational risks, and changes may need to be made to methods of risk assessment and management to accommodate its use.
15
Q
Expand on how risk management can:
support selective growth of the business
A
- Establish a process for assessing new business opportunities. The process should include the assessment of risk adjusted return.
- Allocate capital and other resources to business units or activities with high risk-adjusted return.
16
Q
Expand on how risk management can:
support profitability through risk-adjusted pricing
A
- Prices should reflect the cost of risk (capital) in addition to funding costs and operational expenses.
- Net present value (NPV) and economic value added (EVA) do not fully reflect the cost of risk, usually being based on book values of capital.
17
Q
Expand on how risk management can:
use limit setting to control the size and probability of potential losses
A
- Set basic exposure limits - to provide absolute limits on exposure
- Set stop loss limits - limits on actual losses, which, if reached, trigger management action.
- Set sensitivity limits - limits designed to keep potential losses from potential extreme events within acceptable bounds. They are used to avoid excessive concentrations of risk.
18
Q
Expand on how risk management can:
employ techniques to manage existing risks
A
- Active portfolio management
In essence, a company comprises a portfolio of activities each with their own risk / return characteristics.
The overall risks of this “portfolio” can be assessed and managed in an analogous manner to those of a share portfolio of an active manager. - Reduce risk (eg by duration matching - investing in assets of similar duration to the liabilities so that interest rate risk is reduced).
- Transfer risks to a third party, eg using insurance or derivatives.
19
Q
Discuss why active portfolio management and duration matching are often used in preference to risk transfer strategies.
A
They often represent more cost-effective and longer term solutions.
However, risk transfer strategies tend to be quicker and easier to implement.
20
Q
Describe risk-adjusted return on capital (RAROC)
A
RAROC = risk-adjusted return / capital
RAROC can be calculated for an institution as a whole, or for separate activities.
The ratio can be based either on actual or expected return on capital.
21
Q
Describe the Sharpe ratio
A
Commonly used in the assessment of investment managers.
It measures out-performance (in excess of the risk-free rate of return) compared to the riskiness of the portfolio (as measured by the volatility).
It is often used to compare investment managers who have taken differing levels of risk.
SR = ( Rₚ - rᶠ ) / σₚ
Rₚ is the return on the portfolio
rᶠ is the risk-free rate of return over the period
σₚ is the standard deviation of the portfolio
22
Q
Return on risk-adjusted assets
A
RORAA = net income / risk-adjusted assets
23
Q
Risk-adjusted return on assets
A
RAROA = risk-adjusted return / assets
24
Q
Return on risk-adjusted capital (RORAC)
A
RORAC = net income / capital
or
RORAC = net income / VaR
25
Risk-adjusted return on risk-adjusted assets
RARORA = risk-adjusted return / risk-adjusted assets
26
Total risk on an asset can be divided into: (2)
1. specific risk
Risk to a particular company, which can be eliminated through diversification.
2. Systematic risk
The risk of being in the market, which cannot be diversified away.
27
The separation theorem
The fact that the optimal portfolio of risky assets for an investor can be determined without any knowledge of their preferences towards risk and return (of their liabilities).
28
Portfolio management
How might "unbundling" the business into its component projects aid optimisation of risk-reward?
"Unbundling" the business into its component projects:
- enables management to decide (separately) how to treat each project, eg retain it unchanged, increase / decrease invesmtnet in the project, transfer some of the risks, etc.
- may encourage companies to think about where they add value or can compete - then focusing on that risk area by transferring other risks to those who can manage them more efficiently.
29
Portfolio management
How might
"a mechanism for aggregating risks across the organisation"
aid optimisation of risk-reward?
A mechanism for aggregating risks across the organisation:
- is useful for more transparent reporting and information purposes
- enables transfer of some or all of these risks to a central team. This allows a specialist team to hedge or otherwise manage the risk. In addition, if the business units are charged a price for transferring the risk to the CRF / RMF (the transfer price), the risk-adjusted profitability of the units can be assessed.
30
Portfolio management
How might
"a framework in which concentration limits and asset allocation targets can be set"
aid optimisation of risk-reward?
A framework in which risk concentration limits and asset allocation targets can be set, can provide:
- risk concentration limits and asset allocation targets which operate together to achieve the organisation's desired risk/return profile
- risk concentration limits that impose a minimum level of diversification for the portfolio
- asset allocation targets which aim to ensure most emphasis or resource is allocated to the most promising opportunities / projects
31
Portfolio management
How might
"appropriate investment, transfer pricing and capital allocation decisions"
aid optimisation of risk-reward?
- An organisation can vary the price it charges a business unit to transfer a particular risk to the CRF / RMF, so influencing that business unit to expand / contract in that area.
- Having identified the risk/return characteristics of the organisation's projects, management can allocate most capital to those expected to deliver the highest risk-adjusted returns.
- The market value of an organisation is influenced not only by the products it is selling now, but the products that are "in the pipeline. These "pipeline products" represent options owned by the organisation.
- MPT highlights the importance of diversification as a means of reducing risk without necessarily reducing expected return. Therefore MPT encourages organisations to invest in their "pipeline products" as well as a range of products that are currently generating revenue.
32
Outline a 4-step process to develop risk responses
1. Conduct research about possible responses and their costs.
2. Determine a response for each risk, ensuring that a deadline for implementing the response is specified.
3. Assign a risk manager who is responsible for ensuring the response is implemented.
4. Consider whether secondary risks might emerge and what the residual risks are.
33
How might an insurer return some risk to a policyholder?
- policy excess
| - co-payment
34
3 Factors to be considered before removing a risk
- the cost of removing the risk
- the impact on 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
35
2 Broad categories of ART products
1. Vehicles based on capital market instruments.
| 2. Other unconventional vehicles used to cover conventional risks (eg non-capital market risk transfer)
36
Advantages of ART:
customisation and timing
- ART products are usually designed and/or customised to the organisation in question - enabling it to obtain the level and nature of cover it wants - eg multi-trigger policies to protect against specific concentrations of risk.
- Some ART products (eg cat-e-puts) can provide capital faster than more traditional approaches (eg rights issue), and at the precise time that it is most needed.
37
Advantages of ART:
cost reduction and simplified administration
- A multi-line policy generally costs less than buying a series of policies, each covering a single line. This is because any natural hedges or lack of correlation between lines can be recognised in the pricing of a multi-line product.
- By purchasing multi-line policies, an organisation can reduce the number of separate insurance contracts it required, reducing administrative costs.
- Tax-efficient methods can be employed, eg offshore captives.
- Pooling of risks can lead to cost savings due to diversification, eg risk retention groups.
38
4 Problems with ART
1. ART products may have higher initial costs than conventional products.
2. ART products are more complex than conventional products, increasing the time and cost of developing a solution for an organisation.
3. An organisation may need to change the way it assesses and manages risk in order to gain maximum benefit from ART.
4. Staff need to be educated about ART so that they can:
- - understand the products
- - assess any seller of ART products
- - appreciate the impact of regulations and accounting standards - multiple sets of standards may apply and so expert legal advice should be taken.
