Module 26: Risk optimisation and risk responses Flashcards
Risk management can optimise the risk / return profile of the organisation, with respect to its risk appetite, by: (4)
- 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
5 fundamental concepts in risk portfolio management
- risk
- reward
- diversification
- leverage
- hedging
2 Measures of return that reflect the risk taken to achieve the return
- 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
Mean variance portfolio theory (MVPT): (3)
- 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.
Applying MVPT principles: (4)
- 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.
4 Key types of risk response
- rejection (avoidance / removal)
- acceptance (retention)
- transfer
- management (treatment / reduction without transfer)
Good risk responses are: (6)
- 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
Risk can be transferred to: (2)
- to another part of the same organisation
- to another party, eg
— insurance,
— sharing with the policyholder,
— ART,
— outsourcing
5 Considerations when transferring risk include:
- cost
- loss of upside potential
- counterparty risk
- regulatory restrictions
- market capacity
Risks can be reduced without transfer by: (8)
- 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
Risks may be accepted by an organisation if they are: (3)
- a core component of its core business
- it appears to be the most economical approach
- there is no alternative
Residual risks result from: (4)
- decisions to retain risks
- secondary risks
- imperfect hedges
- an inability to transfer or fully mitigate risks
ART
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).
What are the benefits of ART?
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.
Expand on how risk management can:
support selective growth of the business
- 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.