Module 33: Principal terms Flashcards
Agency risk
Results from the misalignment of interests between different stakeholders.
Sometimes used to refer to the specific risk that the management of an organisation will not act in the best interests of other stakeholders.
Alternative Risk Transfer (ART)
ART is an umbrella term for non-traditional methods by which organisations can transfer risk to third parties.
Broadly these products combine traditional insurance and reinsurance protection with financial risk protection, often utilising the capital markets.
AS/NZS 4360
AS/NZS 4360 is a best practice Risk Management Standard published by Standards Australia, the leading non-government standards development body in Australia.
It has been widely adopted around the world.
Basel II
Basel II is an international capital adequacy framework for banking organisations which aimed to be more risk sensitive than the previous Basel I requirements.
It is based on a three-pillar approach and has been adopted by the EU and other countries.
Some aspects are likely to be strengthened under proposals for Basel III.
Basis risk
Basis risk is the risk arising from differences in the movements of two comparable indices, for example different stock market indices, so that offsetting investments in a hedging strategy will not experience exactly offsetting movements.
Chief Risk Officer (CRO)
Often reporting to the CEO or Chief Financial Officer, the CRO role has responsibility for overall leadership and development of ERM within an organisation.
Coefficient of tail dependence
This is a measure of the correlation between the tails of distributions. It is of relevance when considering the relationship between risks under extreme scenarios, which can differ from the relationship under normal conditions.
Coherent risk measure
A risk measure is said to be coherent if it satisfies a number of conditions which are deemed to represent a “good” measure of risk, particularly relating to its aggregation properties.
Concentration of risk
Concentration of risk occurs when it is not possible to (or it has been decided not to) diversify across a range of different exposures.
Contagion
Contagion is the knock-on effect arising when one risk event generates another.
Financial contagion is a situation where financial losses in one company or sector or country lead to losses in another.
Copula
A copula is used to describe the dependence structure within multivariate distributions.
Copulas can be used to enhance understanding of dependence between risk factors and to build multivariate models for risk management purposes.
Corporate governance
This is the system whereby Boards of directors, or governing bodies, are responsible for the governance of their organisations upon appointment by shareholders.
Correlation
Correlation is the degree to which statistical distributions (and so risks) are related to each other.
There are different types of measure of such dependence including
- linear correlation,
- rank correlation (which is concerned with the ordering of data rather than numerical values) and
- coefficients of tail dependence.
COSO ERM framework
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is a US private sector organisation which issues definitions and standards against which organisations can assess their internal control systems.
In 2004, it published its “Enterprise Risk Management - Integrated Framework” in order to encourage increased focus on ERM practices.
Counterparty risk
Counterparty risk is the risk that another party to a transaction or agreement fails to perform its contractual obligations, including failure to perform them in a timely manner.
Credit risk
Credit risk in its general sense is the risk that a counterparty to an agreement will be unable or unwilling to make the payments required under that agreement.
Some organisations define credit risk more narrowly as the risk that a borrower will partially or wholly default on repayment of debt (interest and/or capital payments), and it may also include risks relating to variations in credit spreads in the market.
Credit spread
This is a measure of the difference between the yield on a risky and a risk-free security, typically a corporate bond and a government bond respectively (although other reference assets may be used, eg swaps). It reflects the expected cost of default, a risk premium relating to the risk of default, and a liquidity premium.
3 Common measures of credit spread
- nominal spread
- static spread
- option-adjusted spread
Nominal (credit) spread
The difference between the gross redemption yields of risky and risk-free bonds.
Static (credit) spread
The addition to the risk-free rate at which discounted cash flows from a risky bond will equate to its price.
Option-adjusted (credit) spread
The option-adjusted spread further adjusts this discount rate through the use of stochastic modelling to allow for any options embedded in the bond.
Cyber risk
Cyber risk relates to the failure of information technology systems, typically where there is online activity and / or the storage of personal data, such as due to security breaches or targeted attacks.
Demographic risk
Demographic risk arises from demographic changes such as mortality rates, impacting both customers and employment. It can also be a component of insurance risk.
Derivatives
These are financial instruments of varying design, which are transacted with third parties and permit the hedging and transfer of market and/or credit risk.
Diversification
This is a method of reducing overall risk exposure to uncorrelated risks.
Dynamic hedging
This is the process of frequently rebalancing a hedging position in order to maintain the effectiveness of the hedge.
Economic capital
An organisation’s economic capital is an assessment of the capital required to cover its risks. It is the amount of capital that an organisation requires to cover its liabilities and obligations (or to remain solvent) under adverse outcomes, with a given degree of confidence and over a given time horizon.
Economic risk
Economic risk is the risk arising from the impact of macroeconomic factors on an organisation and/or its customers. Examples are inflation risks and changes in demand.
Economic value
The present value of all future shareholder profits, determined on a realistic economic basis. It is also known as “shareholder value” or “embedded value”.
Economic value added
If expressed as a percentage, this is the difference between the increase in economic value (expressed as a return on capital) and the weighted average cost of capital.
Efficient frontier
An efficient portfolio is one for which it is not possible to increase the expected return without accepting more risk and not possible to reduce the risk without accepting a lower return.
The efficient frontier is the line joining all efficient portfolios in risk-return space.
In portfolio theory, risk is defined as variance or standard deviation of return.
Emerging risk
An emerging risk can represent either a change in nature of (or in the underlying effectiveness of risk management approaches to) an existing or known risk, or the development of a new risk - ie a risk for which there has been no explicit allowance already made within the existing risk management framework.
Generally, such risks are characterised by a much higher level of uncertainty.
Enterprise risk management
ERM is a holistic risk management process which considers the risks of the enterprise as a whole, rather than considering individual risks and business units in isolation.
Environmental risk
This covers risks relating to the natural environment and human interactions with it. It therefore includes a wide range of drivers, from natural disasters and climate change to pollution and the impact of declining natural resources.
Expected shortfall
Expected shortfall at a given confidence level x% (and given time horizon) is the expected loss over the worst (1 - x%) of possible outcomes, allowing for the probability of loss.
It is closely related to TVaR.
Exposure
The state of being subject to the possibility of loss, or the maximum amount of loss that would be suffered under a risk if that event occurred.
Extreme value theory
This is a statistical methodology for dealing with low probability but potentially high severity events.
Foreign exchange risk
Foreign exchange risk is risk arising due to exposure to movement in foreign exchange rates.
Hedging
This is a strategy designed to minimise exposure to given risks (particularly market risk), for example by taking an equal but opposite position or by using derivatives. Hedging may or may not remove the potential to benefit from upside, depending on its design.
Insurance risk
Insurance risk arises from fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting or pricing.
This will include mortality, morbidity, property and casualty risks.
The definition can be extended to include persistency and expense risks.
Interest rate risk
Interest rate risk arises from changes in interest rates, which could include impact on customer behaviour as well as the financial impact.
ISO 31000
ISO 31000 is a global Risk Management Guidance Standard issued by the International Organization for Standardization. It provides generic guidelines for the principles underlying best practice risk management rather than dealing with specific risks or sectors.
Legal risk
Legal risk is risk arising from the understanding of and adherence to legislation, including changes in accepted interpretation.
Liquidity risk
Liquidity risk can refer to the risk of money markets not being able to supply funding to businesses when required, or more broadly to the management of short-term cashflow requirements.
Alternatively it may refer to an insufficient capacity in the market to handle asset transactions at the time when the deal is required (without a material impact on price).
Loss given default
Loss given default is the loss that occurs if a counterparty defaults on an agreement. For example, in relation to corporate bonds it enables determination of the residual value of the bond after the issuer has defaulted.
Market risk
Market risk is risk arising from changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.
Model risk
Model risk is risk arising from the use of an inappropriate or inaccurate model when assessing or managing risks. It may result in incorrect or suboptimal decisions being made.
Monte Carlo Simulation
Monte carlo simulation is a sampling or modelling technique which considers a large number of randomly generated scenarios.
Moral hazard
Moral hazard refers to the action of a party who behaves differently from the way they would behave 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.
Moral hazard is related to information aymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.
Operational risk
Operational risk is the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events.
Owh Risk and Solvency Assessment (ORSA)
The Own Risk and Solvency Assessment (ORSA) is part of the Solvency II framework, with similar versions having been introduced in other jurisdictions, including the USA.
The ORSA requires each insurer to identify all the risks to which it is exposed, to identify the risk management processes and controls in place, and to quantify its ongoing ability to continue to meet its solvency capital requirements.
Parameter risk
Parameter risk refers to the use of inappropriate or inaccurate parameters or assumptions within a model when assessing or managing risks, which may result in incorrect or suboptimal decisions being made.
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.
Probability of ruin
The probability that the net financial position of an organisation or line of business falls below zero over a defined time horizon.
Project risk
The risk of failure relating to a specific project undertaken by an organisation.
Regulatory risk
The risk of losses arising from changes in legislation or regulation.
Reinsurance
This is a risk transfer arrangement whereby one party (the reinsurer), in consideration for a premium, agrees to indemnify another party (the cedant) against part or all of the liability assumed by the cedant under one or more insurance policies, or under one or more reinsurance contracts. Reinsurance obtained by a reinsurer is known as retrocession.
Reputational risk
The risk that events or circumstances could have an adverse impact on an organisation’s reputation or brand value.
Residual risk
The risk that remains with the organisation following part or all of its risk management process. It may be due to a positive decision to retain that risk, or an inability to mitigate or transfer it. It may also be a secondary risk resulting from another risk response action.
Risk appetite
Risk appetite is the degree of risk that an organisation or individual is willing to accept in order to achieve objectives, both in terms of levels and types of risk.
Risk capacity
Risk capacity is the volume of risk that an organisation can take as measured by some consistent measure, such as economic capital.
Risk discount rate
The risk discount rate is the rate at which future uncertain cashflows are discounted. It typically arises when carrying out a discounted cashflow assessment of value of a project. It represents the risk-free rate of return that providers of capital demand plus an amount to allow for the risk that the profits may not emerge from the project as expected.
Risk limits
This refers to the limits on acceptable actions that might be taken by an organisation. It can be regarded as a component of risk capacity.
Risk management control cycle.
This is a systematic method of planning, managing, and reviewing an organisation’s business in the context of the risks undertaken by that organisation. The cyclical process involves analysis, quantification, management, monitoring and modification.
Risk matrix (or map)
These are tools used in the identification and initial assessment of risks, typically plotting severity against probability (or frequency).
Risk optimisation
The process of achieving the optimal balance between risk and return without any given portfolio. This should be carried out not just in relation to the characteristics of the portfolio but also the risk appetite of the investor.
Risk profile
This phrase is a complete description of the risk exposures of an organisation, including risks that might emerge in the future and that will affect the current business of the organisation.
Risk responses
These are the ways in which an organisation reacts to risk. The key responses to risk are: - avoidance, - acceptance, - transfer and - management.
Risk tolerance
This phrase may refer to a detailed set of statements, many being quantitative or statistical in nature, that describe how much risk the organisation is prepared to retain or how much variability it is prepared to withstand.
Sarbanes-Oxley
The Sarbanes-Oxley Act of 2002 is US legislation that was introduced following a number of high profile corporate scandals, including the collapse of Enron.
It introduced measures to improve the accuracy and reliability of corporate disclosures in order to improve investor protection.
Scenario analysis
Scenario analysis looks at oucomes under devised “what if” scenarios, normally measuring loss under several related stressed variables without considering the probability of occurrence of that scenario. Selection of appropriate and comprehensive scenarios often involves cross-discipline discussions.
Securitisation
A form of ART, securitisation packages risks into capital market instruments.
Severity
This is the amount of loss that is likely to be suffered under a risk if that event occurred.
Solvency II
Solvency II is the set of regulatory requirements that have applied to insurance firms in the EU from the beginning of 2016. The aim of EU solvency rules is to ensure that insurance undertakings are financially sound and can withstand adverse events, in order to protect policyholders and the stability of the financial system as a whole.
Solvency II is based on a three pillar approach similar to Basel II but adapted for insurance.`
Specific risk
Specific risks (also known as non-systematic risks) are risk factors that are uncorrelated with or possibly independent from other sources of risk.
Such risks are largely diversifiable.
Strategic risk
Strategic risk relates to the achievement of an organisation’s overall strategic business plans and objectives.
Stress testing
Stress testing measures loss under extreme values of the chosen variable without necessarily considering the probability of that extreme event. The phrase “sensitivity analysis” is often used to describe a similar test but under less extreme variation.
Swiss Solvency Test
The Swiss Solvency Test is a risk-based regulatory capital regime which has similarities to Pillar 1 of Solvency II, although uses a different calibration measure.
Systematic risk
Systematic risk is risk that cannot be eliminated through diversification.
Systemic risk
The phrase “systemic risk” can be used to mean the same as “systematic risk”, but is also often used more specifically to refer to the risk of problems spreading between entities following a trigger event (see also “Contagion”).
Tail correlation
This is the correlation between observations in the tails of underlying distributions (extreme events). In many cases, tail correlations will differ from the normal correlation.
Tail Value at Risk (TVaR)
TVaR is a measure of risk that is defined at a given confidence level as the expected loss given that the loss exceeds the Value at Risk at the same confidence level.
Time horizon
This phrase is the period over which an organisation expects to be exposed to risk and/or the period over which it chooses to model its exposure.
Value at Risk (VaR)
VaR is a simple measure of risk representing the maximum loss expected with a given probability (the confidence level) over a defined time horizon.
Volatility
Volatility refers to the variability of potential outcomes. In respect of some risks it has a specific meaning; for example under market risk it is equivalent to the standard deviation of returns on investments.
Weighted average cost of capital
This is the aggregate return required by the providers of debt and equity capital, allowing for the effects of tax and the risks borne by the capital providers.
