Module 33: Principal terms

Question 1

Agency risk

Answer 1

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.

Question 2

Alternative Risk Transfer (ART)

Answer 2

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.

Question 3

AS/NZS 4360

Answer 3

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.

Question 4

Basel II

Answer 4

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.

Question 5

Basis risk

Answer 5

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.

Question 6

Chief Risk Officer (CRO)

Answer 6

Often reporting to the CEO or Chief Financial Officer, the CRO role has responsibility for overall leadership and development of ERM within an organisation.

Question 7

Coefficient of tail dependence

Answer 7

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.

Question 8

Coherent risk measure

Answer 8

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.

Question 9

Concentration of risk

Answer 9

Concentration of risk occurs when it is not possible to (or it has been decided not to) diversify across a range of different exposures.

Question 10

Contagion

Answer 10

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.

Question 11

Copula

Answer 11

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.

Question 12

Corporate governance

Answer 12

This is the system whereby Boards of directors, or governing bodies, are responsible for the governance of their organisations upon appointment by shareholders.

Question 13

Correlation

Answer 13

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.

Question 14

COSO ERM framework

Answer 14

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.

Question 15

Counterparty risk

Answer 15

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.

Question 16

Credit risk

Answer 16

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.

Question 17

Credit spread

Answer 17

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.

Question 18

3 Common measures of credit spread

Answer 18

• nominal spread
• static spread
• option-adjusted spread

Question 19

Nominal (credit) spread

Answer 19

The difference between the gross redemption yields of risky and risk-free bonds.

Question 20

Static (credit) spread

Answer 20

The addition to the risk-free rate at which discounted cash flows from a risky bond will equate to its price.

Question 21

Option-adjusted (credit) spread

Answer 21

The option-adjusted spread further adjusts this discount rate through the use of stochastic modelling to allow for any options embedded in the bond.

Question 22

Cyber risk

Answer 22

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.

Question 23

Demographic risk

Answer 23

Demographic risk arises from demographic changes such as mortality rates, impacting both customers and employment. It can also be a component of insurance risk.

Question 24

Derivatives

Answer 24

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.

Question 25

Diversification

Answer 25

This is a method of reducing overall risk exposure to uncorrelated risks.

Question 26

Dynamic hedging

Answer 26

This is the process of frequently rebalancing a hedging position in order to maintain the effectiveness of the hedge.

Question 27

Economic capital

Answer 27

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.

Question 28

Economic risk

Answer 28

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.

Question 29

Economic value

Answer 29

The present value of all future shareholder profits, determined on a realistic economic basis. It is also known as "shareholder value" or "embedded value".

Question 30

Economic value added

Answer 30

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.

Question 31

Efficient frontier

Answer 31

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.

Question 32

Emerging risk

Answer 32

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.

Question 33

Enterprise risk management

Answer 33

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.

Question 34

Environmental risk

Answer 34

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.

Question 35

Expected shortfall

Answer 35

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.

Question 36

Exposure

Answer 36

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.

Question 37

Extreme value theory

Answer 37

This is a statistical methodology for dealing with low probability but potentially high severity events.

Question 38

Foreign exchange risk

Answer 38

Foreign exchange risk is risk arising due to exposure to movement in foreign exchange rates.

Question 39

Hedging

Answer 39

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.

Question 40

Insurance risk

Answer 40

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.

Question 41

Interest rate risk

Answer 41

Interest rate risk arises from changes in interest rates, which could include impact on customer behaviour as well as the financial impact.

Question 42

ISO 31000

Answer 42

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.

Question 43

Legal risk

Answer 43

Legal risk is risk arising from the understanding of and adherence to legislation, including changes in accepted interpretation.

Question 44

Liquidity risk

Answer 44

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).

Question 45

Loss given default

Answer 45

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.

Question 46

Market risk

Answer 46

Market risk is risk arising from changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.

Question 47

Model risk

Answer 47

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.

Question 48

Monte Carlo Simulation

Answer 48

Monte carlo simulation is a sampling or modelling technique which considers a large number of randomly generated scenarios.

Question 49

Moral hazard

Answer 49

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.

Question 50

Operational risk

Answer 50

Operational risk is the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events.

Question 51

Owh Risk and Solvency Assessment (ORSA)

Answer 51

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.

Question 52

Parameter risk

Answer 52

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.

Question 53

Political risk

Answer 53

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.

Question 54

Probability of ruin

Answer 54

The probability that the net financial position of an organisation or line of business falls below zero over a defined time horizon.

Question 55

Project risk

Answer 55

The risk of failure relating to a specific project undertaken by an organisation.

Question 56

Regulatory risk

Answer 56

The risk of losses arising from changes in legislation or regulation.

Question 57

Reinsurance

Answer 57

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.

Question 58

Reputational risk

Answer 58

The risk that events or circumstances could have an adverse impact on an organisation's reputation or brand value.

Question 59

Residual risk

Answer 59

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.

Question 60

Risk appetite

Answer 60

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.

Question 61

Risk capacity

Answer 61

Risk capacity is the volume of risk that an organisation can take as measured by some consistent measure, such as economic capital.

Question 62

Risk discount rate

Answer 62

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.

Question 63

Risk limits

Answer 63

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.

Question 64

Risk management control cycle.

Answer 64

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.

Question 65

Risk matrix (or map)

Answer 65

These are tools used in the identification and initial assessment of risks, typically plotting severity against probability (or frequency).

Question 66

Risk optimisation

Answer 66

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.

Question 67

Risk profile

Answer 67

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.

Question 68

Risk responses

Answer 68

``` These are the ways in which an organisation reacts to risk. The key responses to risk are: - avoidance, - acceptance, - transfer and - management. ```

Question 69

Risk tolerance

Answer 69

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.

Question 70

Sarbanes-Oxley

Answer 70

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.

Question 71

Scenario analysis

Answer 71

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.

Question 72

Securitisation

Answer 72

A form of ART, securitisation packages risks into capital market instruments.

Question 73

Severity

Answer 73

This is the amount of loss that is likely to be suffered under a risk if that event occurred.

Question 74

Solvency II

Answer 74

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.`

Question 75

Specific risk

Answer 75

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.

Question 76

Strategic risk

Answer 76

Strategic risk relates to the achievement of an organisation's overall strategic business plans and objectives.

Question 77

Stress testing

Answer 77

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.

Question 78

Swiss Solvency Test

Answer 78

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.

Question 79

Systematic risk

Answer 79

Systematic risk is risk that cannot be eliminated through diversification.

Question 80

Systemic risk

Answer 80

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").

Question 81

Tail correlation

Answer 81

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.

Question 82

Tail Value at Risk (TVaR)

Answer 82

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.

Question 83

Time horizon

Answer 83

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.

Question 84

Value at Risk (VaR)

Answer 84

VaR is a simple measure of risk representing the maximum loss expected with a given probability (the confidence level) over a defined time horizon.

Question 85

Volatility

Answer 85

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.

Question 86

Weighted average cost of capital

Answer 86

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.