Part 1

Question 1

What is the overall risk portfolio of a company?

Answer 1

It is the collective build-up of individual business decisions and risks, which results in a unique risk profile.

Principal Terms

Lam - ERM Textbook - pg. 4

Question 2

What does a company’s risk profile determine?

Answer 2

It determines the company’s earnings and earnings volatility.

Principal Terms

Lam - ERM Textbook - pg. 4

Question 3

What are the key components of risk management?

Answer 3

1) Using a portfolio approach
2) Establishing control systems
3) Having the right people and risk culture
4) Reducing downside potential
5) Increasing upside opportunity

Principal Terms

Lam - ERM Textbook - pg. 4

Question 4

How is the relationship between risk and return often misunderstood?

Answer 4

Many believe no risk = no return and high risk = high return, viewing it as linear, but it is better to view it as a parabolic relationship focusing on risk-adjusted return.

Principal Terms

Lam - ERM Textbook - pg. 4

Question 5

What does NPV stand for?

Answer 5

Net Present Value.

Principal Terms

Lam - ERM Textbook - pg. 5

Question 6

What does EVA stand for?

Answer 6

Economic Value Added.

Principal Terms

Lam - ERM Textbook - pg. 5

Question 7

Why should a company develop an integrated approach to measuring and managing risk?

Answer 7

To optimize its risk/return profile.

Principal Terms

Lam - ERM Textbook - pg. 6

Question 8

What are the four main reasons that risk management should be important to the management of a firm?

Answer 8

Managing risk …
1) is management’s job
2) can reduce earnings volatility
3) can maximize shareholder value
4) promotes job and financial security

Principal Terms

Lam - ERM Textbook - pg. 6

Question 9

What knowledge is required for effective risk management? Who is responsible for risk management?

Answer 9

1) Knowledge of historical data (risk/return results, volatility, correlations)
2) Current risk exposures
3) Future business plans
The average investor does not have the knowledge or expertise, so it is management’s responsibility to manage the firm’s risk.

Principal Terms

Lam - ERM Textbook - pg. 7

Question 10

How can improvements to shareholder value be achieved through risk management?

Answer 10

In short, it reduces the cost of capital and reduces the uncertainty of commercial activities.
1) Establish target returns
2) Allocate capital to attractive projects (based on risk-adjusted returns)
3) Align performance metrics with risk objectives
4) Give the company the skills to manage risks (like large financial losses or reputation damage)
5) Incorporate risk when making key decisions such as mergers and acquisitions

Principal Terms

Lam - ERM Textbook - pg. 8

Question 11

What types of risks are interdependent? Give an example.

Answer 11

Financial risk, business risk, and operational risk. Within financial risk, market, credit, and liquidity risks are also interdependent.
Ex: The quality of loan documentation is usually considered an operational risk. If the loan is performing, the documentation has no real economic impact. But if the loan is in default, the quality of the loan documentation can have a significant impact on loss severity, with respect to collateral and bankruptcy rights.

Principal Terms

Lam - ERM Textbook - pg. 10

Question 12

Why is a silo-based risk management strategy inferior?

Answer 12

1) It does not account for interdependencies between risks and may overlook the big picture.
2) It is difficult to aggregate risk exposure across an organization if business units use different methodologies and systems.

Principal Terms

Lam - ERM Textbook - pg. 10

Question 13

What is funding risk?

Answer 13

the risk that positions may be profitable in the long run, but bankrupt a company in the short run

Principal Terms

Lam - ERM Textbook - pg. 16

Question 14

What is strategic risk?

Answer 14

the risk that business strategies (mergers, acquisitions, growth strategies, product innovations) are flawed or ineffectively executed

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 15

What is business risk?

Answer 15

Can be considered a type of operational risk. The risk that annual financial and operating results may not meet management and stakeholder expectations

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 16

What is market risk?

Answer 16

the risk that prices and rates will move in a way that has negative consequences for a company

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 17

What is credit risk?

Answer 17

The risk that a customer, counterparty, or supplier will fail to meet its obligations (financial or service). This includes default risk AND downgrade risk.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 18

What is liquidity risk?

Answer 18

the risk that a company cannot raise cash to meet its requirements in a timely and cost-effective manner (without incurring a loss)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 19

What is operational risk?

Answer 19

The risk that people, processes, or systems will fail, or that an external event (e.g., earthquake, fire) will negatively impact the company. (Basically any risk that is not a credit or market risk)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 20

What is compliance risk?

Answer 20

the risk that the company may violate laws and regulations

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 21

What is reputation risk?

Answer 21

the risk that a company’s brand and reputation may be negatively impacted

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 22

What is a second-order risk?

Answer 22

A risk that is a consequence of other primary factors. (Like reputation risk)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 31

Question 23

What are the pros and cons of making risk management a part of every employee’s job responsibility?

Answer 23

Pro: employees know the risks of their work activities best
Pro: risk is managed throughout the company
Con: substantial training and education is required

ERM concept, framework, and process

Lam - ERM Textbook - pg. 32

Question 24

What are the risk concepts?

Answer 24

1) Exposure
2) Volatility
3) Probability
4) Severity
5) Time Horizon
6) Correlation
7) Capital

ERM concept, framework, and process

Lam - ERM Textbook - pg. 32

Question 25

What is risk exposure?

Answer 25

The maximum amount of damange that will be suffered if some event occurs.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

Question 26

How is risk exposure measured?

Answer 26

Exposure measurement is quantitative for credit and market risk, but may be qualitative for others like operational and compliance risk.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

Question 27

What is risk volatility?

Answer 27

The variability of potential outcomes.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

Question 28

How is risk volatility measured?

Answer 28

Volatility risk is quantitative for some risks. For example, for market risk, it is the standard deviation of returns. Other risks need to be considered too like an increase in the turnover rate of programmers could negatively affect a company’s technology initiatives.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

Question 29

What is risk probability?

Answer 29

The likelihood that some event will occur

ERM concept, framework, and process

Lam - ERM Textbook - pg. 33

Question 30

What is risk severity?

Answer 30

How impactful the event is likely to be.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

Question 31

What is a risk’s time horizon?

Answer 31

How long the company is exposed to the risk.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

Question 32

Explain the focus of risk time horizon for financial vs operational risks.

Answer 32

For financial risks, the key issue is the liquidity of the position affected by the risk event.
For operational risks, time horizon can be thought of as the time required to recover from the risk event (like a fire).

ERM concept, framework, and process

Lam - ERM Textbook - pg. 34

Question 33

What is risk correlation?

Answer 33

The relationships between risks

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

Question 34

How is correlation risk managed in financial and operational risks?

Answer 34

Financial: diversification can be achieved through risk limits and portfolio allocation targets to reduce risk concentrations.
Operational: diversification can be achieved through separation of operational units.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

Question 35

What is economic capital?

Answer 35

1) Another name is risk-adjusted capital.
2) It’s capital that a company holds to meet cash requirements (like costs of investments and expenses) and to cover unexpexted losses arising from risk exposures.
3) The value-at-risk assessed on the market value of assets over liabilities.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

Question 36

What is a credit rating?

Answer 36

An estimate of how likely a company is to fail

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

Question 37

How does a company decide how much capital to hold?

Answer 37

The company decides how high it wants its credit rating to be. More capital = higher rating.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 35

Question 38

Why do companies have to allocate capital to its business units?

Answer 38

1) It explicitly links risk and return
2) It allows the profitability of all business units to be compared on a consistent risk-adjusted basis

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

Question 39

What is an internal capital market?

Answer 39

An internal capital market is a market created within one company when economic capital is allocated to business units. Business units that produce the best risk-adjusted returns will thrive while other phase out.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

Question 40

What are the 3 steps in the risk management process?

Answer 40

1) Promote risk awareness
2) Measure risk
3) Control risk

ERM concept, framework, and process

Lam - ERM Textbook - pg. 36

Question 41

What are 4 ways to deal with a risk?

Answer 41

1) Do nothing (accept it)
2) Limit the risk (mitigate it)
3) Reduce the risk (avoid it)
4) Transfer the risk (share it)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 37

Question 42

What is the goal for promoting risk awareness?

Answer 42

To ensure everyone within a business is:
1) Proactively identifying the key risks for the company
2) Seriously thinking about the consequences of the risks for which they are responsible
3) Communicating up and down the organization those risks that warrant others’ attention

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

Question 43

What are the top 5 ways to promote risk awareness in a company?

Answer 43

1) Set the tone from the top
2) Ask the right questions
3) Establish a risk taxonomy
4) Provide training and education
5) Link compensation to risk

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

Question 44

Why is it important for a company to set the tone for risk awareness from the top? (Senior management and especially the CEO?)

Answer 44

Some aspects of risk management are not instinctual. For example, people are eager to talk about their company’s successes, not actual or potential losses. It is crucial that senior management shows their commitment to risk management through words AND actions!

ERM concept, framework, and process

Lam - ERM Textbook - pg. 38

Question 45

How can senior management ask the right questions when it comes to risk management?

Answer 45

Use the RISK acronym.
Return: What are the expected returns on the risks?
Immunization: What risk limits are in place?
Systems: Do we have appropriate systems to track and measure risk?
Knowledge: Do we have the right people and skills for effective risk management?

ERM concept, framework, and process

Lam - ERM Textbook - pg. 39

Question 46

Why is it important for a company to establish a risk taxonomy?

Answer 46

Risk communications can be misunderstood easily without a risk taxonomy: a common structure for describing the categories and sub-categories of risks, as well as the tools, metrics, and strategies for risk management.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 39

Question 47

Why is it important for a company to provide training and development for risk management?

Answer 47

Employees need the skills and tools to manage the risks for which they are responsible.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 40

Question 48

Why is it important for a company to link risk and compensation?

Answer 48

People pay more attention to what their own responsibilities and how their financial incentives are tied to their performance. Risk management should be tied to compensation for employees at all levels. Otherwise, employees will stop paying attention.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 40

Question 49

What items should be included in every risk report?

Answer 49

1) Losses
2) Incidents
3) Risk assessments
4) Key risk indicators

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

Question 50

What should be included in the Losses section of a risk report?

Answer 50

Only overall levels of loss and important trends should be reported to senior management.
Ex: losses above thresholds, actual vs expected

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

Question 51

What should be included in the Incidents section of a risk report?

Answer 51

List the major risk incidents for the period whether they were financial losses or not. Include the potential impact, root causes, and business response. Highlight any patterns.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

Question 52

What should be included in the Risk Assessments section of a risk report?

Answer 52

Advance assessment of potential risks. Ex: absence of key staff, product launches, new technologies, etc.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 41

Question 53

What should be included in the Key Indicators section of a risk report?

Answer 53

Quantifications of important trends and risk exposures for the company that can serve as early warning signals.
Financial risk ex: VaR, P&L, credit exposure vs limit
Operational risk ex: errors, customer complaints

ERM concept, framework, and process

Lam - ERM Textbook - pg. 42

Question 54

How does the self-correcting feature of the risk report work?

Answer 54

Losses and incidents are captured easily. Management may notice that losses and incidents are coming from risks that are not discussed in risk assessments or key indicators. Action can be taken to improve the risk report going forward.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 42

Question 55

What are the 3 ways to control risk that has not yet been taken on?

Answer 55

1) support business growth through capital allocation (to areas with best risk-adjusted return)
2) support profitability through risk-adjusted pricing
3) control downside risks by setting limits

ERM concept, framework, and process

Lam - ERM Textbook - pg. 44

Question 56

What’s wrong with the NPV and EVA techniques for evaluating new investments and business performance?

Answer 56

These tools are usually based on book capital, which typically doesn’t fully capture expected loss, much less unexpected loss, and thus does not correspond to economic capital. Therefore, these methods tend to overstate the profitability of risky business and understate the profitability of low-risk business.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 45

Question 57

How can a company determine its risk appetite?

Answer 57

It depends on the human, financial, and technology resources available. Risk appetite can be expressed in terms of the amount and likelihood of actual and potential loss.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 46

Question 58

What limits should a company set to control downside risks?

Answer 58

1) Use stop-loss limits to control the actual amount of loss it takes.
2) Use sensitivity limits to control the potential losses it may take.
3) Use exposure limits
In all cases, when limits are reached, management actions and decisions should be triggered.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

Question 59

What does TQM mean?

Answer 59

Total quality management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

Question 60

What are the 3 ways to control risk that have already been taken on?

Answer 60

1) Understand the risks through risk analysis
2) Understand which risks offset and exacerbate each other
3) Transfer risk when time, resources, or flexibility are scarce

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

Question 61

What is duration matching?

Answer 61

A common risk management technique under which a financial institution matches the interest rate sensitivities of its assets and liabilities to make sure that their prices change in the same way when interest rates change. (The prices offset)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 47

Question 62

Why can risk be thought of as a bell curve?

Answer 62

The mean of the bell curve represents the expected performance. The objective of risk management is to optimize the shape of the bell curve (improve the expected performance and narrow the distribution of potential outcomes).

ERM concept, framework, and process

Lam - ERM Textbook - pg. 48

Question 63

What risk variables can increase/decrease strategic risk?

Answer 63

1) Macroeconomic conditions
2) Competitive actions
3) The company’s effectiveness in formulating and executing its strategic plan

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 64

What does EPS mean?

Answer 64

Earnings per share

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 65

What risk variables can increase/decrease business risk?

Answer 65

These risks could drive earnings volatility.
1) market share
2) new customers
3) pricing margings
4) cost management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 66

What risk variables can increase/decrease financial risk?

Answer 66

Using interest rate risk as an example:
1) asset/liability duration mismatches
2) interest rate levels
3) pricing spreads

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 67

What risk variables can increase/decrease operational risk?

Answer 67

Using IT as an example:
1) single points of failure (SPOFs) that could bring down critical systems
2) cyber security exposures

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 68

What does IT mean?

Answer 68

Information technology

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 69

What risk variables can increase/decrease regulatory risk?

Answer 69

1) new regulations that the company is not prepared for
2) new employees who are not trained in the company’s compliance procedures

ERM concept, framework, and process

Lam - ERM Textbook - pg. 49

Question 70

What are 5 questions that senior management should be able to answer regarding risk management?

Answer 70

1) What are the company’s top 10 risks?
2) Are any of our business objectives at risk?
3) Do we have key risk indicators that track our critical risk exposures against risk tolerance levels?
4) What were the company’s losses and incidents, and did we identify these risks in previous reports?
5) Are we in compliance?

ERM concept, framework, and process

Lam - ERM Textbook - pg. 52

Question 71

What is the definition of ERM?

Answer 71

Risk is a variable that can cause deviation from an expected outcome. ERM is a comprehensive and integrated framework for managing key risks in order to achieve business objectives, minimize unexpected earnings volatility, and maximize firm value.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 53

Question 72

ERM is all about integration in what 3 ways?

Answer 72

The following items are requred:
1) A centralized risk management unit (like a CRO) to oversee all aspects of risk in the organization.
2) Integration of risk transfer strategies. Transfer only residual undesirable risk, after accounting for offsetting risks.
3) Integration of risk management throughout business processes like risk-adjusted pricing and capital allocation.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 54

Question 73

What are the 3 major benefits of ERM?

Answer 73

1) increased organizational effectiveness
2) better risk reporting
3) improved business performance (reduced losses, lower earnings volatility, increased earnings, and improved shareholder value)

ERM concept, framework, and process

Lam - ERM Textbook - pg. 54

Question 74

What does RAROC mean? How is it calculated?

Answer 74

1) Risk-adjusted return on capital
2) Could calculate by reducing cash flow by cost of capital, increase discount rate for net income in the numerator, or adopt economic capital in the denominator

ERM concept, framework, and process

Lam - ERM Textbook - pg. 57

Question 75

What is a CRO responsible for?

Answer 75

1) Providing leadership for ERM
2) Integrating risk management frameworks across the organization
3) Setting risk appetite (through risk limits)
4) Implementing risk indicators and risk reports
5) Allocating capital to business activities based on risk
6) Communicating the company’s risk profile to key stakeholders
7) Developing the systems to support the risk management program

ERM concept, framework, and process

Lam - ERM Textbook - pg. 58

Question 76

Why is it important for risk managment to have an independent voice? How can it be achieved?

Answer 76

In extreme circumstances like CEO/CFO fraud or excessive risk taking, the CRO may fear for their job security. Communication between the CRO and the board or board risk committee should be established in advance to ensure that risk management concerns are heard.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 59

Question 77

What are the 7 components of ERM?

Answer 77

1) Corporate governance
2) Line management
3) Portfolio management
4) Risk transfer
5) Risk analytics
6) Data and technology resources
7) Stakeholder management

ERM concept, framework, and process

Lam - ERM Textbook - pg. 61

Question 78

What is the role of corporate governance in ERM?

Answer 78

Establish top-down risk management.
It ensures that the board of directors and management have established the appropriate organizational processes and corporate controls to measure and manage risk across the company

ERM concept, framework, and process

Lam - ERM Textbook - pg. 62

Question 79

What is the role of line management in ERM?

Answer 79

Business strategy alignment.
The risks of business transactions should be fully assessed and incorporated into pricing and profitability targets in the execution of business strategy.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 63

Question 80

What is the role of portfolio management in ERM?

Answer 80

Management should act like a fund manager by setting portfolio targets and risk limits to ensure appropriate diversification and optimal portfolio returns. Portfolio management provides a direct link between risk management and shareholder value maximization.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 64

Question 81

What is the role of risk transfer in ERM?

Answer 81

To reduce undesirable risks, management should evaluate derivatives, insurance, and hybrid products on a consistent basis and select the most cost-effective alternative.
Ex: swap undesirable risk exposure for desirable risk exposure through a derivative contract.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 64

Question 82

What is the role of risk analytics in ERM?

Answer 82

Develop advanced analytical tools to consistently quantify and manage risk. For example, the results can be used to:
1) decide whether or not to transfer risk by comparing cost of transfer and cost of retention, for example.
2) support strategic planning by analyzing the probabilities and outcomes of different business strategies.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 65

Question 83

What is the role of stakeholder management in ERM?

Answer 83

Improve risk transparency for key stakeholders such as the board of directors, regulators, and rating agencies.

ERM concept, framework, and process

Lam - ERM Textbook - pg. 66

Question 84

Market risks affect a corporation’s financial position in what 3 ways?

Answer 84

1) Transaction exposure: the direct impact of market movements on revenue and expenses
2) Economic exposure: how market movements affect the competitive position, including buyer and supplier behaviour
3) Translation exposure: how market movements affect financial statements when converting to the home currency

Risk categories and risk identification

Lam - ERM Textbook - pg. 319

Question 85

What is stock price risk?

Answer 85

A type of market risk. The risks that a corporation faces due to its own stock price. High stock prices allow companies to pursue strategic initiatives.

Risk categories and risk identification

Lam - ERM Textbook - pg. 319

Question 86

What are some examples of operational risks faced by non-financial corporations?

Answer 86

1) Liability resulting from defective products
2) Failed mergers and acquisitions
3) R&D underperformance risk
4) Reliance on faulty financial models
5) Changes in tax laws and regulations
6) Organizational and technology risks too

Risk categories and risk identification

Lam - ERM Textbook - pg. 321

Question 87

What is cultural risk?

Answer 87

A form of operational risk. Ex: a company culture of inflexibility leaves the firm vulnerable to rapid business environment changes

Risk categories and risk identification

Lam - ERM Textbook - pg. 324

Question 88

Define outsourcing. Whats the risk?

Answer 88

The utilization of third parties to complete tasks that are normally performed internally. The risk is that the 3rd party is in charge of monitoring and regulating the process. The original firm has less control.

Risk categories and risk identification

Lam - ERM Textbook - pg. 325

Question 89

What are the steps to make a risk map?

Answer 89

1. Establish a top-down framework & taxonomy
2. Create a bottom-up list of specific risks
3. Evaluate the probability and severity of each risk
4. Identify existing controls and consider creating new controls
5. Assign responsibilities for implementing controls, monitoring, and reporting on specific risks
6. Aggregate individual risk maps into an enterprise level risk map
7. Go back to step 1 in order to update and refine the risk mapping process

Risk categories and risk identification

Lam - ERM Textbook - pg. 327

Question 90

Why are risk maps popular? What are they for?

Answer 90

It is a popular risk identification and assessment tool because of its flexibility to incorporate both financial and non-financial risks.

Risk categories and risk identification

Lam - ERM Textbook - pg. 328

Question 91

What qualities should a risk map have?

Answer 91

1) Comprehensive: identifies and assesses all risks faced by the company
2) Consistency: uses a standard taxonomy to discuss and evaluate risks
3) Accountability: BUs are directly involved in identification, assessment, monitoring, and management

Risk categories and risk identification

Lam - ERM Textbook - pg. 328

Question 92

ERM process in general?

Answer 92

1) risk identification and assessment
2) quantification and reporting
3) management and control

Risk categories and risk identification

Lam - ERM Textbook - pg. 326

Question 93

VaR

Answer 93

A summary statistic that quantifies the worst decline in asset or portfolio value for a given level of confidence over a specified period of time.
Ex: Under normal market conditions, the most the portfolio can lose over a month is $X at the 99% confidence level.

Risk categories and risk identification

Lam - ERM Textbook - pg. 329

Question 94

What are the 3 approaches to estimating CFaR and EaR?

Answer 94

1) Pro Forma Analysis
2) Regression Analysis
3) Simulation Analysis

Risk categories and risk identification

Lam - ERM Textbook - pg. 330

Question 95

Summarize what a company should do about their risks

Answer 95

1) High frequency, low-med severity risks: implement control procedures
2) Low frequency, high severity: establish contingency plans and insurance
3) SPOFs: develop back up processes
4) For critical operations and core systems, have excess capacity

Risk categories and risk identification

Lam - ERM Textbook - pg. 333

Question 96

What is the difference between business and financial risks?

Answer 96

Business risks are willingly taken on to create a competitive advantage and add to shareholder value. Financial risks are the other risks, which relate to possible losses from financial market activities.

Risk categories and risk identification

Jorion - Value at Risk - pg. 4

Question 97

What does dollarization mean?

Answer 97

When a country adopts a foreign currency in place of or alongside its domestic currency. It can eliminate risk of sudden devaluation of the country’s exchange rate. However, “giving up fluctuations in currencies in exchange for greater fluctuations in output and employment may not be a bargain.”

Risk categories and risk identification

Jorion - Value at Risk - pg. 10

Question 98

Define derivative

Answer 98

Instruments designed to manage financial risks efficiently. A derivative contract is a private contract deriving its calue from some underlying asset price, reference rate, or index.

Risk categories and risk identification

Jorion - Value at Risk - pg. 10

Question 99

What is a notional amount?

Answer 99

Risk categories and risk identification

Jorion - Value at Risk - pg. 10

Question 100

What’s the difference between a security and a derivative?

Answer 100

Securities (like stocks and bonds) are issued to raise capital. Derivatives are contracts between 2 parties.

Risk categories and risk identification

Jorion - Value at Risk - pg. 10

Question 101

Use notional amount in an example

Answer 101

The simplest example of a derivative is a forward contract on a foreign currency, which is a promis to buy a fixed (notional) amount at a fixed price at a future date. Someone might buy this if they are importing foreign products because they could buy the foreign currency forward, eliminating the risk of subsequent exchange rate fluctuations.

Risk categories and risk identification

Jorion - Value at Risk - pg. 10

Question 102

How does mapping work?

Answer 102

Mapping replaces positions in instruments by exposures to fundamental risk factors. A position in a forward contract is equivalent to the same notional amount invested directly in the spot market, leveraged by cash so that there is no net initial investment.

Risk categories and risk identification

Jorion - Value at Risk - pg. 11

Question 103

What is leverage? Why is it a double-edged sword?

Answer 103

Leverage means using borrowed money. It makes derivatives efficient hedging instruments because of low transaction costs. However, the absence of an upfront cash payment makes it more difficult to assess the potential downside risk.

Risk categories and risk identification

Jorion - Value at Risk - pg. 11

Question 104

What is financial engineering?

Answer 104

A field of finance. The development and creative application of financial technology to solve financial problems and exploit financial opportunities.

Risk categories and risk identification

Jorion - Value at Risk - pg. 11

Question 105

What is financial risk management?

Answer 105

The design and implementation of procedures for identifying, measuring, and managing financial risks.

Risk categories and risk identification

Jorion - Value at Risk - pg. 13

Question 106

What do duration, beta, and delta measure?

Answer 106

(blank) is a linear sensitivity for exposure (blank).
1) Duration: to interest rates
2) Beta (or systematic risk): to stock-market movements
3) Delta: of options to the underlying asset price

Risk categories and risk identification

Jorion - Value at Risk - pg. 15

Question 107

Describe the differences between valuation and risk management approaches to derivatives

Answer 107

valuation vs risk management
1) Principle: expected discounted value vs dist. of future values
2) Focus: center of distribution vs tails
3) Horizon: current value vs future value
4) Precision: high needed for pricing vs less needed b/c errors cancel out
5) Distribution: risk neutral vs actual (physical)

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 108

What are the types of financial risks?

Answer 108

Market, liquidity, credit, and operational

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 109

What are the 2 forms of market risk?

Answer 109

1) Absolute risk (measured in the relevant currency) focuses on volatility of total returns
2) Relative risk (measured relative to a benchmark index) focuses on tracking error

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 110

What is tracking error?

Answer 110

Deviation from the index. Measured in relative risk.

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 111

What are the 2 classifications of market risks?

Answer 111

1) Directional: exposures to movements in financial variables (stock prices, interest rates, etc)
2) Nondirectional: the remaining risks. Nonlinear exposures and exposures to hedged positions or to volatilities.

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 112

What is basis risk?

Answer 112

Risk created from unanticipated movements in the relative prices of assets in a hedged position

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 113

What is volatility risk?

Answer 113

Exposure to movements in the actual or implied volatility

Risk categories and risk identification

Jorion - Value at Risk - pg. 22

Question 114

What are the 2 forms of liquidity risk?

Answer 114

1) asset liquidity risk (or maket/product liquidity risk)
2) funding liquidity risk (or cashflow risk)

Risk categories and risk identification

Jorion - Value at Risk - pg. 23

Question 115

What is asset liquidity risk and how can it be managed?

Answer 115

1) It’s the risk that a transaction can’t be conducted at prevailing market prices due to the asset illiquidity
2) Manage this risk by setting limits on certain markets and products and by diversification.

Risk categories and risk identification

Jorion - Value at Risk - pg. 23

Question 116

What is funding liquidity risk and how can it be managed?

Answer 116

1) It’s the risk that early liquidation of assets is required to meet payment obligations (resulting in realized losses)
2) Manage this risk by setting limits on cashflow gaps and by diversification

Risk categories and risk identification

Jorion - Value at Risk - pg. 23

Question 117

What is a credit event?

Answer 117

A credit event occurs when there is achange in the counterparty’s ability to perform its obligations

Risk categories and risk identification

Jorion - Value at Risk - pg. 25

Question 118

What is sovereign risk?

Answer 118

The risk that countries impose foreign exchange controls that make it impossible for counterparties to honour their obligations. Default risk is usually company specific, sovereign risk is country specific.

Risk categories and risk identification

Jorion - Value at Risk - pg. 25

Question 119

What is settlement risk?

Answer 119

A type of credit risk. The risk that obligations are fulfilled, but not at the agreed-upon time.

Risk categories and risk identification

Jorion - Value at Risk - pg. 25

Question 120

How can credit risk be managed?

Answer 120

Setting limits on notionals, current and potential exposures, and using credit enhancement features like requiring collateral or marking to market

Risk categories and risk identification

Jorion - Value at Risk - pg. 25

Question 121

What is legal risk and how can it be managed?

Answer 121

1) The risk of fines, penalties, and punitive damages from supervisory actions, lawsuits, or private settlements.
2) Manage it by having the legal counsel, risk management, and senior management work together to create company policies, and make sure agreements with counterparties can be enforced.

Risk categories and risk identification

Jorion - Value at Risk - pg. 26

Question 122

What does risk mean?

Answer 122

In a nontechnical context, it means a danger of loss. In a financial context, risk refers to the dispersion of possible outcomes, positive or negative.

Risk categories and risk identification

Jorion - Value at Risk - pg. 75

Question 123

What are the 4 types of market risk?

Answer 123

interest rate risk, exchange rate risk, equity risk, and commodity risk

Risk categories and risk identification

Jorion - Value at Risk - pg. 76

Question 124

How can volatility be measured?

Answer 124

Standard deviation of unexpected outcomes

Risk categories and risk identification

Jorion - Value at Risk - pg. 76

Question 125

What 2 factors cause financial losses?

Answer 125

Volatility in the underlying financial variable and exposure to it. Firms can only control the latter.

Risk categories and risk identification

Jorion - Value at Risk - pg. 76

Question 126

What do convexity and gamma measure?

Answer 126

Both are second-order exposures. Convexity is for the fixed-income market and gamma is for the options market.

Risk categories and risk identification

Jorion - Value at Risk - pg. 76

Question 127

What is skewness? Kurtosis?

Answer 127

1) Skewness describes a distribution’s departure from symmetry
2) Kurtosis describes the degree of flatness of a distribution

Risk categories and risk identification

Jorion - Value at Risk - pg. 86

Question 128

What does ETL mean?

Answer 128

Expected tail loss, expected shortfall, conditional loss, or conditional tail expectation. The average of X given X exceeds a given value.

Risk categories and risk identification

Jorion - Value at Risk - pg. 91

Question 129

What does stationary mean?

Answer 129

If a distribution is stationary, it means the parameters are stable over time

Risk categories and risk identification

Jorion - Value at Risk - pg. 93

Question 130

Why might someone use a geometric rate of return instead of arithmetic (or discrete)?

Answer 130

1) If geometric returns are distributed normally, then the dist can never lead to a negative price (unlike arithmetic)
2) Geometric returns easily allowable extensions into multiple periods. Ex: the 2-month geometric return is the sum of the 2 monthly returns. This is not true for arithmetic.

Risk categories and risk identification

Jorion - Value at Risk - pg. 94

Question 131

What is the time aggregation problem? How do we solve it?

Answer 131

The problem of transforming risk measures from one time horizon to another. To do this, we assume that returns are uncorrelated (independent) over successive time intervals. We assume prices follow a random walk because we assume markets are efficient, and all prices reflect all relevant public information.

Risk categories and risk identification

Jorion - Value at Risk - pg. 97

Question 132

Why might markets have trends in the returns?

Answer 132

This may happen because of illiquidity in the underlying market. The price impact of new can be felt over many periods, creating trends.

Risk categories and risk identification

Jorion - Value at Risk - pg. 99

Question 133

What does FSR mean?

Answer 133

Financial Strength Rating. A rating that DBRS assigns to insurers. It is based on the following 5 elements: franchise strength, risk profile, earnings ability, liquidity, and capitalization

ERM concept, framework, and process

Global Methodology - pg. 4

Question 134

What are the 3 phases to calculating FSR?

Answer 134

1) Evaluate the 5 building blocks
2) Combines the building blocks with assessments (ranging from weak to exceptional)
3) Finalize the ratings for the insurer’s various obligations

ERM concept, framework, and process

Global Methodology - pg. 5

Question 135

How is franchise strength assessed?

Answer 135

1) Market position
2) Distribution channels
3) Diversification of business and/or products
4) Strategic and operational excellence
5) (larger firms also generally have greater franchise strength)

ERM concept, framework, and process

Global Methodology - pg. 6

Question 136

How is market position assessed? Why does it matter for a FRS rating?

Answer 136

Measuring the market share and competitive rankings of the insurer’s key product lines. This directly affects the firm’s ability to attract and retain customers.

ERM concept, framework, and process

Global Methodology - pg. 6

Question 137

How are distribution channels assessed? What are some examples?

Answer 137

Measure the strength and diversity of distribution channels. Ex: company reps, career agents, independent agents, insurance or retail brokerages, and direct-to-client formats like the internet

ERM concept, framework, and process

Global Methodology - pg. 6

Question 138

Why does diversification of business and/or products matter for a FSR?

Answer 138

Diversification of products
1) reduces volatility of earnings
2) provides opportunity to rebalance products and market exposure to manage risk and optimize capital
3) allows the firm to better service clients throughout their changing lifecycle

ERM concept, framework, and process

Global Methodology - pg. 6

Question 139

How is strategic and operational excellence assessed? Why does it matter for a FSR?

Answer 139

1) Management: Does it support and develop the franchise and company culture? Does it have a good relationship with regulators?
2) Ownership: How much of the firm is privately vs publicly owned? This changes how it operates and how it is governed.
3) Governance: The independence, experience, and diversity of the board of the directors

ERM concept, framework, and process

Global Methodology - pg. 7

Question 140

How is risk profile assessed?

Answer 140

1) Product risk
2) Credit risk
3) Market risk
4) Operational risk
5) Risk management

ERM concept, framework, and process

Global Methodology - pg. 9

Question 141

How is product risk assessed?

Answer 141

1) What is the risk level of the firm’s products? Low risk would be ones with short contract durations and price flexibility.
2) What is the reserve development history? If a firm continuously or frequently strengthens reserves, it may indicate that there are continuous estimation errors or unforeseen developments (like a large liability settlement).

ERM concept, framework, and process

Global Methodology - pg. 9

Question 142

How is credit risk assessed?

Answer 142

1) Consider the insurer’s credit risk policies.
2) Analyze the firm’s fixed-income portfolio, in particular, its distribution across asset classes, rating categories, et.
3) Consider the firm’s track record in managing credit risk

ERM concept, framework, and process

Global Methodology - pg. 9

Question 143

How is market risk assessed?

Answer 143

Evaluate the firm’s implicit and explicit guarantee exposures (like from interest rate and equity risk). Here are some examples.
1) Interest rate sensitivities arise when duration mismatches occur between the asset and liability portfolios
2) Equity risk and interest rate risk arises when firms provide guarantees to investment accounts (like a min AV, death, withdrawal, or income benefit guarantee)

ERM concept, framework, and process

Global Methodology - pg. 10

Question 144

How is operational risk assessed?

Answer 144

In general, evaluate the firm’s ability to adapt to changing markets, adapt to changing regulations, and recover from failures

ERM concept, framework, and process

Global Methodology - pg. 10

Question 145

How is risk management assessed?

Answer 145

Evaluate the following:
1) the corporate culture on risk
2) risk management infrastructure. Ex: pricing & underwriting controls, capital models to assess capital adequacy, stress scenarios tested, the hedging program, ability to manage counterparty risk

ERM concept, framework, and process

Global Methodology - pg. 10

Question 146

How is earnings ability assessed?

Answer 146

1) Revenue generation and profitability
2) ROE
3) Combined ratio (P&C). A ratio less than 100% indicates an underwriting profit.
4) Income Stability

ERM concept, framework, and process

Global Methodology - pg. 12

Question 147

Why does earnings ability matter for a FSR?

Answer 147

Earnings are used to fund capital requirements, for future business growth, to provide returns to participating policyholders, and to provide investment returns to investors

ERM concept, framework, and process

Global Methodology - pg. 12

Question 148

How is revenue generation and profitability assessed?

Answer 148

Depends on the products sold. Profitability of short term liabilities can be calculated as the premiums less reserves, claims, expenses, etc. For longer term liabilities, source of earnings statements can be used or PV calcs of future estimated cashflows.

ERM concept, framework, and process

Global Methodology - pg. 12

Question 149

How is income stability assessed? Why does it matter for a FSR?

Answer 149

The ALM policies are assessed because large mismatches between assets and liabilities can lead to volatile income which makes it difficult to manage capital levels and solvency ratios.

ERM concept, framework, and process

Global Methodology - pg. 12

Question 150

What does ROE mean?

Answer 150

Return on equity. Net income for the period divided by the average equity for the period. It is an effective measure of profitability

ERM concept, framework, and process

Global Methodology - pg. 13

Question 151

How is liquidity assessed? Why does it matter for a FSR?

Answer 151

1) Analyze key asset and liability classes, available liquid resources, claims frequency and severity, collateral posting, credit downgrade risk, setting of limits, and strength of stress tests
2) Insurers can suffer losses if forced to sell marketable assets at a discount to meet policyholder demands.

ERM concept, framework, and process

Global Methodology - pg. 14

Question 152

How is capitalization assessed?

Answer 152

1) Capital cushion
2) Financial leverage
3) Fixed-Charge Coverage ratio
4) Capital flexibility
5) Capital generation

ERM concept, framework, and process

Global Methodology - pg. 14

Question 153

Why does capitalization matter for a FSR?

Answer 153

Capital is used to provide a buffer for losses to ensure the timely payment of the insurer’s obligations (and it retains policyholder, investor, and counterparty confidence).

ERM concept, framework, and process

Global Methodology - pg. 15

Question 154

What are the 3 main capital instruments? Give a brief description and DBRS’ opinion on them in terms of capitalization assessments.

Answer 154

1) Common equity: best because they can readily be used to absorb losses
2) Preferred shares: great because they can absorb losses, but not as flexibly (dividends are less flexible vs common equity)
3) Hybrid securities: fine because they can be used to meet regulatory requirements, but in practice, they are not able to absorb losses well

ERM concept, framework, and process

Global Methodology - pg. 15

Question 155

How is the capital cushion assessed?

Answer 155

1) Analyze the insurer’s regulatory solvency ratios (may be multiple, especially if international)
2) Results of stress test studies, especially forward looking ones
3) Analyze the firm’s ability to meet its internal risk and solvency assessment targets
4) Analyze the credit rating of the firm’s reinsurers
5) Evaluate capital structure (% of capital in common equity vs debt, etc)

ERM concept, framework, and process

Global Methodology - pg. 16

Question 156

How is financial leverage assessed?

Answer 156

The financial leverage ratio = (debt + hybrid securities + preferred shares) / total consolidated capitalization

ERM concept, framework, and process

Global Methodology - pg. 16

Question 157

What is operating debt?

Answer 157

Debt dedicated to funding an isolated block of policies regarded as having excess reserves. Over time, as the reserve reduces, the released funds are used to pay down the dedicated funding

ERM concept, framework, and process

Global Methodology - pg. 16

Question 158

What does EBIT mean?

Answer 158

Earnings before interest and taxes

ERM concept, framework, and process

Global Methodology - pg. 17

Question 159

How is the fixed-charge coverage ratio assessed? Why does it matter for a FSR?

Answer 159

1) EBIT is compared with the quantity of fixed charges (like interest payments on debt and dividends paid to preferred shares)
2) Missing preferred share dividend payments, for example, are considered a financial event and indicate a weakened credit profile

ERM concept, framework, and process

Global Methodology - pg. 17

Question 160

Why does capital flexibility matter for a FSR?

Answer 160

Having a variety of capital options allows the company to raise capital in the most cost-efficient form

ERM concept, framework, and process

Global Methodology - pg. 17

Question 161

How is capital generation assessed? Why does it matter for a FSR?

Answer 161

1) Analyze the generation of internal capital, the level and flexibility of dividends paid, and the aggressiveness of share buyback
2) The most flexible form of capital is the capital generated through retained profits

ERM concept, framework, and process

Global Methodology - pg. 17

Question 162

What is sovereign risk? What are some examples of sovereign risk events?

Answer 162

The impacts on a company from economic and political situations in a country in which it operates. This is a concern because many companies invest in government bonds.
Ex: government interventions, regulatory actions, and currency actions may place hardships on companies

ERM concept, framework, and process

Global Methodology - pg. 19

Question 163

How does DBRS rate an insurer’s support of branches?

Answer 163

Branches are part of the same legal entity used to extend the geographic reach of the entity, so branches all get the same ratings.

ERM concept, framework, and process

Global Methodology - pg. 22

Question 164

How does DBRS rate an insurer’s support of subsidiaries?

Answer 164

Assess the importance of the subsidiary to the insurer. Evaluate the extent to which failure to support the subsidiary would have negative implications for the insurer. Evaluate any explicit support provided and the likelihood of implicit support.

ERM concept, framework, and process

Global Methodology - pg. 22

Question 165

What are the ways an insurer might support a subsidiary?

Answer 165

Capital injections, funding, reinsurance, technical assistance

ERM concept, framework, and process

Global Methodology - pg. 22

Question 166

What 4 main factors affect the likelihood that an insurer will support its subsidiary?

Answer 166

1) Importance of the subsidiary to the insurer
2) Public sector ownership
3) Contribution of foreign subsidiaries to the insurer
4) Non-insurance subsidiaries

ERM concept, framework, and process

Global Methodology - pg. 22

Question 167

How can you gauge the importance of a subsidiary to the insurer?

Answer 167

A subsidiary is likely to be important if:
1) they operate in the same country
2) the sub is extensively integrated in the operations of the insurer
3) the names and/or brands are very similar and easily associated

ERM concept, framework, and process

Global Methodology - pg. 22

Question 168

How does public-sector ownership affect the likelihood that an insurer will support a subsidiary?

Answer 168

If the insurer is publicly owned, support of the subsidiary is less likely if:
1) the subsidiary does not support the public sector
2) the subsidiary is largely independent from the insurer (sponsor)
3) the insurer (sponsor) has limited commitments to the sub

ERM concept, framework, and process

Global Methodology - pg. 22

Question 169

How does contribution of foreign subsidiaries to the insurer affect the likelihood that the insurer will support its subsidiaries?

Answer 169

If an insurer has significant key international operations, it is more likely to support its international subsidiaries. The insurer’s track record in supporting its subsidiaries and its competency in managing international operations are key considerations here.

ERM concept, framework, and process

Global Methodology - pg. 22

Question 170

If a subsidiary is not an insurer, how does it affect the likelihood that it will receive support?

Answer 170

Non-insurers are less likely to receive support because the demise of a non-insurance subsidiary may have less of an impact on the insurer. Some non-insurance subs like banking subs, are often exceptions.

ERM concept, framework, and process

Global Methodology - pg. 23

Question 171

What is a captive?

Answer 171

Captives are insurers owned by the insureds and organized for the main purpose of self-funding the owners’ risks. The shareholders/insureds actively participate in decisions influencing the underwriting, operations, and investments of a captive insurer.

ERM concept, framework, and process

Global Methodology - pg. 24

Question 172

How does DBRS assess the FSR of a captive?

Answer 172

Typically, the captive will not have a different FSR than the parent because it typically does not have independent operations and is therefore dependent on the parent. The governance and control protocols are reviewed to assess the company’s ability to shield the captive from the financial hardship of the parent.

ERM concept, framework, and process

Global Methodology - pg. 24

Question 173

What is Solvency II?

Answer 173

Solvency II is a regulation for insurance and reinsurance undertakings in the EU. It has entered into force in January 2016. It aims to protect policyholders and beneficiaries. It has a risk-based approach that assesses the “overall solvency” of insurance and reinsurance undertakings through quantitative and qualitative measures.

ERM concept, framework, and process

CRO Forum - pg. 3

Question 174

What did insurers have to do because of COVID-19?

Answer 174

1) cope with earnings volatility
2) better understand exposures
3) strengthen online channels
4) optimize product mix
5) prepare for increased insurance fraud

ERM concept, framework, and process

CRO Forum - pg. 3

Question 175

What does data quality mean?

Answer 175

It refers to data’s “fitness for use.” It is the ability to fulfill the requirements of intended usage of data in a specific situation.

ERM concept, framework, and process

CRO Forum - pg. 3

Question 176

What is required to ensure effective data quality implementation?

Answer 176

1) Objectives setting
2) Planning
3) Measurement
4) Monitoring
5) Organization
6) Tools management

ERM concept, framework, and process

CRO Forum - pg. 3

Question 177

What 5 things can a CRO do to get involved in data quality management?

Answer 177

1) Promote a vision on data quality benefits
2) Support the definition of optimal data quality governance
3) Assess data quality value and risk in the objectives setting phase
4) Monitor the actual data quality risk profile
5) Help business management to address data quality risk

ERM concept, framework, and process

CRO Forum - pg. 4

Question 178

Why can data quality be considered an intangible asset?

Answer 178

They are both non-physical, separately identifiable, controllable, yield an economic benefit when used, capable of generating future benefit, and cost of its production or procurement can be quantified

ERM concept, framework, and process

CRO Forum - pg. 5

Question 179

What are the data quality dimensions?

Answer 179

Accuracy, completeness, and appropriateness

ERM concept, framework, and process

CRO Forum - pg. 8

Question 180

How can we determine data accuracy?

Answer 180

1) Data is free from material errors.
2) Data from different time periods used for the same estimation is consistent.
3) Data is recorded in a timely manner and consistently over time.

ERM concept, framework, and process

CRO Forum - pg. 8

Question 181

How can we determine data completeness?

Answer 181

1) Data includes sufficient historical information to assess the trend and characteristics of the underlying risk.
2) Data is available for all of the relevant model parameters.
3) Data is not excluded from use in an internal model without justification.

ERM concept, framework, and process

CRO Forum - pg. 8

Question 182

How can we determine data appropriateness?

Answer 182

1) Data is consistent with the assumptions underlying the actuarial and statistical techniques applied in an internal model.
2) Data reflects the relevant risks.
3) Data amount and nature ensure that estimations do not include material errors.
4) Data is collected and processed in a transparent and structured manner according to data definition and quality assessment criteria.
5) Data is updated regularly or whenever circumstances command.

ERM concept, framework, and process

CRO Forum - pg. 8

Question 183

How should a firm treat data quality?

Answer 183

Data quality should be:
1) be a regular item on the Management Board’s agenda
2) receive ongoing priority attention within the organisation
3) be a structural component of operational management
4) be applied to the processes related to Solvency II reporting and also to the insurer’s operational processes in general.

ERM concept, framework, and process

CRO Forum - pg. 8

Question 184

What are the 3 types of metadata?

Answer 184

1) business metadata (definition, data classification, data quality rules)
2) technical metadata (technical name, data type, location)
3) governance metadata (data owner)

ERM concept, framework, and process

CRO Forum - pg. 13

Question 185

What is a data dictionary?

Answer 185

A map of data assets where data is specified including the required metadata

ERM concept, framework, and process

CRO Forum - pg. 13

Question 186

What are the 3 main data quality committee types?

Answer 186

1) Strategic level
2) Tactical level
3) Operational level

ERM concept, framework, and process

CRO Forum - pg. 13

Question 187

What are the 3 approaches for valuing an object?

Answer 187

1) Market approach: value = value of identical or similar objects traded in the market
2) Cost approach: value = cost incurred for making or buying an exact copy
3) Income approach: value = total economic benefit created by the object in the future (NPV)

ERM concept, framework, and process

CRO Forum - pg. 17

Question 188

How can the 3 approaches to valuing objects be used to value data?

Answer 188

1) Market approach: NA as market prices are not given
2) Cost approach: not future-oriented, and doesn’t consider the benefit that data creats
3) Income approach: difficult to calculate (forecast future cashflows created by data)

ERM concept, framework, and process

CRO Forum - pg. 17

Question 189

Define ERM

Answer 189

ERM…
1) is a continuous process
2) assesses risk from the following perspectives: holistic and standalone, positive and negative, short-term and long-term
3) is concerned with all risks (including those that are unquantifiable)
4) aims to achieve an appropriate risk-reward balance

ERM concept, framework, and process

CIA Practice Doc - pg. 4

Question 190

What does CaR mean?

Answer 190

1) Capital at risk.
2) The earnings/capital that would be lost if a predefined event occurs.
3) The expected loss of capital given a probability over a specific time period.

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 191

What does EaR mean?

Answer 191

1) Earnings at risk
2) The reduction in earnings that would occur if a predefined event occurs.
3) ???? ADD

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 192

What does CRO mean?

Answer 192

Chief risk officer. The executive responsible for the risk management of an organization

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 193

What is a contagion?

Answer 193

When one risk event generates another. Financial contagion is the spread of a
financial shock throughout a wider group, such as a financial group, an economy or the world.

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 194

What does economic capital mean?

Answer 194

The amount of capital an organization requires to cover its obligations with a
given degree of confidence over a specific time horizon.

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 195

What does fungibility mean?

Answer 195

The ability to move funds freely from entity to entity within a group of companies in
order to absorb losses wherever they arise

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 196

What does ECM mean? What is its purpose?

Answer 196

1) Economic capital model.
2) A model used to calculate economic capital which is compared to actual available capital to assess capital adequacy.

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 197

What does LICAT mean?

Answer 197

Life insurance capital adeqacy test. The Canadian capital framework for life & health insurers.

ERM concept, framework, and process

CIA Practice Doc - pg. 5

Question 198

What does MCT mean?

Answer 198

Minimumm capital test. The Canadian capital framework for P&C insurers.

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 199

What does ORSA mean? What is its purpose?

Answer 199

Own risk an solvency assessment. An organization’s assessment of its risks and of the solvency needs associated with those risks.

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 200

What does PESTLE mean?

Answer 200

A framework used to analyze the impact of external factors on an organization. It analyses the exposure of the organization to political, economic, social, technological, legal, and environmental factors

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 201

What does RBC mean?

Answer 201

Risk-based capital. Capital requirements that reflect the risk profile of the financial institutions.

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 202

Define risk appetite

Answer 202

The level and type of risk that an organization is willing to accept in order to achieve its objectives (balancing threats and opportunities)

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 203

Define risk capacity

Answer 203

The extent of risk that an organization is able to support before breaching constraints generally determined by regulatory capital & liquidity needs and its obligations.

ERM concept, framework, and process

CIA Practice Doc - pg. 6

Question 204

Define risk limit

Answer 204

A threshold to monitor so that actual risk exposure doesn’t deviate too much from the risk target and stays within the organization’s risk tolerance and risk appetite. Exceeding risk limits will typically act as a trigger for management action.

ERM concept, framework, and process

Airmic

Question 205

Define risk profile

Answer 205

A description of the risk exposures of an organization.

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 206

Define risk tolerance

Answer 206

A quantitative description of the max amount of risk that the organization is willing to take regarding a specific risk. It is generally set by the organization in its risk appetite statement.

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 207

What does SaR mean?

Answer 207

1) Surplus at risk.
2) The shift in financial position that would occur if a predefined event occurs.
3) ??? ADD

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 208

What does VaR mean?

Answer 208

Value at risk. The maximum loss that could occur with a specified probability over a given time horizon.

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 209

What does TVaR mean?

Answer 209

Tail value at risk. the expected loss given that an event outside a given probability level has occurred over a given time horizon (a.k.a. conditional tail expectation).

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 210

Define agency risk

Answer 210

The risk of loss as a result of an agent’s pursuance of his or her own interests rather than the interests of the principal

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 211

Define conduct risk

Answer 211

The risk that firm behaviour will result in poor outcomes for customers

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 212

Define emerging risk

Answer 212

A risk that is developing or changing, is difficult to quantify, and may have a major impact. Often associated with a high degree of uncertainty, a lack of data, and are beyond the firm’s control. Like climate change and risk of pandemic.

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 213

Define equity risk

Answer 213

The risk of loss associated with exposure to an adverse movement in equity prices

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 214

Define inherent risk

Answer 214

The assessed level of raw or untreated risk; that is, the natural level of risk inherent in a process or activity without doing anything to reduce the likelihood or mitigate the severity of a mishap, or the amount of risk before the application of the risk reduction

ERM concept, framework, and process

CIA Practice Doc - pg. 7

Question 215

Define insurance risk

Answer 215

The risk of loss arising from movement in insurance variables including claim incidence, claim termination and persistency

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 216

Define interest rate risk

Answer 216

The risk of loss associated with exposure to adverse movements in interest rates

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 217

Define investment risk

Answer 217

The risk of loss relative to the expected return of any investment

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 218

Define market risk

Answer 218

The risk of loss arising from changes in market variables

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 219

Define mortality risk

Answer 219

The risk of loss arising from movements in mortality variables including morbidity and longevity

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 220

Define residual risk

Answer 220

The risk remaining with an organization following its risk management process and internal controls

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 221

What are the 8 key components of an ERM system?

Answer 221

risk…
1) governance
2) culture
3) identification
4) assessment
5) measurement
6) response
7) monitoring
8) reporting

ERM concept, framework, and process

CIA Practice Doc - pg. 8

Question 222

What is included in the risk governance system of an organization?

Answer 222

1) The assignment of roles and responsibilities
2) The policies and procedures
3) The internal control system

ERM concept, framework, and process

CIA Practice Doc - pg. 9

Question 223

Explain the 3 lines of defence model for ERM

Answer 223

1) first line is the business units who have the primary responsibility
2) second line is risk management and compliance for oversight
3) third line internal audit for independent review

ERM concept, framework, and process

CIA Practice Doc - pg. 10

Question 224

When assigning roles and responsibilities for risk governance, what parties should be considered?

Answer 224

1) Board
2) Risk committee
3) CEO
4) CFO
5) CRO
6) Chief actuary or appointed actuary
7) Compliance
8) Internal audit

ERM concept, framework, and process

CIA Practice Doc - pg. 10

Question 225

What should be included in a risk policy?

Answer 225

1) the organization’s objective with the risk
2) the link to the risk strategy
3) tasks to be performed and how to measure the risk
4) roles and responsibilities
5) reporting procedures
6) escalation process
7) frequency of review of the policy

ERM concept, framework, and process

CIA Practice Doc - pg. 11

Question 226

Define internal control system

Answer 226

A process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance

ERM concept, framework, and process

CIA Practice Doc - pg. 12

Question 227

What are the 5 components of an internal control framework?

Answer 227

1) Control environment
2) Risk assessment
3) Control activities
4) Information and communication
5) Monitoring activities

ERM concept, framework, and process

CIA Practice Doc - pg. 12

Question 228

Define risk culture

Answer 228

The norms and traditions of behavior of individuals and of groups within an organization that determine the way in which they identify, understand, discuss, and act on the risks the organization confronts and the risks it takes

ERM concept, framework, and process

CIA Practice Doc - pg. 12

Question 229

What should be considered during product development and pricing?

Answer 229

1) Economic value creation requirements for shareholders
2) Fair treatment of customers
3) Statutory requirements
4) The speed of recouping the investment capital
5) The impact on financials
6) Tail event impact on risk tolerances

ERM concept, framework, and process

CIA Practice Doc - pg. 12

Question 230

How can an organization monitor risk culture and protect against losses due to risk culture?

Answer 230

1) Measure risk culture through employee surveys testing awareness and views on risk issues
2) To protect against risks that have reputational impacts, organizations can open an anonymous channel for employees to report issues anonymously
3) Organizations can link bonuses to risk-adjusted performance instead of just performance. (Can also defer bonuses to place emphasis on long term risk-adjusted performance rather than short term.)

ERM concept, framework, and process

CIA Practice Doc - pg. 13

Question 231

What are the components of a risk strategy?

Answer 231

For each risk, list the…
1) objectives
2) principles
3) risk appetite
4) responsibilities

ERM concept, framework, and process

CIA Practice Doc - pg. 13

Question 232

What should be risks should be considered for a defined benefit pension plan, specifically?

Answer 232

1) Investment policy (including asset-liability matching, liquidity)
2) Design of the plan (including indexation, anti-selection for optional benefits)
3) Funding policy
4) Plan maturity

ERM concept, framework, and process

CIA Practice Doc - pg. 13

Question 233

How do you express a risk tolerance?

Answer 233

Risk tolerance is often expressed in terms of key measures, including:
1) Capital or funding adequacy
2) Earnings or earnings volatility
3) Liquidity
4) Operational risk

ERM concept, framework, and process

CIA Practice Doc - pg. 14

Question 234

What are the main difficulties that arise when translating organizational risk tolerance into specific risk limits?

Answer 234

1) Technical challenges like projecting future scenarios
2) Availability of data
3) Conflicts between risks and measures (like capital and earnings volatility)
4) Maintaining consistency between BUs and group objectives
5) Interaction of risks and capital

ERM concept, framework, and process

CIA Practice Doc - pg. 15

Question 235

What operations does risk appetite affect?

Answer 235

1) NB mix/budgeting
2) Capital allocation
3) Asset allocation
4) ORSA or ICAAP
5) liquidity management
6) performance measurement and management

ERM concept, framework, and process

CIA Practice Doc - pg. 16

Question 236

How does risk appetite affect NB mix/budgeting?

Answer 236

The analysis of risks would often include both new business mix (looking at risk concentrations as well as opportunities to improve diversification) and volumes, taking into account both available capital and risk concentrations.

ERM concept, framework, and process

CIA Practice Doc - pg. 16

Question 237

List common stakeholders for risk related strategies

Answer 237

1) Regulators
2) Investors
3) Board of directors
4) Senior management
5) Bond holders
6) Credit rating agencies
7) Customers
8) Plan participants

ERM concept, framework, and process

CIA Practice Doc - pg. 16

Question 238

How are risks categorized?

Answer 238

Identify the cause, the event, and the adverse impact of a risk

ERM concept, framework, and process

pg. 18

Question 239

What should be included in a risk assessment report?

Answer 239

1) Detailed description of risk
2) Consequences of risk
3) Categorization of risk
4) Likelihood and impact of risk
5) Assessment of the effectiveness of controls and mitigation strategies
6) Assessment of residual risk
7) Actions required

ERM concept, framework, and process

CIA Practice Doc - pg. 20

Question 240

How should a risk measure be chosen?

Answer 240

1) Objective of analysis. Different measures are better suited for some objectives.
2) Stakeholders. Complex measures will require actuaries to spend time educating others.
3) Data and modeling limitations. Is the amount of effort for the measure worth the benefit?

ERM concept, framework, and process

CIA Practice Doc - pg. 21

Question 241

Why might one use TVaR instead of VaR?

Answer 241

When the loss distribution is heavily skewed

ERM concept, framework, and process

CIA Practice Doc - pg. 23

Question 242

Why might pure risk measures be more appropriate than risk adjusted measures?

Answer 242

Pure risk measures are more constraining, so they should not be ignored. (Ex: mortality risk before vs after reinsurance.) If both pure and adjusted risk measures fall within limits, risk adjusted measures can be used to compare candidate strategies.

ERM concept, framework, and process

CIA Practice Doc - pg. 24

Question 243

What is a simple factor model? Give an example

Answer 243

1) The simplest form of model that can be used to measure risk. A prescribed factor is multiplied by a known base amount to estimate the amount of risk.
2) Ex: When measuring asset default risk, ratings-specific credit default charges are applied to the value of assets held.

ERM concept, framework, and process

CIA Practice Doc - pg. 25

Question 244

What is a standard shock? Give an example.

Answer 244

1) A risk measurement that assesses the financial impact of a prescribed risk factor stress.
2) Ex: To assess mortality risk, you can calculate the financial impact of a 15% increase to BE mortality rates.

ERM concept, framework, and process

CIA Practice Doc - pg. 25

Question 245

What’s the difference between standard shock and own shock?

Answer 245

Instead of using a prescribed stress test, an organization can run their own stress tests.

ERM concept, framework, and process

CIA Practice Doc - pg. 25

Question 246

What is a partial model?

Answer 246

1) A model used to measure a risk.
2) It can be based on a probability distribution or a distribution of scenarios, determined stochastically or deterministically.
3) It can be used in conjunction with other models for other risks to get an aggregate measure of the organization’s risks.

ERM concept, framework, and process

CIA Practice Doc - pg. 25

Question 247

What’s the difference between a full model and a partial model?

Answer 247

1) A full model measures all of an insurer’s risks.
2) A multivariate probability distribution can be used to measure all risks simultaneously. Or each risk can be modelled separately, then aggregated using copulas.

ERM concept, framework, and process

CIA Practice Doc - pg. 25

Question 248

How are market risks modelled?

Answer 248

Market risks depend on external economic factors which are often measured using stochastic models (which may make use of sub-models like economic scenario generators).

ERM concept, framework, and process

CIA Practice Doc - pg. 26

Question 249

How are credit risks modelled?

Answer 249

1) Simple factor models are often used. Ratings-specific credit default charges are applied to the corresponding asset values or exposures.
2) Stochastic models can also be used to define prob of default and loss given default.

ERM concept, framework, and process

CIA Practice Doc - pg. 26

Question 250

What are biometric risks?

Answer 250

Mortality, morbidity, and longevity risks

ERM concept, framework, and process

CIA Practice Doc - pg. 26

Question 251

How are biometric risks modelled?

Answer 251

1) Simple factor models, stress tests, or more sophisticated stochastic models
2) Since biometric risks are long-term in nature, the stress tests and models are usually cashflow projection models which could include stochastic elements.

ERM concept, framework, and process

CIA Practice Doc - pg. 26

Question 252

What are examples of behaviour risks?

Answer 252

Persistency, contribution patterns, exercise of embedded options, management expenses

ERM concept, framework, and process

CIA Practice Doc - pg. 27

Question 253

What is maturity risk?

Answer 253

Organizations like public pension plans adopt investment strategies that align with the current risk profile and ability to bear risk. Maturity risk is the risk that demographic shifts cause risk profile shifts such that the org is unable to bear the risks required to achieve its objectives.

ERM concept, framework, and process

CIA Practice Doc - pg. 27

Question 254

How are operational risks modelled?

Answer 254

Quantifying operational risks is very subjective, so a subjective scenario-based approach is often used, relying on the opinions of experts.

ERM concept, framework, and process

CIA Practice Doc - pg. 27

Question 255

How can a firm decide on a risk aggregation approach?

Answer 255

Factors to decide may include:
1) computing power
2) end-user education
3) complexity vs accuracy tradeoff

ERM concept, framework, and process

CIA Practice Doc - pg. 28

Question 256

Why does ORSA require forward assessment of risk and capital information?

Answer 256

Projection of risk and capital info within the business plan helps to ensure that strategic decisions made by senior management consider the future implications on risk and capital. (The time horizon is usually 3 to 5 years, or whatever is consistent with other business plan metrics.)

ERM concept, framework, and process

CIA Practice Doc - pg. 28

Question 257

What does SST mean? What is its purpose?

Answer 257

Stress and scenario testing. It is used to understand what happens if the external economic and internal business environments are not stationary (like many models assume).

ERM concept, framework, and process

CIA Practice Doc - pg. 30

Question 258

What 3 things will a robust SST framework test?

Answer 258

1) The adequacy of resources held within a business
2) The validity of current strategic business plans and risk appetite
3) The appropriateness of some aspects of resolution and recovery plans

ERM concept, framework, and process

CIA Practice Doc - pg. 30

Question 259

What 5 things can SST do in the ERM process?

Answer 259

1) Assist in determining risk appetite
2) Strategic decision making
3) Model validation
4) Compliance with accounting requirements
5) Interactions with regulators

ERM concept, framework, and process

CIA Practice Doc - pg. 31

Question 260

How can SST assist in determining risk appetite?

Answer 260

SST can help management understand the reasonability of risk limits by showing what conditions would result in risk exposure measures that exceed those limits.

ERM concept, framework, and process

CIA Practice Doc - pg. 31

Question 261

What is reverse stress testing?

Answer 261

The process used to back-solve the required stress and/or scenario events that will produce a specific adverse business outcome.

ERM concept, framework, and process

CIA Practice Doc - pg. 32

Question 262

What are the 4 ways that variables can be related?

Answer 262

1) Immediate dependency (direct immediate causal relationship)
2) Time-lagged dependency (delayed causal relationship)
3) Feedback dependency (variables interact with each other over time)
4) Phase-shift dependency (one variable affects another only after a change has reached a threshold)

ERM concept, framework, and process

CIA Practice Doc - pg. 33

Question 263

What factor must you remember to consider when mitigating or sharing risks?

Answer 263

Remember that mitigating and sharing risks often creates or increases other forms of risk

ERM concept, framework, and process

CIA Practice Doc - pg. 37

Question 264

What qualities does risk management information need to have to be valuable?

Answer 264

1) Timely
2) Comprehensive
3) Consistent
4) Accurate
5) Auditable
6) Forward-looking

ERM concept, framework, and process

CIA Practice Doc - pg. 40

Question 265

What items are required in an ORSA?

Answer 265

1) Assessment of the adequacy of risk management, current and future solvency position, capital resources
2) Comprehensive of all material risks
3) Determination of the financial resources needed to manage its business
4) Analysis of the ability to continue in business and meet capital requirements

Capital Management

CIA Practice Doc - pg. 44

Question 266

What items are included in FCT?

Answer 266

1) Development of a base scenario
2) Analysis of the impact of adverse scenario
3) Identification and analysis of the effectiveness of various corrective actions
4) Results and recommendations
5) Appointed Actuary’s opinion and sign off

Capital Management

CIA Practice Doc - pg. 44

Question 267

What are the pros and cons of standard deviation?

Answer 267

Pro: easy to understand
Con: Not a coherent risk measure because it fails the monotonicity criteria and variance fails the sub-additivity criteria
Con: Doesn’t describe the entire distribution. Skewness and kurtosis are often needed to help explain the tail (the most important part of the distribution).

ERM concept, framework, and process

CIA Practice Doc - pg. 47

Question 268

What are the pros and cons of VaR?

Answer 268

Pro: easy to understand
Con: Not a coherent risk measure because it fails the sub-additivity criteria
Con: Doesn’t describe the tail of the distribution

ERM concept, framework, and process

CIA Practice Doc - pg. 47

Question 269

What are the pros and cons of TVaR?

Answer 269

Pro: Coherent risk measure
Con: Describes the tail of the distribution
Con: Difficult to calculate

ERM concept, framework, and process

CIA Practice Doc - pg. 48

Question 270

How can we define a firm’s willingness to bear risk?

Answer 270

1) The desire or aversion to pursue opportunities in an uncertain business environment
2) How much volatility around an expected outcome is tolerable (in terms of capacity, regulatory compliance, ethics, reputation, and alternative costs)

ERM concept, framework, and process

Airmic

Question 271

Order these risk concepts from most general to most specific: appetite, capacity, limit, target, tolerance.

Answer 271

1) Risk capacity (org level, max risk)
2) Risk appetite (org level, desired)
3) Risk tolerance (risk level, max risk)
4) Risk target (risk level, desired)
5) Risk limit (threshold to monitor and trigger management action)

ERM concept, framework, and process

Airmic

Question 272

Define risk target

Answer 272

The optimal level of risk that an organization wants to take regarding a specific risk in pursuit of a specific business goal

ERM concept, framework, and process

Airmic

Question 273

What qualities should a risk appetite statement have?

Answer 273

Risk appetite statement should be:
1) Comprehensive
2) Measurable, practical, and achievable
3) Consistent and coherent

ERM concept, framework, and process

Airmic

Question 274

How does risk appetite support decision-making?

Answer 274

1) Identify business objectives
2) Understand baseline risk management maturity
3) Define risk appetite
4) Integrate risk appetite into decision-making through performance targets
5) Specify monitoring, reporting, and review processes
6) Implement continuous improvement processes (including regular review of risk appetite)

ERM concept, framework, and process

Airmic

Question 275

What factors might influence an organization’s risk appetite?

Answer 275

1) Economic cycles
2) Competitor activities
3) Capital availability
4) Terms and conditions of borrowed capital
5) Diversification opportunities
6) Insurance market conditions
7) Stakeholder and societal demands
8) Compliance requirements
9) The organization’s own ROI targets and capital requirements

ERM concept, framework, and process

Airmic

Question 276

How do you make a risk appetite statement?

Answer 276

1) Define scope and objectives of statement
2) Define principles of governance (which roles are involved and how their inputs are used)
3) Set review intervals
4) Link risk appetite to objectives, strategies, and KPIs
5) Use appropriate language for the org (like a taxonomy)
6) Ensure consistency with other risk management guidance

ERM concept, framework, and process

Airmic

Question 277

How does OSFI’s risk assessment process work?

Answer 277

1) Evaluate the inherent risk within each significant activity of the insurer and the quality of risk management
2) Determine the level of net risk for each activity and direction (decreasing, stable, increasing)
3) Calculate ONR
4) Develop a Composite Risk Rating (with direction) for the insurer, after assessing earnings, capital, and liquidity in relation to ONR

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 2

Question 278

What does ONR mean?

Answer 278

1) Overall net risk. OSFI calculates the overall net risk of an insurer as part of the risk assessment process.
2) It is a consolidated assessment of the potential adverse impact that the significant activities collectively could have on the insurer’s earnings performance and adequacy of capital.

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 2

Question 279

What are the OSFI capital guidelines and who are they for?

Answer 279

1) MICAT (mortgage insurer capital adequacy test) for mortgage insurers
2) MCT (minimum capital test) for P&C insurers that aren’t mortgage insurers
3) LICAT (life insurance capital adequacy test) for life insurers

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 3

Question 280

Under LICAT, what are the capital resources and the capital requirements?

Answer 280

1) Capital resources are the qualifying regulatory capital.
Total = Available capital + surplus allowance (SA) + eligible deposits (ED)
Core = Tier 1 capital + 70% of SA + 70% of ED
2) Capital requirement is the amount of regulatory capital needed to support the insurer’s risks. Base Solvency Buffer.

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 3

Question 281

What are the capital triggers OSFI has in place?

Answer 281

1) Minimums: the minimum levels of capital necessary for an insurer to cover its risks. (Falling below the minimums would raise major concerns)
2) Supervisory Target: the target levels of capital for an insurer to cover its risks and provide a margin for other risks. (Falling below the targets is an early warning signal and would trigger intervention)

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 4

Question 282

How are the minimums and supervisory targets calculated for LICAT?

Answer 282

1) Total:
Min is 90% of capital requirement
Target is 100% of capital requirement
2) Core:
Min is 55% of capital requirement
Target is 70% of capital requirement

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 5

Question 283

Why should an insurer not solely rely on OSFI’s capital regulations?

Answer 283

The minimums and supervisory targets are based on simplifying assumptions applied to the entire industry. Insurers should conduct an ORSA to determine its own, specific capital needs.

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 5

Question 284

What does internal taget mean?

Answer 284

The target levels of capital determined as part of an insurer’s ORSA. OSFI expects internal targets for total capital and core capital, and they should be set above the supervisory targets. OSFI should be notified when an insurer changes its Internal Targets.

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 6

Question 285

What does capital management mean?

Answer 285

It is the on-going process of determining and maintaining the quantity and quality of capital that is appropriate to support an insurer’s planned operations.

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 6

Question 286

What are the purposes of capital?

Answer 286

1) Maintain financial strength
2) Absorb losses
3) Support growth opportunities
4) Provide assets to meet obligations in the case of insolvency

ERM concept, framework, and process

OSFI Guideline A-4 - pg. 7

Question 287

What 3 focuses does risk appetite have?

Answer 287

1) Protecting and creating value for the business by allowing management to make informed decisions to maximize risk-adjusted returns.
2) Ensure consistency between risk appetite and risk limits. (2008 financial crisis showed that many firms had risk limits higher than appetite)
3) Integrating into the corporate culture to guide risk-taking operations

ERM concept, framework, and process

Risk App. Link Report - pg. 7

Question 288

What items should be included in a risk appetite statement?

Answer 288

1) Enterprise risk tolerance. The aggregate amount of risk the company is willing to take, expressed in terms of the following targets: capital adequacy, earnings volatility, and credit rating.
2) Risk appetite for each risk category
3) Risk limits for each risk category

ERM concept, framework, and process

Risk App. Link Report - pg. 11

Question 289

What are the common quantitative and qualitative risk measures?

Answer 289

Quantitative: VaR and TVaR (for capital and earnings)
Qualitative: lowest desired credit rating, risk preferences (like not doing business in a certain region), and franchise value (from changes in publicity and reputation)

ERM concept, framework, and process

Risk App. Link Report - pg. 12

Question 290

What is the purpose of backtesting? How does it work?

Answer 290

1) Quantitative risk measures are very sensitive to assumptions and model risk, so model validation can be difficult.
2) Tail risk events are rarely experienced in a lifetime, so it can be impossible to test the credibility of the risk measures against reality.
3) Solution: backtest the risk measures against reality. Ex: Use 80% CaR and test it against the past 5 years of experience, for example.

ERM concept, framework, and process

Risk App. Link Report - pg. 15

Question 291

What are the steps to making a risk appetite statement?

Answer 291

1) Bottom-up analysis of the company’s risk profile
2) Interviews with the board to set risk tolerance
3) Alignment of risk appetite with the company’s goal and strategy
4) Finalize statement and get board’s approval
5) Establish risk policies, risk limits, and risk monitoring processes consistent with appetite
6) Communicate with senior management?

ERM concept, framework, and process

Risk App. Link Report - pg. 16

Question 292

What are some risk limits that can be set for market risk?

Answer 292

1) Asset allocation limits
2) Foreign exchange limits
3) Fixed income securities duration limits
4) Asset liability mismatch limits

ERM concept, framework, and process

Risk App. Link Report - pg. 19

Question 293

What risks are components of insurance risk?

Answer 293

1) underwriting risk
2) mortality risk
3) morbidity risk
4) lapse risk
5) expense risk

ERM concept, framework, and process

Risk App. Link Report - pg. 21

Question 294

What risk limit can be set for insurance risks? How can it be calculated and monitored?

Answer 294

A/E ratio. To set the limit, calculate the expected payment under a stress event and divide by the expected payment under best estimate assumptions. To monitor, compare A/E ratios from regular experience studies to the A/E ratio limit.

ERM concept, framework, and process

Risk App. Link Report - pg. 21

Question 294

What risk limit can be set for catastrophe risk?

Answer 294

NAR (net amount at risk). It is the sum assured minus the reserve. It is the additional amount that must be paid in excess of what has been reserved.

ERM concept, framework, and process

Risk App. Link Report - pg. 22

Question 295

What is concentration risk?

Answer 295

The risks caused by a dominating position in a risk category, product line, distribution channel, or asset class.

ERM concept, framework, and process

Risk App. Link Report - pg. 23

Question 296

What risk limit can be set for terrorism risk?

Answer 296

A limit on the concentration of policyholders’ locations

ERM concept, framework, and process

Risk App. Link Report - pg. 23

Question 297

What are some things a firm can do to manage operational risk?

Answer 297

Brand management, anti money laundering, and compliance policies are examples of reputation and legal risk management.

ERM concept, framework, and process

Risk App. Link Report - pg. 23