Part 9 Flashcards
Categories of risk:
• Financial o Market Risk Assets Liabilities Asset/Liability Matching o Credit Risk Asset default Counterparty risk Debtors o Business Risk Underwriting Insurance Financing Exposure o Liquidity Risk
• Non-financial
o Operational Risk
Inadequate internal processes, people or systems
Dominance of a single individual
Reliance on third parties
Failure of plans to recover from an external event
o External Risk
Apply - Certain principles are seen as being fundamental to good lending and in turn to reducing credit risk. A number of key questions have to be asked:
- Is the character and ability of the borrower satisfactory? Is he trustworthy?
- Is there a valid purpose for the loan and is the money to be put to good use?
- Is the amount that is being borrowed reasonable given the purpose it is being put to?
- Does the borrower have the ability to repay?
Examples of business risk to financial providers are:
- A life or general insurer not having adequate underwriting standards and thus taking on risks at an inadequate price – underwriting risk
- An insurer suffering more claims than anticipated – insurance risk
- A provider of finance, such as a bank, investing in a business or project that fails to be successful – financing risk
- A reinsurer having greater exposure than planned to a particular risk event ; for example through writing whole account protection covers as well as primary reinsurance of the risk – exposure risk
Apply - Areas of risk:
- Claims
- Withdrawals
- Expenses
- Mix of business
- Volume of business
- Options and guarantees offered
- Reinsurance
Key risks in a benefit scheme to the beneficiary
- Benefits will be less valuable than expected, or
* They will not be received at the expected (or required) time
Key risks to the sponsor of a benefit scheme
- Costs will be greater than expected, or
* Payments will be required at a inopportune time
Ideas – risks that need to be managed to ensure that sufficient assets are available to meet the liabilities as they fall due
- Inadequate funds due to underfunding
- Inadequate funds due to sponsor insolvency
- Inadequate funds due to asset/liability mismatching
- Illiquid assets, ie funds not available when required
- Risk that the benefit promise is changed, eg by the state
- Members’ needs not being met, either due to design or inflation erosion of value
Ideas – For a defined benefit scheme the risk of inadequate benefits arises from:
- Investment returns being lower than expected, or expense charges higher
- Annuity purchase terms being poorer than expected
- Members’ needs not being met, either due to design or inflation erosion of value
Ideas – Factors that lead to uncertainty of the benefits to be received by beneficiaries whether benefits are defined or not:
- Default by sponsor/provider at a time when the funds held are insufficient
- Default by sponsor/provider when funds held include loans to sponsor/provider
- Failure by sponsor/provider to pay contributions/premiums in a timely manner
- Takeover of the sponsor/provider by an organisation unwilling to continue to meet benefit promises
- Decision by the sponsor/provider that benefits will be reduced
- Inadequate communication by sponsor/provider with beneficiaries, of the strength of the sponsor/provider, guarantee, promise etc, giving rise to complaints and possible compensation to some beneficiaries and shortfall for others
- General economic mismanagement by a sponsor/provider of assets and liabilities may also lead to a risk of benefit shortfall
Ideas – For defined benefit schemes future contributions/premiums are unknown and will depend on:
- Amount of the promised benefit
- Probability of individuals being eligible to accrue benefits
- Probability of members being eligible to receive benefits
- Effect of inflation on the level, or the real level, of the benefits
- The investment return achieved on the contributions/premiums
Ideas – Contribution/premium risks for a defined contribution scheme
- Contributions/premiums are unaffordable and hence not made
- Insufficient liquidity to make the payments in a timely manner
- The contributions/premiums are linked to an inflationary factor, thereby introducing inflationary risk
Ideas – Factors that may lead to uncertainty of the contributions/premiums required whether contributions/premiums are defined or not:
- Loss of funds due to fraud or misappropriation
- Incorrect benefit payments
- Inappropriate advice
- Administrative costs, especially as a result of compliance with changes in legislations
- Decisions by parties to whom power has been delegated (operational risk)
- Fines or removal of tax status resulting from non-compliance with legislative requirements
- Changes to tax rates or status
Extra risks in a hybrid scheme
- Not knowing whether the guarantee will bite or not
- The uncertain cost of the guarantee
- Additional complexity in the areas of administration, investment, regulation, valuation and communication
A risk is insurable if
- The policyholder has an interest in the risk
- The risk is of financial and reasonably quantifiable nature
- The claim amount payable is commensurate with the size of the financial loss
Risk events ideally have to meet the following criteria if they are to be insurable:
- Individual risk events should be independent of each other
- The probability of the event should be relatively small
- Large numbers of potentially similar risks should be pooled in order to reduce the variance and hence achieve more certainty
- There should be an ultimate limit on the liability undertaken by the insurer
- Moral hazards should be eliminated as far as possible because these are difficult to quantify, result in selection against the insurer and lead to unfairness between one policyholder and another
- There should be sufficient existing statistical data/information in order to quantify risk
