Part 9 Flashcards
Categories of risk
3 examples of credit-linked event
- Bankruptcy
- Rating downgrage / upgrade
- Failure to pay
The principles of good lending relate to (4)
- Character and ability of the borrower (is he trustworthy?)
- Purpose of the loan
- Amount of the loan
- Ability of the borrower to repay
Difference between marketability and liquidity
- Marketability is how easy it is to convert an asset into cash
-
Liquidity is a measure how quickly the asset can be converted into cash at a predictable price
- call deposit at a bank is very liquid
- long-term government bond is marketable but not liquid since the market value is volatile
Consequences of mismatching (2)
- Higher liquidity risk
- reinvestment risk
Categories of business risks (4) and examples
-
Underwriting risk
- inadequate underwriting standards and therefore taking on risks at an inadequate price
-
Insurance risk
- Insurer suffering more claims than anticipated
-
Financing risk
- investing in a business that fails to be successful
-
Exposure risk
- A reinsurer having greater exposure than planned to a particular risk event
Main claim risk for an insurance company
- Mortality
- Longevity
- Morbidity
- Medical advances (diagnosis, cures, etc.)
- loose policy wordings
- Accumulation of risks and catastrophes
- anti-selection and moral hazard
Main claim risks for a general insurance company
- Claim frequency
- Claim amount
- Claim inflation
- Claim volatility
- Claim delays
- Claims handling
- Loose policy wordings
- Accumulation of risks and catastrophes
- Anti-selection and moral hazard
Define operational risk
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
Operational risk can arise from: (4)
- Inadequate or failed internal processes, people or systems
- The dominance of a single individual over the running of a business (dominance risk)
- Reliance on third parties to carry out various functions for which the organization is responsible
- The failure of plans to recover from an external event
Examples of defined benefit pension schemes (3)
- Final salary schemes: benefits are based on earnings in the last three years prior to retirement
- Career average scheme: benefits are based on earnings over career, possibly revalued
- Fixed benefit scheme: fixed amount for each year of service
Examples of defined ambition schemes (2)
- A cash accrual scheme where benefits are defined as a lump sum rather than as a pension
- A defined contribution scheme offering a defined benefit underpin e.g. the benefit will not be less than 1/100th of final salary for each year of service
3 key benefit risks for a defined contribution scheme
- Investment returns being lower than expected, or expense charges higher
- Annuity purchase terms poorer than expected
- Members’ needs not being met, either due to design or inflation erosion of value
6 key benefit risks for a defined benefit scheme
- Inadequate funds due to underfunding (insufficient funds set aside)
- inadequate funds due to sponsor insolvency
- inadequate funds due to asset liability mismatching
- illiquid assets
- risks that the benefit promised is changed, e.g. by the state
- members’ needs not met, either due to design or inflation erosion of value
Further benefit risks for both, DB and DC schemes
- default by sponsor
- failure by sponsor to pay contributions/premiums in a timely manner
- takeover of the sponsor
- decision by the sponsor that benefits will be reduced
- inadequate communication by sponsor / provider of assets and liabilities
The overall level of the contributions for a defined benefit scheme depend on (5)
- The amount of the promised benefit
- The probability of individuals being eligible to accrue the beneftis
- The probability of individuals being eligible to receive the benefits
- The effect of inflation on the level, or the real level, of the benefits
- The investment return achieved on the contributions (net of tax and expenses, if appropriate)
Contribution risks for defined benefit schemes
- Future contributions unknown and depend on
- the amount of the benefit
- eligibility to accrue benefits
- eligibility to receive benefits
- inflation
- investment returns net of tax and expenses
- Extra contributions may be required to meet a shortfall, resulting in liquidity risk or excessive contributions
Contribution risks for defined contribution schemes (3)
- Unafforadable contributions
- Insufficient liquidity to make the payments in a timely manner
- Contributions may be linked to an inflationary factor, introducting an inflationary risk
Other word for “timing” of the investment return
Incidence of the return on investments
10 key investment risks for a benefit scheme
- Uncertainty over the level and incidence of income
- Uncertainty over the level and incidence of capital
- Reinvestment risk arising from mismatching assets and liabilities
- Default risk
- Tax and expenses
- Benefits are not appreciated due to poor investment returns
- Inflation erosion
- Opportunity cost of the capital
- Liquidity risk
- Lack of diversification
Define risk classification
Risk classification is a tool for analyzing a portfolio of prospective risks by their risk characteristics, such that each subgroup of risks represents a homogeneous body of risk.
E.g.
- male/female
- smoker/non-smoker
3 criteria that a risk must satisfy in order for an insurer to be preprated to take on the risk (insurability)
- Policy holder must have an interest in the risk being insured (to distinguish between insurance and a wager (Wette))
- A risk must be of a financial and reasonable quantifiable nature
- Insurer need to be able to assess the risk and set an appropriate premium
- The amount payable by the insurance policy in the event of a claim must bear some relationship to the financial loss incurred
- If the claim amount is too small, the policyholder is unlikely to deem the insurance worthwhile, if it is too large, this will encourage fraud and moral hazard
6 additional desirable criteria for a risk to be insurable
- Individual risk should be independent
- the probability of the event occuring should be relatively small
- large number of similar risks should be pooled to reduce variance
- There should be a limit on ultimate liability undertaken
- Moral hazard should be eliminated as a far as possible
- there should be sufficient existing data / information in order to quantify risk
Define risk management
Risk management is the process of ensuring that the risks to which an organisation is exposed
- are the risks to which it THINKS it is exposed
- and tho which it is PREPARED to be exposed
The risk management process consists of (5)
- risk identification
- risk measurement
- risk control
- risk financing
- risk monitoring
Risk management process - risk identification
Recognition of the risks that can threaten the income and assets of an organisation
- high level preliminary analysis
- brainstorming with experts
- desktop analysis
- risk register or risk matrix
Risk management process - risk measurement
measuring the probability and severity of a risk
Risk management process - risk control
Mitigation to reduce the probability / severity of a loss
Through risk managment a provider will be able to
- avoid surprises
- improve the stability and quality of their business
- improve their growth and returns by exploiting risk opportunities
- improve their growth and returns through better management and allocation of capital
- identify opportunities arising from natural synergies
- give stakeholders in their business confidence that the business is well managemed
- price products to reflect the inherent level or risk
- improve job security and reduce variability in employee costs
- detect risks earlier meaning they are cheaper and easier to deal with
- determine cost-effective means of risk transfer
When faced with a risk each stakeholder can choose wheter to (5)
- avoid the risk
- reject the need for financial coverage of that risk because it is either trivial or largely diversified
- retain all the risk
- pay a premium to another party to transfer all the risk to that party
- retain some of the risk and pay a premium to transfer the balance of risk to another party
Risk management process - risk financing
Determining the likely cost of a risk
… and ensuring the availability of adequate financial resources to cover the risk
Risk managment process - risk monitoring
Regular review and reassessment of risks together with an overall business review to identify new / previously omitted risks
Main weakness of VaR
Does not quantify the size of the “tail”
Expected shortfall
Calculate 95% VaR
Conditional Tail VaR
Expected shortfall divided by the shortfall probability
