Past Exam Questions: April 2013 Flashcards
Outline different protection measures that government regulators can implement for financial services companies
- Requirements to provide regular information to investors
- Requirements to provide regular information to customers
- Restrictions on the establishment of new financial institutions
- Qualitative requirements for the management, systems and processes of firms
- Requirements on the quality of directors, management and staff
- Restrictions on insider trading
- Restrictions on lines of business e.g. separating investment and retail banking
- Establishment of industry-wide insurance or compensation schemes
- Acting as a lender of last resort
- Intervention in the management of companies
- Intervention in the ownership of companies
- controls on distribution methods and channels
- restrictions on investments held.
- restrictions on counterparty exposures.
- regular reporting requirements.
- regular inspections.
- keeping different units separately capitalised.
Explain the benefits for the insurer if the risk department also takes account of other stakeholders (beyond only the regulator)
- The regulatory risk and capital adequacy framework may not be very sophisticated.
- By considering risks affecting many stakeholders, the company will have a better understanding of the full range of risks, i.e. risks are less likely to be missed out.
- The insurer may gain greater appreciation of concentrations of risk and diversification issues e.g. activities of the insurer that give rise to diversification / correlation of risks.
- It may also help eliminate different levels of risk appetite in different areas of the company.
- In particular the company may have missed commercial opportunities and exploitation of strategic advantages by concentrating on regulatory aspects which will tend to focus on reducing downside risk.
- Having more information will allow the company to take more appropriate action when managing the risks.
- In particular, considering the balance between the needs of different stakeholders (e.g. shareholders vs policyholders) should help the company to optimise its risk / return trade-off.
- By taking account of credit rating agency requirements the insurer might improve its credit standing and so obtain cheaper access to funding.
Describe the process of developing and implementing a risk map
- Establish a top-down framework: an overall taxonomy for all risks.
- Create a bottom-up list of specific risks by business and functional units based on loss history and self assessments.
- Evaluate the probability [or frequency] and severity of each risk based on judgement or risk models.
- Develop the risk map and plot each risk in turn against the probability and severity axes.
- Identify existing controls to incorporate their impact into the risk map (e.g. well-managed / managed / needs more management) and to determine whether new controls are required.
- Assign responsibilities for implementing new controls and for monitoring and reporting on specific risks.
- Aggregate the individual risk map into an enterprise risk map and determine if new controls are required at the enterprise level.
- Return to the first step.
Give 2 groups of contrasting examples of risks to which an insurance company may be exposed
HIGH SEVERITY, LOW FREQUENCY:
- Default of a reinsurance company
- Property claims arising from a catastrophic earthquake / collapse of a high rise building / terrorist attack
- Own business disruption / operational problems from a similar event
LOW SEVERITY, HIGH FREQUENCY
- Minor mismanagement in claims area leading to higher than expected claims payments
- Aggregation of small property claims due to concentration of sales in a specific area.
How might an insurer reduce the risks to which it is exposed, without increasing its counterparty risk
- If the insurer extends the range of policies sold, there will be diversification benefit, particularly if the policies are different in nature to the existing policies.
- It should consider selling in different geographical areas, either different parts of the country it operates in or abroad.
- Withdraw from the riskier classes of business.
- Improve the underwriting of the business it chooses to keep.
- Reduce underwriting and pricing risks through more intelligent data analysis.
- Introduce lower maximum benefit amounts.
- Having higher policy excesses.
- Reduce market risk by investing in assets which better match the liabilities.
- Diversify assets more across individual counterparties.
- Reduce operational risks through the implementation of strong governance and controls.
- Reduce any existing credit and counterparty risks by using counterparties with higher credit ratings or by using tougher service agreements.
- It may be possible to reduce agency risk through the use of intelligent remuneration and bonus systems that align better the interests of different stakeholders.
- Increase the capital held in order to reduce overall solvency or wind-up risk.
- improve the claims management processes
- tighten up and otherwise alter policy conditions
- business continuity plans
- staff training
- increase pricing margins
Define Prepayment risk
Prepayment risk is the risk involved with the premature return of principal on a fixed-income security.
When principal is returned early, future interest payments will not be paid on that part of the principal, meaning investors in associated fixed-income securities will not receive interest paid on the principal.
Define longevity risk
Longevity risk is the risk that a business experiences losses due to mortality being lighter than expected.
How can an insurer mitigate its longevity risk?
- It should ensure that its annuity rates are priced with appropriate allowance for future mortality improvements.
- It could withdraw annuity products.
- Transfer the annuity portfolio to another insurer.
- Offer enhanced transfer values to deferred members of the pension scheme.
- It can undertake more detailed underwriting / premium rating for its new annuity business so as to generate differing annuity rates for potential customers reflecting how long it expects those potential customers to live.
- It can reinsure its annuity business. This could be proportional - e.g. an identical proportion of each annuity is reinsured - or non-proportional - eg stop loss to limit losses that may arise from advances in medical technology and hence the longer lives of annuitants.
- It may decide to utilise a longevity swap. This typically involves an insurance company making fixed payments based on the expected longevity of the reference population, whilst receiving variable payments based on their actual survival.
- It may elect to close its defined benefit pension scheme to future accruals or to new members, or go further and close the scheme fully.
- Having closed the defined benefit pension scheme, it could seek to transfer the liabilities to another life insurer through a buy-in or buy-out arrangement.
- It could reduce the value of the defined benefit pension scheme to employees through reducing the rate at which benefits are accrued.
- It should ensure that its exposure to longevity risk avoids concentrations of risks that may occur, for example, due to underwriting annuities for a high wealth socio-economic group with greater access to private medical facilities.
- It should seek to diversify its longevity risks through underwriting risks that are not or only very loosely connected with longevity risk.
Some risk may even result in a partial hedge for the longevity risk. For example, mortality risk on term assurance business may partially hedge longevity risk on annuity business.
However, this partial hedge is likely to be far from perfect as term assurances tend to be purchased by policyholders that are younger than those purchasing annuities.
Also, policy durations will be mismatched, e.g. term assurance business may have a 10-20 year terms while annuities are likely to be life annuities.
Longevity Swap
This typically involves an insurance company
… making fixed payments based on the expected longevity of the reference population,
… whilst…
… receiving variable payments based on their actual survival.
Why might a life insurer choose to transfer longevity risk to the capital markets rather than to a reinsurer?
- Reinsurers may have limited capacity or may be reluctant to take on longevity risk at a competitive price.
- Capital market investors are looking for returns uncorrelated with those from the other asset classes they have invested in and hence are willing to accept the longevity risk at a competitive price relative to the reinsurers.
- There may be a wider range of capital market investors looking for opportunities like this.
- Long-dated exposures to reinsurers create significant counterparty risk.
- The insurer may already have significant exposure to those reinsurers willing to accept longevity risk due to the reinsurance of other business, so it may not be willing to accept further exposure to those counterparties.
- The insurer may find it faster to transact with the capital markets.
- The out-of-the-money capital market transactions may be more efficient at improving the surplus assets on the insurer’s risk-based balance sheet.
- There may be tax advantages.
Outline how governments and stock exchanges have mitigated or transferred liquidity risk
- Many large stock exchanges will automatically cease trading if prices move by more than a prescribed amount during a brief prescribed time frame. The intention is to allow participants to assess the new information and restart trading in a calmer frame of mind.
- Derivatives transaction exchanges will generally use a clearing house to hold margin calls.
- Governments support the system with cash loans.
- Governments have used IOUs.
- Governments have resorted to printing money and to quantitative easing.
- Governments have allowed companies not to mark to market so that illiquid assets’ volatile values do not overly influence company results.
- Capital requirements for all market participants designed to cover periods of illiquidity.
Describe the possible consequences of liquidity risk crystallising
A crystallised liquidity risk is not having sufficient cash to meet ones’ obligations.
Its short term consequences might be cost and inconvenience as well as reputational damage.
Its longer term consequences can include bankruptcy.
The consequences of a systemic liquidity risk crystallising due to contagion will likely include
- higher interest rates,
- impaired capital markets,
- credit downgrades,
- reduced economic growth
- reduced bank lending
- increased personal bankruptcies
State with reasons the most common cause of sudden illiquidity in a banking system
Loss of confidence in the trading system.
New information that flows into the system, e.g. the failure of a major player, may precipitate the loss of confidence, but it is not likely to be the cause; the cause often being the larger economic circumstances that led to the failure of the market participant in the first place.
The trading system relies on parties making many trades and when one party has lost confidence in other parties meeting their obligations they will stop trading with those parties and may delay payments that they otherwise owe.
