Past Exam Questions: April 2014

Question 1

Describe the “key man” risks arising from the retirement of a company founder

Answer 1

The risk that the loss of the founder will pose to the ability of the organisation to:

• continue to achieve its strategic objectives
• maintain its profitability
• keep its customers
• avoid an adverse share price impact
• and meet its obligations to customers.

This includes the loss of the founder’s intellectual capital and potential contagion risk from the loss of other members of the management team who might no longer remain loyal to the company.

Question 2

Outline how “key man” risks can be mitigated

Answer 2

Key man risk is not a risk that can be removed by transferring it to an insurer or another party. It has to be retained and the emphasis should therefore be on taking active steps towards reducing the risk exposure.

The main strategy should be a succession plan, which will set out the actions that the firm is taking in this regard.

For example, it should cover:

• Early identification of the intended successor(s) and “job-sharing” towards the retirement date.
• Capturing the founder’s knowledge and ensuring that all processes in which they are involved are well documented.
• Training programs for other staff members.
• Communicating externally to clients and other stakeholders including moving other staff members into key relationship roles.
• Communicating internally to staff on the issue of succession in order to help set career paths.
• Recruitment activities, if necessary.
• An employment contract with the key man with a notice period and other conditions designed to give the company time to replace the key man.
• For example, keep him on in a non-executive role.

There may be “golden handcuff” bonus arrangements with other important staff members, to avoid a contagion effect.

Question 3

State the advantages of setting up a group captive insurer to insure the risks of the rest of the group

Answer 3

• Cheaper - may have lower overhead costs.:
• Cheaper – can retain risk and therefore avoid transferring profit to external insurance providers. Similarly it avoids cash swapping which means paying a premium with the almost certainty of having a large portion of it returned as claims.
• May give the group greater control e.g. over which risks (and how much) are retained.
• Access to wholesale insurance / reinsurance markets.
• Increased purchasing power - buying in large volume rather than by company.
• Possible tax advantages.

Question 4

Comment on the appropriateness of regulation under which there is no distinction between open market and captive insurers

Answer 4

FOR:

• ensures captive insurers are held to the same standards as open market insurers in terms of prudent management and governance.
• no opportunity for regulatory arbitrage.
• may be simpler for the regulator.

AGAINST:

• does not recognise that captives generally take lower overall levels of risk than open market insurers.
• can add to the overhead costs of running a captive insurer.

Question 5

Describe the main risks that a retail bank will be carrying in its asset-liability management programme

Answer 5

CREDIT RISK
Risk of a counterparty being unable or unwilling to make payments required under an agreement.

INTEREST RATE RISK
The risk of changes to the asset-liability value due to changes in interest rates - i.e. the change in the net present value of assets less liabilities.
Second, optionally risks which arise from products that have an option to take certain actions and are more likely to do so in a rising / falling interest rate environment (e.g. early redeemable loan assets)

CURRENCY RISK
Net exposure to changes in foreign exchange rates. For example the bank might borrow in USD and report in USD and may lend some monies in Euros without hedging the exposure.

LIQUIDITY RISK
The ease with which assets can be converted to cash.
Liquidity risk generally increases as the average term of assets less the average term of deposits increases (called the liquidity gap).
Liquidity is highly subject to systemic (contagion) risk as the willingness of banks to lend to each other in times of financial crisis is materially restricted.

Question 6

Loan to deposit ratio (LDR)

Answer 6

The ratio of a bank’s nominal loan book to its deposits.

Question 7

Liquidity Coverage ratio (LCR)

Answer 7

The ratio of a bank’s high quality liquid assets to its 30-day stressed net cash outflows.

Stressed net cash outflows are substantially higher than normal net cash outflows.

Question 8

Net Stable Funding Ratio (NSFR)

Answer 8

The ratio of a bank’s stable funding to its weighted long-term assets.

Stable funding includes equity, customer deposits and long term wholesale funding.

Long term assets includes all loans with maturities longer than one year, a percentage of loans with less than one year to maturity and a percentage of government and corporate bonds.

Question 9

Basel III will likely introduce a minimum LCR requirement of 100% and a minimum NSFR requirement of 100%

Outline the steps that banks should undertake to optimise their funding mix, given these upcoming requirements

Answer 9

• The development of a comprehensive funding plan.
• A review of current liabilities ordered by cost to the bank.
• Determination of the cost of every type of funding and its characteristics over the past 5 years.
• Determination of the expected cost and range of costs of every type of funding and its characteristics over the next 5 years.
• Determination of the optimal funding mix based on stable / non-stable split, regulatory impact and value for money.
• A target date to reach the optimal funding mix and a deposits plan to work in reshaping the balance sheet.

Question 10

2 possible approaches to fitting a distribution to extreme values

Answer 10

BLOCK MAXIMA (RETURN LEVEL) APPROACH

Separate the time series data into evenly-sized blocks. Select the highest observation in each block and fit a generalised extreme value (GEV) distribution function to the data using a maximum likelihood estimator.

PEAKS OVER THRESHOLD APPROACH

Choose a threshold level over which the data are considered to be extreme. Fit a generalised Pareto distribution to all observations minus the threshold (for those observations exceeding the threshold) using a maximum likelihood estimator.

Question 11

BLOCK MAXIMA (RETURN LEVEL) APPROACH

Why is the block size crucial in fitting extreme values?

Answer 11

• If it is too big, then too much data is discarded.
• If it is too small, then too much non-extreme data will be fitted and the goodness of fit will be unduly weighted towards non-extreme data (and likely under-fit the tail).

Question 12

Compare using GPD versus GEV when applying Extreme Value Theory

Answer 12

The GPD will typically keep more data and so is often preferred. The choice of the threshold is important for the same reasons that the choice of the block size is important with the block maxima approach.

Both methods assume that the underlying data are independent and identically distributed.
Seasonality, trends and serial correlation in the data will violate this assumption.

Question 13

State the circumstances under which the shape parameter of both the GPD and GEV density functions would be expected to be nearly the same.

Answer 13

Extreme Value Theory’s asymptotic law states that for long block lengths, the block maxima approach will result in a generalised extreme value function and that for high thresholds the peaks over the thresholds approach will result in a generalised Pareto distribution.

At this point the shape parameters of the fitted GEV and fitted GPD will effectively be the same and their means and variances will be related.

Question 14

Discuss whether flood data can be used to price rainfall derivatives in a given area.

Answer 14

Flood levels are different from precipitation data and precipitation data is likely to be available.

Flooding can occur from rainfall occurring in a different area, e.g. river systems with different catchment areas and snow melt versus rain.

If they are trying to protect against flooding and only precipitation derivatives are available then the results are likely to be helpful, but the precipitation data should also be collected and analysed.

the flooding data would provide the information regarding the appropriate trigger points for the precipitation weather derivative.

Question 15

Main risks an international food company would carry during the early years of implementing large business expansion strategies

Answer 15

• Risk of failing to meet the company values.
• Reputational risk negatively impacting the existing business.
• Impact on the group leverage and cash flow of the business expansion.
• Strategic risk of failing to meet the plans and objectives of the business venture, and ultimately failing to produce the budgeted returns on investment.
• Agency risk associated with new employees having different cultures and values.
• Political risk, being the risk of future government interaction.
• Regulatory and tax changes
• Business risks:
• – competition
• – supply
• – demand
• – input price inflation.
• Currency risk

Question 16

Recommend an appropriate ERM framework for a large, global food company

Answer 16

The purpose of ERM is to identify, quantify and holistically manage all of the individual risks of the enterprise in order to maintain an overall level and set of risks that have been stated to be acceptable to the enterprise in pursuit of its other objectives.

Managing the risks will include monitoring and reporting on the risks and, as appropriate, mitigating, transferring and accepting the diversified pool of remaining risks.

The ERM framework must be fit for this purpose. Further, it must be sized to fit the nature, size and complexity of the enterprise.

ERM must be embedded into the enterprise in order for it to monitor risks in a timely fashion and in order for it to identify new risks as they arise.

In order to be embedded, to save time and costs and not to duplicate work, the framework should start with existing departments and activities in the enterprise.

For trading subsidiaries, these will include:

1. Quality control
2. Purchasing managers
3. Health and Safety
4. Human Resources
5. Food standards laws and agencies
6. Management information.

Every division should employ a part time or full time risk manager depending on workload.

The risk manager will then be responsible for working with all relevant areas to build and maintain a risk register and supporting management information.

The frequency of the management information and the regular risk register review will depend on the nature of the underlying risks.

The framework needs to include the mechanism for ad hoc risk reporting to the risk manager.

The risk manager will then use the management information to produce a set of risk measures and report these monthly to each subsidiary’s risk management committee (RMC).

The risk management committee is likely to include the Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Chief Investment Officer and legal counsel if any.

The committee will also include the (newly appointed) group Chief Risk Officer.

Following monthly meetings, the management may make decisions designed to mitigate, transfer or differently manage the various risks.

The group chief risk officer, working with the various risk managers, will then produce a set of group reports taking into account the various RMC packs and management decisions.

These packs will be presented to the group risk management committee and they will be discussed with the board when it meets.

One of the additional considerations at group level is to ensure that the group is operating within its stated risk appetite, profiles and tolerances.
The framework does not only collect and process information in one direction.
The framework must be designed to report suggested business changes to the appropriate persons and to ensure that they are acted upon.

E.g. the subsidiary risk management committee might be concerned that the held stock position is relatively high and it could cause a hazard.
The Chief Operating Officer being present at the committee will agree to reduce the stock position and the committee will then monitor the impact of the action in future meetings.

Another example would be random hygiene checks at the restaurants.

The framework will include the processes for setting operational limits and rules that seek to ensure that risk levels are not breached.

At regular intervals, the various CEOs and COOs would discuss the risk register, the risk appetite, risk profiles and risk tolerances to design operational limits, rules and systems to work within the appetite, profiles and tolerances.

TURNING TO CORPORATE GOVERNANCE:

The governance structure specifies the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators and other stakeholders) and specifies the rules and procedures for making decisions in corporate affairs.

Governance should be driven from the top of the group downwards. It should prescribe an appropriate culture and put in place the mechanisms to deliver it throughout the company.

Ideally the board could have a majority of independent directors.

The Chief Risk Officer should join the board.

The board should establish committees including risk management, remuneration, and audit.

The committee’s roles and responsibilities will be established in writing and the committees will be chaired by an independent board member.

There should be no need for a formal corporate governance committee or compliance function at a food company. Compliance will largely refer to various health and safety, food standards and consumer affairs regulations. These can most likely be handled by a combination of human resources and the operations managers through the COO.
Of course, they will also be monitored through the RMC.

Group management should produce a paper articulating the company’s core values, its culture and its ethics.
This paper should be approved by the board and issued to all employees to explain how the company requires its employees to behave.

A good culture will be one promoting openness and transparency.

“Risk champions” may be identified in each business area or subsidiary or operational centre.

The company should start to provide far more detailed reporting to its various stakeholders. It should strive to be as transparent as possible in a competitive environment to demonstrate that it is well run and behaving as an upstanding corporate citizen.

Remuneration and personal development processes should be established that encourage and reward appropriate risk-aware behaviours.

Internal audit functions may be established or strengthened.

Question 17

The governance structure

Answer 17

Specifies the distribution of rights and responsibilities among different participants in a corporation.

E.g.

• the board of directors
• managers
• shareholders
• creditors
• auditors
• regulators
• other stakeholders

It also specifies the rules and procedures for making decisions in corporate affairs.

Question 18

The purpose of ERM

Answer 18

The purpose of ERM is to
- identify
- quantify
- holistically manage
all of the individual risks of the enterprise,

in order to maintain an overall level and set of risks that have been stated to be acceptable to the enterprise in pursuit of its other objectives.

Managing the risks will include:
- monitoring and reporting on risks
- mitigating
- transferring
- accepting
the diversified pool of remaining risks.

The ERM framework must be fit for this purpose.
It must be sized to fit the:
- nature
- size
- complexity
of the enterprise.

ERM must be embedded into the enterprise in order for it to:

• monitor risks in a timely fashion
• identify new risks as they arise.

Question 19

Describe the changes that should be made to an ERM framework if a company decided to replace some of its bank debt with rated bonds listed on a major stock exchange.

Answer 19

The credit rating agency rating the bond and the exchange are likely to make suggestions that they feel would help to stregthen the ERM.

This may involve changes to the framework.

Common changes suggested include:

• The timeliness of reporting. They may feel that some information should be available on the company’s systems more frequently.
• The detail of the information being reported through to the various risk management committees. They generally feel that more information is better than less.
• The centralisation of ERM. They may feel that the proposed practical structure doesn’t have sufficient internal audit style checks and verifications of reported data.

Whilst not a change to the framework, the group risk manager will likely change some of the management information to monitor the credit rating of the bond and the potential for a rating change. A decline in rating will make any replacement issue more expensive.

The credit rating agencies’ ERM requirements will likely increase as the rating increases.