Past Exam Questions: April 2015

Question 1

Describe the approach that would be taken to quantify the economic capital for interest rate risk relating to bond yields, by using principal components analysis (PCA).

Answer 1

• Decide on the scale of calculation, e.g. daily, weekly, monthly, or annual data.
• Decide on the timeframe from which the data should be taken balancing between volume and relevance of data.
• The data should represent the gross redemption yields for risk-free bonds from a range of maturities, with the yields for each maturity forming a distinct series.
• For each maturity series, calculate the average of these yields over the period for which the data are taken.
• Determine the deviations from this average.
• Identify a number of principal components that explain a sufficiently high proportion of these past deviations and set them, eg. using an iterative process.
• Project this number of independent, normal random variables with variances equal to the relevant eigenvalues.
• Obtain the projected deviations from the expected yields for each maturity by weighting these series by the appropriate elements from the relevant eigenvectors.
• Derive an expected yield from current risk-free bond prices.
• Add these expected yields to the simulated yield deviations to give a range of projections of future yield curves.
• The analysis can be done by using the yields directly or using their natural logarithms.

Question 2

To quantify the economic capital for interest rate risk relating to bond yields, principal components analysis (PCA) might be used.

Explain how many principal components are likely to be used.

Answer 2

• 3 principal components are likely to be sufficient
• One for changes that cause the whole yield curve to rise / fall
• One for those that cause the slope of the yield curve to change
• One for those that cause the yield curve to bend around a particular term.
• It is expected that around 95% of the variability can be captured using only these 3 principal components.

Question 3

Explain the importance of ERM in an event such as a sovereign debt default crisis

Answer 3

By its nature, a crisis will impact a firm in a number of different ways that cannot be fully known in advance.

Also by its nature, a crisis happens quickly. It is sub-optimal to simply react to it as it unfolds.

It could also trigger a number of contagion events that need to be identified and managed.

ERM:

• Identifies and registers risks
• Quantifies the potential cost of risks given a range of different scenarios
• Is a holistic approach to risk management and so ERM estimates the potential relationships between different risk types and between the same risk types in different operational areas given a range of different scenarios
• Sets limits to SARS’s appetite or tolerance for certain risks.
• Contains a reporting framework including the timing and type of reporting and the personnel involved.

All of these attributes of ERM are needed to develop a comprehensive risk management plan.

ERM will help to enable the board and management to:

BEFORE THE CRISIS:

• Prepare for the crisis by creating a plan and having the plan approved by the board and management.
• Discuss and action measures to avoid, mitigate and/or transfer risks, e.g. sell or hedge any exposure to sovereign debt.
• Implement risk mitigation strategies whilst they are relatively cheaper prior to the crises.

DURING THE CRISIS

• Manage the crisis with increased operational effectiveness.
• Better risk reporting.
• Improved business performance.
• Minimise the financial and operational impact of the crisis.
• Potentially profit from the crisis.
• Reorganise the company.
• Market confidence: protect relationships with external stakeholders including regulators, rating agencies and shareholders.

AFTER THE CRISIS:

• Crisis analysis including lessons learned.
• Contagion now and in the future.
• Market confidence.

Question 4

Analyse the risks that could arise from customers and/or suppliers in the event of a sovereign debt default crisis.

Answer 4

LAPSE RISK from existing customers

• The default could result in a recession or depression which in turn would be expected to increase lapse rates, e.g. due to unemployment or reduced affluence making it more difficult for policyholders to continue to pay premiums or due to policyholders panic selling when the value of the policies fall.
• Higher lapses will mean lower profits as it reduces the flow to the company of revenue in excess of expenses.

NEW BUSINESS VOLUME RISK

• New business placed by third party intermediaries could fall as some of the intermediaries stop trading as a result of the changes in the economy post the default.
• Demand from potential new customers may fall for the same economic reasons.
• Lower than expected new business will mean lower profits.

OPERATIONAL RISK

• Outsourcers and other suppliers may stop trading as a result of changes in the economy.
• A new outsourcing or supplier arrangement may be more expensive.
• Taking any previously outsourced administration functions back in-house will be costly.
• There may be additional legal expenses.
• The default could lead the government to impose additional costs and taxes.

Question 5

Describe how emerging risks could be analysed and identified

Answer 5

• A holistic view is required for emerging risk identification and analysis, considering all possible impacts of the new risk before this is reduced to the more structured analysis approach typically taken for known risks within a risk framework.
• The key risk identification tool is HORIZON SCANNING.
  i. e. the systematic search for potential developments over the longer term with the emphasis on those changes that are at the edges of current thinking.
• This requires input from experts who understand the underlying drivers and the technological/scientific/economic/socioeconomic aspects.
• It is most likely that expertise will need to come from external sources.
• This includes academic journals and websites relevant to the specific area.
• Since by definition, it is unlikely that there will be a definitive study on any particular aspect, each needs to be assessed from different angles and sources.
• Risk management decisions then need to be weighted according to the credibility and reliability of the underlying “evidence”.
• Continual monitoring of developments in relevant research will be important in order to refresh these decisions.
• The more alarmist media reports can be useful in alerting the organisation to potential areas for further investigation.
• However, they should not in themselves be used as a basis for decision-making.
• Additional analysis should be performed where the potential financial impact rests on the likely future legal approaches to such emerging factors.
• An analysis of trends is important.
• Also need to monitor regulatory activity and lobbying activity in the relevant sectors.
• When analysing trends, it is important to keep dependencies in mind, as well as changes in dependencies.

Question 6

Describe the potential implications of diminishing natural resources for a pension scheme.

Answer 6

ASSETS

• Resource contraints will steadily increase as the earth’s finite natural resources are used by the increasing population.
• This could lead to an increase in energy prices and commodity prices over the duration of the scheme’s liabilities (say the next 30 years.
• Increases in the cost of energy and commodities may result in lower economic growth.
• This is likely to lead to an increased indebtedness and hence an increase in bankruptcies and defaults.
• Lower economic growth could lead to reduced international coordination, which is ultimately self-defeating leading to even lower economic growth.
• This could take the form of trade barriers or selective defaults on overseas holdings of government debt.
• Worse still, international security may be reduced as governments scramble for limited resources.
• This may lead to differential investment returns where governments direct investment into alternative sectors to make their economies more stable.
• The cost of that stability may be so high as to elevate debt levels beyond already heightened levels.
• This may lead to an increase in bankruptcy of governments.
• Increased social tension may arise as inequality and hardships are heightened resulting in challenges to law and order.
• Property damage could be expected to increase as a result of vandalism or riots.
• This is likely to lead to a lower value being placed on property assets held by the pension scheme.
• Further still, increases in the prices of energy and commodities may lead to decreases in the prices of other assets such as properties, as the higher prices previously demanded can no longer be afforded.

LIABILITIES

• Increases in input costs will lead to higher price inflation.
• Higher inflation will, usually, increase the value of the schemes’ liabilities.
• To ensure energy security, governments may opt to utilise fossil fuels, accelerating climate change.
• The more extreme temperatures could lead to a reduction in the food available to feed an increasing population.
• This could lead to higher food prices and poorer diets, leading to reductions in life expectancy.
• Lower access to affordable medical care, brought about by the increased costs of that care and lower disposable incomes, may lead to reductions in life expectancy.

Question 7

DO QUESTION 3

Answer 7

DO QUESTION 3