Past Exam Questions: September 2016 Flashcards
Outline the uses of capital allocation to a global insurer
- Performance management purposes
- To inform salary and bonuses
- To determine an appropriate return on capital for each business / product line
- To identify underperforming businesses/product lines and close these
- To improve pricing (allow more appropriately for the cost of capital)
- Efficient use of capital: not leaving it unused at Group level
- To manage and optimise risks holistically across the Group
- To impose risk-based restrictions on the amount of business that can be written in each business area / product line
- To optimise the risk/return balance
- Helps the company to better understand diversification benefits
Assess the possible implications for the risk profile of an insurer if the province in which the insurer is located, aims to gain independence from a larger country, with its own government and currency.
- Market instability (at least in the short term)
- Increase the risks to the insurer
- Risk that the currency could devalue
- Any assets held in this currency will lose value if this happens.
- The country’s stockmarket values may fall or become more volatile to reflect this devaluation risk.
- Interest rates may become more volatile,
… or move adversely (i.e. increased interest rate risk) - Credit risk may also increase for corporates…
… or for the government. - Market risk is exacerbated by any mismatching between assets and liabilities, e.g. by currency.
- There is a risk that there will be insufficient availability of suitable assets for matching purposes.
- There will be greater uncertainty in relation to future inflation rates
… and future investment returns for the two separate parts of the country
… given that the economic potential of each country on a standalone basis is less certain than at present. - New business / renewal risk may increase.
- The publicity and uncertainty may lead to policyholders behaving unexpectedly,
… mass lapses
… extremely low renewal levels
… or reduction in new business - Increased political risk.
- Risk that the new government will bar the insurer from selling business.
- Insurance risk may increase.
… claims experience may be different to previously, requiring different demographic assumptions.
Regulatory risk, since new regulations could be introduced.
Operational risks may increase, due to the systems developments/changes that will be required (new currency etc.)
- Expense risk increases
… due to uncertainties involved. - Increased counterparty default risk,
… if an outsourcer is no longer able to provide services across borders. - Restrictions on repatriation of profits (currency controls)
- Upside risks, presenting opportunities
- Model risk may increase (pricing model)
- Liquidity risk
- Increased strategic risk
How might a Generalised Pareto Distribution be used to model the likelihood of wind speeds of above 150 mph?
- Take the annual wind speed observations {Xn}
Determine an appropriate threshold, u:
— this is done by determining where the “tail: of the distribution lies
… using the empirical mean excess function e(u)
… given by e(u) = SUM (Xn - u) I(Xn > u) / SUM I(Xn > u)
- This involves plotting e(u) against u…
… for various values of u - Look for the point at which this function becomes linear (which represents the start of the tail of the distribution)
- Choose a value of u for which e(u) has become a linear function of u and remains so.
- Use the data for this value of u and above to fir the GPD to Xn - u (for Xn > u)
- Do this using a technique such as the method of moments or maximum likelihood estimation.
- Then evaluate the distribution function for wind speeds greater than 150 mph.
Advantages of using a GPD to model high wind speeds (above 150mph)
- Winds of over 150 mph are extreme values, and the GPD is used for modelling extreme values (so is appropriate).
- It is not necessary to know the distribution of the wind speeds themselves.
- Unlike the Generalised Extreme Value (GEV) return period approach, it does not need observations above the critical point to make an estimate.
- Allows the possibility of wind speeds over 150 mph to be modelled even if they haven’t yet been seen.
- Uses data over a long time horizon.
- GPD is a distribution, so gives confidence levels.
Disadvantages of using a GPD to model high wind speeds (above 150mph)
- The approach does not allow for the possibly changing nature of the risk over time
- This might mean that the risk is understated.
- When applying the GPD method, the choice of threshold is difficult, and involves a subjective choice.
- The observations are not necessarily independent.
Steps in the ISO 31000 Risk Management Process
Establish the context
RISK ASSESSMENT
- risk identification
- risk analysis
- risk evaluation
Risk treatment
Monitoring and review
Communication and Consultation
Main risk management principles under ISO 31000
- risk management should both create and protect value
- it should be an integral part of all processes in an organisation
- as such, it should also form part in decision-making processes
- it should address uncertainty explicitly
- the processes of risk management should be carried out in a systematic, structured and timely manner
- decisions taken should be tailored to the specific nature of the organisation
- this means it should take into account all human and cultural factors
- the approach should be transparent, inclusive and relevant
- it should not be static - the process should be dynamic, iterative and should respond to changing needs
- it should facilitate the improvement of an organisation on a continuous basis
Define:
“credit rating”
A credit rating is a combination of letters / numbers
… given to the issuer of debt
… or to the debt issue itself
… by a credit rating agency
… that represents the likelihood that the debt will be repaid in full.
3 Definitions of liquidity risk
- The risk of money markets not being able to supply funding to businesses when required.
- Risk relating to management of short-term cash flow requirements.
- Insufficient capacity in the market to handle asset transactions at the time when a deal is required without a material impact on price.
Explain how liquidity risk may affect a typical shop owner.
- The shop may be unable to meet short term cash flow requirements
… such as the payment of salaries, rent, or other creditors. - Stores should also cover the short-term interest payments on their loans.
- Liquidity risk may arise due to unexpected payments being needed
… or due to having insufficient cash inflows from sales to meet expected outflows
… or due to having insufficient cash funds in reserve. - The shop may be subject to liquidity risk if short-term funding becomes unavailable
… or too expensive
… e.g. due to a wider banking liquidity crisis
… or due to a change in the bank’s view of the credit worthiness of the shop. - The shop may have to accept substantially reduced prices for their goods
… in order to meet short term cashflows. - Buyers may not make payments immediately.
Describe an approach for modelling the level of liquidity risk for a retail store
- Consider the current funding and mix of business.
- Allow for proposed advance purchases…
… and the level of borrowing that this implies. - Choose a timescale.
- Build a cash flow model / project known cash outflows (rent, wages, interest).
- Project income from sales and all expenditure relating to sales.
- The model should give output that reflects timing mismatches.
- It should reflect past internal experience / data where appropriate.
- Seasonal variations should be allowed for.
- Perform stress testing, eg changes in interest rates, sales.
- And scenario testing to the extent that cashflows are uncertain.
- Include “worst case” scenarios.
- Consider scenarios based on worst historical events in terms of prices and volumes.
- May need some expert input to set appropriate stress and scenario tests.
- And external data.
- If sufficient data are available, consider stochastic modelling.
- Determine the confidence level at which the store would (just) have sufficient liquidity.
- Allow for correlations with other risks, e.g. interest rate risk.
How might a store manage its liquidity risk?
- Reduce the level of borrowing.
- Reduce sales.
- Change the mix of business.
- Use forwards / futures.
- Form a co-operative society.
- Arrange emergency overdraft facilities.
- Hold higher cash reserves.
- Close monitoring of cash flows.
- Active creditor / debtor management.
- Take advance customer orders.
- Use casual labour.
- Negotiate a reduced / partial payment to suppliers.
- Fix interest rates on funding for more than one year.
- Diversify into other goods / services.
- Find alternative funding.
- Link salaries to sales volumes.
- Negotiate lower rent.
Would a small store benefit from an ERM framework? How?
- All organisations can benefit from an ERM framework…
… though the level of complexity / detail will depend on the size and complexity of the organisation. - Cost considerations need to be taken into account.
- It is important to view risks holistically…
… so that any concentrations of risk can be recognised…
… as well as diversification potential. - It is important to set out the risk appetite…
… and to determine whether the level of risk being taken is consistent with this. - It is important to mitigate excessive risks where these do exist.
- For a small store it is particularly important to have some form of risk management process…
… as it can be easier for the inappropriate actions of an individual to bring down the company. - Without the framework, the manager may be too dominant
… and not subject to sufficient challenge from junior employees in terms of decisions being made. - Not all risks need to be analysed quantitatively - qualitative may be more appropriate in some cases.
- Having some form of risk management framework may result in lower borrowing costs.
- Would be useful simply to keep a risk register.
- And educate / increase risk awareness / bring in risk management culture of / for the employees.
- ERM can help to identify opportunities to exploit.
- Would help to prepare for future expansion.