Past Exam Questions: September 2016

Question 1

Outline the uses of capital allocation to a global insurer

Answer 1

• 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

Question 2

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.

Answer 2

• 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

Question 3

How might a Generalised Pareto Distribution be used to model the likelihood of wind speeds of above 150 mph?

Answer 3

• 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.

Question 4

Advantages of using a GPD to model high wind speeds (above 150mph)

Answer 4

• 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.

Question 5

Disadvantages of using a GPD to model high wind speeds (above 150mph)

Answer 5

• 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.

Question 6

Steps in the ISO 31000 Risk Management Process

Answer 6

Establish the context

RISK ASSESSMENT

• • risk identification
• • risk analysis
• • risk evaluation

Risk treatment

Monitoring and review

Communication and Consultation

Question 7

Main risk management principles under ISO 31000

Answer 7

• 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

Question 8

Define:

“credit rating”

Answer 8

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.

Question 9

3 Definitions of liquidity risk

Answer 9

• 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.

Question 10

Explain how liquidity risk may affect a typical shop owner.

Answer 10

• 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.

Question 11

Describe an approach for modelling the level of liquidity risk for a retail store

Answer 11

• 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.

Question 12

How might a store manage its liquidity risk?

Answer 12

• 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.

Question 13

Would a small store benefit from an ERM framework? How?

Answer 13

• 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.