Past Exam Questions: September 2017 Flashcards
Suggest a structure of a small insurer’s central risk function
The function does not to be alternatively large or complicated.
One or two people should work directly with the CRO to help collate risk information from the business teams and to draft risk protocols, working closely with the various business teams.
Members of each business team should also have responsibilities to fulfil risk-related duties, but in a first-line context.
the CRF should:
- provide advice to line managers
- report to the board
- have appropriate resources and technical skills
How might ERM considerations have influenced a business expansion & diversification strategy for an insurer?
- Having a diversified business reduces the changes of a concentration of risk.
- It also reduces the seasonality of claims.
- Diversification between insured risks is increased,
which would use capital more efficiently. - This should increase the volume of business meaning the risk of insolvency from a large single loss should be reduced and it will reduce random fluctuation / stochastic risk.
- ERM may have highlighted total risk was lower than the risk appetite encouraging the expansion in strategy.
- ERM may have highlighted upside risks in the new strategy.
How might issues arise from an ERM approach where the Central Risk Function is located centrally, and not embedded in business units?
- Having the CRF confined to a single space means that risks in the wide company might be missed.
- Since they receive data without being embedded in teams, the CRF might not understand the context of the risk information.
- The CRF might not understand the context when drafting risk procedures.
- The CRF might lose touch with the changing business environment.
- There might be resentment from business units receiving missives from a “distant” CRF.
- The relationship between the CRF and business units may be adverserial.
- Communication between the CRF and business units may not be open.
- It might be more likely that the business units will “hide” problems / risk events / accidental policy violations. Problems may only be discovered when it is too late to rectify them effectively.
Outline additional risks an insurer could face if it expands to offices in other countries.
CURRENCY RISK
- non-domestic claims and premiums
REGULATORY RISK
from operating in different insurance regimes
INSURANCE RISK
significantly increased exposure to perils not relevant to the domestic country.
PRICING RISK
from lack of experience in relation to these different levels of insurance risk.
INVESTMENT RISK
if appropriate risk-free / matching assets are unavailable.
OPERATIONAL RISK
from operating in countries with different languages and setting up systems for operating cross border, etc.
MARKET DEMAND RISK
uncertainty as to the level of demand for such insurance in other countries.
ECONOMIC RISK
level of demand may be dependent on economic conditions in overseas countries.
COUNTERPARTY RISK
if local assistance / expertise is required in setting up in overseas countries.
POLITICAL RISK
attitude towards non-domestic insurers may change.
REPUTATIONAL RISK
may not have sufficient brand awareness overseas.
STRATEGIC RISK
management may be stretched too thinly if they try to expand too quickly.
Describe the coefficient of lower tail dependence and its relevant to risk modelling
It defines the relationship between two variables (X and Y) at their lower margin.
The coefficient lies in the range [0.1].
If it equals 0, there is no lower tail dependence.
The presence of lower tail dependence can help determine which copula is most appropriate to use for a particular dataset.
Tail dependence is important for risk management as it describes potential concentrations of risk at the point in the distribution where this risk really matters.
2 Similarities between futures and forwards
They both allow an investor to fix now the price of an asset at some point in the future.
They both allow an investor to take either a long or a short position in the asset.
5 Differences between futures and forwards
Futures are exchange-traded
whereas forwards are traded over-the-counter.
Futures have a high degree of security; counterparty risk is an issue for forwards.
Margins are posted for futures.
Collateral can be used for forwards (but not always).
Futures are highly standardised contracts; forwards less so and therefore more flexible.
Futures are highly liquid contracts; forwards have less liquidity.
Describe how the upside on individual equity positions could be sold to buy downside protection on the same equities.
SELL A CALL option with a strike price above the current share price.
Use the proceeds to BUY A PUT option with a strike price below the current share price.
Describe the main financial risks facing
a small society providing bank accounts and mortgages, investing in bonds and cash.
INTEREST RATE RISK
- increase in interest rates would reduce the value of the bonds held
- Interest rate risk also arises from changes in interest rates which have a financial impact on the savings accounts / mortgages.
- Interest rates also impact on customer behaviour.
- Could impact levels of demand for the products.
- Additional risk arises due to the duration mismatch between assets (bonds and mortgages) and liabilities (deposits).
LIQUIDITY RISK
- risk of not being able to meet cashflow requirements as and when they arise
- or being unable to carry out asset transactions without materially impacting market prices.
- May not always have sufficient available cash to meet customers’ deposit withdrawal requirements.
CREDIT / COUNTERPARTY RISKS
- risk of increased credit spreads reducing the value of corporate bonds
- risk of higher than expected defaults on corporate bonds
- risk of higher than expected defaults on customer mortgages
FX RISK
if overseas bonds are hed
MISMATCH RISK
PROPERTY RISK
Risk of significant falls in property values, increasing credit risk on mortgages.
INFLATION
which will increase the society’s expenses.
List the likely components of a society’s risk policies that will influence its decisions on corporate bond investment.
- Authority limits
- Concentration / exposure limits
- Limits on creditworthiness / credit ratings
- Limits on transaction sizes
- Limits on timings of transactions
- Limits on single counterparties/issuers
- Limits on single industries
- Limits on currencies
- Gov vs Corporate bond balance
- Due diligence checks on each transaction
- Reporting procedures
- Valuation metrics
- Regulatory considerations
- Liquidity limits
- Duration of bonds
- Where the bonds are traded
- How the bonds are traded
- Extent to which the use of credit derivatives is permitted
Discuss whether an investor should look at S&P’s enterprise risk management evaluation reports for companies in which corporate bonds are sought.
- Additional information could be used by investment managers as part of the corporate bond selection criteria
- It should be correlated to the probability of default.
- E.g. only invest in companies with ERM classified as “excellent” or “strong”.
- The investor would not be in a position to perform such detailed assessments itself.
- Information in the reports could help to improve the investor’s own internal ERM.
——- however ——–
- this only reflects the view of one rating agency
- only available for insurance companies
- the method of assessment and measurement criteria are not transparent
- model risk relating to the models used by S&P
- risk management is already considered within credit ratings.
- the assessment may not be complete.
Discuss the approaches a bank could use to measure its liquidity risk exposure
- For each asset position held, calculate the time that it would take (in days) to liquidate that position under adverse market conditions.
- Calculate the RATIO OF LIQUID ASSETS to total assets.
- Compare this to other companies.
- Or to a benchmark position.
- Use CASHFLOW MODELS
- Which project both asset cashflows and liability cashflows
- Over a chosen time horizon
- To gain an understanding of the timing and uncertainty of cashflows.
- E.g. may measure by duration mismatch.
- Could STRESS TEST company-specific events
- Like a run on the bank’s deposits
- And market-wide events
- Like a fall in interest rates
- Could perform SCENARIO TESTS, which allow for multiple conditions to occur simultaneously
- Model “worst case” scenarios, like a recession / serious contraction of bank lending.
- Consider scenarios based on historical events
- Consider scenarios that may occur in the future (potential black swans)
- May need expert input to set appropriate stress/scenario tests
- and external data.
- The stress/scenario tests need to model the ability to sell assets…
… and the price at which such assets may be realised
… and the ability to raise capital under the chosen conditions.
Such tests can also measure the capital required to restore the position.
Or can use metrics like VaR,
with a chosen confidence interval (or alternatively, determine the confidence level at which we expect to have sufficient liquidity).
- Allow for correlations with other risks, e.g. interest rate risk.
Comment on a bank wanting to mitigate liquidity risk by holding more cash.
- Cash is normally liquid, so this does increase liquidity.
- However, it is likely to earn LOWER RETURNS than other assets.
- This reduces profitability
- Impact on share price
- Higher mortgage rates for clients
- Lower savings rates for clients
- the bank would be less competitive.
- there would be trading costs incurred in changing from the banks current portfolio.
- There is counterparty risk if the cash is with another bank.
- Lower capital requirement from holding cash.
- Might not be easy to increase cash allocation in a short time horizon.
Suggest ways a bank could manage its liquidity risk
- Improve asset-liability matching, particularly for short-term durations.
- Increase notice periods on savings accounts
- Limit daily cash withdrawals.
- Invest in other types of liquid assets, e.g. cash or government bonds from high-rated governments, or high-rated corporate bonds.
- Use sources of emergency funding.
- Contingency arrangements with other institutions / emergency overdraft facilities.
- Insurance arrangements.
- Implement active liquidity monitoring / management processes.
- Actively manage creditor / debtor balances.
A bank plans to launch an insurance subsidiary and the board requests the following from the RMF:
- current risk appetite
- current risk profile
- projected risk profile
- economic capital requirement for the insurance subsidiary
Explain why the board has requested this information?
- The board intends to consider risk in its decision-making
- This is appropriate as decisions should not be made on the basis of profit alone
- RISK APPETITE is the targets and limits for the risk across the whole organisation
- These may be broken down into more detailed risk tolerances
- The board can compare the risks arising with the risk appetite
- RISK PROFILE is the complete description of the organisation’s risk exposures
- The board can look at the change in the risk profile
- ECONOMIC CAPITAL is the amount of capital required to ensure a given level of solvency of an organisation at a given confidence level.
- It may be consistent with the solvency target set by the regulator.
- or the board may wish to target a specific credit rating.
- The board will be able to see whether it has sufficient available capital
- or whether it would need to raise additional capital
- or implement additional risk mitigation activities
- The results of these comparisons/assessments may automatically reject an option.
- The economic capital requirement information will help to assess a risk-adjusted return on capital.
