Risks Flashcards
Definitions, sources, impacts, management, NOT how to model or quantify
Definition of agency risk
Risk of loss due to an agent pursuing their own interests instead of the interests of the principal as they should. The costs that arise are called agency costs
How to manage agency risk
Adjust remuneration to incentivize the desired behaviors
Give examples of agents acting on behalf of principals
1) Directors and employees acting on behalf of shareholders and policyholders
2) Internal auditors acting on behalf of directors and shareholders
3) Investment managers acting on behalf of clients
Definition of basis risk
Risk that the price of an asset and an associated derivative do not move together as expected, exposing the company to variation and possibly nullifying intended hedging benefits
Definition of biometric risk
Mortality, morbidity, and longevity risk
Definition of business risk
Risks that are willingly taken on to create a competitive advantage and to add shareholder value
Sources of business risk
Changes in market share, pricing margins, cost management, and the competitive environment
Impacts of business risk
1) Annual financial and operating results may not meet management and stakeholder expectations
2) Revenue may not cover costs within a given period of time
Definition of business volume and mix risk
Risk that the volume and/or mix of new business is materially different than expected. This causes a materially different capital position.
Why is business volume and mix risk important?
This risk can cause a materially different capital position.
If sales are low, the insurer may not be able to cover expenses.
If sales are high, there could be severe capital strain.
Unexpected business mix could shift the risk profile.
What are some sources of low sales?
Reputation damage, credit rating downgrade, new or strengthened competitors, changes in the economic environment or tax laws, loss of a key distributor
What are some sources of high sales?
Unexpected success (beating previously stronger competitors), exit of a competitor from the market, tightening of product features or increased prices from competitors, change in reinsurance such that risk retention is higher on new business
What are some sources of business mix risk?
Lower sales than expected for some products, higher for others. Unexpected lapses impacting some products more than others.
What are some impacts of low sales?
Poor coverage of maintenance expenses, adverse claims experience on remaining business, and high lapses
What are some impacts of high sales?
Capital strain, problems managing underwriting and expenses. Especially if sales are driven by older products, claims experience may end up being quite different than expected in the future.
What to do about low sales
- Review remuneration for agents and brokers
- Diversify into multiple lines of business
- Control fixed expenses
- Maintain contingency action plans
What to do about high sales
- Put capital-raising plans in place (with a parent company or external source)
- Improve operational readiness to handle increased volumes of business
- Review rates and underwriting guidance
- Review the use of reinsurance to mitigate the need for additional capital
- Withdraw a product or line of business
Definition of catastrophe risk
- Risk that arises from single, unlikely, major incidents
- An element of operational risk
How to manage catastrophe risk
- If possible, reduce frequency and severity of the risk (like reinsurance and location diversification)
- Monitor the environment for early warning signs
- Prepare an action plan
How to manage an action plan
- Prepare details for different levels of severity
- Maintain and update the action plan
- Run role-playing simulations to ensure the action plan works and is well understood by key players
- If implementing the action plan, dynamically adjust the response throughout the crisis
Definition of climate risk
Risks that arise from climate change, especially:
- Physical Risk: the risk of loss due to increased frequency and severity of climate events and
- Transition Risk: the risk of loss due to the transition to a lower carbon footprint economy
Why is climate risk important
- Global wealth will be diverted to managing environmental changes
- Political instability is likely
- Essential infrastructure is highly vulnerable
- Natural resources will be depleted
- Increased likelihood and severity of hurricanes, wildfires, droughts, and desertification
- Increased likelihood of pandemics and infectious disease
What are some impacts of climate risks
1) Legal risk, regulatory risk, and reputational risk if firms fail to follow environmental laws, regulations, and best practices
2) Increase in mortality and morbidity
3) Increased lapses and decreased new business
4) Increased cost of climate change adaptation leading to credit, market, liquidity, and expense risk
How to manage climate risk
1) Adjust investment strategies. Look for opportunities like renewable energy.
2) Review concentration risk and diversify lines of business and geographic locations
3) Review types of products offered
Definition of compliance risk
The risk that the firm will violate laws and regulations (legal risk and regulatory risk)
Definition of concentration risk
Risk of increased exposure to losses due to a concentration of investment in a risk category, a product line, a distribution channel, an asset class, a geographical area, or other. Concentration risk amplifies other risks
Definition of counterparty risk
Risk that a counterparty in an over-the-counter financial contract (like interest rate swap or forward contract) will default. A form of credit risk.
How to manage counterparty risk
- Netting: contracts with positive values are offset by negative values of other contracts
- Collateral
- Central Counterparties (CCPs): an institution that acts as an intermediary in a derivative transaction
What’s the difference between credit risk and counterparty risk?
Counterparty risk is bilateral because both parties bear some risk. In traditional credit risk, only the lender assumes the risk
Definition of culture risk
A form of operational risk. Risk that a firm’s Risk Culture negatively impacts the firm. Ex: a company culture of inflexibility leaves the firm vulnerable to rapid business environment changes
Definition of emerging risk
Risk that is developing or changing, is difficult to quantify, and may have a major impact. Often associated with a high degree of uncertainty, a lack of data, and are beyond the firm’s control like climate change and some cyber risk.
Definition of equity risk
The risk of loss associated with exposure to an adverse movement in equity prices. A form of market risk.
Definition of expense risk
Risk of unexpected adverse expense experience
Sources of expense risk
New business, litigation, inflation increasing costs, technology risks especially after a cyber attack, mergers and acquisitions may not bring as much expense reduction as expected, and the performance of related companies in an enterprise may mean changes in the expense allocation throughout the enterprise
Definition of foreign exchange risk
Risk that the relative changes in currency values:
- decrease the value of foreign assets or
- increase the value of obligations denominated in foreign currencies
What are the components of foreign exchange risk?
- Transaction risk
- Economic risk
- Translation risk
As a component of foreign exchange risk, what is transaction risk?
Risk that arises when a firm has current contractual obligations in a foreign currency
As a component of foreign exchange risk, what is economic risk?
General economic exposure to exchange rate fluctuations.
- Firms that import or export goods
- Firms that invest in foreign markets
- Firms whose good experiences demand slumps when exchange rate movements make imported competitive goods relatively cheaper
As a component of foreign exchange risk, what is translation risk?
Risk that arises from the requirements of financial reporting for a firm with assets and liabilities designated in different currencies.
Ex: A foreign subsidiary might show significant volatility in net assets between reporting periods due to exchange rate movements even if the value has been stable in the subsidiary’s home currency
Definition of funding risk
The risk that positions may be profitable in the long run, but bankrupt a company in the short run
Definition of inflation risk
Risk of reduction in returns due to falling purchasing power
Why is inflation risk important
If incoming net CFs are fixed in monetary terms, the impact of inflation reduces their value and therefore, the real return.
Long-term, fixed amount CFs are most vulnerable.
Anticipated inflation is not a concern as it can be prepared for and managed. Even unanticipated inflation is not a concern if cash flows move in parallel, maintaining the real returns.
Impacts of inflation risk
Changes in foreign exchange rates, increase in interest rates, increase in morbidity
How to manage inflation risk
- Implement rate increases
- Review the extent of the coverage and cost containment features
- Review the asset mix to increase real rates of return
- Review policies, procedures, and staffing to control costs
Definition of inherent risk
The natural level of risk inherent in a process or activity without doing anything to reduce the likelihood or mitigate the severity
Definition of investment risk
The risk of loss relative to the expected return of any investment
Definition of lapse risk
Risk of loss due to unexpected lapse experience
Sources of lapse risk
- Changes to the firms products and reputation
- Changes to competitor’s products
- Changes in the economic environment and policyholders’ need for insurance
- Misestimation of expected experience
Impacts of lapse risk
- Anit-selection lapse causing worsened mortality and morbidity in the cohort remaining
- Mismatch of asset and liability cash flows
- Increased unit expenses
- Worsened liquidity (like a run on the bank)
- unexpected shift to less profitable or more capital-intensive mix of business
How to manage lapse risk
- For adjustable products, change premiums and/or benefits
- Adjust the price of new business
- Seek reinsurance solutions
Definition of legal risk
The risk of fines, penalties, and punitive damages from supervisory actions, lawsuits, or private settlements.
This includes risk of loss from unsuccessful lawsuits the firm files.
Sources of legal risk
- Risk of lawsuit (employee health and safety, civil liability, etc)
- Defective contracts
- Failure to protect assets (physical or intellectual property)
Impacts of legal risk
- damaged reputation
- rating downgrade
- lower sales
- higher lapses
How to manage legal risk
Have the legal counsel, risk management, and senior management work together to create company policies, and make sure agreements with counterparties can be enforced
Definition of liquidity risk
The risk that a company cannot raise cash to meet its obligations in a timely and cost effective manner due to insufficient liquid assets
Sources of liquidity risk
- High lapses and low new business
- Deterioration of the economy
What are the components of liquidity risk
- Market liquidity risk (or asset liquidity risk): Risk that market conditions restrict access to liquidity, so transactions can’t be conducted at normal market prices.
Ex: In a volatile, falling market, the cost of borrowing may be very high and the value of assets may be very low since there are so few buyers in the market. - Funding liquidity risk: Risk that early liquidation of assets is required to meet payment obligations, resulting in realized losses
How to manage liquidity risk
Set limits on cash flow gaps and diversify
Definition of maturity risk
The risk that demographic shifts cause risk profile shifts such that the firm is unable to bear the risks required to achieve its objectives. Important for pension plans.
Definition of model risk
The risk that inappropriate conclusions and decisions are made from model results due to issues in the model itself or the way it was used. A form of operational risk
Components of model risk
- Defective model risk.
Model errors
Right model, wrong parameters
User generated errors (after installation)
Data quality issues
Inconsistent models - Defective model application risk
Right model, wrong application
Poor communication
Over-reliance on the model
Failure to heed the model
Sources of defective model risk
- Errors of in the methodology
- Extrapolation beyond available data
- Material changes in the environment, making the model obsolete
- Inappropriate selection of underlying distribution or number of parameters
- Fat finger errors
- Poor data quality
- Inconsistent models
Sources of defective model application risk
- Right model, wrong application
- Poor communication and understanding, especially about limitations of the model
- Over-reliance on the model, especially when results look good
- Failure to heed the model, especially when results look bad
How to manage model risk
- Monitor the environment for changes that would make the model obsolete
- Conduct thorough reviews when models are created or updated
- Make a reasonable attempt to understand the models you use
- Use preventative measures and best practices to mitigate the likelihood and severity of implementation and application errors
What could make a model obsolete?
- Changes in underlying risks
- Improvements in the theory or practice being modelled
- Availability of more/better data
How to review a model
Ideally get an independent review and document everything.
1) Validate the input data
2) Validate the assumptions
3) Validate the results
How to validate model input data
- Do the data meet the requirements of the model specification?
- If the model will be used repeatedly, are the data in a consistent format every time?
- Reconcile the data to other sources and prior periods for accuracy
- Investigate outliers and any missing data. How does missing data affect the model? Errors?
How to validate model assumptions
Are the assumptions appropriate, documented, and used in the model as intended?
Ex: a common assumption is assuming independence of events
How to validate model results
- Are outputs consistent with inputs and expectations (like sensitivity tests)? Ideally, test results against other models to verify calculations.
- What are the limitations of the model? Are they documented?
- Are results in an appropriate format for the intended users and purpose?
What’s the best practice for model risk when using a model you’re not familiar with?
Make a reasonable attempt to understand the following:
- The basic workings of the model (inputs, outputs, general approach)
- The testing and validation done
- The model’s complexity and the control framework
- The model’s limitations
List some best practices to mitigate model risk
- Acquire highly qualified staff and conduct training
- Use rigorous approval requirements (model result stakeholders shouldn’t be approvers)
- Keep the end user in mind
- Restrict access and use to prevent mistakes
- Create feedback channels to correct mistakes
- Create built-in checks
- Record and test model and parameter uncertainty
Definition of moral hazard risk
Risk that the presence of insurance gives the insured an incentive to increase the level of risk taken.
Definition of morbidity risk
The risk of:
- Increases in incidence rate for disability, medical, dental, and critical illness coverage
- Decreases in the rate of claim termination
Sources of morbidity risk
A prolonged recessionary environment, a pandemic, mortality improvements prolonging lives, improved diagnostic technology, escalation of medical costs, and misestimation of expected experience
Impacts of morbidity risk
If there are rate guarantees that limit or delay premium rate increases, financial losses may occur. If the firm increases premiums, there may be lapses, low sales, and a reputation impact.
How to manage morbidity risk
Increase premium rates, and conduct more active claims management
Definition of mortality risk
The risk of loss arising from unexpected mortality experience
Sources of mortality risk
Catastrophe, anti-selective lapse experience, a weakening in underwriting standards, new illnesses, misestimation of expected experience, medical advancements, and mortality improvement assumptions that aren’t fully realized
Impacts of mortality risk
Steady and continued deterioration in mortality causing routine reprices can have knock-on impacts to new business and expense coverage
How to manage moratlity risk
For adjustable products, change the premiums and/or benefits. Adjust the price of new business. Get reinsurance. Issue mortality bonds.
Definition of people risk
An element of operation risk. Risk that arises from human employees, in general. Ex: staff constraints, incompetence, dishonesty
Definition of physical risk
An element of climate risk. Risk arising from extreme weather and environmental events.
Impacts of physical risk
Disruptions to critical operations, reduced value of investments (especially property and infrastructure), increase in insurance risks
Definition of policyholder behavior risk
Risk that the insurance company’s policyholders will act in ways that are unanticipated and have an adverse effect on the company
- Ex: Persistency, contribution patterns, exercise of embedded options, management expenses
Sources of model risk
Inappropriate:
1) projection of past trends into the future
2) selection of an underlying distribution
3) number of parameters
Definition of political risk
Risk of government actions impacting the firm, especially if there was no warning or time to prepare.
- Sometimes changes can be done retroactively with no grandfathering provisions
Impacts of political risk
1) Changes in regulations like an increased capital requirement
2) Tax changes
3) Political instability causing market risks, exchange risks, low sales, high reinsurance prices, etc
4) Changes impacting a product line like some new public health care
5) Changes affecting investments like a reduction in the gov’t’s need to borrow funds
Definition of pricing risk
Risk that the prices charged by the company for insurance contracts will be ultimately inadequate to support the future obligations arising from those contracts.
- If prices are too high, then there’s risk that the firm may not capture enough market share to recoup its initial outlay.
Sources of pricing risk
Incorrect assumptions in the pricing model or parameters. Adverse selection (policyholders passing more risk than expected).
How to manage pricing risk
Consider the following during product development and pricing:
1) Economic value creation requirements for shareholders
2) Fair treatment of customers
3) Statutory requirements
4) The speed of recouping the investment capital
5) The impact on financials
6) Tail event impact on risk tolerances
Definition of process risk
An element of operational risk that arises from ineffective and inefficient processes. The key is to balance efficiency and effectiveness of business processes.
Sources of process risk
Model risk, parameter risk, health and safety risks (like human error in following protocol or inaccessible emergency exits), and manufacturing process risk (like human error in implementation or defective construction)
Definition of project risk
Risk that a project is not executed as expected and causes losses
Components of project risk
Scope risk, defect risk, schedule risk, and resource risk
As a component of project risk, what is scope risk?
Risk that the project goals are changed during the implementation phase, leading to overruns in time or budget and potentially failing to meet the original project objectives. This can come from scope creep or gap risk (the original project planning was not sufficiently thorough so adjustments had to be made).
As a component of project risk, what is defect risk?
Risk that hardware or software acquired or developed to implement a project doesn’t meet the project needs
As a component of project risk, what is schedule risk?
Risk of loss due to schedule failure. Project planning is important. Too aggressive, there will be bottlenecks and wasted resources from overruns. Too conservative, there will be waste if resources are allocated for longer than they are required.
As a component of project risk, what is resource risk?
Risk of loss due to resources not being available when required.
- Ex: losing key people before the project is completed
- Ex: running out of money to complete the work
Definition of regulatory risk
Risk of regulator actions impacting the firm, especially if there was no warning or time to prepare
Sources of regulatory risk
New regulations either directly from regulators or from the government. New employees who aren’t trained in the company’s compliance procedures.
Definition of reinsurance held risk
Risk that a reinsurer will fail to meet its obligations or that a market change causes an increase in reinsurance premiums or otherwise inadequate or unaffordable coverage.
Sources of reinsurance held risk
- increases in reinsurance premiums
- reduction in reinsurance capacity available for the financing of new business
- disputes with reinsurers over policy conditions (like terrorism exclusions)
How to manage reinsurance held risk
Renegotiate terms with the reinsurer or recapture ceded business. If a reinsurer becomes insolvent:
- the insurer will have a preferred position relative to other creditors
- the insurer will have access to amounts on deposit or assets in trust
Definition of reinvestment risk
Risk that it will be impossible to reinvest cashflows at their current rate of return
Sources of reinvestment risk
Reinvestment risk increases when interest rates decrease
Definition of related companies risk
Risk that the actions of a related company (like a parent, subsidiary, or other company in the same enterprise) will impact the firm
Sources of related companies risk
- Financial support is no longer guaranteed from a parent
- Reallocation of group expenses to the firm
- The group gets a credit rating downgrade
- Related company is in financial difficulty. Pressure to support or not able to sell/close firm in a timely manner.
Definition of reputation risk
The risk that a company’s brand and reputation may be negatively impacted
Impacts of reputation risk
Low sales, high lapse
Definition of reserve risk
Risk that the provisions held in the insurer’s financial statements for its policyholder obligations will prove to be inadequate
Definition of settlement risk
The risk that obligations are fulfilled, but not at the agreed-upon time. A type of credit risk.
Definition of sovereign risk
The risk that a country will default on its government bonds or impose foreign exchange controls that make it impossible for other counterparties to fulfill their obligations. A type of Credit Risk
Definition of spread risk
A type of interest rate risk. Risk that yield curve movements or changes in the shape of the yield curve negatively impact a firm.
Definition of stock price risk
Risk from changes in the firm’s own stock price. A type of market risk. (High stock prices allow companies to pursue strategic intiatives easier)
Definition of strategic risk
The risk that business strategies are flawed or ineffectively executed
How to manage strategic risk
Ensure adequate understanding of the risks being taken on with the strategic decision, and prepare plans in case of adverse events.
Definition of system risk
Definition of parameter risk
Risk that parameters used in a model are not adequate (even if the rest of the model is)
Sources of parameter risk
Insufficient or inaccurate data used to estimate parameters. Ex: if we use whole population data to model the mortality of individual members of a pension plan, we are ignoring the fact that pension plan members tend to have better health than the general population
Definition of credit risk
The risk that a customer, counterparty, or supplier will fail to meet its obligations (financial or service)
Components of credit risk
Direct default risk (settlement risk, sovereign risk, counterparty risk, and outsourcing risk) and downgrade risk
Sources of credit risk
1) Changes in interest rates and inflation
2) Poor returns on equities and real estate
3) Fluctuations in exchange rates
Impacts of credit risk
1) Exposed risk positions as a result of counterparty defaults
2) Liquidity issues caused by large sustained credit-related losses
3) Reduced availability of derivatives used for hedging strategies
How to manage credit risk
1) Set limits on notional amounts and current and potential exposures
2) Get collateral
3) Use covenants
Definition of dowgrade risk
In the context of Credit Risk: Risk of changes in the perceived probability of a future default of an obligor, affecting the present value of the contract today
Otherwise, the risk the the firm itself receives a credit rating downgrade.
Impacts of downgrade risk
If the firm receives a downgrade:
1) Liquidity risk because borrowing will become more expensive
2) Lapse risk, making liquidity even worse
3) Low sales
4) Damaged reputation
Definition of disintermediation risk
Risk that policyholders bypass intermediares (like financial institutions) to directly access a better deal elsewhere. The motivation may be to reduce cost, increase return, or increase delivery speed.
Ex: lapse annuity to attempt to achieve a higher return investing directly in the market
Sources of disintermediation risk
Disintermediation risk increases when interest rates increase because policyholders lapse their annuities in favor of products with higher returns
Impacts of disintermediation risk
Lapses and low sales cause large cash outflows and decreasing liability duration
Definition of financial risk
Risk that arises from financial market activities
Components of financial risk
Market, credit, foreign exchange, credit, spread, and liquidity risk
Sources of financial risk
- Asset/liability duration mismatches
- Interest rate levels
- Pricing spreads
Definition of insurance risk
Risk arising from movement in insurance variables including claim incidence, claim termination, and persistency
Components of insurance risk
Persistency, underwriting, mortality, morbidity, lapse, and expense risk
