Unit 5

Question 1

6 reasons why we analyse risk

Answer 1

1. Prioritise risks for treatment in terms of their significance
2. Compare risks with the risk appetite
3. Achieve consistent perceptions of significance
4. Inform decisions on how scarce resources are allocated
5. Inform decisions about new investment/ project
6. Ensure capital adequacy

Question 2

2 dimensions of risk analysis

Answer 2

Likelihood and impact

Likelihood made up of frequency and probability

Impact can be qualitative or quantitative. Measured in magnitude and consequence

Question 3

What makes our risk significant?

Answer 3

That is what risk analysis is trying to answer. Can do so by setting a benchmark test for significance such as:

FIRM
Financial: impact on balance sheet of 0.25%
Infrastructure: disruption to normal operations of 1/2 day
Reputational: share price falls by 10%
Marketplace: impact on b/sheet of 0.5% of turnover

Question 4

Inherent vs residual

Answer 4

Inherent- apply control first -reduced impact and likelihood to current level. If target state lower then can apply another control

Thinking about when does the additional cost of controls exceed the benefit?

Question 5

How Pillar 1 of Basel 3 and Solvency 2 set out capital requirements?

Answer 5

Capital requirements are expressed in terms of a size of loss or risk event. Solvency 2 requires insurers to hold capital equivalent to a loss of a 1 in 200 yr equivalent, expressed as 99.5% VAR over a 1 yr horizon

Question 6

2 ways to calculate

Answer 6

Standardised approach (banks) or Standard formula (insurance) prescribes a set of stress tests and calculations.
Basel 2 covers range of exposures-corporate, sovereign and bank exposures, retail, equity and purchased receivables.
Solvency 2 requires a series of risk modules covering risks such as insurance risk, underwriting risk and catastrophe risk.

Or own internal model. Basel 3 allowed for credit, mkt and op risk. New requirements reducing use for credit risk. Limited to 27.5% of SA values

Question 7

Supervisory authority approve models if:

Answer 7

• the bank’s risk management system is conceptually sound and is implemented with integrity
• the bank has enough staff skilled in the use of sophisticated models in trading areas, risk control, audit and back office functions
• the bank’s models have a proven track record of measuring risk with reasonable accuracy
• the bank regularly conducts prescribed stress tests

Question 8

3 advantages of internal models

Answer 8

1. Ensures they use a comprehensive risk management system
2. Incentivises firm to improve their own estimate of risk exposure
3. Firm can hold lower regulatory minimum capital

Question 9

Methods for calculating capital according to Basel 2 - table

Answer 9

Credit risk Market risk Op risk
1. Standardised 1. Stand. 1. Basic
Approach Approach Indicator
2. Foundation 2. Internal 2. Stand.
IRB approach Models app Approach
3. Advanced 3. Advanced
IRB approach Measurement
Approach
RWA value Mkt risk Op risk
for credit risk capital capital
charge. charge

Question 10

Solvency 2 - internal models-when used?

Answer 10

Pillar 1 - internal model used to calculate whole or part of pillar 1 SCR. Would incorporate insurance, credit, market and op.

Pillar 2 - ORSA use of internal model, no approval required

Question 11

Solvency 2 6 tests

Answer 11

1. Statistical quality standards. Demonstrating that the methodology assumptions and data underlying model are sound.
2. Calibration standards. Model is calibrated to a level equivalent to the Standard Formula for the purposes of the SCR calculation.
3. Validation standards. Substantiating a sound control environment around the model
4. Documentation. Enable a 3rd party to reproduce the model.
5. Profit and Loss attribution. Demonstrating an ability to reconcile the sources of variance (or P&L) in the results of the model with the risks included in the model.
6. Use test. Demonstrating model is used within business for wider range of purposes.

Question 12

Principles of solvency 2 internal models:

Answer 12

Senior management understand the internal model.

The internal model fits the business model.

The internal model is used to support and verify decision making.

The internal model is widely and consistently integrated into the risk management system and covers enough risks to make it useful for risk management and decision making.

The internal model is used to improve the firm’s risk management system.

Question 13

Upside risk definition

Answer 13

Opportunities that can be seized with a desirable outcome

Question 14

The upside of risk in relation to strategy is

Answer 14

Increasing the likelihood and positive impact of the particular strategic decision

Question 15

The upside of risk management in terms of tactics or change management to implement strategy

Answer 15

The upside of risk here is around selecting the best change activities to implement strategy, and ensuring the selected change activities are effectively delivered.

Question 16

Upside of risk in operations

Answer 16

Efficient processes. This can help place the organisation at a competitive advantage over its competitors, thus identifying further strategic opportunities.

Question 17

Cycle in the upside of risk management

Answer 17

moving from strategy to tactics, tactics to operations and operations back to strategy.

Question 18

Riskiness index

Answer 18

The level of risk faced by Finances; infrastructure; reputation; marketplace.

How can risk management reduce this without effecting Strategy; Tactics; Operations; Compliance

Question 19

Risk evaluation - after analysing a risk to estimate its severity, we then have to decide whether to:

Answer 19

• respond to the risk in some form in order to reduce our exposure (hazard risk), reduce the level uncertainty (control risk), or modify the investment (opportunity risk);
• or simply tolerate the level of risk that we have estimated without any further action;
• or decide whether to accept a particular risk proposal either as is or by amending the proposal.

Question 20

Orange book -risk evaluation

Answer 20

Should involve comparing the results of the risk analysis with the nature and extent of risks that the organisation is willing to take- its risk appetite- to determine where and what additional action is required

Question 21

Op Risk measurement- 3 approaches

Answer 21

Basic indicator- total annual gross income- annual gross income as a fixed percentage averaged over 3 years

Standardised approach- split activities into 8 business lines and apply beta factor or fixed percentage against this.
To use must have op risk function and systems in place.

AMA - internally generated models. Must pass credibility test. Strict qualitative and quantitative criteria. Supervisory monitoring