Chapter 26 - Risk identification and classification

Question 1

Provide a brief outline of the risk identification process

Answer 1

Recognise key risks that can threaten the organisation’s business plan

Determine risk control processes that can be put in place which will reduce each risk’s likelihood and/or impact

Identify opportunities to exploit risks and gain a competitive advantage in the market

It is important that all staff are involved in risk identification, not just management. External views could also be sought.

Question 2

Discuss some ways of identifying risks.

Answer 2

Use risk classification to ensure all types of risk have been considered

Use project management techniques

• Perform high level preliminary risk analysis to determine if project is worth pursuing
• Hold an initial brainstorming session with the following goals:
  1) Identify all risks and their potential upsides and downsides
  2) Discuss interdependency and other characteristics of risks
  3) Place rough valuation on risks
  4) Generate and discuss initial mitigation options
• Perform more in depth analysis to validate results from brainstorming session
• Obtain further expert opinion
• Set out risks in risk register or risk matrix

Use risk checklists as used by regulators

• Some risk-based capital requirement regimes, such as solvency II, have lists of risks that regulators believe are relevant to the business.
• This list may, however, not be exhaustive

Use experience of staff who have joined from similar organisations, as well as consultants with broad experience and knowledge.

Question 3

What do the rows and columns of a risk matrix represent?

Answer 3

Rows: Stage of the project

Columns: Causes or types of risk

Question 4

List and briefly discuss the main risk categories.

Answer 4

Market risk (pp. 9-11)

• Risks related to changes in investment market values or economic variables correlated with investment markets
• Can be divided into three categories:
  1) Risk of asset value changes
  2) Risk of liability value changes (including creditors and reserves)
  3) Risk of not matching assets and liabilities
• Effect of interest and inflation rates on assets and liabilities are important

Credit risk (pp. 12-14)

• Risk of failure of third parties to meet financial obligations
• Could also relate to risk of credit ratings changing and volatility of credit spreads (i.t.o. bonds)

Liquidity risk (pp.15-18)

• Risk that individual or company does not have available sufficient financial resources to meet financial obligations as they fall due, or could only do so at an excessive cost.
• Maintain degree of liquidity to protect against larger than expected increase in or change in timing of liabilities

Business risk (pp. 19-20)
- Any risks specific to the business undertaken
- Those which, unlike operational risk, cannot be avoided through pure organisation - they are inherent in the type of business
- For financial product providers, these can be divided into
> underwriting risk
> insurance risk
> financing risk
> exposure risk

Operational risk

• Risk arising from inadequate or failed internal processes, people and systems, or from external events.
• Typically non-financial risks that have financial consequences
• Can be mitigated through organisation
• Requires input from experienced individuals or consultants with detailed working knowledge of the operations of the business/business class.

External risk

• Arise from external events out of the companies control, such as fire or terrorist attack
• Also regulatory, legislative and tax changes
• Non-financial risks
• Generally systematic risks

(From lecture) Could also classify into:
Financial versus non-financial risks
Systematic versus diversifiable risk

Also note difference between business and operational risk

Also note failure to mitigate for external risks is an operational risk

Question 5

How much liquidity risk do the following types of institutions have and explain briefly:

a) Non-financial institutions
b) Insurance companies and benefit schemes
c) Banks
d) CISs and Insurance funds

Answer 5

a) Depends on assets and liabilities. Could range from very little to a lot.
b) Low liquidity risk. Large portion of investments are in cash deposits, bonds and stocks which can usually be readily sold.
c) High liquidity risk. Long term loans and need to provide immediate access to cash for deposits leads to high need for liquidity, and therefore high liquidity risk.
d) High liquidity risk. Need protection in event that clients request money back if pool is invested in illiquid assets. Can put certain measures in place to protect themselves from disaster.

Question 6

What are non-financial risks?

Answer 6

Risks arising from events, rather than financial transactions, that can negatively impact the operations of a company.