Chapter 29: Risk measurement and reporting

Question 1

Define 5 ways in which risks can be evaluated

Answer 1

1. Scenario analysis
   Consider the financial impact of a plausible and possible adverse set of events or sequence of events, e.g., the financial impact on a company following the outbreak of a global pandemic
2. Stress testing
   A projection of the financial conditions of a company under a specific adverse event over a period of time
3. Combination of stress and scenario testing
   Stress test is performed by considering the impact of a set of related adverse conditions that reflect the chosen scenario
4. Reverse stress testing
   A scenario is identified which would just be enough to stop the company from being able to fulfil business plans (regulatory requirement)
5. Stochastic modelling
   Key risk factors are modelled as a probability distribution, allowing for dynamic interactions between varables, the output is a distribution of possible results

Question 2

What are the steps involved in scenario testing

Answer 2

1. Group risk exposures into broad categories, e.g., risks that can lead to systematic system failure
2. For each group, develop a plausible adverse scenario. The scenario is then representative of all risks in that group
3. Costs are assessed by key members of staff.

Question 3

Where is stress testing mostly used

Answer 3

Financial risks - Equity market movements, interest rate changes

Business risk, e.g., mortality improvements

Question 4

What is the most common capital requirement

Answer 4

Capital that is able to withstand an event that occurs in 12 months with a probability of 0.5%

Question 5

Explain how the capital requirement is calculated for:

• Fully dependent risks
• Fully independent risks
• Partially dependent risks

Answer 5

Fully dependent risks: The capital requirement is the sum of the capital required for each risk

Fully independent risks: Overall capital requirement is lower than the sum of all capital requirements

Partially dependent: Various techniques, e.g., use of correlation matrices or copulas

Question 6

What are the three deterministic approaches to measuring risk

Answer 6

1. Notional approach, e.g., under Basel III banks use credit ratings from credit rating agencies to quantify the credit capital requirement or factor-based charges in SAM
2. Factor-sensitive approach, e.g., to what degree a change in a single underlying factor has on the financial position
3. Scenario sensitivity approach, e.g., changing a set of underlying factors in a mutually consistent way

Question 7

What are four probability approaches to measure risk

Answer 7

1. Deviance, e.g., standard deviation, standard deviation from the mean, tracking error
2. Value-at-Risk (mainly used for market risks), this gives the maximum potential loss over a given time period with a given degree of confidence. Does, however, have a normality assumption. Also doesn’t say anything exceeding VaR
3. Tail Value-at-Risk: Losses exceeding VaR should VaR occur
4. Probability of ruin: Probability of financial position < 0

Question 8

What is a risk register

Answer 8

RIsk register categorises risks to which a business is exposed, along with the quantification thereof (impact and probability of occurring)

The responses to risks can also be included

Question 9

What are the 4 main responses to risks

Answer 9

1. Avoid
2. Retain
3. Diversify
4. Mitigation

Question 10

Why is risk reporting important (9)

Answer 10

1. Management can fully understand and manage the risks
2. Identify new risks faced y the organisation
3. Better understand risks and their full impact
4. Determining appropriate controls to manage risks
5. Monitor the risk controls
6. Access if risks are changing over time
7. Interaction between individual risks
8. Appropriate prices charged, reserves held and capital requirements
9. Give regulator a better understanding