# 28 - Risk Measurement & Reporting Flashcards Preview

## CP1 Flashcards > 28 - Risk Measurement & Reporting > Flashcards

Flashcards in 28 - Risk Measurement & Reporting Deck (23)
1
Q

Two key features to be assessed wrt any risk:

A
• The probability of risk occurring

- The expected loss if the event occurs

2
Q

Methods to quantify risk are:

A
• Subjective assessment
o Score freq/severity of event on scale of 1-5 or 1-3
o Product of the two scores for risks gives an approach to ranking the risks
o If risk controls are placed, the score should reduce by an amount that justifies the cost of the control
• Using a model
o Need to assign a dbn to both the probability of event occurring & loss if the event occurs
o Need to define the risk event clearly to quantify it
o Need sufficient quality data to choose what type of model to use and to parameterise the model
3
Q

What are the methods available to evaluate risks?

A
• Scenario Analysis
• Stress testing
• Combination of stress/scenario testing
• Reverse stress testing
• Stochastic modelling
4
Q

Methods to quantify operational risk:

A
• Adding a percentage to total aggregated risks other than operational risks
• Scenario analysis: divide operational risk into different categories and assessing the cost of a plausible adverse scenario
5
Q

In which situation is scenario testing useful to evaluate risks?

A

When it is difficult to fit full probability dbns to risk events (hence a stochastic model would be inappropriate)
- Used to evaluate operational risks and impacts of global recessions for example

6
Q

What are the steps to follow when scenario testing?

A
• Group risk exposures into various broad categories
• Develop a plausible adverse scenario representative of all risk in each group
• Translate the consequences of the scenario into assumptions for various risk factors in the model
• Total costs calculated are taken as the financial cost of all risks represented by the chosen scenario

** One drawback of scenario analysis is that it only models the severity of the scenario and not the probability of it occurring

7
Q

Outline stress testing:

A
• Deterministic projection of the financial condition of a company under a specific adverse event over a period of time
• Risks incurred by extreme events can be identified & investigated using stress testing
8
Q

Outline the combination of stress & scenario testing:

A
• Stress testing can be coupled with scenario testing to determine a stress scenario
• Stress test is conducted by considering the impact of a set of related adverse conditions that reflect the chosen risk scenario
• When constructing a stress scenario, decisions need to be made about how various aspects of business will react to the stress event

e. g. Unit-linked investment bonds experience lasting reduction in mkt values which affects:
- Income from management charges
- Persistency of existing investment bonds
- Value of shareholders interests
- Probability of guarantees biting
- Regulatory capital requirements going forward

• Scenarios should also be tailored to reveal weak areas of the portfolio in terms of risk exposure & sensitivity
o Should thus focus on risk factors to which business is most vulnerable.
9
Q

Two types of stress test:

A
• Identify weak areas of the portfolio & investigate the effects of localised stress situations by looking at the effect of different combinations of correlations & volatilities
• Gauging impacts of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are ‘stressed’
10
Q

Describe reverse-stress testing:

A
• It is about identifying a plausible scenario that would be just enough to stop the company from fulfilling strategic business plan
• Business plan failure needs to be defined by the firm for both short-term & long-term

eg.
- Having insufficient capital to meet statutory requirements or to cover minimium risk appetite
- Non-financial external event causes company to lose access to its major mkt.

11
Q

Outline stochastic modelling:

A
• Variables give rise to being incorporated as probability distributions
• Full set of dynamic interactions b/w variables are specified
• The model can then determine the amount of capital needed to avoid ruin over a specified time horizon at a desired probability level
12
Q

How to limit the scope of the stochastic model to accommodate computing power limitations:

A
• Limit the time horizon being modelled
• Limit the no. of variables being modelled stochastically eg. make variables that have one way adverse or favourable effects deterministic.
• Carry out a number of runs w different single stochastic variables followed by a single deterministic run using all the worst case scenarios together
o This will determine the interactions b/w various variables
13
Q

Diversification benefit defn:

A

The extent to which the overall capital requirement is less than the sum of the capital requirements for each individual risk

14
Q

What are the asset risks that need to be measured?

A
• Tactical asset allocation error
• Strategic allocation risk
• Duration risk
• Counterparty, interest rate & equity market risk

** Need to allow for diversification benefits when measuring asset portfolio risks

15
Q

Risk measurement techniques for asset risks:

A

ASSET RISKS:
Tactical asset allocation risk
- Historic tracking error: retrospective annualised std. deviation of difference b/w portfolio performance & target benchmark
- Forward looking tracking error: prospective equivalent to historic tracking error, determined using modelling techniques

Strategic allocation risk
- Both forward-looking/retrospective tracking error approaches can be used to find the effects of the actual strategic allocation compared to the target asset allocation

Duration risk

• For portfolio with need to closely match A&L there will be an acceptable range for the duration of fixed interest element
• Otherwise vulnerable to reinvestment & liquidity risk
• Retrospective/prospective approaches can be used to gauge this risk as used for SA risk and TA risk

Counterparty, interest rate & equity market risk

• Best proxy to quantify counterparty (default) risk taken is to use the amount of capital necessary to hold against the risk.
• Equity market & interest rate risk is assessed using VaR methods as prescribed in Solvency II wrt. an internal model or a standard formula as appropriate.
16
Q

How do we measure liability risks?

A

By analysis of experience -> Ratio of actual occurrences of an event to the expected occurrences when the risk was expected

** Ensure that there is correspondence b/w the classification & measurement of not only risk events but also the population exposed to risk

17
Q

Value at risk (VaR) definition:

A

VaR represents the maximum potential loss on a portfolio over a given future period with a given degree of confidence

• VaR could be measured in relative or absolute terms
18
Q

VaR pros and cons:

A

Pros:
- Easy to interpret & very widely used

Cons:

• Does not give info on what the loss might be in extreme cases
• May be misleading if the underlying dbn is wrong
• VaR does not quantify the size of the tail
• Hence needs sufficient data within the tails of the dbn for meaningful results (may be difficult to obtain)
• VaR might give a measure of risk that ignores the sub-additivity of risk rule of investing in more than one asset. ie. It may produce a measure of risk larger than the sum of the individual risks measures
19
Q

What is in a risk portfolio?

A
• The risk portfolio categorises the various risks to
• Against each risk would be a recorded quantification of the risk’s impact and probability
• The product of the impact and the probability measures gives an idea of the relative importance of the various risks
• Risk response: records how the risk was accepted, rejected, transferred, mitigated or reduced
20
Q

What does a risk register include? How does it come about?

A
• For risks that are retained, the risk portfolio becomes a more detailed risk register.
• It is used throughout the process to monitor and report on the risks
• Risk registers include:
o Details of CONTROL MEASURES
o REASSESSMENT of value and impact after controls are put in place (to see if mitigation measures are worthwhile)
o Risk OWNER
o Board committee or senior manager with OVERSIGHT of the risk (key strategic risks overseen by the full Board)
o Identification of CONCENTRATIONS of risk and the need for management action in these areas
21
Q

What is the purpose of regular risk reporting?

A
• IDENTIFY any new risks faced by the business
• To better UNDERSTAND risks faced by the business in terms of quantifying:
o Materiality
o Financial impact of individual risks
• Determine appropriate RISK and CONTROL systems to manage specific risks
• Proactively MONITOR and MANAGE the effectiveness of risk and control systems within its business
• Assess whether risks faced are CHANGING over time
• Assess the INTERACTION between individual risks
• Appropriately PRICE, RESERVE and determine any CAPITAL REQUIREMENTS for its business

For STAKEHOLDERS:
- Give shareholders or potential shareholders greater understanding of the INVESTMENT PROSPECTS

• CREDIT RATING agencies can determine an appropriate rating more easily
• Gives REGULATOR greater understanding of the areas within a business which could require more scrutiny
22
Q

What is risk reporting cross an enterprise concerned with?

A
• REPORTING the risk exposures taken up by business units consistently across the enterprise
• OPTIMIZING risk appetite allocation across business units
• Additional capital may have to be held to cover UNMATCHED exposures across business units at enterprise level
23
Q

What are the main issues FSPs face in assessing capital requirements at a given ruin probability?

A
• Time HORIZON to be used for calculation (1 year or run-off of the business)
• CORRELATION matrix used to assess correlation b/w risks is subjective
• INTERACTION effects b/w risks need to be addressed
• Some risks are highly SUBJECTIVE to assess eg. operational risk -> constructing plausible adverse scenarios that occur w low probability to assess it
• Use of past data in estimating future consequences should be undertaken w caution especially for rare events