Module 26: Risk optimisation and risk responses

Question 1

Risk management can optimise the risk / return profile of the organisation, with respect to its risk appetite, by: (4)

Answer 1

• supporting selective growth of the business
• supporting profitability through risk-adjusted pricing
• using limit setting to control the size and probability of potential losses
• employing techniques to manage existing risk

Question 2

5 fundamental concepts in risk portfolio management

Answer 2

1. risk
2. reward
3. diversification
4. leverage
5. hedging

Question 3

2 Measures of return that reflect the risk taken to achieve the return

Answer 3

• RAROC - can be based on actual or expected return and capital
• the Sharpe ratio - a measure of out-performance compared to the riskiness of the portfolio

Question 4

Mean variance portfolio theory (MVPT): (3)

Answer 4

• can be extended to any portfolio of risks, eg an organisation’s projects
• states that optimal combinations of risky assets can be determined without any knowledge of the investor’s preferences towards risk and return (the separation theorem)
• states that the investors’ choice from the set of efficient portfolios will be determined by their risk appetite or, equivalently, their utility function.

Question 5

Applying MVPT principles: (4)

Answer 5

• encourages companies to “unbundle” the business into component projects
• provides a mechanism for aggregating risks across the business
• provides a framework in which risk concentration limits and asset allocation targets can be set
• influence investment, transfer pricing and capital allocation decisions.

Question 6

4 Key types of risk response

Answer 6

• rejection (avoidance / removal)
• acceptance (retention)
• transfer
• management (treatment / reduction without transfer)

Question 7

Good risk responses are: (6)

Answer 7

• economical
  the cost of implementation should not exceed the reduction in risk.
• well matched to the risk
  to avoid introducing basis risk
• simple
  to avoid making mistakes in executing the response
• active
  the response should not simply inform, but also investigate action
• flexible and dynamic
  reacting to changing circumstances

Question 8

Risk can be transferred to: (2)

Answer 8

• to another part of the same organisation
• to another party, eg
  — insurance,
  — sharing with the policyholder,
  — ART,
  — outsourcing

Question 9

5 Considerations when transferring risk include:

Answer 9

• cost
• loss of upside potential
• counterparty risk
• regulatory restrictions
• market capacity

Question 10

Risks can be reduced without transfer by: (8)

Answer 10

• taking on uncorrelated (or negatively correlated) risks
• increasing the size of a portfolio
• greater matching of assets and liabilities
• implementation of strong internal controls and governance
• robust underwriting practices, analysis using appropriate homogeneous groupings and taking into account both past and likely future trends
• robust due diligence practices, and tightly worded agreements
• remuneration and bonus systems that align agents’ interests
• increased capital or funding

Question 11

Risks may be accepted by an organisation if they are: (3)

Answer 11

• a core component of its core business
• it appears to be the most economical approach
• there is no alternative

Question 12

Residual risks result from: (4)

Answer 12

• decisions to retain risks
• secondary risks
• imperfect hedges
• an inability to transfer or fully mitigate risks

Question 13

ART

Answer 13

ART products are non-traditional risk transfer products which often combine features of both (re)insurance products and financial risk protection products utilising the capital markets (eg derivatives).

Question 14

What are the benefits of ART?

Answer 14

D - Diversification
E - Exploiting risk as an opportunity
S - Solvency management
C - Cheaper cover possibly
A - Available cover, when reinsurance isn't
R - Results smoother
T - Tax advantages
E - Effective risk management
S - Security is greater

• improve the focus on the core business, and capital efficiency
• provide a quick and potentially more tailored solution, although more complex and bespoke arrangements can take time to develop
• reduce total costs, although they may involve higher initial costs
• stabilise earnings
• help establish a market price for risk
• simplify administration by reducing the number of risk transfer arrangements, although the use of ART could potentially increase operational risks, and changes may need to be made to methods of risk assessment and management to accommodate its use.

Question 15

Expand on how risk management can:

support selective growth of the business

Answer 15

• Establish a process for assessing new business opportunities. The process should include the assessment of risk adjusted return.
• Allocate capital and other resources to business units or activities with high risk-adjusted return.

Question 16

Expand on how risk management can:

support profitability through risk-adjusted pricing

Answer 16

• Prices should reflect the cost of risk (capital) in addition to funding costs and operational expenses.
• Net present value (NPV) and economic value added (EVA) do not fully reflect the cost of risk, usually being based on book values of capital.

Question 17

Expand on how risk management can:

use limit setting to control the size and probability of potential losses

Answer 17

• Set basic exposure limits - to provide absolute limits on exposure
• Set stop loss limits - limits on actual losses, which, if reached, trigger management action.
• Set sensitivity limits - limits designed to keep potential losses from potential extreme events within acceptable bounds. They are used to avoid excessive concentrations of risk.

Question 18

Expand on how risk management can:

employ techniques to manage existing risks

Answer 18

• Active portfolio management
  In essence, a company comprises a portfolio of activities each with their own risk / return characteristics.
  The overall risks of this “portfolio” can be assessed and managed in an analogous manner to those of a share portfolio of an active manager.
• Reduce risk (eg by duration matching - investing in assets of similar duration to the liabilities so that interest rate risk is reduced).
• Transfer risks to a third party, eg using insurance or derivatives.

Question 19

Discuss why active portfolio management and duration matching are often used in preference to risk transfer strategies.

Answer 19

They often represent more cost-effective and longer term solutions.

However, risk transfer strategies tend to be quicker and easier to implement.

Question 20

Describe risk-adjusted return on capital (RAROC)

Answer 20

RAROC = risk-adjusted return / capital

RAROC can be calculated for an institution as a whole, or for separate activities.

The ratio can be based either on actual or expected return on capital.

Question 21

Describe the Sharpe ratio

Answer 21

Commonly used in the assessment of investment managers.

It measures out-performance (in excess of the risk-free rate of return) compared to the riskiness of the portfolio (as measured by the volatility).

It is often used to compare investment managers who have taken differing levels of risk.

SR = ( Rₚ - rᶠ ) / σₚ

Rₚ is the return on the portfolio
rᶠ is the risk-free rate of return over the period
σₚ is the standard deviation of the portfolio

Question 22

Return on risk-adjusted assets

Answer 22

RORAA = net income / risk-adjusted assets

Question 23

Risk-adjusted return on assets

Answer 23

RAROA = risk-adjusted return / assets

Question 24

Return on risk-adjusted capital (RORAC)

Answer 24

RORAC = net income / capital

or

RORAC = net income / VaR

Question 25

Risk-adjusted return on risk-adjusted assets

Answer 25

RARORA = risk-adjusted return / risk-adjusted assets

Question 26

Total risk on an asset can be divided into: (2)

Answer 26

1. specific risk
   Risk to a particular company, which can be eliminated through diversification.
2. Systematic risk
   The risk of being in the market, which cannot be diversified away.

Question 27

The separation theorem

Answer 27

The fact that the optimal portfolio of risky assets for an investor can be determined without any knowledge of their preferences towards risk and return (of their liabilities).

Question 28

Portfolio management

How might “unbundling” the business into its component projects aid optimisation of risk-reward?

Answer 28

“Unbundling” the business into its component projects:

• enables management to decide (separately) how to treat each project, eg retain it unchanged, increase / decrease invesmtnet in the project, transfer some of the risks, etc.
• may encourage companies to think about where they add value or can compete - then focusing on that risk area by transferring other risks to those who can manage them more efficiently.

Question 29

Portfolio management

How might
“a mechanism for aggregating risks across the organisation”
aid optimisation of risk-reward?

Answer 29

A mechanism for aggregating risks across the organisation:

• is useful for more transparent reporting and information purposes
• enables transfer of some or all of these risks to a central team. This allows a specialist team to hedge or otherwise manage the risk. In addition, if the business units are charged a price for transferring the risk to the CRF / RMF (the transfer price), the risk-adjusted profitability of the units can be assessed.

Question 30

Portfolio management

How might
“a framework in which concentration limits and asset allocation targets can be set”
aid optimisation of risk-reward?

Answer 30

A framework in which risk concentration limits and asset allocation targets can be set, can provide:

• risk concentration limits and asset allocation targets which operate together to achieve the organisation’s desired risk/return profile
• risk concentration limits that impose a minimum level of diversification for the portfolio
• asset allocation targets which aim to ensure most emphasis or resource is allocated to the most promising opportunities / projects

Question 31

Portfolio management

How might
“appropriate investment, transfer pricing and capital allocation decisions”
aid optimisation of risk-reward?

Answer 31

• An organisation can vary the price it charges a business unit to transfer a particular risk to the CRF / RMF, so influencing that business unit to expand / contract in that area.
• Having identified the risk/return characteristics of the organisation’s projects, management can allocate most capital to those expected to deliver the highest risk-adjusted returns.
• The market value of an organisation is influenced not only by the products it is selling now, but the products that are “in the pipeline. These “pipeline products” represent options owned by the organisation.
• MPT highlights the importance of diversification as a means of reducing risk without necessarily reducing expected return. Therefore MPT encourages organisations to invest in their “pipeline products” as well as a range of products that are currently generating revenue.

Question 32

Outline a 4-step process to develop risk responses

Answer 32

1. Conduct research about possible responses and their costs.
2. Determine a response for each risk, ensuring that a deadline for implementing the response is specified.
3. Assign a risk manager who is responsible for ensuring the response is implemented.
4. Consider whether secondary risks might emerge and what the residual risks are.

Question 33

How might an insurer return some risk to a policyholder?

Answer 33

• policy excess

- co-payment

Question 34

3 Factors to be considered before removing a risk

Answer 34

• the cost of removing the risk
• the impact on removing the risk on the likelihood of the project meeting its original objective
• whether any opportunities will be lost as a result of removing the risk

Question 35

2 Broad categories of ART products

Answer 35

1. Vehicles based on capital market instruments.

2. Other unconventional vehicles used to cover conventional risks (eg non-capital market risk transfer)

Question 36

Advantages of ART:

customisation and timing

Answer 36

• ART products are usually designed and/or customised to the organisation in question - enabling it to obtain the level and nature of cover it wants - eg multi-trigger policies to protect against specific concentrations of risk.
• Some ART products (eg cat-e-puts) can provide capital faster than more traditional approaches (eg rights issue), and at the precise time that it is most needed.

Question 37

Advantages of ART:

cost reduction and simplified administration

Answer 37

• A multi-line policy generally costs less than buying a series of policies, each covering a single line. This is because any natural hedges or lack of correlation between lines can be recognised in the pricing of a multi-line product.
• By purchasing multi-line policies, an organisation can reduce the number of separate insurance contracts it required, reducing administrative costs.
• Tax-efficient methods can be employed, eg offshore captives.
• Pooling of risks can lead to cost savings due to diversification, eg risk retention groups.

Question 38

4 Problems with ART

Answer 38

1. ART products may have higher initial costs than conventional products.
2. ART products are more complex than conventional products, increasing the time and cost of developing a solution for an organisation.
3. An organisation may need to change the way it assesses and manages risk in order to gain maximum benefit from ART.
4. Staff need to be educated about ART so that they can:
   - - understand the products
   - - assess any seller of ART products
   - - appreciate the impact of regulations and accounting standards - multiple sets of standards may apply and so expert legal advice should be taken.