Past Exam Questions: September 2016 Flashcards

1
Q

Outline the uses of capital allocation to a global insurer

A
  • Performance management purposes
  • To inform salary and bonuses
  • To determine an appropriate return on capital for each business / product line
  • To identify underperforming businesses/product lines and close these
  • To improve pricing (allow more appropriately for the cost of capital)
  • Efficient use of capital: not leaving it unused at Group level
  • To manage and optimise risks holistically across the Group
  • To impose risk-based restrictions on the amount of business that can be written in each business area / product line
  • To optimise the risk/return balance
  • Helps the company to better understand diversification benefits
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2
Q

Assess the possible implications for the risk profile of an insurer if the province in which the insurer is located, aims to gain independence from a larger country, with its own government and currency.

A
  • Market instability (at least in the short term)
  • Increase the risks to the insurer
  • Risk that the currency could devalue
  • Any assets held in this currency will lose value if this happens.
  • The country’s stockmarket values may fall or become more volatile to reflect this devaluation risk.
  • Interest rates may become more volatile,
    … or move adversely (i.e. increased interest rate risk)
  • Credit risk may also increase for corporates…
    … or for the government.
  • Market risk is exacerbated by any mismatching between assets and liabilities, e.g. by currency.
  • There is a risk that there will be insufficient availability of suitable assets for matching purposes.
  • There will be greater uncertainty in relation to future inflation rates
    … and future investment returns for the two separate parts of the country
    … given that the economic potential of each country on a standalone basis is less certain than at present.
  • New business / renewal risk may increase.
  • The publicity and uncertainty may lead to policyholders behaving unexpectedly,
    … mass lapses
    … extremely low renewal levels
    … or reduction in new business
  • Increased political risk.
  • Risk that the new government will bar the insurer from selling business.
  • Insurance risk may increase.
    … claims experience may be different to previously, requiring different demographic assumptions.

Regulatory risk, since new regulations could be introduced.

Operational risks may increase, due to the systems developments/changes that will be required (new currency etc.)

  • Expense risk increases
    … due to uncertainties involved.
  • Increased counterparty default risk,
    … if an outsourcer is no longer able to provide services across borders.
  • Restrictions on repatriation of profits (currency controls)
  • Upside risks, presenting opportunities
  • Model risk may increase (pricing model)
  • Liquidity risk
  • Increased strategic risk
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3
Q

How might a Generalised Pareto Distribution be used to model the likelihood of wind speeds of above 150 mph?

A
  • Take the annual wind speed observations {Xn}

Determine an appropriate threshold, u:
— this is done by determining where the “tail: of the distribution lies
… using the empirical mean excess function e(u)
… given by e(u) = SUM (Xn - u) I(Xn > u) / SUM I(Xn > u)

  • This involves plotting e(u) against u…
    … for various values of u
  • Look for the point at which this function becomes linear (which represents the start of the tail of the distribution)
  • Choose a value of u for which e(u) has become a linear function of u and remains so.
  • Use the data for this value of u and above to fir the GPD to Xn - u (for Xn > u)
  • Do this using a technique such as the method of moments or maximum likelihood estimation.
  • Then evaluate the distribution function for wind speeds greater than 150 mph.
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4
Q

Advantages of using a GPD to model high wind speeds (above 150mph)

A
  • Winds of over 150 mph are extreme values, and the GPD is used for modelling extreme values (so is appropriate).
  • It is not necessary to know the distribution of the wind speeds themselves.
  • Unlike the Generalised Extreme Value (GEV) return period approach, it does not need observations above the critical point to make an estimate.
  • Allows the possibility of wind speeds over 150 mph to be modelled even if they haven’t yet been seen.
  • Uses data over a long time horizon.
  • GPD is a distribution, so gives confidence levels.
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5
Q

Disadvantages of using a GPD to model high wind speeds (above 150mph)

A
  • The approach does not allow for the possibly changing nature of the risk over time
  • This might mean that the risk is understated.
  • When applying the GPD method, the choice of threshold is difficult, and involves a subjective choice.
  • The observations are not necessarily independent.
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6
Q

Steps in the ISO 31000 Risk Management Process

A

Establish the context

RISK ASSESSMENT

    • risk identification
    • risk analysis
    • risk evaluation

Risk treatment

Monitoring and review

Communication and Consultation

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7
Q

Main risk management principles under ISO 31000

A
  • risk management should both create and protect value
  • it should be an integral part of all processes in an organisation
  • as such, it should also form part in decision-making processes
  • it should address uncertainty explicitly
  • the processes of risk management should be carried out in a systematic, structured and timely manner
  • decisions taken should be tailored to the specific nature of the organisation
  • this means it should take into account all human and cultural factors
  • the approach should be transparent, inclusive and relevant
  • it should not be static - the process should be dynamic, iterative and should respond to changing needs
  • it should facilitate the improvement of an organisation on a continuous basis
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8
Q

Define:

“credit rating”

A

A credit rating is a combination of letters / numbers
… given to the issuer of debt
… or to the debt issue itself
… by a credit rating agency
… that represents the likelihood that the debt will be repaid in full.

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9
Q

3 Definitions of liquidity risk

A
  • The risk of money markets not being able to supply funding to businesses when required.
  • Risk relating to management of short-term cash flow requirements.
  • Insufficient capacity in the market to handle asset transactions at the time when a deal is required without a material impact on price.
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10
Q

Explain how liquidity risk may affect a typical shop owner.

A
  • The shop may be unable to meet short term cash flow requirements
    … such as the payment of salaries, rent, or other creditors.
  • Stores should also cover the short-term interest payments on their loans.
  • Liquidity risk may arise due to unexpected payments being needed
    … or due to having insufficient cash inflows from sales to meet expected outflows
    … or due to having insufficient cash funds in reserve.
  • The shop may be subject to liquidity risk if short-term funding becomes unavailable
    … or too expensive
    … e.g. due to a wider banking liquidity crisis
    … or due to a change in the bank’s view of the credit worthiness of the shop.
  • The shop may have to accept substantially reduced prices for their goods
    … in order to meet short term cashflows.
  • Buyers may not make payments immediately.
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11
Q

Describe an approach for modelling the level of liquidity risk for a retail store

A
  • Consider the current funding and mix of business.
  • Allow for proposed advance purchases…
    … and the level of borrowing that this implies.
  • Choose a timescale.
  • Build a cash flow model / project known cash outflows (rent, wages, interest).
  • Project income from sales and all expenditure relating to sales.
  • The model should give output that reflects timing mismatches.
  • It should reflect past internal experience / data where appropriate.
  • Seasonal variations should be allowed for.
  • Perform stress testing, eg changes in interest rates, sales.
  • And scenario testing to the extent that cashflows are uncertain.
  • Include “worst case” scenarios.
  • Consider scenarios based on worst historical events in terms of prices and volumes.
  • May need some expert input to set appropriate stress and scenario tests.
  • And external data.
  • If sufficient data are available, consider stochastic modelling.
  • Determine the confidence level at which the store would (just) have sufficient liquidity.
  • Allow for correlations with other risks, e.g. interest rate risk.
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12
Q

How might a store manage its liquidity risk?

A
  • Reduce the level of borrowing.
  • Reduce sales.
  • Change the mix of business.
  • Use forwards / futures.
  • Form a co-operative society.
  • Arrange emergency overdraft facilities.
  • Hold higher cash reserves.
  • Close monitoring of cash flows.
  • Active creditor / debtor management.
  • Take advance customer orders.
  • Use casual labour.
  • Negotiate a reduced / partial payment to suppliers.
  • Fix interest rates on funding for more than one year.
  • Diversify into other goods / services.
  • Find alternative funding.
  • Link salaries to sales volumes.
  • Negotiate lower rent.
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13
Q

Would a small store benefit from an ERM framework? How?

A
  • All organisations can benefit from an ERM framework…
    … though the level of complexity / detail will depend on the size and complexity of the organisation.
  • Cost considerations need to be taken into account.
  • It is important to view risks holistically…
    … so that any concentrations of risk can be recognised…
    … as well as diversification potential.
  • It is important to set out the risk appetite…
    … and to determine whether the level of risk being taken is consistent with this.
  • It is important to mitigate excessive risks where these do exist.
  • For a small store it is particularly important to have some form of risk management process…
    … as it can be easier for the inappropriate actions of an individual to bring down the company.
  • Without the framework, the manager may be too dominant
    … and not subject to sufficient challenge from junior employees in terms of decisions being made.
  • Not all risks need to be analysed quantitatively - qualitative may be more appropriate in some cases.
  • Having some form of risk management framework may result in lower borrowing costs.
  • Would be useful simply to keep a risk register.
  • And educate / increase risk awareness / bring in risk management culture of / for the employees.
  • ERM can help to identify opportunities to exploit.
  • Would help to prepare for future expansion.
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