CH 0 - 5 Risk – broadening your view

Question 1

Stakeholder Risk and Situational Risk – Summary

Answer 1

Risk is situation-dependent – different stakeholders face different types of risks based on their role and expectations.

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🔹 Examples of Stakeholder-Specific Risks:

• Investors – Market prices don’t grow as expected → lower returns
• Lenders / Creditors – Borrowers fail to repay debts → financial loss
• Trustees – Flawed professional advice leads to poor financial decisions
• Pension Scheme Members – Inflation rises faster than pension payments → reduced real income
• Insurers – Underestimated mortality → higher claims and underwriting losses
• Insurance Beneficiaries – Health benefits are insufficient due to medical cost inflation
• Reinsurers – Multiple insurers cede correlated risks → one event causes large aggregate loss

Question 2

🔹 General Causes of Risk:
🔹 Key Types of Asset Risk:

Answer 2

🔹 General Causes of Risk:

1. Asset-side risk – actual returns or cashflows from assets differ from expectations.
2. Liability-side risk – actual outgo or claims are higher than expected.

🔹 Key Types of Asset Risk:

• Market Risk: Changes in market prices affect asset values.
• Credit Risk: Borrowers or counterparties fail to repay.

🟦 Example to Understand:

A pension fund trustee invests based on advice assuming stable inflation. If inflation rises rapidly and the advice was flawed, the pension payments lose value in real terms. This creates a risk for pensioners and shows how risk varies by stakeholder and situation.

Question 3

Liability Outgo Risk & Asset-Liability Matching – Summary

🔹 Key Reasons Liability Outgoes May Differ from Expectations:

Answer 3

🔹 Key Reasons Liability Outgoes May Differ from Expectations:

1. Inflation Risk: Rising costs (e.g. salaries, medical bills) increase liability value unexpectedly.
2. Underwriting Risk: Poor risk assessment leads to underpriced insurance.
3. Insurance Risk: More frequent or severe claims than expected (e.g. high mortality).
4. Exposure Risk: Unexpectedly large losses due to concentration of similar risks (e.g. many policies in one disaster-prone region).
5. Finance Risk: Difficulty raising funds or doing so at a higher-than-expected cost.
6. Operational Risk: Internal losses from fraud, error, or poor management.
7. External Risk: Regulatory changes or court rulings increase liabilities.

Question 4

Liability Outgo Risk & Asset-Liability Matching – Summary

🔹 Importance of Asset-Liability Matching:
🔹 When Risk Becomes a Problem:

Answer 4

🔹 Importance of Asset-Liability Matching:

• If asset proceeds align with liability outgoes, overall risk is reduced.
• Well-matched assets and liabilities mean even if both deviate from expected, the net effect is smaller.
• Such assets are considered a “good match” for the liabilities.

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🔹 When Risk Becomes a Problem:

1. Assets alone are unpredictable and important to the stakeholder.
2. Liabilities alone are unpredictable and important to the stakeholder.
3. Mismatch between assets and liabilities in value or cashflow matters to the stakeholder.

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🟦 Example:

An insurance company sells policies with medical claims linked to inflation.

• If they invest in fixed-return bonds, and medical inflation rises, liability outgo increases, but asset proceeds do not.
• This mismatch increases risk.
• But if they invest in inflation-linked bonds, both sides move similarly → better asset-liability match → reduced risk.