Chapter 26: Risk identification and classification

Question 1

What techniques can be used as part of the risk identification process?

Answer 1

• risk classification (to ensure full coverage)
• risk checklists, e.g. as used for setting
  regulatory capital requirements
• experience of staff joining from similar
  organisations, consultants, experts
• project management risk identification
  techniques:
  -> high-level preliminary analysis
  -> brainstorming
  -> desktop analysis
  -> risk register/ risk matrix

Question 2

Outline the techniques that can be used to identify the risks associated with a project.

Answer 2

-. High level preliminary analysis to confirm
that there are no big risks that mean it is
not worth continuing.

• Brainstorming with project experts and
  senior internal/external people to:
  -> identify likely/unlikely, upside/downside
  risks
  -> discuss these risks and their
  interdependency
  -> broadly evaluate the frequency and
  severity of each risk
  -> generate and discuss initial mitigation
  options
• Desktop analysis to supplement
  brainstorming, which involves looking at
  similar projects undertaken by the
  sponsor and others.
• Consult with experts who are familiar with
  the details of the project and the plans for
  financing it.
• Risk register or risk matrix setting out
  risks and their interdependencies

Question 3

List the 6 major types of risk categories faced by an organisation.

Answer 3

1. market risk
2. credit risk
3. liquidity risk
4. business risk
5. operational risk
6. external risk

Question 4

Suggest 7 categories of risks that could be used in a risk matrix for a typical project.

Answer 4

PNEFCPB

1. Political - opposition to project, war,
   terrorism, etc
2. Natural - earthquakes, hurricanes
3. Economic - interest rate or exchange rate
   movements
4. Financial - sponsor default, incorrect
   cashflow estimates
5. Crime - fraud, theft
6. Project - time delays, budget overruns,
   bad design
7. Business - competition/lack of demand,
   operational problems

Question 5

Market risk

Answer 5

The risk related to changes in investment market values or other features correlated with investment markets such as interest rates/inflation.

Question 6

Credit risk

Answer 6

The risk of failure of third parties to meet their obligations.

Question 7

Liquidity risk

Answer 7

Liquidity risk is the risk that an individual or company, although solvent, does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at excessive cost.

The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets

Liquidity risk arises when the market does not have the capacity to handle that volume of transacted asset without a potential adverse price impact.

Question 8

Business risk

Answer 8

Risk specific to the business undertaken.

Question 9

Operational risk

Answer 9

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Question 10

External risk

Answer 10

External risk arises from external events.

In general, external risk is systematic (i.e. non-diversifiable) risk.

Question 11

Outline 3 subdivisions of market risk.

Answer 11

1. changes in asset values - due to changes
   in the market value of assets or changes
   in interest rate, inflation rate, exchange
   rate or market crashes.
2. investment market value changes on
   liabilities - where liabilities are directly
   related to investment market values,
   interest rates or inflation rates.
3. mismatching asset and liability
   cashflows.

Question 12

Market risk could be removed through holding an asset portfolio that perfectly matches the liability portfolio.

Give reasons why a perfect match may not be possible in practice

Answer 12

• There may not be a wide enough range of
  assets available; in particular it may may
  not be possible to find assets in
  sufficiently long duration.
• Liabilities may be uncertain in amount
  and timing.
• Liabilities may include options and hence
  have uncertain cashflows after the option
  date.
• Liabilities may include discretionary
  benefits.
• The cost of maintaining a full-matched
  portfolio is likely to be prohibitive.

Question 13

Credit rating

Answer 13

A credit rating is a rating given to a company’s debt by a credit-rating agency as an indication of the likelihood of default.

Question 14

List examples of credit risk.

Answer 14

• borrowers defaulting on interest and
  capital payments (including credit
  concentration risk and possibly also credit
  spread changes), e.g. issuers of
  government or corporate bonds.
• counterparties to a transaction failing to
  meet their obligations (including
  settlement risk), e.g. banks, reinsurers,
  external investment fund managers
• debtors failing to pay for purchased
  goods/ services, e.g. policyholders,
  brokers

Question 15

How can credit risk be reduced when lending money?

Answer 15

Security (or collateral) may be required from the borrower as a way of reducing credit risk when lending money.

Question 16

Outline the considerations when determining what security should be taken from the borrower.

Answer 16

• nature of transaction underlying the
  security
• covenant (credit worthiness) of the
  borrower
• what security is available
• comparative negotiating strength between
  lender and borrower
• market circumstances

Question 17

What is a liquid asset and how does this differ from a marketable asset?

Answer 17

A liquid asset is one that either:
- is close to cash in nature, or
- can be converted to cash quickly and the
amount of cash it would become is almost
certain

A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain.

Question 18

What makes a market liquid?

Answer 18

A liquid market is likely to be a large market with lots of ready participants.

Question 19

Why are banks exposed to significant liquidity risk?

Answer 19

Banks lend depositors’ funds and funds raised from the money markets to other organizations for potentially long periods. Customers may want instant access to their deposits, creating a need for liquidity. There is a risk that more customers than expected demand cash.

Question 20

Outline 4 examples of business risks to a financial provider.

Answer 20

1. Inadequate underwriting standards
   leading to the mis-pricing of risks
   (underwriting risk).
2. More claims than anticipated (insurance
   risk).
3. Investment in a business or project that
   fails to be successful (financing risk).
4. Greater exposure than planned to a
   particular risk event (exposure risk).

Question 21

Outline 5 examples of operational risk.

Answer 21

1. Inadequate or failed internal processes,
   people or systems e.g. fraud,
   mismanagement, system failure.
2. The dominance of a single individual over
   the running of a business (dominance
   risk).
3. Poor conduct towards customers / the
   market (conduct risk).
4. Reliance on third parties to carry out
   various functions for which the
   organization is responsible, e.g.
   outsourcing
5. The failure of plans to recover from
   external events.

Question 22

List examples of external risks.

Answer 22

• Natural disasters such as storm, fire, flood
• Terrorist attacks
• Regulatory, legislative and tax changes

Question 23

How are operational risks likely to be identified and analyzed?

Answer 23

A model could be used but such models are only as good as the parameters input.

Identification and analysis of operational risks typically requires considerable input from the owners of a business, senior management and other individuals with a good working knowledge of the business.

Question 24

Outline 3 risks to a financial company, that may be generated by climate change.

Answer 24

1. physical – arising from the first-order
   effects of environmental changes, e.g.
   extreme weather
2. transition – arising from economic,
   political and market changes, e.g.
   reduced fossil fuel consumption
3. liability – relating to compensation claims
   due to the impacts of climate change, e.g.
   claims arising from professional
   indemnity or public liability insurance