Chapter 26: Risk identification and classification Flashcards
(22 cards)
What are some techniques that are available to ensure that all relevant risks have been identified?
- Use risk classification to ensure that all types of risk have been considered
- Use techniques from project management
- Use risk checklists, as used for regulatory purposes
- Use the experience of staff who have joined from similar organisations, and of consultants with broad experience of the industry concerned.
Outline 5 methods of identifying the risks associated with a project
- High level preliminatry 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 wtih the details of the project and the plans for financing it.
- Risk register or risk matrix setting out risks and other interdependencies.
Suggest 7 categories of risks that could be used in a risk matrix for a typical project
- Political - opposition to project, war, terrorism, etc.
- Natural - earthquakes, hurricanes
- Economic - interest rate or exchange rate movements
- Financial - sponsor default, incorrect cashflow estimates
- Crime - fraud, theft
- Project - time delays, budget overruns, bad design
- Business - competition / lack of demand, operational problems.
Wider risk identification techniques
- Risk classification
- Risk checklists
- Utilising the experience of staff
What are the main categories of risk?
- Market risk
- Credit risk
- Liquidity risk
- Business risk
- Operational risk
- External risk
Market risk
The risk related to changes in investment market values or other features correlated with investment markets such as interest rates / inflation
What categories can market risk be divided into?
- The consequences of changes on asset values
- The consequences of investment market value changes on liabilities
- The consequences of a provider not matching asset and liability cashflows
Asset value changes can result from:
* Changes in the market values of equities and property
* Changes in interest and inflation rates
Liability value changes may arise because promises to stakeholders, policyholders or benefit scheme members are directly related to investment market values or interest rates. Alternatively, a change in interest or inflation rates might affect the level of provisions a provider needs to establish for future liabilities.
If it were possible to find a perfectly matched asset for your liability, then market risk could be compeletely diversified away, but such a perfect match is in practice, impossible. The existence of free assets gives freedom to intentionally take an unmatched position in the hope of achieving an additional return.
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
- There may not be a wide enough range of assets available; in particular it 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 maintenance a full-matched portfolio is likely to be prohibitive.
Credit risk
The risk of failure of third parties to meet their obligations
Outline 4 factors that an investor should consider when assessing the security of a debt and the borrower
- The nature of the debt
- The covenant of the borrower (e.g. credit rating, income and asset cover, level of gearing, prior ranking debt)
- Market circumstances and the relative negotiating strength of the borrower and lender
- What security is available and whether it can be realised if necessary
What is a credit rating?
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
Liquidity risk
The risk that an insurer, although solvent, does not have sufficient capital available to enable it to meet its obligations as they fall due. The risk for an insurer is usually low since investments usually include a large proportion of cash, bonds and stock market assets.
What is a liquid asset?
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 liquid market is likely to be a large market with lots of ready participants.
(A marketable asset is one that can be converted to cash quickly, but the amount of cash received is uncertain)
Why are banks exposed to significant liquidity risk?
Banks lend depositors’ funds and funds raised from the money markets to other organisations 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.
Business risk
Risks that are specific to the business undertaken
What are the subcategories of business risks for financial providers?
- Underwriting risk - arising in relation to the underwriting approach taken
- Insurance risk - arising from the uncertainties relating to claim rates and amounts
- Financing risk - arising in relation to the financing of projects or other activities
- Exposure risk - arising in relation to the amount of business sold or retained, or to its concentration or lack of diversification.
Outline some examples of business risks
- A life or general insurer not having adequate underwriting standards, and thus taking on risks at an inadequate price
- An insurer suffering more claims than anticipated
- A provider of finance, such as a bank, investing in a business or project that fails
- A retail bank’s newly launched card product does not sell as expected
- A reinsurer having greater exposure than planned to a particular risk event
- A music production company promoting a CD that fails to sell
- A competitor launching a new product in the week before your similar product launch
- An umbrella manufacturer whose sales suffer in a drought
Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
External risk
Arises from external events
Outline where operational risk can arise from
- Inadequate or failed internal processes, people or systems
- Conduct risk, for example mis-selling, interest rate manipulation and money laundering
- The dominance of a single individual over the running of a business, sometimes called dominance risk
- Reliance on third parties to carry out various functions for which the organisation is responsible, e.g. if administration or investment work is outsourced
- The failure of plans to recover from an external event.
How are operational risks likely to be identified and analysed?
While it is possible to develop computer models to analyse and price operational risk, such models are only as good as the parameter input. Whether or not a model is used, identification of operational risks requires considerable input from owners, senior management and other individuals who have a detailed working knowledge of the operations of the business.
Discuss external risks
External risk is a form of non-financial risk but is separate to operational risk. It arises from external events, such as flood, storm, fire and terrorist attack.
However, the failure to arrange mitigation against such risks is an operational risk.
