Chapter 28: Accepting risk Flashcards
Define ‘Risk profile’
This is a complete description of the risk exposures of an organisation, including risks that might emerge in the future and that will affect the current business of the organisation
Define ‘Risk limits’
This is a group of guidelines that set limits on acceptable actions that might be taken today. If risk limits are adhered to, then each individual unit of the business should be deemed to be working within its permitted risk tolerances.
Define ‘Risk capacity’
This is the volume of risk that an organisation can take as measured by some consistent measure, such as economic capital. If there is spare capacity, then it might be possible to take positive actions that add economic value to the organisation without breaching existing risk tolerances or risk limits.
List features of a company that might influence its risk appetite
- Existing exposure to a particular risk
- Culture of the company
- Size of the company
- Period of time for which it has operated
- Level of available capital
- Existence of a parent company / other guarantors
- Level of regulatory control to which it is exposed to
- Institutional structure (mutual, proprietary)
- Previous experience of board members
- Attitude to risk of owners and other providers of capital
How does a ‘market for risk’ arise?
The fact that different entities have different appetites for risk enables there to be a market for risk, and for risk to be transferred from entities with a small risk appetite to those with a larger risk appetite. Almost all financial transactions can be simplified down to a transfer of risk from one entity to another in exchange for a payment of money.
What makes a market for risk transfer ‘risk efficient’?
A risk efficient market is one of a reasonable size.
Participants with excess risk are able to transfer the excess to other participants who have less risk than they are prepared to accept
Explain how investment in a CIS results in risk transfer
CISs allow individuals to transfer the risk of making poor investment decisions due to a lack of expertise or lack of time to perform research.
Outline the ways in which risk and product design are related
- Financial products as a risk transfer mechanism
- The price of a product needs to cover the cost of the risk being transferred and allow the party taking on the risk to make a profit
- The cost of risk relates not just to the features of that product but also on the other business of the provider (diversification, hedging)
- Good product design techniques will identify all the risks involved in a product and consider how each is managed
- In order to determine an appropriate cost for a particular policy, it is necessary to perform risk classification.
- There is a risk that a new product design does not meet the needs and desires of the beneficiaries.
- Additional options (and other design complexities) introduce new risks, which need to be allowed for in the costing.
What 3 factors make a risk insurable?
- The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager.
- The risk must be of a financial and reasonable quantifiable nature.
- The amount payable in the event of a claim must bear some relationship to the financial loss incurred.
Why do insurance companies aim to pool risk?
Pooling risk means that there is greater certainty in the future payments to be made on the occurrence of an insured event. This is due to the law of large numbers.
List 6 additional criteria that a risk should ideally meet to be insurable
MUD PIS
Moral hazard eliminated as far as possible
Ultimate limit on liability undertaken
Data exists with which to price risk
Pooling a large number of similar risks
Independent risk events
Small probability of occurrence
Accumulations of risk
An accumulation of risk occurs when a portfolio of business contains a concentration of risks that might give rise to exceptionally large losses from a single event
Self-insurance
The retention of risk by an individual or organisation, as distinct from obtaining insurance cover
