Chapter 28: Accepting risk

Question 1

List features of a company that might influence its risk appetite

Answer 1

Existing exposure to a particular risk
Culture of the company
Size of the company
Period of time for which it has operated
Level of capital available
Existence of a parent company / other guarantors
Level of regulatory control to which its exposed
Institutional structure (mutual, proprietary)
Previous experience of board members
Attitude to risk of owners and other providers of capital

Question 2

How does a market for risk arise?

Answer 2

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.

Question 3

What makes a market for risk transfer risk efficient?

Answer 3

A risk efficient market is one of a reasonable size.

Participants with excess risk are able to transfer the excess risk to other participants who have less risk than they are prepared to accept.

Question 4

Explain how investment in a CIS results in risk transfer

Answer 4

CISs allow individuals to transfer the risk of making poor investment choices due to a lack of expertise or lack of time to perform research.

Question 5

Outline the ways in which risk and product design are related

Answer 5

• Financial products transfer risk between parties
• 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.

Question 6

What 3 factors make a risk insurable?

Answer 6

• The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager.
• The risk must be of financial and reasonable quantifiable nature.
• The amount payable in the event of a claim must bear some relationship to the financial loss incured.

Question 7

Why do insurance companies aim to pool risk?

Answer 7

Pooling risk means that there is greater certainty in the future payments to be made on the occurence of an insured event. This is due the law of large numbers.

Question 8

List 6 additional criteria that a risk should ideally meet to be insurable

Answer 8

MUD PIS
Moral hazzard 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 occurance

Question 9

Accumulaions of risk

Answer 9

An accumulation of risk occurs when a portfolio business contains a concentration of risks that might give rise to exceptionally large losses from a single event.

Question 10

Self-insurance

Answer 10

The retention of risk by an individual or organization as distinct from obtaining insurance cover.