Chapter 28: Accepting risk

Question 1

What is “risk profile”, “risk limits” and “risk capacity” in conjunction with risk appetite?

Answer 1

Risk profile - this is a compelete 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

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.

Risk capacity - this is the volume of risk that an organisation can take as measured by some consistent measure. 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

Question 2

List the features of a company that might influence its risk appetite

Answer 2

1. Existing exposure to a particular risk
2. Culture of the company
3. Size of the company
4. Period of time for which it has operated
5. Level of available capital
6. Existence of a parent company / other guarantors
7. Level of regulatory control to which it is exposed
8. Institutional structure (mutual, proprietary)
9. Previous experience of board members
10. Attitude to risk of owners and other providers of capital

Question 3

How does a “market for risk” arise?

Answer 3

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 4

What makes a market for risk transfer “risk efficient”?

Answer 4

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.

Question 5

Explain how investment in a CIS results in risk transfer

Answer 5

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.

Question 6

How can risk appetite be translated into action?

Answer 6

After developing a risk management policy, the senior risk managers have the task of translating the higher level statements of risk appetite into a more detailed set of risk tolerances and risk limits across the enterprise.

A risk tolerance statement describes the level(s) of risk that the insurer is willing to bear.

Ultimately, these statements of risk tolerances must be expressed in a way that can be easily understood and implemented by all staff within the organisation. In many cases this might manifest itself through statements of risk limits.

Systems need to be in place that considers new products, opportunities or initiatives at an organisational level, instead of being obstructed by local risk tolerances and risk limits, especially if the new opportunity is considered to be to the company’s benefit.

Organisations may find it useful to develop a suite of risk metrics to support the implementation of their risk appetite framework. These risk metrics will consist of quantitative and qualitative indicators of the level of risk in a specific part of the organisation.

To avoid financial product providers adopting an inappropriate risk appetite, regulatory authorities may impose minimum levels of retained solvency capital derived from a risk assessment of the business.

Question 7

Outline the ways in which risk and product design are related

Answer 7

1. Financial products transfer risk between parties
2. 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
3. The cost of risk relates not just to the features of that product but also on the other busienss of the provider (diversification, hedging)
4. Good product design techniques will identify all the risks involved in a product and consider how each is managed
5. In order to determine an appropriate cost for a particular policy, it is necessary to perform risk classification.
6. There is a risk that a new product design does not meet the needs and desires of the beneficiaries
7. Additional options (and other design complexities) introduce new risks, which need to be allowed for in the costing.

Question 8

What 3 factors make a risk insurable?

Answer 8

1. The policyholder must have an interest in the risk being insured, to distinguish between insurance and a wager
2. A risk must be of a financial and reasonably quantifiable nature
3. The amount payable in the event of a claim must bear some relationship to the financial loss incurred.

Question 9

Why do insurance companies aim to pool risk?

Answer 9

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

Question 10

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

Answer 10

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

Question 11

Accumulations of risk

Answer 11

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.

Question 12

Self-insurance

Answer 12

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