ERM Chapter 3 Flashcards
What is a risk?
The uncertainty of possible future random events, in terms of possibility of the event and the degree of harm associated with such an event.
What types of risks exist?
- Market risk
- Economic risk
- Interest rate risk
- Foreign exchange risk
- Basis risk
- Credit and counterparty risk
- Liquidity risk
- Insurance risk
- Operational risk
- Environmental risk
- Legal risk
- Regulatory risk
- Political risk
- Agency risk
- Reputational risk
- Project risk
- Strategic risk
- Demographic risk
- Moral hazard risk
- Conduct risk
What is market risk?
Risks arising from changes in investment market values or other features correlating with investment markets such as interest and inflation rates. This includes the consequence of investment market value changes on liabilities, and may also include the consequence of mismatching asset and liability cashflows.
e.g. Risks arising from movements in own stock price (acquisition strength and takeover risk, efficiency in raising capital), investment risks (interest rate risk, mismatching of assets and liabilities, effect on pension scheme liabilities), and the uncertainty of input and output prices.
Another interpretation of market risk is the risk of lower sales or profit margins resulting from changes in market conditions, where market is interpreted as the market into which products or services of that entity are sold.
What is economic risk?
Risk arising from the effects of macroeconomic factors on an organisation and/or its customers. Examples include inflation risk and changes in demand. Factors include aggregate supply and demand, own and foreign government policies (trade barriers), employment levels, inflation, interest and exchange rates, and accommodation costs.
What is interest rate risk?
Risks arising from changes in interest rates, which could include customer behaviour as well as the financial impact. It may be considered a subset of market risk, or as a component of economic risk.
What is foreign exchange risk?
Risks due to exposure in foreign exchange rates.
- Foreign revenues and costs as expressed in home currency (transaction exposure)
- Prices of exported goods thereby affecting foreign sales (economic exposure)
- Consolidated accounts (translation exposure) whereby the value of assets, liabilities or equity is expressed in a foreign currency.
What is basis risk?
Risks arising from movements in two comparable indices, for example different stock market indices, so that offsetting investments will not experience exactly offsetting movements.
What is credit risk?
The risk that a counterparty to an agreement will be unable or unwilling to make the payments required under that agreement. May be defined more narrowly as the risk that a borrower will partially or wholly default on repayment of debt. The two components of credit risk are the probability of default, and the loss (or recovery) on default.
What is counterparty risk?
The risk that another party to a transaction or agreement fails to perform its contractual obligations, including failure to perform them in a timely manner. E.g. default of a counterparty within a derivatives transaction, or the failure of an outsourcing company.
What is liquidity risk?
The risk that money markets are unable to supply funding to businesses when required, or more broadly the management of short-term cashflow requirements. An insufficient capacity in the market to handle asset transactions at the time when a deal is required without having a material impact on the price.
What is insurance risk?
Risk arising from fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting or pricing. This includes mortality, morbidity, property and casualty risks.
What is underwriting risk?
The inappropriate selection and approval of insurance risks.
- Demographic risks (mortality, longevity, morbidity, proportions married and age difference of partners)
- Non-life insurance risks (property risks, casualty risks)
- Other insurance risks (persistency, expense risks)
What is operational risk?
The risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events.
- Process risk (efficiency vs. effectiveness, processing errors resulting in costs, inadequate documentation resulting in costs, model and data risks)
- People risk (key positions remaining unfilled, wrong people employed/promoted/retained, absenteeism, lack of risk awareness, incompetence, dishonesty, agency risk, moral hazard risk, risk of adverse selection)
- System/technology risk (Out-of-date functionality, lack of sufficient access or capacity, unauthorised use or access to data, failure of technology, inadequate backup systems or disaster plans, software errors)
- Event risk (business continuity risk, ineffective internal-change management, ineffective external-change management)
- Business risk (inappropriate business strategy, inadequate business plans, changes in the external business environment, business results do not meet stakeholder expectations, damage to reputation or brand value)
- Crime risk (people risk, technological risk, legal risk)
What is environmental risk?
Risks relating to the natural environment and humans interactions with it. It includes a wide range of drivers, form natural disasters and climate change, to associated problems such as pollution and the impact of declining natural resources.
e.g. fines, depletion of stock/increased prices, emission quotas, negative publicity and reputational damage, business interruption, effects of global warming.
What is legal risk?
Risk arising from the understanding of and adherance to legislation, including changes in accepted interpretation.
- New legislation in place due to political or social pressures, which could impact an organisation positively or negatively. Additional compliance costs may be introduced as a result or prohibit some activities.
- Provision in certain contracts, whereby significant problems would arise if they were to occur.
- Court judgements against an organisation, for example that that prompted the collapse of Equitable Life.
